

[Federal Register: September 7, 2006 (Volume 71, Number 173)]
[Notices]               
[Page 52829-52831]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr07se06-95]                         

-----------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-54389]

 
Order Granting an Exemption for Qualified Contingent Trades From 
Rule 611(a) of Regulation NMS Under the Securities Exchange Act of 1934

August 31, 2006.

I. Introduction

    Pursuant to Rule 611(d) \1\ of Regulation NMS \2\ under the 
Securities Exchange Act of 1934 (``Exchange Act''), the Securities and 
Exchange Commission (``Commission''), by order, may exempt from the 
provisions of Rule 611 of Regulation NMS (``Rule 611'' or ``Rule''), 
either unconditionally or on specified terms and conditions, any 
person, security, transaction, quotation, or order, or any class or 
classes of persons, securities, quotations, or orders, if the 
Commission determines that such exemption is necessary or appropriate 
in the public interest, and is consistent with the protection of 
investors.\3\ As discussed below, the Commission is exempting each NMS 
stock component of certain qualified contingent trades (as defined 
below) from Rule 611(a) of Regulation NMS.
---------------------------------------------------------------------------

    \1\ 17 CFR 242.611(d).
    \2\ 17 CFR 242.600 et seq.
    \3\ See also 15 U.S.C. 78mm(a)(1) (providing general authority 
for Commission to grant exemptions from provisions of Exchange Act 
and rules thereunder).
---------------------------------------------------------------------------

II. Background

    The Commission adopted Regulation NMS in June 2005. \4\ Rule 611 
addresses intermarket trade-throughs of quotations in NMS stocks.\5\ 
The Rule applies only to quotations that are immediately accessible 
through automatic execution.
---------------------------------------------------------------------------

    \4\ See Securities Exchange Act Release No. 51808 (June 9, 
2005), 70 FR 37496 (June 29, 2005) (``Regulation NMS Adopting 
Release'').
    \5\ An ``NMS stock'' means any security or class of securities, 
other than an option, for which transaction reports are collected, 
processed, and made available pursuant to an effective transaction 
reporting plan. See 17 CFR 242.600(b)(46) and (47).
---------------------------------------------------------------------------

    The Securities Industry Association (``SIA'') has requested that 
the Commission exempt certain qualified contingent trades from Rule 
611(a) of Regulation NMS.\6\ According to the SIA Exemption Request, a 
contingent trade ``is a multi-component trade involving orders for a 
security and a related derivative, or, in the alternative, orders for 
related securities, that are executed at or near the same time.'' \7\ 
The SIA notes that the economics of a contingent trade are based on the 
relationship between the prices of the security and the related 
derivative or security, and that the execution of one order is 
contingent upon the execution of the other order. The SIA states that 
the sought-after spread or ratio between the relevant instruments is 
known and specified at the time of the order, and this spread or ratio 
stands regardless of the prevailing price at the time of execution. 
Therefore, the parties to these transactions are focused on the spread 
or ratio between the transaction prices for each of the component 
instruments, rather than on the absolute price of any single component 
instrument. Because the focus of such trades is on the relative prices 
of the component instruments, the price of a component of a particular 
trade may or may not correspond to the prevailing market price of the 
security. For contingent trades, the parties to the trade will not 
execute one side of the trade without the other component or components 
being executed in full (or in ratio) and at the specified spread or 
ratio.\8\
---------------------------------------------------------------------------

    \6\ Letter to Nancy M. Morris, Secretary, Commission, from 
Andrew Madoff, SIA Trading Committee, SIA, dated June 21, 2006 
(``SIA Exemption Request'').
    \7\ SIA Exemption Request at 2.
    \8\ See SIA Exemption Request at 2.
---------------------------------------------------------------------------

    The SIA states that contingent trades play an important role in the 
investment and trading strategies of investors. They are the mechanism 
through which large institutional and broker-dealer proprietary traders 
enter and exit the market for many securities, including those that are 
involved in a merger, those representing different classes of shares of 
the same issuer, those with convertible securities that are related to 
the common stock, and those with actively traded equity derivatives 
such as options.\9\ The SIA believes that, as a general rule, the 
market view on what constitutes an appropriate spread or

