| Release No. 34-15533 January 29, 1979
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 Table of Contents
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I. SECTION 11(a) AND THE NATIONAL MARKET SYSTEM
A. Background
In its February 1978 recommendation to the Congress that legislation be enacted to delay the full effectiveness of Section 11(a)(1), the Commission expressed its concern that full implementation of the prohibitions of that section on May 1, 1978 would be undesirable in light of the continuing rapid pace of economic, technological and regulatory changes in the markets. The Commission referred particularly to the development of market linkage, order routing, and limit order protection systems for a national market system. 19
During the last year, two experimental facilities have been initiated by the securities industry and the self-regulatory organizations as a means of accomplishing certain statutory objectives for a national market system. These two systems, the ITS and the CSE Trading Facility, currently are operated on a pilot basis and permit transactions to be effected through the use of the facilities of existing national securities exchanges. The mechanics of the two systems differ, and each system has different implications for the development of a national market system. The operation of the ITS and the CSE Trading Facility, however, raises certain questions regarding the application of Section 11(a) to trading that occurs through them.
B. Application of Section 11(a) to Existing Automated Facilities Maintained by National Securities Exchanges
1. ITS.
The ITS began operation in April 1978. It establishes a communications network linking several national securities exchanges 20 and permits members on the trading floor of a participating exchange to send orders for the purchase and sale of certain multiply traded securities to any participating exchange. 21 The ITS provides facilities and procedures for (i) display on the floors of each of the participating exchanges (at the designated trading posts for ITS-traded securities) of composite quotation information disseminated pursuant to Rule 11Ac1-1 under the Act, 22 thereby permitting members of each participating exchange to determine readily the best bid and offer available from any participant for a particular multiply traded security, (ii) routing of "commitments to trade" and administrative messages between and among the participants, and (iii) participation, under certain conditions, by members of all participating exchanges in opening transactions on those exchanges. 23
The Commission has reviewed the operation of the ITS in terms of the prohibitions of Section 11(a)(1) and the exemptions thereunder. One question that has arisen under Section 11(a) concerning the ITS is whether a commitment to trade sent through the ITS by a firm that is a member of both the exchange from which it was sent and the exchange at which it was received would satisfy the off-floor transmission requirement 24 in the effect versus execute rule, Temporary Rule 11a2-2(T). A "commitment to trade"-which, for purposes of the Commissions rules under Section 11(a)(1), would be treated as an order-transmitted through the ITS is sent from the exchange floor where the order originated and is received directly on the receiving exchanges floor. In view of the ITSs method of operation, the Commission believes that an order executed on the floor of an exchange, after having been transmitted to that exchange through the ITS from another exchange, should be deemed to have been transmitted from off the floor of the exchange on which the order is executed. 25 The order would qualify for exemption under the effect versus execute rule 26 if it is effected in compliance with the other conditions set forth in that rule. 27
2. CSE Trading Facility.
The CSE Trading Facility began operation in April 1978. 28 It is an automated electronic communication system designed by the Cincinnati Stock Exchange, Inc. (the "CSE") for multiple dealer trading. Through it, bids and offers of competing dealers, as well as public bids and offers, are consolidated for execution. The process of execution is fully automated and is governed by certain auction-type principles. The CSE Trading Facility accepts orders, in certain securities that are either listed on the CSE or admitted to unlisted trading ("designated issues"), from several classes of "users": (i) members of the CSE, (ii) "access non-members" of the CSE, and (iii) specialists and exchange market makers in designated issues registered as such on other exchanges who may (along with CSE members) become approved dealers on the CSE. Members of the CSE and approved dealers may enter both agency and principal orders; access non-members of the CSE may enter only agency orders. 29 Transactions for covered accounts effected by members of the CSE in the CSE Trading Facility would be subject to Section 11(a)(1).
The Commission has reviewed the operation of the CSE Trading Facility in terms of the prohibition of Section 11(a)(1) and the exemptions thereunder. Unlike certain order routing systems in operation today, the CSE Trading Facility is an electronic market in which CSE members may effect transactions directly as dealers. Thus, for purposes of Section 11(a) and the Commissions rules, it does not appear appropriate to treat covered account transactions effected in the CSE Trading Facility in essentially the same manner as transactions involving only order routing systems such as DOT 30 and the ITS.
Nevertheless, the Commission believes that Section 11(a)(1) may not in fact have a substantial impact on current operation of the CSE Trading Facility because several of the exemptive provisions apply to trading through the CSE Trading Facility. For example, a CSE member who is an approved dealer and, with respect to a security, holds himself out in the CSE Trading Facility as being willing to buy and sell such security for his own account on a regular or continuous basis 31 would be entitled to rely on the market maker exemption in Section 11(a)(1)(A).
Other transactions in the CSE Trading Facility for covered accounts by CSE members who are approved dealers and transactions by other CSE members would also need a statutory exemption under Section 11(a)(1) or an exemption pursuant to one of the rules under Section 11(a). In the case of proprietary trading by CSE members, the exemption provided by Section 11(a)(1)(G) and Temporary Rule 11a1-1(T) thereunder will apply to any member that meets the "business mix" test set forth in those provisions since the yielding procedures required by Section 11(a)(1)(G)(ii) 32 are appropriately reflected in the CSE rules applicable to the CSE Trading Facility. 33 In the case of accounts as to which the CSE member exercises investment discretion, 34 the Commission believes that an exemption under the effect versus execute rule will be available where either (i) the initiating member arranges to have another member enter the order for such an account into the CSE Trading Facility, or (ii) the initiating member enters the order itself at a limit price that is higher, in the case of an order to sell, or lower, in the case of an order to buy, than the best bid or offer, as the case may be, that is currently displayed in the CSE Trading Facility. 35
II. EXEMPTIONS UNDER SECTIONS 11(a)(1)(A) AND (D)
Section 11(a)(1) contains a number of exemptions for principal transactions by members and their associated persons. In order to assist exchanges and exchange members in complying with Section 11(a), the Commission has determined to set forth certain interpretive statements concerning the application of the market making, bona fide arbitrage, risk arbitrage, and bona fide hedge exemptions provided in Sections 11(a)(1)(A) and (D).
The Commission believes that, in light of the purposes of Section 11(a)(1), custom in the securities markets and the usage of those terms among the highly specialized securities traders and arbitrageurs who engage in those activities are the best determinants of the meaning and application of those terms under Section 11(a)(1). In fact, specialized technical terms such as "block positioner," "bona fide arbitrage," "risk arbitrage" and "bona fide hedge" are largely descriptive of custom and practice in the securities markets.
The legislative history of Section 11(a) indicates that the Congress believed that the transactions for which exemptions were provided in Section 11(a)(1) either contributed to the fairness and orderliness of exchange markets, or at least had not given rise to serious problems. 36 It does not appear from the legislative history that the Congress intended to impose excessively rigid limits on the activities of arbitrageurs and other specialized "upstairs" traders in connection with block positioning transactions and transactions of the types listed in Section 11(a)(1)(D). Section 11(a)(1) was not designed to narrow or complicate those activities unduly.
The Commission has concluded nevertheless that it should provide some interpretive guidance concerning the scope of the exemptions provided for those activities in order to assist exchange members who seek to establish their entitlement to any such exemption. In providing such guidance, which is intended solely for purposes of Section 11(a)(1) and is not controlling in other contexts, 37 the Commission believes, at present, that it would be unwise, if not impossible, to provide a complete description of these activities. 38 Such description, even if accurate, could rapidly become obsolete as trading practices and the markets evolve. In part for that reason, the Commissions statements are not intended to be exclusive; they do not provide any comprehensive definitions. Furthermore, the Commissions statements should not be construed by negative implication to make the exemptions in Sections 11(a)(1)(A) and (D) inapplicable to activities that are not specifically covered by the discussion and that would normally and properly be considered to be within those specialized terms.
