[Federal Register Volume 61, Number 15 (Tuesday, January 23, 1996)]
[Notices]
[Pages 1791-1796]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-835]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-36710; File Nos. SR-Amex-94-56, SR-CBOE-95-14, and SR-
PSE-95-01]
Self-Regulatory Organizations; American Stock Exchange, Inc.;
Chicago Board Options Exchange, Inc.; and Pacific Stock Exchange, Inc.;
Order Approving Proposed Rule Changes and Notice of Filing and Order
Granting Accelerated Approval of Amendments Thereto Relating to Buy-
Write Option Unitary Derivatives (``BOUNDs'')
January 11, 1996.
Pursuant to Section 19(b) of the Securities Exchange Act of 1934
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ the American Stock
Exchange, Inc. (``Amex''), Pacific Stock Exchange, Inc. (``PSE''), and
Chicago Board Options Exchange, Inc. (``CBOE'') (collectively, the
``Exchanges'') submitted to the Securities and Exchange Commission
(``SEC'' or ``Commission''), proposed rule changes (``proposals'') to
permit trading in Buy-Write Options Unitary Derivatives
(``BOUNDs'').\3\
\1\ 15 U.S.C. Sec. 78s(b)(1) (1988 & Supp. V 1993).
\2\ 17 CFR 240.19b-4 (1994).
\3\ The Amex, CBOE, and PSE rule filings were submitted on
December 12, 1994, February 1, 1995, and February 6, 1995,
respectively. On December 23, 1994, the Amex submitted Amendment No.
1 (``Amex Amendment No. 1'') to its filing to provide that BOUNDs
will be listed with a maximum expiration date corresponding to the
longest prescribed long-term equity options (``LEAPs'') then
available for trading, which is currently 39 months. See Letter from
William Floyd-Jones, Jr., Assistant General Counsel, Amex, to
Michael Walinskas, Derivative Products Regulation, SEC, dated Dec.
23, 1994. The Amex originally proposed listing BOUNDs with 60 month
expirations and extending the maximum duration of LEAPs from 39
months to 60 months.
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Notice of the proposed rule changes and Amex Amendment No. 1 were
published for comment and appeared in the Federal Register.\4\ Two
comment letters were received in response to the Amex proposal,\5\ and
one letter was submitted in response to the CBOE and PSE proposals.\6\
The Amex responded to both comment letters.\7\
\4\ See Securities Exchange Act Release Nos. 35327 (Feb. 3,
1995), 60 FR 7805 (Feb. 9, 1995) (Amex); 35430 (March 2, 1995), 60
FR 12991 (March 9, 1995) (CBOE); and 35436 (March 2, 1995), 60 FR
12998 (March 9, 1995) (PSE).
\5\ See Letters to Jonathan G. Katz, Secretary, SEC, from James
E. Buck, Senior Vice President and Secretary, NYSE, dated February
27, 1995; and Carl F. Koenemann, Executive Vice President and Chief
Financial Officer, Motorola, Inc., dated March 1, 1995.
\6\ See Letter from James E. Buck, Senior Vice President and
Secretary, NYSE, dated March 15, 1995 to Jonathan G. Katz,
Secretary, SEC. This letter incorporates the same comments raised by
the NYSE in response to the Amex proposal.
\7\ See Letter from William Floyd-Jones, Jr., Assistant General
Counsel, Amex, to Stephen Youhn, Esq., Derivative Products
Regulation, SEC, dated March 21, 1995.
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The Amex subsequently submitted Amendments No. 2 and 3 to the
proposal on December 19, 1996 (``Amex Amendment No. 2'') and January
11, 1995 (``Amex Amendment No. 3'').\8\ The CBOE subsequently submitted
Amendment No. 1 (``CBOE Amendment No. 1'') to the proposal on January
4, 1996.\9\ The PSE subsequently submitted Amendments No. 1, 2, and 3
to the proposal on June 27, 1995 (``PSE Amendment No. 1''), January 2,
1996 (``PSE Amendment No. 2''), and January 4, 1996, respectively
(``PSE Amendment No. 3'') (collectively, with all of the Exchanges'
amendments, the ``Amendments'').\10\
\8\ See Letters from William Floyd-Jones, Jr., Assistant General
Counsel, Amex, to Michael Walinskas, Derivative Products Regulation,
SEC dated December 15, 1995 and to Stephen Youhn, SEC, dated January
11, 1996, respectively.
\9\ See Letter from Janet Angstadt, Schiff Hardin & Waite, to
Michael Walinskas, SEC, dated January 4, 1996.
\10\ See Letters from Michael Pierson, Senior Attorney, PSE, to
Stephen M. Youhn, SEC, dated June 20, 1995, December 29, 1995, and
January 3, 1996, respectively.