[[Page 52830]]

ratio between related securities is less volatile than the quoted 
prices for the stocks that are part of these contingent trades and, 
consequently, contingent trades act as a stabilizing factor in the 
markets.\10\
---------------------------------------------------------------------------

    \9\ See SIA Exemption Request at 2. In an appendix to its 
letter, the SIA provided detailed discussions of three types of 
contingent trades, namely, a risk or merger arbitrage transaction, a 
convertible security transaction, and a stock option transaction, 
and how these trades would be affected by Rule 611. See SIA 
Exemption Request at 8-12.
    \10\ See SIA Exemption Request at 2-3.
---------------------------------------------------------------------------

    To effectively execute a contingent trade, its component orders 
must be executed in full or in ratio \11\ at its predetermined spread 
or ratio. According to the SIA, parties seeking to effect contingent 
trades involving NMS stocks in many instances would be able to comply 
with the Rule, but in other instances--such as trades involving two or 
more NMS stocks or circumstances in which there was insufficient 
flexibility to adjust the execution price of the non-NMS stock 
component of a contingent trade--compliance with Rule 611 would not be 
possible. In such instances, if the designated price of an NMS stock 
that was a component order of a proposed contingent trade was inferior 
to a protected bid or offer, as relevant, the Rule would require the 
better protected bids or offers to be satisfied prior to the execution 
of the NMS stock component of the contingent trade, thus preventing the 
trade from being executed in accordance with the original terms. The 
SIA believes that, by breaking up one or more components of the 
contingent trade and requiring that such component(s) be separately 
executed from the entire trade package and at prices inappropriate for 
the desired trading strategy, Rule 611 would effectively undermine the 
contingent aspect of the trade and leave one or more parties to the 
trade ``out of hedge.'' \12\
---------------------------------------------------------------------------

    \11\ ``In ratio'' clarifies that component orders of acontingent 
trade do not necessarily have to be executed in full, but any 
partial executions must be in a predetermined ratio.
    \12\ See SIA Exemption Request at 3.
---------------------------------------------------------------------------

    Without an exemption from Rule 611, the SIA believes that customers 
might be unable to complete contingent trades. In particular, dealers 
might be unable to commit capital to those customers who requested it, 
which could reduce or eliminate this type of trading activity and 
remove liquidity from the market. The SIA believes that such a result 
would disadvantage the market as a whole.\13\
---------------------------------------------------------------------------

    \13\ See SIA Exemption Request at 4.
---------------------------------------------------------------------------

    In its exemption request, the SIA states that the requested relief 
is narrowly drawn, noting that the number of qualified contingent 
trades is small in comparison to the overall number of trades executed 
in NMS stocks. It therefore believes that the number of possible 
exempted trade-throughs would similarly be small. The SIA also noted 
that the requirement that the NMS stock component of a contingent trade 
be of block size further reduces the risk that the exemption will used 
inappropriately for transactions of retail size.\14\
---------------------------------------------------------------------------

    \14\ See SIA Exemption Request at 6.
---------------------------------------------------------------------------

III. Discussion

    After careful consideration and for the reasons discussed below, 
the Commission hereby grants an exemption from Rule 611(a) for any 
trade-throughs caused by the execution of an order involving one or 
more NMS stocks (each an ``Exempted NMS Stock Transaction'') that are 
components of a qualified contingent trade. A ``qualified contingent 
trade'' is a transaction consisting of two or more component orders, 
executed as agent or principal, where:
    (1) At least one component order is in an NMS stock;
    (2) All components are effected with a product or price contingency 
that either has been agreed to by the respective counterparties or 
arranged for by a broker-dealer as principal or agent;
    (3) The execution of one component is contingent upon the execution 
of all other components at or near the same time;
    (4) The specific relationship between the component orders (e.g., 
the spread between the prices of the component orders) is determined at 
the time the contingent order is placed;
    (5) The component orders bear a derivative relationship to one 
another, represent different classes of shares of the same issuer, or 
involve the securities of participants in mergers or with intentions to 
merge that have been announced or since cancelled; \15\
---------------------------------------------------------------------------