Since exchange members may effect principal transactions under the effect versus execute rule regardless of whether a statutory exemption is also available, exchange members do not need to rely on statutory exemptions for principal transactions unless they plan to use their own associated persons on the exchange floor to participate in executing those transactions or, for other reasons, do not plan to rely on the effect versus execute rule for those transactions. At the same time, it appears that exchange member firms currently engaged in block positioning, arbitrage and hedge transactions frequently execute those transactions directly on exchanges. If the exemptions in Section 11(a)(1)(D) were construed too narrowly, such an interpretation would disadvantage specialized "upstairs" traders in a fashion that the Congress does not appear to have contemplated.
A. Block Positioning Transactions
Section 11(a)(1)(A) exempts any transaction by a dealer acting in the capacity of a "market maker." The term "market maker," as defined in Section 3(a)(38) of the Act, 39 includes a "block positioner." In January 1976, the Commission posed several questions concerning the meaning of that term. The Commission asked whether or not the definitions of that term under certain exchange rules and Commission reporting rules, and the credit regulations adopted by the Board of Governors of the Federal Reserve System, would be appropriate for the purposes of Section 11(a)(1) and, if not, what would be an appropriate definition. The Commission also asked whether restrictions should be adopted governing permissible time periods for liquidating, or "lay-off," transactions in which the block positioners securities position is liquidated after the block transaction has been effected.
The commentators responses generally favored a broad definition of the term "block positioner." 40 The Association of the Bar of the City of New York and the NYSE rejected the definitions set forth in Rule 17a-17 under the Act and Regulation U. 41 They suggested that the term "block positioner" should be defined to mean any dealer who (i) has and maintains net capital as defined in Rule 15c3-1 under the Act 42 (or in the net capital rules of the appropriate exchange) of $1,000,000, (ii) engages in the activity of purchasing long or selling short as principal, from time to time, from or to one or more unrelated customers 43 a block of stock with a current market value of $200,000 or more, in a single transaction (or in several transactions at approximately the same time from a single source), to facilitate a sale or purchase by such customers, and (iii) sells the securities comprising the block as rapidly as possible, commensurate with the circumstances. The commentators opposed specific time limits for lay-off transactions in view of the large sums of capital at risk in block transactions, the volatility of conditions in the exchange markets, and the difficulty of predicting the amount of time that is necessary to liquidate a block of stock under a particular set of circumstances.
The Commission believes that the term "block positioner" is generally used to describe a broker-dealer that facilitates the execution of a block transaction in an equity security by positioning at least some part of the block-that is, by purchasing securities for its own account to fill all or part of a customers block sale order, or by selling securities for its own account, as either a short sale or a sale from its inventory, to fill all or a part of a customers block purchase order. 44 An exchange member may be presumed to be acting in the capacity of a "block positioner" for purposes of the market-maker exemption under Section 11(a)(1)(a) if that member is a dealer who establishes a position by purchasing long or selling short as principal from or to a customer with which it is not associated some or all of a block of an equity security 45 in a single transaction (or in several transactions at approximately the same time) to facilitate a purchase or sale by such customer. A transaction liquidating part or all of a position (long or short) so acquired may be presumed to qualify as a block positioners transaction if liquidation of the position acquired has not been delayed for tax purposes, investment purposes, or other purposes unrelated to the current state of the market in the security involved.
B. Arbitrage and Hedge Transactions
Section 11(a)(1)(D) provides an exemption for any "bona fide arbitrage transaction" as well as "any risk arbitrage transaction in connection with a merger, acquisition, tender offer, or similar transaction involving a recapitalization." 46 In the January 1976 Release, the Commission solicited public comment on these exemptions. In discussing whether there should be time limits on block positioning "lay-off" transactions exempt under Section 11(a)(1)(A), 47 the Commission asked whether time limits would be appropriate for arbitrage transactions. It also asked whether arbitrageurs should be subject to the limitations or obligations of exchange market makers or specialists. 48
The commentators generally believed that limitations should not be imposed on the arbitrage or hedge exemptions and that the Commissions authority to modify the exemptions under Section 11(a)(1) was significantly limited. One commentator suggested that the primary function and benefit of arbitrage is to narrow spreads between markets or between similar and exchangeable securities or securities which are expected to become similar or exchangeable in the future. The NYSE stated that its criteria for a "bona fide" arbitrage transaction are: (i) the possibility of a profit after expenses, (ii) the necessity of an existing equivalent bid, and (iii) practically simultaneous purchases and offsetting sales. 49
1. Bona fide arbitrage.
The term "bona fide arbitrage" generally describes an activity undertaken by market professionals in which essentially contemporaneous purchases and sales are effected in order to "lock in" a gross profit or spread resulting from a current differential in pricing. For example, an arbitrageur may effect an offsetting purchase and sale of the same security in different markets on the basis of an existing price differential between those markets, or may effect offsetting transactions in the same market in a security and another security convertible into the first. 50 In either event, the essence of the bona fide arbitrage is a bona fide effort to profit from an existing price differential. Bona fide arbitrage has been thought to be beneficial to the markets in that it tends to reduce irrational pricing disparities.
The Commission understands that many transactions currently being undertaken by those who are regularly engaged in arbitrage involve some limited, intentional delay (usually a matter of minutes or hours but sometimes, under extraordinary circumstances, as long as a day or even two days) in between the transaction in which the first leg of the arbitrage is established and the subsequent transaction in which the second, offsetting, leg is completed.
Known as "legging" or "legging in," the practice of introducing a delay between putting down the first leg and completing the second leg of the arbitrage is frequently designed to permit the market professional to combine the opportunity to profit from a spread existing at the time the first leg is put down with the opportunity to profit from a favorable short-term price movement, widening the spread, before the arbitrage is completed. 51 Indeed, in situations where the initial spread is very small, the attendant transaction costs, risks and carrying charges may make it uneconomical to attempt the arbitrage unless the existing spread can be combined with an expected favorable intra-day or other very short term price movement. Also, the legging in practice may be adopted in circumstances where market conditions, such as the inability of the market to absorb a large transaction without significant price movement, make it advisable to avoid immediate execution of an entire arbitrage order.
In light of the legislative history and unique purposes underlying Section 11(a), 52 the Commission believes that the bona fide arbitrage exemption in Section 11(a)(1)(D) should be construed very broadly. While the term "bona fide arbitrage" in other contexts is not generally used to described transactions that are not essentially contemporaneous, the Commission believes that the types of market operations described above should be viewed as bona fide arbitrage within the special meaning of Section 11(a)(1)(D). The "legging in" technique departs from the classic notion of bona fide arbitrage as a simultaneous, or essentially simultaneous, pair (or group) of transactions, and injects some limited element of market prediction and market risk into what would otherwise be purely an activity aimed at profiting from contemporaneous pricing differentials. Nevertheless, in the Commissions view, where a member has begun an arbitrage in the presence of an existing pricing differential (although perhaps one not great enough to outweigh expected transaction costs and carrying charges), time lags alone on the order of those discussed above do not in and of themselves cause the transaction no longer to be covered by the Section 11(a)(1)(D) exemption. 53
