[Federal Register Volume 62, Number 205 (Thursday, October 23, 1997)]
[Notices]
[Pages 55289-55293]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-28027]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-39244; File No. SR-CBOE-97-25]
Self-Regulatory Organizations; Order Approving Proposed Rule
Change by the Chicago Board Options Exchange, Incorporated, Relating to
the Listing and Trading of Options on the Lipper Analytical/Salomon
Brothers Growth and Growth & Income Fund Indexes
October 15, 1997.
I. Introduction
On June 4, 1997, the Chicago Board Options Exchange, Incorporated
(``CBOE'' or ``Exchange'') filed a proposed rule change with the
Securities and Exchange Commission (``SEC'' or ``Commission''),
pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Act'') \1\ and Rule 19b-4 thereunder,\2\ to list and trade options
on two mutual fund indexes designed by Lipper Analytical Services, Inc.
in conjunction with Salomon Brothers Inc.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
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Notice of the proposal was published for comment and appeared in
the Federal Register on June 17, 1997.\3\ No comment letters were
received on the proposed rule change. This order approves the
Exchange's proposal.
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\3\ See Securities Exchange Act Release No. 38730 (June 10,
1997), 62 FR 32846.
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II. Description of the Proposal
The Exchange is proposing to list and trade cash-settled, European-
style options on two mutual fund indexes designed by Lipper Analytical
Services, Inc. (``Lipper Analytical'' or LAS) \4\ in
conjunction with Salomon Brothers Inc.--the Lipper Analytical/Salomon
Brothers Growth Fund Index (``Growth Fund Index'') and the Lipper
Analytical/Salomon Brothers Growth & Income Fund Index (``Growth &
Income Fund Index'').
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\4\ Lipper Analytical is a major provider of mutual fund
information and currently calculates approximately 100 other mutual
fund indexes designed to track specific investment objectives.
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A. Index Design
The Indexes are composed of the 30 largest U.S. funds in each
investment
[[Page 55290]]
objective (i.e., Growth or Growth & Income), based on their total net
assets as of the close on the last trading day of December. The Indexes
include only those funds that report net asset values (``NAV'') through
the facilities of the National Association of Securities Dealers
Automated Quotation System (``Nasdaq''). Some mutual funds are composed
of more than one class which have different fees and expenses. If there
is more than one class of a specific mutual fund, only the class with
the highest total net assets will be included. As of December 31, 1996,
the Growth Fund Index had total net assets (``TNA'') of $218.6 billion,
an average TNA per component of $7.3 billion and a median TNA per
component of $4.2 billion. The TNAs ranged from $2.5 billion to $54.0
billion. As of the same date, the Growth & Income Fund Index had a TNA
of $241.2 billion, an average TNA per component of $8.0 billion and a
median TNA per component of $5.0 billion. The TNAs ranged from $2.5
billion to $30.9 billion.
Lipper Analytical determines the investment objective of each fund
by reviewing both the language in the prospectus and the fund's
investment characteristics as shown in the Lipper-Equity Analysis
Report on the Weighted Average Holdings of Large Investment Companies.
A Growth Fund is described as a fund that normally invests in companies
whose long-term earnings are expected to grow significantly faster than
earnings of the stocks represented in the major unmanaged stock
indexes. A Growth & Income Fund is described as a fund that combines a
growth of earnings orientation and an income requirement for level and/
or rising dividends.
B. Calculation
The Indexes are equal-dollar weighted and re-balanced quarterly
after the close on expiration Fridays in March, June, September, and
December. The Index value is calculated in essentially the same manner
as other equal-dollar weighted indexes. The total number of shares for
each component is calculated by dividing $1,000 by the closing NAV,
adjusted for distributions, of the component on the re-balancing date
and rounding to two decimal places. The share amount is held constant
throughout the quarter. The Indexes are calculated by summing the
product of the current NAV adjusted for distributions and the share
amount for each component and then dividing by the index divisor. The
divisors were calculated to produce a value of 150.00 for the Growth
Fund Index and 250.00 for the Growth and Income Fund Index as of
December 31, 1996, the base date. The Indexes are calculated once per
day as soon as the NAVs for each of the components are available.\5\
The Index values will be disseminated by CBOE through the facilities of
the Options Price Reporting Authority (``OPRA'') prior to the opening
on the next business day.