    \15\ Transactions involving securities of participants in 
mergers or withintentions to merge that have been announced would 
meet this aspect of the requested exemption. Transactions involving 
cancelled mergers, however, would constitute qualified contingent 
trades only to the extent they involve the unwinding of a pre-
existing position in the merger participants' shares. Statistical 
arbitrage transactions, absent some other derivative or merger 
arbitrage relationship between component orders, would not satisfy 
this element of the definition of a qualified contingent trade.
---------------------------------------------------------------------------

    (6) The Exempted NMS Stock Transaction is fully hedged (without 
regard to any prior existing position) as a result of the other 
components of the contingent trade; \16\ and
---------------------------------------------------------------------------

    \16\ A trading center may demonstrate that an Exempted NMS 
StockTransaction is fully hedged under the circumstances based on 
the use of reasonable risk-valuation methodologies.
---------------------------------------------------------------------------

    (7) The Exempted NMS Stock Transaction that is part of a contingent 
trade involves at least 10,000 shares or has a market value of at least 
$200,000.\17\
---------------------------------------------------------------------------

    \17\ See 17 CFR 242.600(b)(9) (defining ``block size'' with 
respect to an order as at least 10,000 shares or $200,000 in market 
value).
---------------------------------------------------------------------------

    The Commission notes that a trading center must meet all of the 
foregoing elements of a qualified contingent trade to qualify for the 
exemption. The exemption is not restricted to dealers or the over-the-
counter market. It can be used by any trading center that meets the 
terms of the exemption.
    Rule 611 requires trading centers to establish, maintain, and 
enforce written policies and procedures that are reasonably designed to 
prevent trade-throughs, or, if relying on one of the Rule's exceptions, 
that are reasonably designed to assure compliance with the 
exception.\18\ In addition, a trading center is required to regularly 
surveil to ascertain the effectiveness of its policies and procedures 
and to take prompt action to remedy deficiencies.\19\ The Rule also 
includes a number of exceptions, such as intermarket sweep orders \20\ 
and orders executed at ``benchmark'' prices that were not reasonably 
determinable at the time the commitment to execute the order was 
made.\21\ Without an exemption, however, qualified contingent trades 
generally would be subject to the Rule.
---------------------------------------------------------------------------

    \18\ See 17 CFR 242.611(a)(1).
    \19\ See 17 CFR 242.611(a)(2).
    \20\ See 17 CFR 242.611(b)(5) and (6).
    \21\ See 17 CFR 242.611(b)(7).
---------------------------------------------------------------------------

    As discussed in the Regulation NMS Adopting Release, the Commission 
previously considered comments favoring a general exception from the 
Rule for broad categories of transactions, variously described as 
``contingency'' transactions, ``arbitrage'' transactions, ``spread'' 
transactions, and transactions priced with reference to 
derivatives.\22\ It noted, however, that any exception for such a broad 
category of transactions potentially could unduly detract from the 
objectives of Rule 611. Therefore, when adopting Regulation NMS, the 
Commission stated that the most appropriate process to handle 
suggestions that specific types of transactions should be excluded from 
the coverage of the Rule would be through the exemptive procedure set 
forth in paragraph (d) of the Rule.
---------------------------------------------------------------------------

    \22\ Regulation NMS Adopting Release, 70 FR at 37528.
---------------------------------------------------------------------------

    The Commission recognizes that contingent trades can be useful 
trading tools for investors and other market participants, particularly 
those who trade the securities of issuers involved in mergers, 
different classes of shares of the same issuer, convertible securities, 
and equity derivatives such as options.

[[Page 52831]]