2. Risk arbitrage.
The term "risk arbitrage" is itself a misnomer in that the transactions to which it is generally applied do not involve arbitrage in the classic sense of an effort to "lock in" a profit resulting from an existing spread, or differential, between the prices of the same security in different markets or of one security and a second security convertible into the first. Rather, risk arbitrage involves a risking of capital on a contingent event; to be exempt under Section 11(a)(1)(D) it must be in connection with a proposed merger, acquisition, tender offer, or other similar transaction involving a recapitalization ("risk arbitrage event"). 54
The Commission believes that the exemption for risk arbitrage in Section 11(a)(1)(D) applies to transactions which are effected with a view to profiting from the consummation of a risk arbitrage event as well as to transactions effected in order to profit from the unsuccessful termination of such an event. It applies regardless of whether the risk arbitrage event involves a proposed exchange of securities or cash tender offer or acquisition. 55 The exemption applies only to transactions effected after the public announcement of the risk arbitrage event 56 and before completion or termination of the risk arbitrage event. In addition, the exemption applies to transactions that liquidate a risk arbitrage position before completion or termination of the risk arbitrage event or within a reasonable period of time thereafter. 57
3. Hedge transactions.
Section 11(a)(1)(D) also provides an exemption for "any bona fide hedge transaction involving a long or short position in an equity security and a long or short position in a security entitling the holder to acquire or sell such equity security...." The Act does not otherwise specify what type of transaction will result in a "bona fide hedge." While the application of that term is largely a matter of custom and practice, the Commission believes that it implies that an appreciable offset of risk, for all or part of the position being hedged, must be involved. 58
A bona fide hedge may be established either by contemporaneous transactions in two securities where each position acquired reduces the risk of the other, 59 or by a single transaction in which a position acquired in one security reduces the risk of a previously established position in another security. 60 To the extent, however, that a position does more than offset the risk of the position or positions on the other side, the excess position is not part of a "bona fide hedge" for purposes of Section 11(a)(1)(D). Where a bona fide hedge has been established, the exemption under Section 11(a)(1)(D) also applies to the transaction or transactions that liquidate the hedge. 61
III. TEMPORARY EXEMPTIVE RULE FOR BONA FIDE HEDGE TRANSACTIONS IN CERTAIN SECURITIES (TEMPORARY RULE 11a1-3(T))
With respect to the exemption for "bona fide hedge" transactions, the wording of Section 11(a)(1)(D) refers, on the one hand, to a position in an equity security and, on the other hand, to a position in a security entitling the holder to acquire or sell that security. By its terms the exemption does not apply to a hedge that involves options exclusively. The Commission currently believes, however, that it is appropriate to accord such options hedges a temporary exemption. That conclusion is prompted in part by the fact that members of the options exchanges currently conduct such activities on those exchanges and that the prohibition of such activities by Section 11(a)(1) could cause unnecessary disruption in the operation of the options markets without serving the purposes of Section 11(a). 62 While the market making exemption under Section 11(a)(1)(A) applies to proprietary trading by floor members who are acting as market makers, 63 option-to-option hedging by other members does not have any exemption comparable to the Section 11(a)(1)(D) exemption.
The options markets have developed substantially since the time Section 11(a) was adopted. Options hedging strategies are part of the options activities of professional traders. Even though the Commission has not completed its evaluation of the current operations of the options markets, it currently believes that exemptive relief under Section 11(a)(1)(H) for options hedging transactions is appropriate to avoid any immediate disruption. Furthermore, it appears that the Congress may possibly have intended to include option-to-option hedging under the exemption for bona fide hedge transactions when it enacted Section 11(a) as part of the Securities Acts Amendments of 1975. 64
The legislative history of Section 11(a)(1)(D) indicates that certain persons believed that its wording would in fact cover hedging between or among options positions. 65 As noted above, however, it does not appear to the Commission that the language of Section 11(a)(1)(D) accomplishes that purpose.
The Commission is adopting a temporary rule, Temporary Rule 11a1-3(T), that would establish an exemption comparable to the hedging exemption in Section 11(a)(1)(D) for, among other things, option-to-option hedging. The temporary rule would permit members of a national securities exchange to effect, for their own accounts or the accounts of their associated persons, bona fide hedge transactions between or among securities entitling the holder to sell or acquire the same equity security, which would include option-to-option hedging. The exemption provided by the temporary rule does not exempt transactions for accounts with respect to which a member or an associated person thereof exercises investment discretion, 66 in view of the potential fiduciary problems which the Congress identified with respect to transactions for such accounts.
The Commission has not adopted Temporary Rule 11a1-3(T) as a permanent rule for two reasons. First, the options markets have developed substantially since the time Section 11(a) was adopted, and the Commission has been studying those developments with a view to determining any appropriate and necessary regulatory action. The Commission has not completed its review of current market operations conducted by options traders and others and is not able to conclude finally whether the options trading that would be covered by the temporary rule should be exempted permanently. Second, although option-to-option hedging is an existing practice among securities professionals, its place in an active trading environment in which Section 11(a) is fully effective has not been gauged. The Commission plans to continue its consideration of Temporary Rule 11a1-3(T) and, if necessary, to revisit these issues at a later date.
Commentators are requested to provide their views on the issues discussed above and on any other matters relating to the adoption of Temporary Rule 11a1-3(T) that they believe the Commission should consider.
IV. AMENDMENTS TO THE PROPRIETARY TRADING RULE (TEMPORARY RULE 11a1-1(T))
The proprietary trading rule was adopted under Section 11(a)(1)(G) to implement that provisions exemption for members proprietary transactions. Under Section 11(a)(1)(G), as implemented, a member may effect a transaction for its own account if, among other things, (i) the member derives more than 50% of its gross income from certain types of business (the "business mix" test), and (ii) the transaction yields priority, parity, and precedence in execution to orders for the account of persons who are not members or associated with members of the exchange.
The Commission is responding below to comments concerning whether revenues derived from exempt bond trading activities may be included within the categories of business enumerated in the "business mix" test (referred to in the April 1978 Release as "eligible income"). The Commission also briefly reviews below the treatment under Section 11(a) of covered account orders which are left before February 1, 1979 on limit order books maintained on exchange floors but which are not executed until after that date.
A. Bond Trading Revenues
In April 1978, the Commission adopted the bond trading rule (Temporary Rule 11a1-4(T)) to exempt from Section 11(a)(1) all bond transactions on an exchange for the account of a member or its associated person. Two persons commented on the bond trading rule. While they supported that rule, they contended that revenues from proprietary transactions under the bond trading rule should be considered as "eligible income" for purposes of the "business mix" test under Section 11(a)(1)(G)(i). They stated that these revenues are derived from activities which have beneficial and constructive effects on the exchange markets. They also observed that revenues derived from transactions exempted under paragraphs (A), (B) and (D) of Section 11(a)(1) are deemed to be "eligible income" for purposes of the "business mix" test of the proprietary trading rule, and stated that revenues derived from exempt bond trading deserve similar treatment. 67
In adopting the bond trading rule, the Commission concluded that principal bond trading on exchanges provides a relatively liquid market for transactions of small size, that exchange bond markets do not appear to offer exchange members an opportunity for special "time and place" advantages, and that such trading would not raise any of the problems concerning institutional exchange membership articulated by the Congress when it enacted Section 11(a). 68 Furthermore, when the proprietary trading rule was amended to permit revenues from transactions exempted under paragraphs (A), (B), and (D) of Section 11(a)(1) to be treated as "eligible income" for purposes of the "business mix" test, the Commission stated that such transactions represent a "traditional" securities business and that the Congress believed them to have a beneficial, or at least not deleterious, impact on the exchange markets. 69
The reasons behind that revision of the proprietary trading rule are equally applicable with respect to revenues derived by members from exchange bond trading activities. Accordingly, the Commission is adopting an amendment to paragraph (b) of the proprietary trading rule, to permit members to count as "eligible income" for purposes of the "business mix" test revenues derived from effecting transactions under the bond trading rule.