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\5\ The Exchange represents that Index values are updated only
at the close of trading each day because that is the only time when
the fund net asset values comprising the Indexes are determined and
disseminated. The Exchange believes that this should not pose an
obstacle to options trading, any more than it prevents investors
from entering intra-day orders to purchase or redeem shares of the
funds themselves at closing net asset values that are unknown at the
time the orders are entered.
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Lipper has informed the Exchange that it has not had any difficulty
in obtaining net asset values for the funds in the Indexes. The funds
comprising the Indexes are among the largest funds in existence. In the
unlikely event that any of these funds do not comply with Rule 22c-1
under the Investment Company Act of 1940, which requires daily
computation of a fund's current net asset value, the Exchange would
follow the same procedure it uses for dissemination of standard indexes
when a component price is unavailable; it will use the last available
price.\6\
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\6\ The Commission notes that pursuant to Article XVII, Section
4 of the OCC by-laws, OCC is empowered to fix an exercise settlement
amount in the event it determines a current index value is
unreported or otherwise unavailable. See Securities Exchange Act
Release No. 37315 (June 17, 1996), 61 FR 42671 (order approving SR-
OCC-95-19).
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C. Maintenance
Lipper Analytical has the sole responsibility of maintaining the
Indexes. Salomon Brothers acted as an adviser to provide technical
support, including advice on index design and the methodology of index
construction.\7\ Lipper Analytical reviews the components annually
after the close on the last trading day of December to include the
thirty largest funds by total net assets. Any component changes
resulting from the annual review will be announced by LAS and CBOE at
least two weeks prior to implementation which will occur after the
close on expiration in March. The index calculation reflects
reinvestment of all distributions of component funds. Generally, there
will be no need for any other adjustments intra-quarter.
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\7\ Because Salomon's only role is to continue to provide
technical support on such things as index design and the index
construction methodology, and is not involved in any way with the
ongoing maintenance of the Indexes, it is not necessary to erect
informational barriers at Salomon with regard to the Indexes at this
time. The Commission notes, however, that should Salomon's role
change so that it is involved, whether through consultation or
directly, in any maintenance of the Indexes, it may need to erect an
informational barrier between personnel having access to information
and Salomon's sales and trading personnel concerning changes and
adjustments to the Indexes. Accordingly, should Salomon become
involved in any maintenance of the Indexes, the CBOE should contact
the Commission's Division of Market Regulation immediately to
determine if CBOE may continue to list and trade options overlying
the Indexes until such informational barriers are in place.
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D. Index Option Trading
The proposed options on the Indexes will be cash-settled, European-
style options.\8\ Standard options trading hours for broad-based index
options (8:30 a.m. to 3:15 p.m. Chicago time) will apply to the
contracts. The multiplier for each Index will be 100. The Exchange
intends to list up to three near-term months plus up to 3 months on a
quarterly cycle. The Exchange proposes to base trading in options on
the Lipper Analytical Indexes on the full-value of each Index. Further,
the exchange also may list full-value long-term index option series
(``LEAPS''), as provided in Rule 24.9. The Exchange also
may provide for the listing of reduced-value LEAPS, for which the
underlying value would be computed at one-tenth of the value of the
Index. The current and closing index value of any such reduced-value
LEAP will, after such initial computation, be rounded to the nearest
one-hundredth.
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\8\ A European-style option can be exercised only during a
specified period before the option expires.
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E. Exercise and Settlement
Options on the Indexes will settle based on the closing NAVs of the
component funds two business days prior to expiration. The proposed
options will expire on the Saturday following the third Friday of the
expiration month. Thus, the last day for trading in an expiring series
will be two business days (ordinarily a Thursday) preceding the
expiration date. The settlement value (which is the same as Thursday's
closing value) will be disseminated prior to the opening on Friday.
