New Exercise Advice Procedures For Expiring Equity Options

Executive Summary

New uniform provisions regarding the exercise cut-off rules for expiring equity options will become effective commencing with the February 1995 expiration at each of the five registered national options exchanges and the National Association of Securities Dealers, Inc, (the SROs).¹ This circular describing these new provisions and requirements was prepared by the SROs acting jointly as members of the Intermarket Surveillance Group (ISG).

The exercise cut-off rules continue to require that exercise decisions relating to expiring equity options that are contrary to the Options Clearing Corporation's (OCC) Exercise-by-Exception (Ex-by-Ex)² procedure, be made and recorded by clearing firms prior to 5:30 p.m. Eastern Time, 4:30 p.m. Central Time, or 2:30 p.m. Pacific Time on the last business day prior to expiration (i.e., the exercise cut-off time). The new rules, however, required that evidence of such contrary exercise decisions must also be submitted in the form of a Contrary Exercise Advice to an eligible options exchange³ or directly to OCC prior to the cut-off time.

Contrary Exercise Advices represent decisions of an option holder to either (1) exercise an out-of-the-money expiring equity options position or (2) not exercise an in-the-money expiring equity options position, as defined by the Ex-by-Ex procedures of OCC Rule 805. In addition, cancellations or changes to previously submitted Contrary Exercise Advices also must be submitted to an eligible exchange or to OCC prior to the cut-off time.

Member organizations that maintain standing instructions from customers or market makers to routinely exercise options contracts at closing values below the OCC Exercise-by-Exception parameters, will not be required to submit a Contrary Exercise Advice in those instances where the closing value meets or exceeds the standing instruction. Member organizations must retain such dated standing instructions on file and submit copies of the instructions to each options SRO of which they are a member (market-maker standing instructions need only be forwarded to the exchange where the market maker is a member). Should a customer or member elect to take action on a specific occasion that differs from a standing instruction, a Contrary Exercise Advice must be submitted in the prescribed form and the member organization must prepare for its files a time-stamped written memorandum prior to the exercise cut-off time detailing the change.

The rules require member organizations that maintain proprietary or customer account positions in expiring equity options to be responsible for ensuring that Contrary Exercise Advices are communicated to an eligible exchange or directly to OCC (by OCC clearing members) regarding such positions. In addition, member organizations may make arrangements to indicate their final exercise decisions to an OCC clearing member that has accepted the responsibility to submit Contrary Exercise Advices on their behalf. The OCC clearing member shall take reasonable steps to ensure that such decisions are properly submitted to an eligible exchange or directly to OCC.

Contrary Exercise Advices must be submitted at the place designated by each exchange. In the alternative, Contrary Exercise Advices may be submitted by OCC clearing members directly to OCC via the electronic Clearing Management and Control System (C/MACS). A sample of a Contrary Exercise Advice Form (see Attachment 1) used for manual submission to an exchange is attached, as well as a sample of OCC's automated C/MACS Contrary Exercise Advice page (see Attachment 2), to be used for electronic submissions.

It should be noted that the responsibility of providing an explanation regarding late submissions or the failure to submit a Contrary Exercise Advice (under the extraordinary circumstance exception of the Rules), is the responsibility of the member or member organization holding the options position, unless that member or member organization has appropriately submitted the instruction to a clearing member that has agreed to make the submission on that member's or member organization's behalf. Explanations relating to extraordinary circumstances must be submitted by members or member organizations to each SRO of which they are a member on the business day following expiration.

Member organizations may wish to establish a time by which customers must inform them of contrary exercise intentions. Such times should be sufficiently prior to the SROs' exercise cut-off time to allow the clearing member adequate time for the processing of Contrary Exercise Advices.

It is important to note that, while submission of a Contrary Exercise Advice evidences that a contrary exercise decision was made prior to the exercise cut-off time, it does not serve as an effective notice to OCC to exercise or not exercise the option in question. The Expiration Saturday procedure for the submission of exercise notices to OCC is not affected by these new procedures.

The primary purpose of these new provisions is to promote fairness among options market participants by ensuring compliance with the SROs' exercise cut-off rules. In this regard, members and member organizations are hereby advised that a decision to either exercise an option that is out-of-the-money, or not exercise an option that is in-the-money, on the basis of news obtained after the exercise cut-off time will be deemed to be conduct inconsistent with just and equitable principles of trade in violation of exchange and NASD rules, and may also be fraudulent activity in violation of the federal securities laws.

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Questions regarding the new provisions may be directed to the Market Surveillance representatives at each of the following SROs or OCC:

AMEX: George Peckman
(212) 306-1550

CBOE: Jeffrey Schroer
(312)786-7716

NASD: Joseph Alotto
(301) 590-6845

NYSE: Hope Duffy
(212) 656-6197

OCC: Stan Schretter
(312)322-4534

PHLX: Rick McDonald
(215) 496-5407

PSE: Thao Ngo
(415) 393-7957.

¹ American Stock Exchange – Rule 980 Chicago Board Options Exchange – Rule 11.1 National Association of Securities Dealers, Inc. – Uniform Practice Code, Section 63 New York Stock Exchange – Rule 780 Philadelphia Stock Exchange – Rule 1042 Pacific Stock Exchange – Rule 6.24

² Under OCC's Exercise-by-Exception procedure, expiring equity options that are 3/4 of a point or more in-the-money for customer accounts and 1/4 of a point or more for firm or market-maker accounts are automatically exercised. Expiring options that are below these parameters, will be exercised only if the OCC clearing member holding the position submits an Exercise Notice to OCC.

³ An eligible exchange is an exchange of which a member or member organization is a member and which lists a particular option.

Attachment 1

Attachment 2

INSTRUCTIONS:

1. ENTER THE QUANTITY NOT TO BE EXERCISED IF THE SERIES IS IN THE MONEY BY THE THRESHOLD AND WILL BE EXERCISED BY OCC.

2. ENTER THE QUANTITY TO BE EXERCISED IF THE SERIES IS NOT IN THE MONEY BY THE THRESHOLD AND WILL NOT BE EXERCISED BY OCC.

SEQUENCE