B. Pre-February 1979 Limit Orders
In the April 1978 Release, the Commission adopted a new paragraph (c) to the proprietary trading rule. That paragraph provides that any limit order that was left with a specialist or any other person maintaining a limit order book on a national securities exchange before May 1, 1978, and not executed before that date, shall be deemed, if executed before January 1, 1979, to be an order for the account of a person who is not, and is not associated with, a member. Paragraph (c) was summarily adopted to avoid the significant problem of marking orders left on limit order books for purposes of the proprietary trading rule within the extremely short time that remained before May 1, 1978, when Section 11(a)(1) was originally scheduled to become fully effective.
The Commission believes that the exchanges have had sufficient time to alert their members to this problem and to encourage or require members to mark any orders left on limit order books for purposes of the proprietary trading rule. Accordingly, the Commission is rescinding paragraph (c) of the proprietary trading rule and is not adopting any comparable rule for the period following January 1, 1979.
V. SOLICITATION OF COMMENTS
The Commission hereby requests all interested persons to provide data, views, and arguments on the new temporary rule, the rule amendments, and the interpretation adopted herein, and any other matters pertaining to Section 11(a) of the Act. Comments must be submitted by April 1, 1979 in accordance with the instructions set forth near the beginning of this release under the caption "ADDRESSES."
VI. STATUTORY BASIS
The Securities and Exchange Commission, acting pursuant to the Securities Exchange Act of 1934, and particularly Sections 2, 3, 6, 11, 11A, and 23 thereof (15 U.S.C. 78b, 78c, 78f, 78k, 78k-1, and 78w), hereby adopts Temporary Rule 11a1-3(T) and an amendment to paragraph (b) of Temporary Rule 11a1-1(T), and rescinds paragraph (c) of that rule. The adoption and rescission shall both take effect on February 1, 1979. The Commission has determined that Temporary Rule 11a1-3(T), and the amendment to Temporary Rule 11a1-1(T), are consistent with the purposes of Section 11(a), the protection of investors, and the maintenance of fair and orderly markets.
The Commission finds, in accordance with Section 4(b)(B) of the Administrative Procedure Act (the "APA"), 70 that notice and public procedure on the adoption of Temporary Rule 11a1-3(T) are impracticable and contrary to the public interest. Accordingly, the Commission finds that good cause exists to adopt Temporary Rule 11a1-3(T) without notice and public procedure. The trading activity covered by the exemption provided by Temporary Rule 11a1-3(T) is ongoing and has occurred in the past. Although the Commission has raised substantial questions about options trading and the operations of options exchanges, 71 the Commission has not concluded at this time that the trading activity covered by the temporary rule has caused serious problems or has resulted in disruption of the exchange markets. On the other hand, the effectiveness of Section 11(a) with respect to all exchange members and their associated persons on February 1, 1979, without the exemptive relief accorded by the adoption of Temporary Rule 11a1-3(T), could disrupt existing trading patterns in a fashion that the Congress appears not to have contemplated. The problem raised by the exclusion of option-to-option hedging from the exemption provided by Section 11(a)(1)(D) was addressed by three commentators, who urged the Commission to take appropriate action to exempt such exchange transactions from the prohibition of Section 11(a)(1). Adoption of the temporary rule effective February 1, 1979, the date Section 11(a)(1) becomes generally effective, will alleviate certain of the options trading problems that implementation of Section 11(a)(1) would otherwise cause. For the reasons expressed above, the Commission finds good cause to make the temporary rule effective less than 30 days after its adoption, in accordance with Section 4(c) of the APA. 72 In addition, publication is not required because the temporary rule grants an exemption.
The amendment to paragraph (b) of Temporary Rule 11a1-1(T) is an extension of the exemptive treatment accorded to exchange bond trading under Temporary Rule 11a1-4(T), which was adopted in April 1978. That rule was addressed by only two commentators, both of which requested the Commission to adopt an amendment similar to the one adopted today. Moreover, the amendment clarifies the treatment of bond trading revenues under the "business mix" test in Section 11(a)(1)(G)(i) and Temporary Rule 11a1-1(T) and thus permits members in the bond business to complete their preparations for the full effectiveness of Section 11(a)(1) on February 1, 1979. In view of the foregoing discussion, and the February 1, 1979 date for full effectiveness of Section 11(a)(1), the Commission finds that notice and public procedure in accordance with Section 4(b)(B) of the APA are impracticable, unnecessary and contrary to the public interest. Accordingly, the Commission finds that good cause exists to adopt the amendment concerning bond trading revenues to paragraph (b) of Temporary Rule 11a1-1(T) without notice and public procedure. For the same reasons, the Commission finds good cause to make that amendment effective less than 30 days after its adoption, in accordance with Section 4(c) of the APA. In addition, publication of notice before the amendments effectiveness is not required because that amendment broadens an existing exemption.
The Commission finds that neither Temporary Rule 11a1-3(T) concerning bona fide hedge transactions in certain securities, including options, nor the amendment, concerning bond trading revenues, to paragraph (b) of Temporary Rule 11a1-1(T), will impose any burdens on competition that are not necessary or appropriate in furtherance of the purposes of the Act. Temporary Rule 11a1-3(T) will create an exemption from Section 11(a)(1) that the Commission believes is necessary or appropriate to prevent possible disruption of options trading and diminution of the ability of securities traders to offset the risks they assume in effecting other transactions. The amendment to Temporary Rule 11a1-1(T) will broaden an existing exemption under that rule. In addition, it will avoid any disparity in treatment between exchange members relying on Temporary Rule 11a1-4(T) and members relying on certain other statutory exemptions since the amendment permits a member to count revenues earned from exchange bond transactions as "eligible income" for purposes of the "business mix" test in Section 11(a)(1)(G)(i) and Temporary Rule 11a1-1(T).
The Commissions rescission of paragraph (c) of Temporary Rule 11a1-1(T) deletes a provision which refers to transactions effected before January 1, 1979. The Commission finds that notice and public procedure in accordance with Section 4(b) of the APA would be unnecessary, that good cause exists to make the rescission amendment effective less than 30 days after its adoption and that the rescission of paragraph (c) will not impose any burdens on competition.
Part 241 of Chapter II of Title 17 of the Code of Federal Regulations is amended, effective February 1, 1979, by the inclusion of this release therein. Part 240 of Chapter II of Title 17 of the Code of Federal Regulations is amended, effective February 1, 1979, by amending paragraph (b) and deleting paragraph (c) of §240.11a1-1(T), and by adding §240.11a1-3(T), as follows:
§240.11a1-1(T) Transactions yielding priority, parity and precedence.
* * * * *
(b) A member shall be deemed to meet the requirements of section 11(a)(1)(G)(i) of the Act if during its preceding fiscal year more than 50 percent of its gross revenues was derived from one or more of the sources specified in that section. In addition to any revenue which independently meets the requirements of section 11(a)(1)(G)(i), revenue derived from any transaction specified in paragraph (A), (B), or (D) of section 11(a)(1) of the Act or specified in 17 CFR 240.11a1-4(T) shall be deemed to be revenue derived from one or more of the sources specified in section 11(a)(1)(G)(i). A member may rely on a list of members which are stated to meet the requirements of section 11(a)(1)(G)(i) if such list is prepared, and updated at least annually, by the exchange. In preparing any such list, an exchange may rely on a report which sets forth a statement of gross revenues of a member if covered by a report of independent accountants for such member to the effect that such report has been prepared in accordance with generally accepted accounting principles.