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Amex and PSE Amendments No. 2 and CBOE Amendment No. 1 primarily
relate to the elimination of certain spread margin treatment provisions
and the conforming of the Exchanges' rules to those of the Options
Clearing Corporation (``OCC'') in order to avoid potential conflict. In
addition, Amex Amendment No. 2 and CBOE Amendment No. 1 also clarify
that their respective ``ten-up rules'' (Amex Rule 958A and CBOE Rule
8.51) will not be applicable to the trading of BOUNDs. Amex and PSE
Amendments No. 3 and CBOE Amendment No. 1 eliminate the use of escrow
receipts and letters of guarantee as adequate margin cover for short
BOUNDs positions. Finally, PSE Amendment No. 1 establishes that BOUNDs
are designated as Tier I securities for purposes of PSE Rule 3. This
order approves the proposals, as amended.
I. Description of the Proposal
The Exchanges, for some time, have sought a replacement for the
expired Americus Trust PRIMEs and SCOREs (``PRIMEs and SCOREs'').\11\
During this process, the Exchanges began to list and trade a
standardized option product called LEAPs. Like SCOREs, LEAPs enable
investors to receive the benefits of a stock's price appreciation above
a fixed dollar amount over a long period of time. Currently, however,
there is no generally available replacement for the PRIMEs component.
\11\ PRIMEs and SCOREs were unit investment trusts that allowed
investors to separate their common stock securities holdings into
distinct trading components representing discrete interests in the
income and capital appreciation potential of the securities
deposited in the trust. See Securities Exchange Act Release No.
21863 (March 18, 1985), 50 FR 11972 (March 26, 1985) (``PRIMEs
Adopting Release'').
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The Exchanges, accordingly, propose to list BOUNDs as a replacement
for PRIMEs. BOUNDs will offer essentially the same economic
characteristics as covered calls with the added benefits that BOUNDs
can be traded in a single transaction and are not subject to early
exercise. BOUND holders will profit from appreciation in the underlying
stock's price up to the strike price until expiration and will receive
payments equivalent to any cash dividends declared on the underlying
stock. As with PRIMEs, the strike price will serve as a ``cap'' to
effectively limit the amount of upside appreciation an investor may
receive.
OCC will be the issuer of all BOUNDs traded on the Exchanges, which
are proposed to be treated as standardized options pursuant to Rule 9b-
1 of the Act (``Rule 9b-1'').\12\ As with all OCC issued options,
BOUNDs will be created when an opening buy or an opening sell order are
executed and the execution of such orders will increase the open
interest in BOUNDs. On the dividend payable date for the underlying
stock, OCC will debit all accounts with short positions in BOUNDs and
credit all accounts with long positions in BOUNDs with an amount equal
to the cash dividend on the underlying stock.\13\ Except as described
herein, BOUNDs will be subject to the rules governing standardized
options.
\12\ 17 CFR 240.9b-1 (1994).
\13\ See Amex and PSE Amendments No. 2 and CBOE Amendment No. 1.
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The Exchanges anticipate listing BOUNDs on those underlying
securities that have listed LEAPs. The criteria for stocks underlying
BOUNDs will be same
[[Page 1792]]
as the criteria for stocks underlying LEAPs.\14\
\14\ See, e.g., Amex Rule 915.
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The Exchanges also anticipate that the sum of the market prices of
a LEAP and a BOUND on the same underlying stock with the same
expiration and exercise price will closely approximate the market price
for the underlying stock. The Exchanges further believe that certain
BOUNDs-related arbitrage strategies will help to ensure this price
relationship with the underlying security. Nevertheless, the Exchanges
will conduct surveillance of BOUNDs in the same manner it surveils
listed equity options.\15\
\15\ See Amex and PSE Amendments No. 2 and CBOE Amendment No. 1.
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BOUNDs will have the same expiration dates as their respective
LEAPs, however, the Exchanges will list only strike prices that are the
same or very close to the price of the underlying stock at the time of
listing, or that are below the price of the stock at that time. For
example, at the time of initial listing, the strike prices for a BOUND
with the underlying stock trading at $50 per share, would be set at $40
and $50. An Exchange would not list a BOUND with a strike price of $60
in this example.
The Exchanges anticipate listing new complementary LEAPs and BOUNDs
on the same underlying securities annually, or at more frequent
intervals, depending on market demand. The Exchanges have the current
authority to list LEAPs with up to 39 months until expiration and,
therefore, seek to introduce BOUNDs with up to the same 39 month
duration.\16\
\16\ The Amex originally proposed listing BOUNDs with 60 month
expirations and extending the maximum duration of LEAPs from 39
months to 60 months. See Amex Amendment No. 1.