Those who engage in contingent trades can benefit the market as a whole 
by studying the relationships between the prices of such securities and 
executing contingent trades when they believe such relationships are 
out of line with what they believe to be fair value.
    Contingent trades therefore are one example of a wide variety of 
trades that contribute to the efficient functioning of the securities 
markets and the price discovery process. The Commission believes that 
qualified contingent trades potentially could become too risky and 
costly to be employed successfully if they were required to meet the 
trade-through provisions of Rule 611. Absent an exemption, participants 
in contingent trades often would need to use the Rule's intermarket 
sweep order exception and route orders to execute against protected 
quotations with better prices than an NMS stock component of the 
contingent trade. Any executions of these routed orders could throw the 
participants ``out of hedge'' and necessitate additional transactions 
in an attempt to correct the imbalance. As a practical matter, the 
difficulty of maintaining a hedge, and the risk of falling out of 
hedge, could dissuade participants from engaging in contingent trades, 
or at least raise the cost of such trades. The elimination or reduction 
of this trading strategy potentially could remove liquidity from the 
market. The Commission therefore has determined to exempt qualified 
exempted trades from Rule 611.
    To minimize the effect of an exemption on the objectives of Rule 
611, the exemption is narrowly drawn to encompass only those trades 
most in need of relief to remain part of a viable trading strategy and 
where execution of the NMS stock component at a trade-through price is 
reasonably necessary to effect the contingent trade. In particular, 
elements (1) through (6) of the exemption, as set forth above, require 
a close connection between any Exempted NMS Stock Transaction and the 
other components of a qualified contingent trade. This close connection 
should both significantly limit the number of Exempted NMS Stock 
Transactions and help assure that the exemption applies only to those 
trades most in need of flexibility to be executed efficiently. For 
example, the execution of one component of the transaction must be 
contingent upon the execution of all other components at or near the 
same time, and the Exempted NMS Stock Transaction must be fully hedged 
(without regard to any prior existing position) as a result of the 
other components of the contingent trade.\23\ In addition, there must 
be a specified relationship between the instruments involved in the 
component orders. The component orders must bear a derivative 
relationship to one another, represent different classes of shares of 
the same issuer, or involve the securities of participants in mergers 
or with intentions to merge that have been announced or since 
cancelled.\24\ The exemption does not apply to contingent trades, such 
as statistical arbitrage transactions, if their components do not 
involve instruments with a specified relationship. Finally, the 
Exempted NMS Stock Transaction must be of block-size, involving at 
least 10,000 shares or having a market value of at least $200,000. This 
element further limits the exemption to those transactions where an 
exemption is likely to be most needed to facilitate the trading 
strategies of informed customers.
---------------------------------------------------------------------------

    \23\ The requirement that an Exempted NMS Stock Transaction be 
fullyhedged should significantly limit the scope of the exemption. 
For example, a contingent trade would not qualify for the exemption 
if an NMS stock transaction was the purchase or sale of 50,000 
shares, and the only other component was the purchase or sale of a 
small quantity of options on the NMS stock. A trading center may 
demonstrate that an Exempted NMS Stock Transaction is fully hedged 
under the circumstances based on the use of reasonable risk-
valuation methodologies.
    \24\ Transactions involving cancelled mergers would be 
qualifiedcontingent trades only to the extent that they involve the 
unwinding of a pre-existing position in the merger participants' 
shares.
---------------------------------------------------------------------------

    Accordingly, the exemption should provide appropriate relief in 
those circumstances where compliance with Rule 611 could be most 
difficult as a practical matter, but also is limited to a small number 
of transactions that should not unduly undermine the objectives of Rule 
611.\25\ In this regard, the Commission notes that the exception is 
premised on an expectation that qualified contingent trades will 
continue to be used for essentially the same valid trading purposes as 
they are currently and as described in the SIA Exemption Request. A 
material change in the nature or frequency of such trades could cause 
the Commission to reconsider the terms of the exemption.
---------------------------------------------------------------------------

    \25\ See SIA Exemption Request at 5-6 (representing that the 
number of qualified contingent trades is small in comparison to the 
overall number of trades executed in NMS stocks and, therefore, the 
overall number of possible exempted trade-throughs is similarly 
small).
---------------------------------------------------------------------------

    For the foregoing reasons, the Commission finds that granting an 
exemption from Rule 611 for qualified contingent trades, as defined 
above, is necessary and appropriate in the public interest, and is 
consistent with the protection of investors.

IV. Conclusion

    It is hereby ordered, pursuant to Rule 611(d) of Regulation NMS, 
that each NMS stock component of qualified contingent trades, as 
defined above, shall be exempt from Rule 611(a) of Regulation NMS.
    For the Commission, by the Division of Market Regulation, pursuant 
to delegated authority.\26\
---------------------------------------------------------------------------

    \26\ 17 CFR 200.30-3(a)(82).

Nancy M. Morris,
Secretary.
 [FR Doc. E6-14806 Filed 9-6-06; 8:45 am]

BILLING CODE 8010-01-P