(c) Deleted
§240.11a1-3(T) Bona fide hedge transactions in certain securities.
A bona fide hedge transaction effected on a national securities exchange by a member for its own account or an account of an associated person thereof and involving a long or short position in a security entitling the holder to acquire or sell an equity security, and a long or short position in one or more other securities entitling the holder to acquire or sell such equity security, shall be deemed to be of a kind which is consistent with the purposes of section 11(a)(1) of the Act, the protection of investors, and the maintenance of fair and orderly markets.
(Secs. 2, 3, 6, 11, 11A, and 23, 89 Stat. 97, 104, 110, 111, 156 (15 U.S.C. 78b, 78c, 78f, 78k, 78k-1, 78w), Secs. 2, 3, 11, 23, 48 Stat. 881, 882, 885, 891, 901, as amended).
By the Commission.
Two other intra-market facilities, the PSEs Communications and Execution System ("COMEX") and the Phlxs Automated Communications and Execution System ("PACE") differ from order routing facilities like the CSE Trading Facility. COMEX and PACE combine automated order routing, formula pricing, and automatic execution functions. Execution of COMEX market orders is effected automatically at prices determined by a formula designed to approximate the execution price the order would have received had it been transmitted instead to the NYSE or the Amex. The PSE is in the process of changing its COMEX pricing formula. For securities included in the ITS, COMEX would automatically execute an order at a price the order could have received had it been transmitted through the ITS. For securities not included in the ITS, the new COMEX formula would produce an execution at whichever was the best bid or offer from among the bids disseminated by the NYSE and the PSE specialist pursuant to Rule 11Ac1-1 under the Act. Limit orders in the COMEX system are routed to the appropriate specialist and executed manually. Orders in the PACE system are executed automatically pursuant to a pricing formula. Unlike ITS, DOT and the CSE Trading Facility, PACE and COMEX permit the entry of agency orders only; the application of requirements under the effect versus execute rule to these systems is therefore limited to orders for managed accounts.
In the case of both PACE and COMEX, the initiating member relinquishes any ability to influence or guide the execution of its order at the time that order is transmitted into the system. While the execution of the order is thereafter automatic and does not involve any independent executing member, the design of those systems insures that members do not possess any special or unique trading advantages in handling their orders after transmitting them to the floors of the Phlx or the PSE. consequently, the Commission believes that executions obtained through either system should be regarded as satisfying paragraphs (a)(2)(i), (a)(2)(ii) and (a)(2)(iii) of the effect versus execute rule.
In the case of an initiating member that is a member of two exchanges participating in the ITS, it is conceivable that an associated person of the initiating member might unknowingly participate (e.g., as a specialist or a floor broker) on the other side of a covered account transaction that had been transmitted from one exchange to the other. A similar problem could arise with respect to a single exchanges trading floor. In that case, an associated person of the initiating member also might unknowingly participate on the other side of a covered account transaction which had simply been transmitted by the initiating member to an unaffiliated member on the exchange floor.
The conditions under Temporary Rule 11a2-2k(T)(a)(2) (i) and (iii) were not intended to cover such fortuitous events. Accordingly, the Commission believes that an initiating member does not violate these two conditions in these cases if the associated persons participation is limited to acting for the order on the other side of the initiating members transaction and if neither the initiating member nor its associated person knows, or has reason to know, that the associated person will so participate.
That limited exclusion is appropriate in the CSEs case. Under the CSEs access provisions, non-CSE member specialists who have become approved dealers (unlike other non-members of the CSE) are afforded all the trading rights and advantages available to CSE members and, therefore, should not be afforded the benefit which the Congress, in fashioning Section 11(a)(1)(G)(ii), intended to restrict to non-members who do not enjoy any privileged rights of access to exchange markets.
On the other hand, where an order is entered into the CSE Trading Facility by a member at a limit price away from the market, the resulting transaction satisfies the requirement in paragraph (a)(2)(i) of the effect versus execute rule. Such an order would be queued along with other orders awaiting execution and the member would not retain any ability to control the timing of execution or otherwise to enjoy the kind of special order-handling advantages inherent in being on an exchange floor. (Similar principles may well apply to limit orders entered in electronic limit order loading mechanisms that are currently being developed by other exchanges. See, e.g., letter to George A. Fitzsimmons, Secretary of the Commission, from James E. Buck, Secretary of the NYSE (May 31, 1978), Securities and Exchange Commission File No. S7-735. See also April 1978 Release at n. 16.) The CSE member entering an order away from the market would remain subject to the limitation on transaction-related compensation contained in paragraph (a)(2)(iv) of that rule in effecting transactions for an account (other than one described in Section 11(a)(1)(E) of the Act) as to which it or one of its associated persons exercises investment discretion.
An arbitrageur is not an investor in the formal sense of the word; i.e., he is not normally buying or selling securities because of their investment value. He is, however, committing capital to the "deal"-the merger, tender offer, recapitalization, etc-rather than to the particular security. He must thus take a position in the deal in such a way that he is at the risk of the deal, and not at the risk of the market. He accomplishes this by taking a short position in the securities which are being offered, as part of the deal, in exchange for the securities which he purchases.
Wyser-Pratte, Risk Arbitrage, Bulletin Nos. 74-75, New York University Graduate School of Business Administration, Institute of Finance (May 1971) at 11-12.
The question whether particular combinations of stock positions and options positions result in risk reduction in each of the positions involves subjective judgments as to the volatility and risk characteristics of those positions. For example, "ratio" hedges are frequently used when the risk involved in a stock position is offset by the writing of options. In such ratio hedges, the number of underlying shares deliverable upon exercise of the options exceeds the number of shares in the stock position that is being hedged. The hedge ratio reflects a calculation of the relative degree of risk involved in each position. In establishing a suitable ratio, some industry participants use the "delta factor" derived from the Black-Scholes pricing formula; the delta factor predicts price movements in an option as a function of movements in the underlying stock. Other industry participants have developed their own models. The Commission recognizes that the calculation of volatility and risk can only be approximate, and believes that, for purposes of Section 11(a)(1)(D), the determination of what constitutes an offset may be made by the use of any responsible method of calculating the risk of stock and options positions.
In addition, the Commission recognizes that the "legging in" technique discussed above is used also in establishing hedges and that a similar "legging out" technique is used in liquidating some hedges. The Commission believes that, where either technique is used, the hedging exemption should apply on the same basis as is discussed above in connection with bona fide arbitrage. See text accompanying nn. 51-53, supra.
115 U.S.C. 78k(a)(1).
2In addition to being subject to Section 11(a), exchange members firms are subject to comparable provisions in the Employee Retirement Income Security Act of 1974 ("ERISA") Pub. L. No. 94-402, 94th Cong., 1st Sess. (1974), in connection with, among other things, exercising investment discretion over an employee benefit plan that is subject to ERISA. In that regard, the Department of Labor (the "Department") has extended to May 1, 1979 a temporary class exemption delaying the application of those ERISA provisions. In addition, the Department has adopted a permanent class exemption allowing persons who serve as fiduciaries for employee benefit plans to effect securities transactions for those plans under certain circumstances. Department of Labor, Class Exemption for Certain Transactions Involving Employee Benefit Plans and Broker-Dealers (Prohibited Transaction Exemption 79-1) (Jan. 23, 1979). Unlike Section 11(a)(1), ERISA and the class exemption also apply to (i) non-member broker-dealers that provide such services to employee benefit plans and (ii) transactions effected for employee benefit plans in the over-the-counter market by exchange members and by non-member broker-dealers acting as fiduciaries for those plans.
