Self-Regulatory Organizations; American Stock Exchange LLC; Order Approving Proposed Rule Change To Rescind Exchange Rule 106, “Substitute Principals”

I. Introduction

On September 1, 1999, the American Stock Exchange LLC (“Amex” or “Exchange”) submitted to the Securities and Exchange Commission (“SEC” or ‘Commission”) pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (‘Act”), and Rule 19b-4 thereunder, a proposed rule change to rescind Exchange Rule 106. The proposed rule change was published for comment in the Federal Register on October 22, 1999. The Commission did not receive any comment letters with respect to the proposal. This order approves the Exchange's proposal.

II. Description of the Proposal

The Amex proposes to delete Exchange Rule 106, “Substitute Principals.” Exchange rule 106 currently provides that: “No party to a contract shall be compelled to accept a substitute principal unless the name proposed to be substituted was declared in, and as part of, the bid or offer giving rise to the contract.” Rule 106 dates back to the 1921 Constitution of the New York Curb market, a predecessor of the Exchange. The Rule's original purpose appears to be related to the clearance and settlement of trades, specifically, the terms of contracts and the creditworthiness of counterparties. The proposed rule change was filed in response to a recent dispute where an Exchange member invoked Rule 106 in an attempt to renege on a contract. Apparently, the Exchange member's counterparty provided an incorrect give-up at the time of the trade, and later sought to correct the error by substituting the correct clearing member.

III. Discussion

For the reasons discussed below, the Commission finds that the proposed rule change is consistent with the Act and the rules and regulations under the Act applicable to national securities exchange. In particular, the Commission believes the proposed rule change is consistent with the Section 6(b)(5) requirements that the rules of an exchange be designed to promote just and equitable principles of trade, prevent fraudulent and manipulative acts and practices, and protect investors and the public interest. The Commission also finds that the proposal may serve to remove impediments to and perfect the mechanism of a free and open market by rescinding Rule 106, which provides a potential basis for parties to Exchange contracts to break trades without appropriate justification.

Since Exchange Rule 106 was adopted in 1921 the process of clearance and settlement has evolved. Broker-dealers no longer compare individual trades as was the case at the time of the inception of Exchange Rule 106. Today, trades executed on the Amex are required to be cleared and settled through a registered clearing agency. Typically, clearing agencies guarantee the completion of a transaction by becoming the counterparty to each side of the transaction. This has substantially reduced the risk of trade default and made concerns about counterparty identity largely irrelevant.

Clearing agencies perform comparison, clearance, and settlement of trades. Clearance activities confirm the identity and quantity of the security being bought or sold, the transaction price and date, and the identity of the buyer and the seller, Settlement is the fulfillment, by the parties to the transaction, of the obligations of the trade.

The largest clearing agency is the National Securities Clearing Corporation (“NSCC”), which acts as the contraside to every trade it processes. The NSCC guarantees the trades of its member participants and incurs the risk of default from the time of the guarantee until the settlement of obligations and payments. Thus, it is the NSCC and not the Exchange member—as was the case in 1921—who assumes counterparty risk. When the NSCC guarantees a trade, it becomes the buyer to every seller and the seller to every buyer. As a result, the clearing corporation incurs the risk that a counterparty to a transaction might default on its obligations.

Rule 106 was adopted in another era, prior to the utilization of modern clearing practices. The total assumption of default risk by clearing agencies has obviated the need for Exchange members to maintain strict control over the identify of trading counterparties. Because clearing corporations like NSCC eliminate the risk of trade default, trades are guaranteed irrespective of the identity of a counterparty. Thus, in light of clearance corporations and modern clearance and settlement practices, Rule 106 no longer serves the purpose of protecting a counterparty from the default risks associated with a trade.

Furthermore, Rule 106 may have the disruptive effect of permitting parties to Exchange contracts to break trades without appropriate justification. This kind of action is contrary to the goals of preserving the public's interest and protecting investors. The Commission therefore believes it is appropriate for the Exchange to rescind Rule 106.

IV. Conclusion

It is therefore ordered, pursuant to Section 19(b)(2) of the Act, that the proposed rule change (SR-Amex-99-35) is approved.

For the Commission, by the Division of Market Regulation, pursuant to delegated authority.