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Like regular options, BOUNDs will trade in standardized contract
units of 100 shares of underlying stock per BOUND so that at
expiration, BOUND holders will receive 100 shares of the underlying
stock for each BOUND contract held if, on the last day of trading, the
underlying stock closes at or below the strike price. However, if at
expiration the underlying stock closes above the strike price, the
BOUNDs contract holder will receive a cash payment equal to 100 times
the BOUND's strike price for each BOUND contract held. BOUND writers,
depending on the price of the underlying stock at expiration, will be
required to deliver either 100 shares of the underlying stock for each
BOUND contract (if the price of the underlying stock is at or less than
the strike price) or the strike price multiplied by 100 at expiration
(if the price of the underlying exceeds the strike price). This
settlement design, from the perspective of the long BOUNDs holder, is
economically similar to the situation where an investor purchases a
covered call (i.e., long stock, short call) and holds that position to
the expiration of the call option.
For example, if the XYZ BOUND has a strike price of $50 and XYZ
stock closes at $50 or less at expiration, the holder of the XYZ BOUND
contract will receive 100 shares of XYZ stock. This is the same result
as if the call option in a covered call position had expired out of the
money; i.e., the option would expire worthless and the writer would
retain the underlying stock. If XYZ closes above $50 per share, then
the holder of an XYZ BOUND will receive $5,000 in cash (100 times the
$50 strike price). This mimics the economic result to the covered call
writer when the call expires in the money.
The settlement mechanism for the BOUNDs will operate in conjunction
with that of LEAP calls. For example, if at expiration the underlying
stock closes at or below the LEAP strike price, the LEAP call will
expire worthless, and the holder of a corresponding BOUND contract will
receive 100 shares of stock from the short BOUND. If, on the other
hand, the LEAP call is in the money at expiration, the holder of the
LEAP call is entitled to 100 shares of stock from a short LEAP upon
payment of the proper exercise amount, and the holder of a BOUND
contract is entitled to the cash equivalent of the strike price times
100 from the short BOUND. An investor long both a LEAP and a BOUND,
where XYZ closes above the $50 strike price at expiration, would be
entitled to receive $5,000 in cash from the short BOUND and, upon
exercise of the LEAP, would be obligated to pay $5,000 to receive 100
shares of XYZ stock.
An investor long the underlying stock, and who writes both a LEAP
and a BOUND, will be obligated to deliver the stock to the long LEAP
call if the underlying stock closes above the strike price, in exchange
for payment of the strike price times 100, which amount will then be
delivered to the long BOUND. Accordingly, the Exchanges believe a
covered BOUND/LEAP writer's position is effectively closed upon the
delivery of the underlying stock. If a writer of both instruments has
deposited cash or securities other than the underlying stock as margin
for a short LEAP call and BOUND, then the BOUND/LEAP writer delivers
100 shares of stock (purchased on the open market) to the long LEAP
call upon payment of the strike price times 100. The writer of the
BOUND then delivers the cash value of 100 times the strike price to the
holder of the long BOUND.
It should be noted that LEAPs are American-style options whereas
BOUNDs are European-style.\17\ The Exchanges believe that it would be
inappropriate for the BOUND holder to have an American-style exercise
right since the BOUND will tend to trade at a discount to the price of
the underlying stock and BOUND strike price.
\17\ A European-style option may only be exercised during a
limited period of time before the option expires. An American-style
option may be exercised at any time prior to its expiration.
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Sales Practices
BOUNDs will be subject to the Exchanges' sales practice and
suitability rules applicable to standardized options. Accordingly,
BOUNDs will only be sold to investors whose accounts have been approved
for options trading.
Adjustments
BOUNDs will be subject to adjustments for corporate and other
actions in accordance with the rules of OCC. Furthermore, the Options
Price Reporting Authority represents that it has the necessary systems
capacity to accommodate any new series that would result from the
introduction of BOUNDs.\18\
\18\ See Memorandums from Joe Corrigan, OPRA, to Michael
Walinskas, SEC, dated December 26, 1995 (``Amex OPRA Letter'');
Eileen Smith, CBOE, dated January 3, 1996 (``CBOE OPRA Letter'');
and Kim Koppien, PSE, dated January 9, 1996 (``PSE OPRA Letter'').
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Position Limits
BOUNDs will be subject to the position limits for equity
options.\19\ In addition, BOUNDs will be aggregated with other equity
options on the same underlying stock for purposes of calculating
position limits. Since a BOUND to the holder is a bullish position, the
Exchanges propose that long BOUNDs be aggregated with long call and
short put positions in the related class of equity options. Similarly,
since the Exchanges believe the BOUND, from the perspective of the
seller, is a ``bearish'' position (i.e., it is the equivalent of a long
put position where the strike price has been prepaid), they propose to
aggregate short BOUNDs with short call and long put positions in the
related class of equity options.
\19\ See, e.g., Amex Rule 904.