F. Exchange Rules Applicable
Except as modified herein, the Rules in Chapter XXIV will be
applicable to mutual fund index options. Index option contracts based
on the Lipper Analytical Indexes will be subject to a position limit
and exercise limit of 75,000 contracts, with no more than 50,000
contracts in the nearest expiration month. Ten reduced-value options
will equal one full-value contract for such purposes. The Exchange
believes that the proposed position limits are reasonable and
[[Page 55291]]
appropriate for this product, and are consistent with the position and
exercise limits that apply to other index options.
The Exchange is proposing to amend Rule 24.9 Interpretation and
Policy .01(a) to include 2\1/2\ point strike price intervals for mutual
fund indexes with strike prices less than $200. Broad-based margins
will apply to mutual fund index options. CBOE is also amending Rule
24.1(e) to reflect the fact that mutual funds can underlie indexes.
CBOE is also proposing to amend Exchange Rule 24.14 in order to include
specific reference to Lipper Analytical Services as entitled to the
benefit of the disclaimer of liability in respect of the Indexes.
Exchange rules applicable to options on both Indexes will be
identical to the rules applicable to other broad-based index options
for purposes of trading rotations, halts, and suspension,\9\ and margin
treatment.\10\
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\9\ See CBOE Rule 24.7
\10\ See CBOE Rule 24.11
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G. Surveillance
As with any other option product, the CBOE will closely monitor
activity in these options and therefore, should be able to identify any
potentially unusual activity in the options. It should be noted that
with respect to the component funds that comprise the Indexes, trading
in the funds themselves has no effect on the value of the Indexes.
Instead, the value of the Indexes depends entirely on the net asset
values of the component funds, which in turn depends on the values of
the stocks held in the portfolios of the various funds. The Exchange
believes that the concerns with manipulative activity are not as great
with respect to options on these Indexes as they are on stock index
options. First, the Indexes are equal-dollar weighted, thus no single
component dominates the Index. Therefore any person attempting to
manipulate the Indexes would have to manipulate the NAVs of a majority
of the Index components. Second, in order to manipulate the NAVs of the
component funds, a person would have to have knowledge of the component
securities held by the funds. This information is not disseminated to
the public until after the fact (generally only quarterly);\11\ thus
the Exchange believes that it would be difficult for any individual to
know, with any degree of certainty, the components of enough of the
funds to make any manipulative efforts worthwhile. The CBOE also states
that if it became necessary, the CBOE could examine the activity in the
underlying stocks being held by various funds if it detects unusual
activity in the Index options.
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\11\ Section 13(f) of the Act requires institutional investment
managers to file reports with the Commission, generally quarterly,
that disclose each equity security held on the last day of the
reporting period by accounts with respect to which the institutional
investment manager exercises investment discretion, the name of the
issuer and the title, class, CUSIP number, number of shares or
principal amount, and aggregate fair market value of each such
security. 15 U.S.C. 78m(f).
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H. Capacity
CBOE has the necessary systems capacity to support new series that
would result from the introduction of the Lipper Analytical/Salomon
Brothers Index options. CBOE has also been informed that OPRA has the
capacity to support such new series.
III. Commission Findings and Conclusions
The Commission finds that the proposed rule change is 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) of the Act.\12\
Specifically, the Commission finds that the trading of options based on
the Lipper Analytical/Salomon Brothers Growth and Growth & Income Fund
Indexes, including full-value and reduced-value LEAPS, will serve to
protect investors, promote the public interest, and help to remove
impediments to a free and open securities market by providing investors
with a means to hedge exposure to market risk associated with some of
the largest U.S. mutual funds holding securities representing the
growth and growth & income portion of the U.S. equity market.\13\
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\12\ 15 U.S.C. 78f(b)(5). In approving this rule, the Commission
notes that it has considered the proposed rule's impact on
efficiency, competition, and capital formation. 15 U.S.C. 78c(f).
\13\ Pursuant to Section 6(b)(5) of the Act, the commission must
predicate approval of any new securities product upon a finding that
the introduction of such product is in the public interest. Such a
finding would be difficult with respect to a warrant 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.
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The Commission believes that the Indexes are broad-based, and the
proposed options are designed to reduce the potential for manipulation,
and is consistent with the CBOE's obligation to promote investor
protection.\14\ Moreover, the Commission believes, for the reasons
discussed below, that the CBOE has adequately addressed issues related
to customer protection, index design, surveillance, and market impact
of options based on the Lipper Analytical/Salomon Brothers Growth and
Growth & Income fund Indexes.
