American Stock Exchange
Chicago Board Options Exchange, Incorporated
International Securities Exchange, Inc.
The Options Clearing Corporation
Pacific Exchange, Inc.
Philadelphia Stock Exchange
March 1, 2004
Mr. Jonathan G. Katz
Secretary
Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549
Re: File No. S7-05-04
Dear Mr. Katz:
The American Stock Exchange, the Chicago Board Options Exchange, Incorporated, the International Securities Exchange, Inc., The Options Clearing Corporation, the Pacific Exchange, Inc., and the Philadelphia Stock Exchange, Inc., appreciate the opportunity to comment on File No. S7-05-04, Collection Practices Under Section 31 of the Exchange Act ("the Release").1 Our comment letter addresses only the application of the proposed rules to the options markets. In the Release, the Securities and Exchange Commission ("Commission") proposes rules applicable to the method of calculation and payment of fees payable under Section 31 of the Securities Exchange Act of 1934 ("Exchange Act"). The Commission has never before prescribed either the method for calculating or paying these fees. One of the Commission's reasons for proposing this rule is a concern that the diverse methods of paying Section 31 fees "may create uncertainties about whether the proper amounts due pursuant to Section 31 are being paid to the Commission."2
The Release proposes significant changes from current practice in the way that fees on sales of exchange-traded options and fees on sales of securities resulting from the exercise of physical delivery exchange-traded options are paid. In our view, these changes will create inefficiencies in the collection of Section 31 fees and impose new burdens on both the options exchanges and the National Association of Securities Dealers ("NASD") without providing any benefit to the Commission or increasing the certainty that the correct amount of Section 31 fees is being collected on options and options exercise transactions. Rather, the Commission's proposal would create inefficiency and duplication of efforts, which could lead to potential errors and the very uncertainty that the Commission is seeking to avoid. We recommend that the Commission adopt final rules that would permit the current system for collecting and paying Section 31 fees on options and options exercise transactions to continue with minor modifications.3
Currently, the Options Clearing Corporation (OCC) computes, bills and collects Section 31 fees from its clearing members and remits them to the Commission as a centralized service to its six options exchanges and two security futures exchanges.4 OCC has provided this service since the inception of the trading of exchange-traded options over 30 years ago. OCC aggregates a lump-sum amount of all Section 31 fees collected and wire transfers this payment to the Commission on or before March 15 and September 30 of each year. OCC currently does not have the ability to determine the amount being paid on behalf of each exchange. In addition, OCC does not currently provide the Commission with information distinguishing the amount of Section 31 fees being paid as the result of options transactions from those being paid as a result of options exercise transactions.
OCC's centralized collection and payment of Section 31 fees on behalf of the options exchanges is very efficient and cost effective for both its clearing members and exchanges. OCC has in place a system to calculate and bill its clearing members for all Section 31 fees due from the sale of all exchange-traded options, wherever the transaction occurred, and the sales of securities resulting from the exercise of physical delivery exchange-traded options, on a monthly basis. The use of a centralized system, rather than up to six separate systems by different exchanges, makes it easy for clearing members to maintain records on the amount of Section 31 fees paid on all options and options exercise transactions. The use of a centralized system frees exchange personnel to work on developing and maintaining trading systems that provide unique benefits to their members and customers, rather than building and maintaining billing systems that duplicate OCC's system or the systems on other options exchanges.
The Commission is proposing several changes to the current system. Each exchange would have to file a monthly report with the Commission detailing, among other things, the aggregate dollar amount of sales of options that occurred on the exchange during the previous month. Under the proposed rules, OCC would be required to provide this figure to each of its exchanges so that they could file the report. The Commission would issue a bill for Section 31 fees to each exchange based on the monthly report. The proposed rules require the exchange, not OCC acting on behalf of the exchange, to pay Section 31 fees to the Commission on March 15 and September 30 of each year. The Commission advances two reasons for not permitting OCC to pay Section 31 fees on behalf of the options exchanges. First, Section 31 places responsibility for the payment of Section 31 fees on an exchange. Second, the Commission is concerned that "the proposed rule would be more difficult to administer if it had to track multiple payments made by or on behalf of each covered SRO."5 Four of the six options exchanges for which OCC clears also trade equities.