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The Exchanges propose that positions in BOUNDs shall be reported in
accordance with existing options rules, with the minimum position in an
account to be reported being 200
[[Page 1793]]
BOUNDs on the same underlying security. Finally, due to the lack of
trading experience with BOUNDs, Amex and CBOE will not apply their
``ten-up'' rules, Amex Rule 958A and CBOE Rule 8.51, to BOUNDs
transactions.\20\
\20\ See Amex Amendment No. 2 and CBOE Amendment No. 1.
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Customer Margin
The Exchanges propose to apply options margin treatment to BOUNDs
as follows:
1. Long BOUND Positions: full payment required at the time of
purchase.
2. Short BOUND Positions: the BOUND seller receives full payment
for the BOUND at the time of the initial sale and receives no further
payment when the contract is settled either by payment of the strike
price or delivery of the underlying stock. Short BOUND positions,
therefore, will be margined in an amount equal to the current market
price of the BOUND plus an amount equal to an ``add-on'' used to margin
short call options times the market value of the BOUND. Since the
maximum obligation of the seller of a BOUND cannot exceed the strike
price, however, the amount of margin will never exceed the strike
value. For example:
A. Assume a stock of $50, an exercise price of $50, a margin add-on
percent of 20% and the BOUND trading at $40. In this case, the short
seller would have to pay $48 to margin the position, i.e., $40 BOUND
price plus 20% of $40.
B. Assume a stock price of $40, an exercise price of $50, a margin
add-on percent of 20% and the BOUND trading at $35. In this case, the
margin would be 42, i.e., $35 BOUND price plus 20% of $35.
3. Covered Positions: Short BOUND positions offset by the
equivalent number of shares of the underlying stock will not require
any additional margin since the seller's obligation to the buyer will,
in all cases, be covered by the position in the underlying stock.
Further, since it is expected that the sum of the prices of a LEAP and
a BOUND will be approximately equal to the price of the underlying
stock, a long stock position is cover for both a short BOUND and a
short LEAP position, provided the LEAP and BOUND have the same strike
price and expiration date.\21\
\21\ See Amex and PSE Amendments No. 2.
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4. Spread Positions
i. Same Expiration--Different Strike Prices: There will be no
margin requirement for BOUND positions which are long the higher strike
price and short the lower strike price since the long BOUND more than
covers the obligation of the short side of the position. For positions
short the higher strike price and long the lower strike, a customer
will be required to post the difference between the strike prices.
ii. Different Expiration-Same Strike Price: No margin will be
required for positions long the nearest expiration and short the longer
expiration since the value of the long BOUND will cover the obligation
on the short leg of the position.\22\ Positions that are short the near
expiration and long the distant expiration will require full margin on
the short position and payment in full on the long position.\23\
\22\ For positions that are long the nearest expiration, full
margin will be required on the short position once the long position
expires.
\23\ See Amex and PSE Amendments No. 2 and CBOE Amendment No. 1.
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iii. Different Expiration-Different Strike Prices: There will be no
margin required for positions that are long the near expiration and
short the distant expiration when the strike price on the near
expiration is higher than the strike on the distant expiration. For
positions which are long the near expiration and short the distant
expiration where the strike price on the near expiration is lower than
the strike on the distant contract, the margin will be the difference
in the strike between the near term and distant strikes. For positions
which are short the near expiration and long the distant expiration,
full margin will be required on the short position and payment in full
on the long position.\24\
\24\ See Amex and PSE Amendments No. 2 and CBOE Amendment No. 1.
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II. Comments Received
The Commission received comment letters from the New York Stock
Exchange (``NYSE Letter'') and Motorola, Inc. (``Motorola Letter'') in
response to its publication and request for comments on the
proposals.\25\ The NYSE Letter expresses the belief that BOUNDs should
be classified an equity product as opposed to a standardized option and
that BOUNDs raised significant investor protection concerns.
\25\ See supra notes 5 and 6 and accompanying text.
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The NYSE Letter suggests several reasons to categorize BOUNDs as
equities and not as options. First, the NYSE argues that BOUNDs do not
perform like an option since they do not confer upon the holder a right
to buy or sell anything. Second, the NYSE notes that although an option
may be either ``in'' or ``out of the money'' and may expire worthless,
BOUNDs are always in the money and cannot expire worthless unless the
underlying stock expires worthless. Third, they note that while options
are used to transfer risk, BOUNDs do not transfer risk; instead, they
believe a BOUND seller only transfers the essential elements of stock
ownership, i.e., dividend stream and appreciation up to the cap price
to the buyer.
With respect to investor protection concerns, the NYSE Letter noted
that Rule 10a-1 under the Act, the ``short-sale'' rule, would not apply
to BOUNDs if they were classified as options and that this could lead
to price manipulation of the underlying stock through unregulated short
selling of the BOUND. Second, they argue that although position limits
would impose an overall limit on the amount of BOUNDs that could be
sold by a single trader, there would be no overall limits on the number
of LEAPs and BOUNDs that could be sold into the market place, which
could cause extreme market volatility. Finally, they argue that while
stock specialists have specific affirmative and negative obligations to
help ensure orderly markets in the stock, the Commission and the
options markets traditionally have not applied such obligations in the
options market due to the derivative nature of the instruments and that
this creates the potential for market confusion and unequal regulation.
