October 13, 2005
Dear Mr. Elliott:
In your letter dated September 30, 2005, as supplemented by telephone conversations with the staff of the Division of Market Regulation ("Division"), you requested on behalf of the Pacific Exchange, Inc. ("PCX" or "Exchange"), through its wholly owned subsidiary PCX Equities, Inc. ("PCXE"), clarification regarding Rule 10a-1 under the Securities Exchange Act of 1934, as amended ("Exchange Act"), and Rule 200(g) of Regulation SHO in connection with trades executed through the Archipelago Exchange's ("ArcaEx") Portfolio Crossing Service ("PCS") and on behalf of Equity Trading Permit Holders ("ETP Holders") that execute trades through the proposed PCS.1 Your request is limited to those trades that ETP Holders execute in the PCS process.
A copy of your letter is attached to this response. By including a copy of your correspondence, we avoid having to repeat or summarize the facts you presented. The defined terms in this letter have the same meaning as in your letter, unless otherwise noted.
In your letter you make the following representations, among others:
(i) You state that ArcaEx is an all-electronic stock market which trades equity securities listed with the New York Stock Exchange, Nasdaq, American Stock Exchange and Pacific Exchange, as well as exchange-traded funds and other exchange-listed securities. Currently, ArcaEx operates as the exclusive equities trading facility of PCXE, a wholly-owned subsidiary of the PCX. Only registered broker-dealers who have applied for and received an Equity Trading Permit are permitted to trade on ArcaEx.
(ii) You state that the ArcaEx matching engine follows price-time priority rules for displayed orders and supports additional order types to augment traditional limit and market orders. ArcaEx maintains an electronic file of orders, called the ArcaEx Book. ArcaEx ranks and maintains limit orders on the ArcaEx Book based on a number of execution processes based on order type. At the ETP Holder's option, ArcaEx may route orders that are not matched on the ArcaEx Book to a different market center for execution.
(iii) You state that the proposed PCS rules would provide ETP Holders an alternative method of trade execution and reporting for qualifying portfolio trade activity. Under the proposed rules, ETP Holders would be able to submit qualifying cross orders which are part of a portfolio basket trade in equity securities for execution. Qualifying baskets would be required to include matched buy and sell orders for a minimum of 15 securities having a minimum dollar value of $1 million. ETP Holders would be able to submit eligible orders into PCS at any time trading occurs on the Exchange (currently, 4:00 a.m. Eastern Time to 8:00 p.m. Eastern Time). However, these orders will be held by the system and will not execute until at least one minute after the close of trading on the Exchange, i.e., 8:01 p.m. Eastern Time. Each side of the coupled orders entered into PCS would execute without regard to the priority of other orders entered into PCS or ArcaEx.
In view of these representations, you have requested clarification that: (i) the executions in PCS will be exempt from the tick test of Rule 10a-1 under Rule 202T of Regulation SHO's pilot program ("Pilot Program") because such executions will occur after 8:00 p.m. Eastern Time but before 4:00 a.m. Eastern Time; and (ii) ETP Holders may mark PCS Orders submitted during the trading day as "short" rather than "short exempt" in reliance on the Order Masking Letter,2 provided that PCS as a market center meets the conditions set forth in such Order Masking Letter.
Rule 200(a) of Regulation SHO3 defines the term "short sale," and Rule 10a-1 governs short sales generally. Paragraph (a) of Rule 10a-1 covers transactions in any security registered on a national securities exchange, if trades in such security are reported pursuant to an "effective transaction reporting plan" ("Reported Securities"). A short sale of a Reported Security may not be effected at a price either: (1) below the last reported price of a transaction reported in the consolidated transaction reporting system ("minus tick"); or (2) at the last reported price if that price is lower than the last reported different price ("zero-minus tick").