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\14\ The CBOE is a member of the Intermarket Surveillance Group
(``ISG'') which was formed on July 14, 1983 to, among other things,
coordinate more effectively surveillance and investigative
information sharing arrangements in the stock and options markets.
See Intermarket Surveillance Group Agreement, July 14, 1983. The
most recent amendment to the ISG Agreement, which incorporates the
original agreement and all amendments made thereafter, was signed by
ISG members on January 29, 1990. See Second Amendment to the
Intermarket Surveillance Group Agreement, January 29, 1990. The
members of the ISG are: the Amex; the Boston Stock Exchange, Inc.;
the CBOE; the Chicago Stock Exchange, Inc.; the National Association
of Securities Dealers, Inc. (``NASD'') the NYSE; the Pacific
Exchange, Inc.; and the Philadelphia Stock Exchange, Inc. Because of
potential opportunities for trading abuses involving stock index
futures, stock options, and the underlying stock and the need for
greater stock options, and the underlying stock and the need for
greater sharing of surveillance information for these potential
intermarket trading abuses, the major stock index futures exchanges
(e.g., the Chicago Mercantile Exchange and the Chicago Board of
Trade) joined the ISG as affiliate members in 1990.
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A. Index Design and Structure
The Commission finds that it is appropriate and consistent with the
Act for the CBOE to designate the Indexes as broad-based. Specifically,
the Commission believes the Indexes, representing the growth and growth
& income portion of the U.S. equity market, are broad-based for the
following reasons. First, the indexes each consist of the 30 largest
U.S. funds in each investment objective, based on their total net
assets as of the close on the last trading day of December. The Indexes
include only those funds that report net asset values (``NAV'') through
the facilities of the National Association of Securities Dealers
Automated Quotation System (``Nasdaq''). Second, the total net assets
of the mutual funds comprising the Indexes are very large. As of
December 31, 1996, the Growth Fund Index had total net assets (''TNA'')
of $218.6 billion, an average TNA per component of $7.3 billion and a
median TNA per component of $4.2 billion. The TNAs ranged from $2.5
billion to $54.0 billion. As of the same date, the Growth & Income Fund
Index had a TNA of $241.2 billion, an average TNA per component of $8.0
billion and median TNA per component of $5.0 billion. The TNAs ranged
from $2.5 billion to $30.9 billion. Third, no one particular mutual
fund or group of mutual funds dominates the weight of the Index. As
noted above, each Index value is calculated using an equal-dollar
weighting methodology. Specifically,
[[Page 55292]]
each component will account for approximately 3.33% of its respective
Index, and the Exchange will re-balance to equal-dollar weighting
quarterly. Accordingly, the Commission believes it is appropriate to
classify the Index as broad-based.
B. Customer Protection
The Commission believes that a regulatory system designed to
protect public customers must be in place before the trading of
sophisticated financial instruments, such as options on the Lipper
Analytical/Salomon Brothers Growth and Growth & Income Fund Indexes
(including full-value and reduced value LEAPS), can commence on a
national securities exchange. The Commission notes that the trading of
standardized, exchange-traded options occurs in an environment that is
designed to ensure, among other things, that: (1) The special risks of
options are disclosed to public customers;\15\ (2) only investors
capable of evaluating and bearing the risks of options trading are
engaged in such trading; and (3) special compliance procedures are
applicable to options accounts. Accordingly, because options on both
Indexes will be subject to the same regulatory regime as the other
standardized options currently traded on the CBOE, the Commission
believes that adequate safeguards are in place to ensure the protection
of investors in options on the Lipper Analytical/Salomon Brothers
Growth and Growth & Income Fund Indexes.