The Release asks whether the Commission should allow an exchange to request a clearing agency to pay Section 31 fees on its behalf. We emphatically believe that the Commission should permit the current practice to continue in this regard. The Commission has not articulated any reason that requires a change in the current system of collection and payment of Section 31 fees on options. Section 31 clearly makes exchanges responsible for the payment of Section 31 fees. However, nothing in the Exchange Act prohibits regulated entities from using an agent to perform a statutory duty, so long as the regulated entity remains responsible for performance of the duty. In fact, this sort of delegation is not uncommon respecting other SRO responsibilities, such as arbitration programs.6 If the Commission permits the options exchanges to outsource or delegate the responsibility to pay Section 31 fees to the OCC, the exchanges will remain responsible for their payment. If it would increase the Commission's comfort level, we would not object if the Commission required that any arrangement to have a clearing agency pay Section 31 fees on behalf of an exchange be contained in a written agreement which states that the exchange retains ultimate liability for payments of these fees.
The Commission should be confident that OCC has the information that it needs to properly bill clearing members for Section 31 fees because it is relying on OCC to provide the information that the exchanges need to file their monthly reports. This reliance is well founded because, as the Commission states, "market participants have a strong incentive to ensure the accuracy of trade data reported to the clearing agencies.7" OCC will be ready to provide the Commission with information specifying the amount that it is paying on behalf of each exchange by the time that the Commission finalizes its Section 31 fee collection rules. This information will assist the Commission in determining if it is receiving the correct amount from each exchange. Since the Commission will be receiving two payments from four of the exchanges for which OCC clears options and one payment from the other two options exchanges, it should not be unduly burdensome for the Commission to keep track of these payments.
If the Commission does not permit OCC to pay Section 31 fees on sales of options on behalf of the options exchanges, the administrative burden on exchanges will increase without any benefit to the Commission. The Release is not clear on the issue of whether exchanges are required to collect Section 31 fees themselves as part of their responsibility to pay Section 31 fees or whether OCC may continue to collect Section 31 fees and then forward them to the exchanges for payment to the Commission. Requiring the exchanges to bill for and collect Section 31 fees would be very inefficient. The exchanges would have to divert scarce resources from existing technology projects which are usually centered on increasing value for customers in order to build six separate billing systems that replicate OCC's existing system. OCC clearing members would no longer be able to receive one Section 31 fee bill for options. Instead, they would receive up to six bills, which will increase their administrative costs. The creation of six separate billing systems for Section 31 fees will not increase the certainty that the Commission is receiving the correct amount of Section 31 fees on options transactions, because, under the proposal, the exchanges will be billing their members based on data from OCC. Even if the Commission allows OCC to continue to collect Section 31 fees but requires OCC to transmit these funds to the exchanges for payment to the Commission, this change will not add value, only complexity, to the current efficient process. We urge the Commission to permit OCC to continue to collect Section 31 fees as well as pay them to the Commission on behalf of any options exchange that requests this service.
The Commission is proposing to have a national securities association, currently the NASD, pay Section 31 fees resulting from the exercise of exchange-traded options. Under the proposed rules, NASD would include the aggregate dollar amount of sales of securities resulting from the exercise of physical delivery exchange-traded options in the previous month on its monthly report. OCC would be required to provide this data to NASD. The Commission concluded that NASD is the correct entity to pay Section 31 fees resulting from option exercise by a process of elimination. OCC currently does not attribute options exercises to any exchange. This is because operationally the exercise of an option takes place through instructions communicated by the holder of the option to OCC, rather than to or through an exchange. From this, the Commission concluded that option exercises do not occur on an exchange, and, therefore, NASD is the proper entity to pay Section 31 fees on these transactions.8
However, that conclusion is inconsistent with the historical interpretation of Section 31 and with Rule 12a-6(b)(2) under the Exchange Act9, and would create more problems than it would solve. First, Section 31 (c) states that "each national securities association shall pay a fee…of the aggregate dollar amount of sales transacted by or through any member of such association..."10 A number of options specialists and market makers are not required to be, and are not, members of NASD. These market participants exercise options as part of their market making function. In addition, not all OCC clearing members (a group that includes seven Canadian broker-dealers) are members of NASD. If exercises were deemed to take place otherwise than on a national securities exchange, Section 31 fees would not be payable on options exercises by non-NASD members clearing through non-NASD members, because Section 31(c) fees are payable on off-exchange trades only where they are transacted by or through NASD members. Since NASD could not collect Section 31 fees on these transactions by virtue of the statutory language, the Commission would have to forego this revenue. In addition, this result would be unfair to non-NASD members who do clear through NASD members, a group that includes the vast majority of retail investors.