The Motorola letter expresses concern that LEAPs and BOUNDs may
allow an investor with no economic interest in a company to maintain
voting rights. Specifically, an investor could purchase the underlying
stock and then sell both a LEAP and a BOUND. Motorola argues that this
division of economic and voting interests is contrary to corporate
governance and that significant matters, including corporate control,
could be determined by groups of stockholders with absolutely no stake
in the outcome. They further state that the ``division of economic and
voting interests'' could create ``cheap votes'' which could then be
sold to the highest bidder.
The Amex submitted a response letter to the Commission, addressing
the NYSE's and Motorola's concerns.\26\ Amex believes the NYSE and
Motorola Letters share an unstated premise that BOUNDs are unique in
allowing the creation of a synthetic position in stock. In this regard,
Amex notes that investors currently utilize several existing strategies
to establish synthetic positions, for example, through the use
[[Page 1794]]
of options and equity linked notes \27\ and over-the-counter
strategies.
\26\ See supra note 7.
\27\ Equity linked notes are hybrid instruments whose value is
linked to the performance of a highly capitalized, actively traded
common stock. See, e.g., Securities Exchange Act Release No. 32343
(May 20, 1993).
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Amex asserts several arguments in response to the NYSE's investor
protection/short sale concerns. First, Amex notes that the underlying
stock will continue to be subject to the short sale rule and that this
would restrain any downward pressure on the price of the underlying
stock which might be caused by the BOUNDs. Second, they note that
several options strategies (i.e., selling an in the money call, buying
a put and selling a call, or buying an in the money put) currently
exist for synthetically selling a stock short and that none of these
strategies is subject to the Rule 10a-1 tick test nor have such
strategies been utilized to manipulate the underlying. Third, Amex
believes that the proposed BOUNDs position limit rules will act to
limit the number of BOUNDs that may be sold short. Fourth, Amex argues
that BOUNDs, by virtue of their options pricing, are an inefficient
method of generating selling pressure on the underlying. Fifth, Amex
does not believe that the type of price manipulation that rule 10a-1
was intended to prevent can be effected through the derivatives market.
Furthermore, Amex believes that ongoing surveillance would adequately
address any manipulative activity affected in the derivatives market
for the purpose of manipulating the underlying. Finally, Amex argues
that the options markets are transparent due to the interposition of
OCC, which records all options positions and establishes reporting
requirements for options positions of more than 200 equity options
contracts. Therefore, Amex believes it would be able to detect
suspicious trading activity in BOUNDs promptly.
Amex also responded to Motorola's ``cheap vote'' concerns by
stating that the practical effect of BOUNDs on corporate governance
issues would be substantially limited by position limit rules and the
requirement that BOUNDs be aggregated with other options positions on
the same side of the market. Accordingly, Amex does not believe that
BOUNDs will have an effect on proxy contests or tender offers.
Furthermore, Amex points out that BOUNDs are inferior to over-the-
counter derivatives as a means of affecting shareholder votes since
over-the-counter options positions may be tailored by expiration date
(e.g., expire the day after a proxy contest) and price (e.g.,
establishment of a zero-cost collar).
Finally, the Amex has received a letter from the Commodity Futures
Trading Commission (``CFTC'') expressing the opinion that BOUNDs are
not futures contracts on a single security.\28\ In reaching this
conclusion, the CFTC noted that given the restrictions on setting
strike prices (as discussed above), BOUNDs predominantly exhibit the
one-way indexing characteristic of stock options.
\28\ See Letter from Andrea M. Corcoran and Pat G. Nicolette,
Co-Chairpersons, Off-Exchange Task Force, CFTC, to Nathan Most, New
Product Development, Amex, dated July 27, 1994. The CFTC letter is
based upon the assumption that BOUNDs strike prices will be set at-
the-money or out-of-the-money.
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III. Discussion
After careful consideration of the comments received and the
applicable statutory provisions, the Commission finds that the proposed
rule changes are consistent with the requirements of the Act and the
rules and regulations thereunder applicable to a national securities
exchange, and, in particular, the requirements of Section 6(b)(5).
Specifically, the Commission finds that the Exchanges' proposals to
list and trade BOUNDs strike a reasonable balance between the
Commission's mandates under Section 6(b)(5) to remove impediments to
and perfect the mechanism of a free and open market and a national
market system, while protecting investors and the public interest. The
Commission believes that BOUNDs will provide a new derivative
instrument for investors to more closely approximate their desired
investment objectives. For the reasons discussed below, the Commission
has concluded that the proposals are consistent with the Act.\29\
\29\ Pursuant to Section 6(b)(5) of the Act, the Commission is
required to find, among other things, that trading in BOUNDs will
serve to protect investors and contribute to the maintenance of fair
and orderly markets. In this regard, the Commission must predicate
approval of any new derivative product upon a finding that the
introduction of the derivative instrument is in the public interest.