315 U.S.C. 78k(a)(3). As originally enacted in 1975, Section 11(a)(3) delayed until May 1, 1978 the effective date of Section 11(a)(1) for transactions by persons who were exchange members on May 1, 1975. Section 11(a)(3) was amended in 1978 to delay until February 1, 1979 the effective date of Section 11(a)(1) for transactions by persons who were exchange members on February 1, 1978. Pub. L. No. 95-283, 95th Cong., 2d Sess. §19 (1978).
4These exemptions are: (i) transactions by a dealer acting in the capacity of market maker; (ii) transactions for the account of an odd-lot dealer in its registered securities; (iii) certain stabilizing transactions to facilitate a distribution of securities; (iv) certain arbitrage, risk arbitrage and hedge transactions; and (v) transactions to offset transactions made in error. Sections 11(a)(1)(A) through (D) and (F), 15 U.S.C. 78k(a)(1)(A) through (D) and (F).
515 U.S.C. 78k(a)(1)(E).
615 U.S.C. 78k(a)(1)(G).
7See text accompanying nn. 67-69, infra.
815 U.S.C. 78k(a)(1)(H).
915 U.S.C. 78k(a)(2). Under Section 11(a)(2), the Commission, by rule, as it deems necessary or appropriate in the public interest and for the protection of investors, to maintain fair and orderly markets, or to assure equal regulation of exchange markets and over-the-counter markets, may regulate or prohibit (i) transactions not prohibited by Section 11(a)(1) that are effected on exchanges by members for covered accounts (other than market maker or odd-lot dealer transactions); (ii) over-the-counter transactions for covered accounts by members and non-member broker-dealers (other than market maker transactions); and (iii) exchange transactions for covered accounts by non-member broker-dealers (other than market maker transactions). The Commissions authority under Section 11(a)(2) is complemented by Sections 11(b) and 15(c)(5), 15 U.S.C. 78k(b) and 78o(c)(5), and by its general rulemaking authority under Section 23(a)(1), 15 U.S.C. 78w(a)(1).
1015 U.S.C. 78k(c). The Commission has used its authority under Section 11(c) in the past to exempt regional exchanges from the requirements under Rules 11a-1 (17 CFR 240.11a-1) and 11b-1 (17 CFR 240.11b-1). See Securities Exchange Act Release Nos. 7290 (Apr. 9, 1964), 7330 (June 2, 1964) and 7465 (Nov. 23, 1964), 29 FR 5168 (Apr. 15, 1964), 29 FR 7380 (June 6, 1964), and 29 FR 15862 (Nov. 26, 1964).
11See Securities Exchange Act Release Nos. 14563 (Mar. 17, 1978) (the "March 1978 Release") and 14713 (Apr. 27, 1978) (the "April 1978 Release"), 43 FR 11542 (Mar. 17, 1978) and 43 FR 18557 (May 1, 1978). See also Securities Exchange Act Release Nos. 13388 (Mar. 8, 1977) (the "March 1977 Release") and 12055 (Jan. 27, 1976) (the "January 1976 Release"), 42 FR 16745 (Mar. 29, 1977) and 41 FR 8075 (Feb. 24, 1976).
12Temporary Rule 11a2-2(T), 17 CFR 240.11a2-2(T).
13Rule 11a1-2, 17 CFR 240.11a1-2.
14Temporary Rule 11a-1-4(T), 17 CFR 240.11a1-4(T).
15Temporary Rule 11a1-1(T), 17 CFR 240.11a1-1(T).
1615 U.S.C. 78c(a)(35).
17Securities Exchange Act Release No. 14795 (May 24, 1978), 43 FR 23777 (June 1, 1978).
1815 U.S.C. 78k-1.
19Letters from Harold M. Williams to Walter F. Mondale, Thomas P. ONeill, Jr., Harley O. Staggers and Harrison A. Williams (Feb. 22, 1978), and Memorandum of the Securities and Exchange Commission in Support of its Recommendation that the Congress Delay the Full Effectiveness of Section 11(a) until November 14, 1979. The Commissions memorandum is reprinted in Report, together with Additional Views, to Accompanying H.R. 11567, H.R. Rep. No. 95-1010, 95th Cong., 2d Sess. (1978).
20At this time, the participating exchanges in the ITS are the American Stock Exchange, Inc. (the "Amex"), the New York Stock Exchange, Inc. (the "NYSE"), the Boston Stock Exchange Inc., the Midwest Stock Exchange, Inc., the Pacific Stock Exchange, Inc. (the "PSE") and the Philadelphia Stock Exchange, Inc. (the "Phlx").
21See Securities Exchange Act Release Nos. 14661 and 14662 (Apr. 14, 1978), 43 FR 17419, 17422 (Apr. 24, 1978).
2217 CFR 240.11Ac1-1.
23See Securities Exchange Act Release Nos. 14661 and 14662 (Apr. 14, 1978), 43 FR 17419, 17422 (Apr. 24, 1978).
24The off-floor transmission requirement in the effect versus execute rule provides that the order for the covered account must be transmitted from off the exchange floor. Temporary Rule 11a2-2(T)(a)(2)(ii). See letter to Philip J. Lo Bue, Senior Vice President of the PSE, from Richard A. Steinwurtzel of the Commissions staff (Dec. 22, 1978), Securities and Exchange Commission File No. S7-613 ("File No. S7-613").
25See Rule 11a2-2(T)(a)(2)(ii). An ITS order would thus be treated under Temporary Rule 11a2-2(T) in a manner similar to an order sent to an exchange floor through one of several intra-market order routing systems, e.g., the NYSE Designated Order Turnaround ("DOT") System. March 1978 Release, n. 41. In that regard, the Commission notes that orders sent to the Amex floor through the Amexs Post Executing Reporting System and the Amex Options Switching System are similar to DOT orders and that the use of those systems would satisfy the off-floor transmission requirement in Temporary Rule 11a2-2(T).
26The ITS also permits specialists on participating exchanges who open their markets in ITS securities to obtain pre-opening indications of interest ("pre-opening notifications") in certain circumstances from other specialists registered in those securities on other participating exchanges. To the extent a specialist who is a member of two participating exchanges effects principal transactions on one of those exchanges in response to pre-opening notifications, the specialist may effect those transactions in reliance on the market making exemption under Section 11(a)(1)(A).
27The effect versus execute rule has two other conditions that might present a problem for members using the ITS. First, the covered account transaction must be executed otherwise than by an associated person of the initiating member. Second, the initiating member and its associated persons must not participate in the execution of the covered account transaction after the transmission of the order from off the exchange floor. Temporary Rule 11a2-2(T)(a)(2) (i) and (iii).
28Securities Exchange Act Release No. 14674 (Apr. 18, 1978), 43 FR 17894 (Apr. 26, 1978). The Commission recently approved an extension of the operation of the CSE Trading Facility from January 31, 1979 to January 31, 1980. Securities Exchange Act Release No. 15413 (Dec. 15, 1978), 44 FR 129 (Jan. 2, 1979).
29CSE Rule 9D3 (Temporary). According to the auction-type principles programmed into the CSE Trading Facility, execution priority is granted to orders first by price (i.e., the highest bid and lowest offer) and then, as to orders at the same price, by time of entry, except that "public agency orders," regardless of time of entry, are granted priority over other orders at the same price. A "public agency order" is "any order for the account of a person other than an Approved Dealer, a Member or a person who could become an Approved Dealer by complying with this Rule with respect to his use of the System, which order is represented, as agent, by a User." Id. Once entered, a public agency order which has not been executed may be removed in only three circumstances: (1) upon cancellation, (2) in connection with a transfer of the order to another exchange, or (3) in order to permit the approved dealer or member who entered the order to execute such order as principal pursuant to a prior guarantee to provide such execution in the event a trade takes place in another market at the specified limit price. Id.