Second, NASD has absolutely no nexus to options trading. NASD neither operates an options exchange nor clears options transactions. It is more logical for OCC to pay these fees, as OCC has long-been not just the clearing agency for options, but, of course, the issuer of options as well. Third, NASD would have to build a new system to bill OCC's clearing members based on information that OCC provides to NASD. The Commission estimates that this system development work will take only 15 staff hours. We find this estimate to be surprisingly low considering that the Commission estimates that it would take OCC 180 staff hours to modify its existing systems to identify the exchange on which a particular options transaction occurs. We cannot estimate how many staff hours NASD would require modifying its Section 31 billing system to handle options exercises but we are confident that it will be significantly greater than the 15 hours estimated by the Commission. In addition, this new system likely would duplicate OCC's existing billing system. Fourth, NASD would have to await payment from OCC clearing members while OCC has the ability to collect amounts due without any action by the clearing member pursuant to its existing collection mechanism. Fifth, OCC clearing members would be required to pay one entity for Section 31 fees incurred for options transactions (assuming that OCC is allowed to continue to collect such fees) and another for Section 31 fees incurred on exercises. This bifurcation of payments would require systems changes by all OCC clearing members. These issues make the need for an alternative to the proposed rules obvious and we believe that placing the responsibility on the NASD would cause inefficiencies and burdens in the options industry.
The multiple issues that arise with NASD payment of Section 31 fees on exercises can be avoided. The logical and most efficient manner of collecting and paying the Section 31 fees on exercises is for the Commission to continue, as in the past, to treat them as exchange transactions, and for OCC to continue to collect and pay the related fees on behalf of the options exchanges. OCC can modify its system to attribute options exercises to exchanges based on their market share for the previous month. Each exchange could then report this information, separately from information on sales of options, to the Commission on its monthly report. Section 31(a) requires the Commission to collect transaction fees. In discharging this responsibility, the Commission has the ability to determine how to collect transaction fees on a type of transaction that did not exist when Section 31 became law. Exchange-traded options did not begin to trade until nearly 40 years after Section 31 was enacted. Perhaps this is the reason that the payment of Section 31 fees resulting from the exercise of exchange-traded options does not fit neatly into the language of Section 31. However, it is clear that Section 31 fees should be paid on the sales of securities that result from the exercise of physically delivered exchange-traded options just as on the sales of other securities. The Commission could determine that since options exercise transactions are the direct result of options that were transacted on an exchange, the fees on exercise should be paid by an exchange. Our proposed solution, while imperfect, takes advantage of OCC's efficient existing collection system and minimizes burdens on OCC clearing members while insuring that the Commission receives the Section 31 fees due it from the exercise of physically delivery exchange-traded options.
* * * *
Thank you again for the opportunity to comment on the proposed rules on collection practices under Section 31. If you would like to discuss any of the issues raised in this letter, please contact Susan Milligan at the Options Clearing Corporation at (202) 756-1972.
Sincerely,
American Stock Exchange
Chicago Board Options Exchange, Incorporated
International Securities Exchange, Inc.
The Options Clearing Corporation
Pacific Exchange, Inc.
Philadelphia Stock Exchange, Inc.
Endnotes
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