Such a finding would be difficult for a derivative instrument that
served no hedging or other economic function, because any benefits
that might be derived by market participants likely would be
outweighed by the potential for manipulation, diminished public
confidence in the integrity of the markets, and other valid
regulatory concerns. As discussed below, the Commission believes
BOUNDs will serve an economic purpose by providing an alternative
product that will allow a BOUND holder to forego some of the
potential for upside appreciation in return for enhanced income.
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As an initial matter, the Commission must determine whether it is
appropriate for the Exchanges to regulate BOUNDs as standardized
options. The Commission is authorized pursuant to Rule 9b-1(a)(4) under
the Act to include within the definition of standardized options ``* *
* such other securities as the Commission may, buy order, designated.''
\30\ The proposed classification of BOUNDs as standardized options
presents certain difficult and unique issues. As discussed above,
BOUNDs are intended as a replacement product to the expired PRIMEs.
PRIMEs (and SCOREs) were subject to separate unit trust listing
standards specifically designed to accommodate their listing and were
not treated as standardized options within the meaning of Rule 9b-1.
Nevertheless, the Commission believes that BOUNDs, despite possessing
some attributes of PRIMEs, can be designated as standardized options
for purposes of Rule 9b-1 under the Act.
\30\ 17 CFR 240.9b-1(a)(4) (1988). In amending the definition of
the term standardized option to include ``such other securities as
the Commission may, by order, designate'' the Commission noted that
it added the new language ``to authorize the Commission, by order,
to allow the use of Rule 9b-1 for new investment vehicles that the
Commission believes should be included within the new disclosure
framework.'' See also Securities Exchange Act Release No. 19055
(Sept. 16, 1982), 47 FR 41950, 41954.
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In this respect, the Commission notes that the value of a
particular BOUNDs is derivative of the value of its underlying stock.
Moreover, its terms are standardized in the same manner as option
contracts, with an underlying security, standardized expiration dates
and strike prices. Second, BOUNDs will be subject to options margin
treatment. Third, because long BOUNDs positions have the same economic
attributes present when a market participant implements a covered call
writing strategy, they constitute an aggregation of a synthetic long
stock position and short call option position in a single transaction.
Accordingly, BOUNDs possess a significant options component. Fourth,
while not necessarily determinative of whether a product is an option,
BOUNDs, like all other options traded on national securities exchanges,
will be issued and cleared by OCC, a registered clearing agency. Fifth,
BOUNDs open interest will be created in a manner similar to options.
Finally, like a long options position, a long BOUNDs position is
created by the deposit of a fully paid for premium, which is the
maximum loss on the position.
The Commission recognizes that, as the NYSE letter indicates,
BOUNDs differ in several respects from traditional options.
Nevertheless, for the reasons stated above, the Commission does not
believe it is unreasonable to treat BOUNDs as standardized options.
[[Page 1795]]
Indeed, options treatment may provide a more tailored trading and
disclosure regime to the products.\31\ Therefore, the Commission has
determined the BOUNDs are a type of security that falls into the
category of ``other security'' under Rule 9b-1(a)(4) which the
Commission should treat as standardized options for purposes of Rule
9b-1 under the Act.
\31\ This determination does not preclude another market from
trading a PRIME-like product under stock or hybrid product trading
rules. It may be appropriate to use a different regulatory structure
than that applicable to BOUNDs for a product that combines equity
and derivative features. For BOUNDs, the Commission merely is
determining that it is consistent with the Act for the Amex, CBOE,
and PSE to apply their options rules and to treat the product as a
standardized option.
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In treating BOUNDs as options, the Commission must ensure that the
Exchanges' proposed regulatory requirements provide for adequate sales
practice requirements, position and exercise limits, margin
requirements and disclosure. These rules minimize the potential for
manipulation and help to address any prudential concerns from a
derivative product. In addition, these standards should address the
special risks to customers arising from transactions in BOUNDs. For the
reasons discussed below, the Commission believes the proposals will
provide significant flexibility to list BOUNDs without compromising the
effectiveness of the Exchanges' regulatory programs for standardized
options.
First, the Exchanges' options sales practice and suitability rules
apply to transactions in BOUNDs. The Commission believes it appropriate
to apply the heightened requirements of options account opening and
suitability rules to BOUNDs transactions because of the significant
derivative characteristics of the product. Thus, no member or member
organization of any of the Exchanges may accept an order from a
customer to purchase, or recommend to any customer any BOUND
transaction, unless the account has been approved for options trading
and the member or member organization has reasonable grounds to believe
that any recommended transaction is not unsuitable for such customer.