30See n. 25, supra.
31See Section 3(a)(38) of the Act, 15 U.S.C. 78c(a)(38).
3215 U.S.C. 78k(a)(1)(G)(ii).
33CSE Rule 9D3 (Temporary) provides, in essence, that a CSE members proprietary order must yield priority, parity, and precedence in execution to orders for the account of persons who are not members or associated with members of the CSE. An exception to that general principle is provided in the case of orders entered in the CSE Trading Facility by a non-CSE member who is a specialist on another national securities exchange and has become an approved dealer. Orders for that type of non-CSE member would not be within the class of non-member orders to which members orders must yield.
34See Section 3(a)(35) of the Act, 15 U.S.C. 78(c)(35). See also March 1978 Release at text accompanying nn. 19-23. An exemption under the effect versus execute rule would not be needed, of course, if the account was a "natural person" account to which Section 11(a)(1)(E) applies. See April 1978 Release at text accompanying nn. 34-36.
35The CSE Trading Facility is similar to PACE and COMEX in that the facility itself performs the execution function that on exchange floors is performed by members themselves. A CSE member who entered a market order into the CSE Trading Facility for immediate execution against an existing bid or offer in the system would have met the off-floor transmission requirement (paragraph (a)(2)(ii) of the effect versus execute rule) and the requirement that the member not participate in the execution of the order after transmission (paragraph (a)(2)(iii) of that rule). Unlike PACE and COMEX, however, a CSE member can achieve immediate and direct control over the execution of a market order up to the time of execution. For that reason, the Commission believes that the initiating member would not satisfy the requirement in paragraph (a)(2)(i) of that rule that he not execute the order directly. The entry of an order into the CSE Trading Facility hitting an existing bid or offer involves the initiating member directly in executing the order.
36Securities Acts Amendments of 1975, Report of the Senate Comm. on Banking, Housing and Urban Affairs to Accompany S.249, S. Rep. No. 94-75, 9th Cong., 1st Sess. 99 (1975).
37See, e.g., Section 16(e) of the Act, 15 U.S.C. 78p(e); Rule 10a-1(e)(7) and (e)(8), 17 CFR 240.10a-1(e)(7) and (e)(8); Rule 15c3-1, 17 CFR 240.15c3-1; and Rule 16e-1, 17 CFR 240.16e-1.
38Cf. letter to Andrew M. Klein of the Commissions staff from Judith Shepard presenting the views of Goldman, Sachs & Co. and Salomon Brothers (Jan. 5, 1979), File No. S7-613.
39Section 3(a)(38), 15 U.S.C. 78c(a)(38), provides that the term "market maker" means "any specialist permitted to act as a dealer, any dealer acting in the capacity of block positioner, and any dealer who, with respect to a security, holds himself out (by entering quotations in an interdealer communications system or otherwise) as being willing to buy and sell such security for his own account on a regular or continuous basis."
40See March 1977 Release, Appendix A, at text accompanying nn. 55-68.
4117 CFR 240.17a-17 and 12 CFR 221.3(z)(2). Rule 17a-17 defines the term "block positioner" for purposes of that rule to mean any registered dealer or exchange member in compliance with applicable capital requirements who, among other things, (i) engages, from time to time, in the activity of buying long or selling short as principal, from or to a customer, a block of stock with a market value of $200,000 or more in a single transaction, or in several transactions at approximately the same time from a single source to facilitate a sale or purchase by such customer; (ii) sells the shares comprising the block as rapidly as possible commensurate with the circumstances; and (iii) does not hold, except under exceptional circumstances and then only for five day extension periods, such block continuously for more than 20 business days and before the expiration of such 20 business day period either extinguishes the exempt credit received or brings such credit into conformity with the initial margin requirements of Regulation U. The definition of the term "block positioner" in Regulation U parallels the definition of that term in Rule 17a-17.
4217 CFR 240.15c3-1.
43The suggested definition would have excluded purchases and sales from or to (i) a partner of the dealer or (ii) a joint venture or other entity which has as a participant a partner of the dealer, the dealer itself, or a person associated with the dealer, as defined in Section 3(a)(18) of the Act, 15 U.S.C. 78c(a)(18).
44See Securities Exchange Act Release No. 15219, (Oct. 6, 1978), 43 FR 47495 (Oct. 16, 1978). Although the term "block" is not defined in the Act or in the rules thereunder, the Commission has stated in the past that the term "block transaction" means a transaction in which a member firm, by reason of the size of the order in relation to conditions in the exchange market, reasonably concludes that it is in the interest of the customer to search and negotiate for a matching interest on the other side of the market (including negotiating as principal with the customer) rather than to accept or submit a bid or offer in the ordinary course of the auction market. Securities Exchange Act Release No. 8791 (Dec. 31, 1969). See also NYSE Rules 97.10 and 127.10, New York Stock Exchange Guide (CCH) 2097.10 and 2127.10.
45For purposes of Section 11(a)(1), a customers order may be presumed to be a block order if it represents at least 10,000 shares, or a quantity of securities that has a current market value of at least $200,000, which-ever is less. See NYSE Rule 127.10. Contrast the block guidelines under Rule 10b-10, Securities Exchange Act Release No. 15219 (Oct. 6, 1978), 43 FR 47495 (Oct. 16, 1978), and under proposed Rule 13e-2(d), Securities Exchange Act Release No. 10539 (Dec. 6, 1973), 38 FR 34341 (Dec. 13, 1973).
46Section 11(a)(1)(D) also exempts "bona fide hedge" transactions in certain securities from the prohibitions of Section 11(a)(1). The hedge exemption is discussed at text accompanying nn. 58-61, infra.
47See text accompanying nn. 39-45, supra.
48January 1976 Release, Question 1.
49See March 1977 Release, Appendix A, at text accompanying nn. 69-75.
50See March 1977 Release, Appendix A, at text accompanying nn. 69-75. Although the need for a statutory exemption for members trading is lessened in view of the Commissions effect versus execute rule, Temporary Rule 11a2-2(T) under the Act, the requirement under that rule that a member arrange to have an independent member execute the transaction may effectively prevent member firms from engaging in certain kinds of arbitrage transactions where the spread sought to be realized, or "cash flow," is sufficiently small to make the hiring of an independent broker uneconomical.
51For example, in a bona fide arbitrage between a common stock and a convertible debt security, the arbitrageur who believed the price of the common stock would decline in the immediate future might effect a short sale in the stock before making a long purchase in the convertible debt security; if the prediction were accurate, the proceeds on the short sale would be maximized and the arbitrageur could expect to acquire the convertible debt security price) declined. If, instead, the arbitrageur believed the stock price would shortly rise, he might effect the transactions in the reverse order.
52See text accompanying n. 36, supra.
53In some circumstances, an arbitrage begun in good faith may be abandoned because of unfavorable (and unexpected) market changes. In such circumstances, the failure to complete the arbitrage would not cause the transaction establishing the first leg to cease to qualify for exemption as "bona fide arbitrage" under Section 11(a)(1)(D). The question whether the first transaction was part of a contemplated arbitrage involves a factual determination. One relevant, although not necessarily determinative, consideration would be whether that transaction was effected in an account reserved primarily for arbitrage and like transactions by an exchange member regularly engaged in arbitrage. See Section 1233(f) of the Internal Revenue Code of 1954, as amended, 26 U.S.C. 1233(f), and the regulation thereunder, 26 CFR 1.1233-1(f)(3).