Rule 202T of Regulation SHO4 is a temporary rule that creates procedures for the Commission to establish, through separate orders, a Pilot Program. Pursuant to Rule 202T, the Commission may exclude designated securities from the operation of the "tick" test of Rule 10a-1(a) and any short sale price test of any exchange or national securities association (collectively, a "Price Test"). The Commission has approved two orders relating to the Pilot Program.5 Pursuant to the Pilot Orders, there are three different categories of securities in the Pilot Program: (a) the securities identified in Appendix A of the first Pilot Order that are never subject to short sale Price Tests; (b) the securities that are eligible for the Pilot Program from 4:15 p.m. Eastern Time until the open of the consolidated tape the next day; and (c) all other securities, which are not subject to a short sale Price Test from the close of the consolidated tape until the open of the consolidated tape the next day6 (the "Category C Pilot Securities"). The Pilot Program began on May 2, 2005 and will end on April 28, 2006. The Commission may from time to time approve further orders affecting the Pilot Program.
Accordingly, on the basis of your representations and the facts presented, and without necessarily concurring in your analysis, the Division hereby confirms that executions in PCS will be exempt from the tick test of Rule 10a-1 under the Pilot Program, provided that such executions occur after the close of the consolidated tape (8:00 p.m. Eastern Time) but before the open of the consolidated tape the next day (4:00 a.m. Eastern Time). This interpretation is subject to change in the event that the times at which the consolidated tape opens and closes change in the future. In addition, the suspension of the tick test for the Pilot Securities will expire upon termination of the Pilot Program, currently scheduled for April 28, 2006.
Rule 200(g) of Regulation SHO provides that a broker-dealer must mark all sell orders of any equity security as "long," "short," or "short exempt." Rule 200(g)(2) requires that a short sale order must be marked "short exempt" if the seller is relying on an exception from the tick test of Rule 10a-1 of the Exchange Act or any short sale Price Test of any exchange or national securities association. Since short sales in Pilot Securities effected during any pilot period would be exempt from any such Price Test, these orders would be required to be marked "short exempt." However, on April 15, 2005, the Division issued the Order Masking Letter to the Securities Industry Association confirming that the Division would not recommend to the Commission enforcement action against a broker-dealer that marks "short," rather than "short exempt," a short sale effected in any security included in the Regulation SHO Pilot Program.7 Each broker-dealer relying on the Order Masking Letter must route orders during the Pilot Program to market centers that have certain "masking" processes in place. Because PCS Orders will not be subject to the tick test, as they qualify as "Category C Pilot Securities," an ETP Holder may mark such orders as "short," rather than "short exempt," if all of the conditions set forth in the Order Masking Letter are satisfied.
Accordingly, on the basis of your representations and the facts presented, and without necessarily concurring in your analysis, the Division hereby confirms that ETP Holders may mark PCS Orders submitted during the trading day as "short" rather than "short exempt" in reliance on the Order Masking Letter relating to Pilot Securities, provided that PCS as a market center meets the conditions set forth in the Order Masking Letter.8 This interpretation is also subject to change in the event that the times at which the consolidated tape opens and closes changes in the future. In addition, the suspension of the tick test for the Pilot Securities will expire upon termination of the Pilot Program, currently scheduled for April 28, 2006.
The foregoing interpretations regarding Rule 10a-1 of the Exchange Act and Rule 200(g) of Regulation SHO are based solely on your representations and the facts presented, and are strictly limited to the application of these rules to the proposed transactions as described above. Such transactions should be discontinued, pending presentation of the facts for our consideration, in the event that any material change occurs with respect to any of those facts and representations. The interpretations are subject to modification or revocation if at any time the Commission or the Division determines that such action is necessary or appropriate in furtherance of the purposes of the Exchange Act.
In addition, your attention is directed to the anti-fraud and anti-manipulation provisions of the Exchange Act, particularly Sections 9(a) and 10(b), and Rule 10b-5 thereunder. Responsibility for compliance with these and any other applicable provisions of the federal securities laws must rest with the Exchange. The Division expresses no view with respect to any other questions that the proposed transactions may raise, including, but not limited to, the adequacy of the disclosure concerning, and the applicability of any federal or state laws to, the proposed transactions.
Very truly yours,
James A. Brigagliano
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