Second, the Exchanges propose that equity option position and
exercise limit rules be applicable to transactions in BOUNDs and that
BOUNDs be aggregated with other equity options on the same underlying
stock for the purpose of calculating position limits. The Commission
believes that since BOUNDs are standardized options which replicate a
covered call writing strategy, it is appropriate to apply equity
options position limits to BOUNDs transactions. The Commission believes
it is appropriate to aggregate BOUNDs with equity options (including
LEAPs) on the same side of the market on the same underlying stock
(i.e., long BOUNDs with long calls and short puts). This will ensure
that the protection afforded by options position limits (e.g.,
prevention of manipulation of the underlying security) will apply to
BOUNDs.
As discussed above, the NYSE and Motorola Comment Letters raise
short sale and ``cheap vote'' concerns, respectively. With respect to
the ``cheap vote'' concerns, the Commission agrees with Amex's response
and notes that there are several existing strategies whereby an
investor can synthetically divest the economic attributes of common
stock from actual ownership. As to NYSE's short sale concerns, in light
of the fact that BOUNDs will be regulated as standardized options, it
is appropriate to grant them the same treatment under Rule 10a-1 of the
Act as existing options. Moreover, the Commission notes a BOUNDs'
underlying stock will remain subject to Rule 10a-1 at all times.
Furthermore, the Commission believes that the proposed position limit
and aggregation rules (in addition to margin requirements) should
adequately protect against BOUNDs short selling any potential concern
over the division of economic and voting interests.
Third, the Exchanges propose that their options margin rules be
applicable to transactions in BOUNDs. The initial sale of a BOUND, by
definition, will require the seller to go short. In this regard, the
Exchanges have submitted proposed rules establishing margin levels for
the purchase and sale of BOUNDs, for covered positions (e.g., long
stock, short BOUND), and for spread positions involving BOUNDs (e.g.,
long and short BOUND with same expiration date but different strike
prices). The Commission believes that the options-like margin treatment
for BOUNDs, as amended, provides for adequate margin coverage for long,
short, covered, and spread positions.\32\
\32\ The Commission staff consulted with staff of the Federal
Reserve Board in reaching this determination.
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The Commission notes that strike price interval, bid/ask
differential and continuity rules will not apply to transactions in
BOUNDs until the time to expiration is less than nine months. This
approach is consistent with the approach currently being taken by the
Exchanges with regard to their long-term equity and index options. The
Commission notes that although specific bid/ask differential and
continuity rules do not apply to BOUNDs with over nine months to
expiration, the Exchanges' general rules that obligate registered
options traders, specialists, and market makers to maintain a fair and
orderly market will continue to apply.\33\ The Commission believes that
the requirements of these rules are broad enough, even in the absence
of bid/ask differential and continuity requirements, to provide the
Exchanges with the authority to make a finding of inadequate registered
option trader, specialist, or market maker performance should these
market participants enter into transactions or make bids or offers (or
fail to do so) in BOUNDs that are inconsistent with the maintenance of
a fair and orderly market.
\33\ See, e.g., Amex Rules 950 and 958 and CBOE Rule 8.7.
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In order to promote investor protection and to ensure adequate
disclosure in connection with BOUNDs, the rules pertaining to
standardized options and the requirements of Exchange Act Rule 9b-1
will apply to trading in BOUNDs. As with other securities issued by
OCC, the clearing corporation interposes itself between BOUND buyers
and sellers, and is technically the ``issuer'' of each contract.
Moreover, just as with other OCC issued securities, the Commission
believes providing investors with information regarding the rights and
characteristics of BOUNDs would provide more useful information to
investors than additional information on the issuers underlying the
BOUNDs.\34\ In this regard, BOUNDs investors will receive a special
supplement to the ODD (``BOUNDs supplement'') explaining in detail the
economic and risk characteristics of BOUNDs, the mechanism of buying,
selling and exercising BOUNDs and the market in which BOUNDs will
trade.\35\ In addition, the Exchanges will require that every exchange
member and member organization deliver to each customer a current ODD
and BOUNDs supplement at or prior to the time such
[[Page 1796]]
customer's account is approved for BOUNDs trading.
\34\ The Commission notes that standardized options are
registered with the Commission on Form S-20 Registration Statement
under the Securities Act of 1933. This information includes the
prospectus and financial statements of OCC, which is the issuer of
all standardized options.
\35\ In reviewing any disclosure materials submitted, the
Commission intends to assure that the materials specifically
describe BOUNDs, explain their uses, detail the special risks
associated with BOUNDs trading, and emphasize that BOUNDs contracts,
unlike other standardized options, subject a writer to dividend-
equivalent payment obligations. The trading of BOUNDs is expressly
contingent upon the Commission's approval of such an ODD supplement.