54One leading risk arbitrageur has described risk arbitrage activities as follows:
55The term "risk arbitrage" is customarily applied to the activities of arbitrageurs in connection with both cash and exchange tender offers, mergers and acquisitions. Section 11(a)(1)(D) refers to "any risk arbitrage transaction in connection with a merger, acquisition, or tender offer...." No distinction is made between cash offers and exchange offers. Moreover, while risk arbitrage in the context of a cash tender offer or cash merger is in some respects indistinguishable from other types of speculation on the future value of a particular security, it does resemble other forms of arbitrage and risk arbitrage in other respects. Like other forms of risk arbitrage, it involves speculation on a particular deal rather than on the corporate fortunes of the issuer or issuers involved. Like bona fide arbitrage between the prices of a security in differing markets, risk arbitrage in the context of a cash tender offer or cash merger involves differing prices for the same security in what may be viewed as two markets, the current market price and the contingent parity value if the risk arbitrage event is consummated. At the same time, of course, not every purchase of a target companys stock is undertaken as risk arbitrage. Generally, risk arbitrage (as opposed to other speculative trading not covered by Section 11(a)(1)(D) is undertaken only by professional arbitrageurs who are regularly engaged in that activity. Generally, it is undertaken for their own accounts or the accounts of their firms, but it is sometimes undertaken on behalf of others. Risk arbitrageurs generally maintain separate accounts for tax and other purposes. The presence or absence of any such factor would not be determinative, but would be relevant, as to whether a claim to the risk arbitrage exemption was proper.
56The first public announcement pertaining to such an event often does not contain the precise terms of the offer or other risk arbitrage event. Where it does not, arbitrageurs cannot determine the exact amount of the consideration to be offered. Nevertheless, the amount of the premium over market value is generally within a predictable range. In that situation, arbitrageurs generally assume that the premium will be within that range, and structure their transactions accordingly, even in the absence of an announcement of all the price terms.
57A position assumed by a risk arbitrageur could of course be maintained for tax or investment purposes after the termination or completion of the risk arbitrage event. The later liquidation of such a position would not, however, be considered to be risk arbitrage for purposes of the Section 11(a)(1)(D) exemption.
58For example, while the risk of a short stock position might theoretically be reduced by a "deep-out-of-the-money" long call position, there generally would not be any realistic expectation that the call would offset any appreciable amount of the risk assumed in the short stock position. In such a case the two positions would not involve a bona fide hedge for purposes of Section 11(a)(1)(D). At the same time, a transaction establishing an "in-the-money" or "near-the-money" long call position covering 100 underlying shares of stock could be a hedge transaction for purposes of Section 11(a)(1)(D) for part of a preexisting short stock position of much greater size.
59For example, a bona fide hedge may involve essentially contemporaneous transactions in a stock and in one or more options to buy or sell that stock where the stock and option positions so acquired reduce the risks of each other. Where a bona fide hedge position is established by contemporaneous transactions, each such transaction qualifies for the hedge exemption.
60A transaction to hedge a previously established position does not retroactively confer a hedge exemption on the transaction that established the original position. For example, a short stock position that had been established on February 1 could be hedged by a long call transaction on March 1. In that example, only the March 1 long call transaction could qualify as a bona fide hedge transaction. The February 1 short stock transaction would not, even though it later became involved in a hedge; if the transaction establishing the February 1 position had violated Section 11(a), the violation would not be cured by the March 1 transaction.
61When a hedge is liquidated, the hedge exemption applies to the transaction or transactions that eliminate the hedge, regardless of whether the transaction that originally established the position being liquidated was an exempt bona fide hedge transaction. If a hedge is eliminated by liquidating all the positions at the same time, or by legging them out, each liquidating transaction qualifies for the hedge exemption. For example, where a short stock position established on February 1 was hedged contemporaneously by a long call position, or was hedged at a later time (e.g., on March 1) by such a position, both positions could be liquidated, or "legged out," under the hedge exemptions. If, on the other hand, a hedge is eliminated by liquidating only one of the positions that constituted the hedge, only that liquidating transaction qualifies for the hedge exemption; transactions liquidating the remaining positions that had formerly been, but were no longer, part of an existing hedge would not qualify for the hedge exemption (unless a hedge had been reestablished involving those positions). For example, where the hedge referred to above was eliminated by the liquidation of only the February 1 short stock position, that transaction would qualify for the hedge exemption, but the later liquidation of the March 1 long call position would not qualify under the hedge exemption (unless a hedge had been reestablished by acquiring a third position- e.g., another short stock position).
62See letter to Andrew M. Klein of the Commissions staff from Judith Shepard, presenting the views of Goldman, Sachs & Co., and Salomon Brothers (Jan. 5, 1979), and letter to Lee A. Pickard of the Commissions staff from Pope, Ballard, Shepard & Fowle on behalf of Harris Associates, Inc. (Jan. 5, 1977), File No. S7-613. Exchange members could, after February 1, 1979, employ unaffiliated brokers, pursuant to the effect versus execute rule (Temporary Rule 11a2-2(T)), to effect the transactions between or among options. The Commission does not currently believe any useful purpose would be served in compelling exchange members to use an unaffiliated broker in order to effect such transactions.
63See March 1978 Release, at text accompanying n. 69.
64Pub. L. No. 94-29, §6 (June 4, 1975).
65In February 1975, the Senate Subcommittee on Securities of the Committee on Banking, Housing and Urban Affairs held hearings on S.249, the Senates version of the Securities Acts Amendments of 1975. At that time, Section 11(a)(1)(D) provided an exemption for "any bona fide arbitrage transaction." In its written statement (Mar. 13, 1975) to the Subcommittee, the Chicago Board Options Exchange, Inc. (the "CBOE") commented that it was important that certain members trading be preserved from the prohibition of Section 11(a)(1). The CBOE then stated:
In particular, subparagraph (D), exempting "any bona fide arbitrage transaction" is important to an options market, since arbitrage type spread transactions among the various options series and arbitrage between an options position and a position in the underlying stock serve important functions in maintaining proper price relationships and otherwise contributing to a fair and orderly market.
The CBOE apparently believed that bona fide arbitrage transactions included the hedge transactions it described in its letter. The CBOE suggested expansion of Section 11(a)(1)(D) to assure that such transactions were exempted; to accomplish this result it proposed language that is precisely the same as the language which the Congress ultimately adopted as Section 11(a)(1)(D). Hearings on S.249 before the Subcomm. on Securities of the Senate Comm. on Banking, Housing and Urban Affairs to Accompany S.249, 94th Cong., 1st Sess., Appendix at 485-486 (1975). See letter to Roger D. Blanc of the Commissions staff from Bernard H. Garil on behalf of Oppenheimer & Co. Inc. (Dec. 27, 1978), File No. S7-613.
66Such transactions may, of course, be effected pursuant to an available statutory or rule exemption under Section 11(a)(1), such as Section 11(a)(1)(E) or the effect versus execute rule (Temporary Rule 11a2-2(T)).
67Responses of Asiel & Co. (Jul. 24, 1978) and Mabon, Nugent & Co. (May 24, 1978), File No. S7-613. See Rule 11a1-1(T)(b).
68April 1978 Release, at text accompanying nn. 11-13.
69Id., at text accompanying n. 23.
705 U.S.C. 553(b)(B).
71See, e.g., Securities Exchange Act Release No. 14056 (Oct. 17, 1977), 42 FR 56706 (Oct. 27, 1977).
725 U.S.C. 553(d).
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