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As discussed above, the Exchanges propose to have BOUNDs issued,
cleared and settled by OCC. In this regard, on December 27, 1995, OCC
filed with the Commission a proposed rule change to enable it to issue,
clear, and settle BOUNDs.\36\ The OCC proposal, when approved, should
allow OCC to process BOUNDs transactions in accordance with procedures
that are substantially similar to its existing well-established systems
and procedures for the clearance and settlement of exchange-traded
options.\37\ In this respect, the Commission notes that the initiation
of trading of BOUNDs is conditioned upon Commission approval of OCC's
proposal to issue, clear and settle BOUNDs, as well as a Commission
order approving the BOUNDs ODD supplement.
\36\ See SR-OCC-95-20.
\37\ The Commission has not yet approved OCC's proposed rule
filing to issue, clear, and settle BOUNDs (SR-OCC-95-20).
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The Commission finds good cause for approving the Amendments to the
proposed rule changes prior to the thirtieth day after the date of
publication of notice of filing thereof in the Federal Register.\38\
The Commission notes that the Amendments bring the BOUNDs margin rules
applicable to spread positions into conformity with the margin
treatment currently applicable to other standardized options.
Furthermore, the Amendments also bring the Exchanges' rules into
conformity with those of OCC which, the Commission notes, reduces the
potential for conflict between an Exchanges' and OCC's rules.\39\ Also,
the Commission believes it is appropriate for Amex and CBOE to not
apply their ``ten-up'' rules to BOUNDs transactions (i.e., the minimum
size guarantee for BOUNDs quotes). In the absence of trading experience
or other indication of adequate market liquidity, the Commission
believes it is reasonable for the Amex and CBOE to determine that
specialists or market makers should not be required to make ten-up
markets for transactions in BOUNDs. The Amendments also eliminate the
use of escrow receipts and letters of guarantee as adequate margin
cover for BOUNDs. The Commission notes that because it is unknown
whether BOUNDs will be settled in cash of the underlying stock until
expiration of the BOUNDs position, this raises issues as to whether
such instruments serve as adequate cover for short BOUNDs positions.
Accordingly, the Commission believes this issue is better addressed in
the context of a separate OCC filing. Finally, the Commission notes
that PSE's designation of BOUNDs as a Tier I security is consistent
with the treatment afforded standardized equity options and, therefore,
does not raise any new or unique issues. Accordingly, the Commission
believes it is consistent with Sections 6(b)(5) and 19(b)(2) of the Act
to approve the Amendment on an accelerated basis.
\38\ Amex Amendment No. 1 was noticed and published for comment
with the original filing. The Commission, therefore, is not seeking
comment on Amex Amendment No. 1.
\39\ For example, one of the changes alters the timing of the
payment of the BOUNDs dividends equivalent. The Commission notes
that this change, which brings the Exchanges' rules into conformity
with the rules of OCC, will harmonize the payment date for BOUNDs
with that of the underlying stock, and that this should make trading
strategies involving both the BOUNDs and underlying stock more
efficient.
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IV. Solicitation of Comments
Interested persons are invited to submit written data, views and
arguments concerning the Amendments. Persons making written submissions
should file six copies thereof with the Secretary, Securities and
Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549.
Copies of the submission, all subsequent amendments, all written
statements with respect to the proposed rule change that are filed with
the Commission, and all written communications relating to the proposed
rule change between the Commission and any person, other than those
that may be withheld from the public in accordance with the provisions
of 5 U.S.C. 552, will be available for inspection and copying in the
Commission's Public Reference Section, 450 Fifth Street, N.W.,
Washington, D.C. Copies of such filing will also be available for
inspection and copying at the principal office of the above-mentioned
self-regulatory organization. All submissions should refer to the file
numbers in the caption above and should be submitted by February 13,
1996.
Based upon the aforementioned factors, the Commission finds that
the proposed rule changes relating to the listing and trading of BOUNDs
are consistent with the requirements of Section 6(b)(5) and the rules
and regulations thereunder. The initiation of BOUNDs trading, however,
is conditioned upon the issuance of an order approving the OCC's
proposed rule change to issue, clear, and settle BOUNDs and also upon
the Commission's review and approval of an ODD BOUNDs supplement,
pursuant to Rule 9b-1 of the Act.
It therefore is ordered, pursuant to Section 19(b)(2) of the
Act,\40\ that the proposed rule changes (SR-Amex-94-56, SR-CBOE-05-14,
and SR-PSE-95-01) are approved, as amended.
\40\ 15 U.S.C. Sec. 78s(b)(2) (1988).
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For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\41\
\41\ 17 CFR 200.30-3(a)(12) (1994).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 96-835 Filed 1-22-96; 8:45 am]
BILLING CODE 8010-01-M