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\15\ The Commission notes that in order to promote investor
protection and to ensure adequate disclosure in connection with
Mutual Fund Index options, the rules pertaining to standardized
options and the requirements of Exchange Act Rule 9b-1 will apply to
trading in Growth and Growth & Income Fund Index Options. The
Commission believes it is important to provide investors with
information regarding the rights and characteristics of these
options. In this regard, Growth and Growth & Income Fund Index
options investors will receive a special supplement to The Options
Clearing Corporation's (``OCC'') Options Disclosure Document (``ODD
Supplement'') explaining in detail the risks and characteristics of
Packaged Spreads. In reviewing any disclosure materials submitted,
the Commission intends to assure that the materials specifically
describe the risks and characteristics associated with trading
Mutual Fund Index Options. The CBOE's trading of Growth and Growth &
Income Fund Index options is expressly contingent upon the
Commission's approval of such an ODD supplement.
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C. Surveillance
The Commission believes that is important to ensure the
availability of information necessary to detect and deter potential
manipulation and other trading abuses, thereby making the mutual fund
index product less likely to be manipulated. Further, the Commission
believes that an exchange proposing to list a mutual fund index
derivative where the mutual fund components themselves are not traded
in the secondary market, must have in place appropriate surveillance
procedures for the derivative product and the markets trading the
underlying securities that comprise the mutual fund components. In this
regard, the Commission notes that the CBOE will closely monitor
activity in these options and should be able to identify any
potentially unusual activity in the options. Moreover, the CBOE
represents that if it became necessary, the CBOE could examine the
activity in the underlying stocks if it detects unusual activity in the
Index options. The Commission believes that this arrangement ensures
the availability of information necessary to detect and deter potential
manipulations and other trading abuses, thereby making the Index
options and full-value and reduced-value Index LEAPS less susceptible
to manipulation.
D. Market Impact
The Commission believes that the listing and trading of Growth and
Growth & Income Fund Index options on the CBOE will not adversely
impact the securities markets in the United States.\16\ First, the
Commission notes that the Indexes are broad-based and diversified and
include component mutual funds that comprise the 30 largest U.S. funds
in each investment objective. Second, the 75,000 contract position and
exercise limit, with no more than 50,000 contracts in the nearest
expiration month, will serve to minimize potential manipulation and
other market impact concerns. Third, the risk to investors of contra-
party non-performance will be minimized because the Index options, and
full-value and reduced-value LEAPS, will be issued and guaranteed by
The Options Clearing Corporation, similar to all other standardized
options traded in the United States.
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\16\ In addition, the CBOE has represented that it and OPRA have
the necessary systems capacity to support those new series of index
options that would result from the introduction of options and LEAPS
based on both Indexes.
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E. Index Calculation and Dissemination
As discussed above, the CBOE is proposing to update the Indexes'
values at the close of trading each day when the net asset values of
the component funds of the Indexes are determined and disseminated. The
result of this is that the disseminated value during the trading day is
based on the prior day net asset value established at the prior day
close.
Generally, the Commission believes that continually updated index
values on a real-time basis are essential to the trading of any index
product. The Commission has only allowed exceptions to this for certain
indexes composed of foreign securities where the primary market for the
component securities are closed during the U.S. trading hours for the
overlying options and thus the value of the components are generally
not changing during the U.S. trading day. In contrast, in the case of
the Growth Fund Index and the Growth Fund Index, the Index values are
based on closing NAVs, even though the component funds' portfolio
securities are themselves trading during the same trading hours as the
Index options thereby causing the value of the portfolio to fluctuate
throughout the trading day.
Nevertheless, the Commission has determined to allow the CBOE to
trade options overlying the Indexes using the Indexes' values
established at the prior day close because only the fund manager will
have knowledge of the funds' portfolio securities and their values on a
regular basis throughout the trading day. Information regarding the
component funds' portfolios will only be generally available to the
public on a quarterly basis as required under Section 13(f) of the Act
and all investors should have equal access to this information when it
is disseminated.\17\ Further, CBOE surveillance should also help to
detect and deter manipulation through the misuse of such intra-day
information available only to the component fund managers. Finally,
there are other widely published resources and indexes available that
track growth and growth & income stocks which investors may use to
determine an indicative value for the Growth and the Growth & Income
Fund Indexes.\18\
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\17\ See supra note 11.
\18\ If any one of these factors were not present, the
Commission may have determined it was not appropriate to allow the
product to trade without real-time dissemination of Index values.
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IV. Conclusion
Based upon the aforementioned factors, the Commission finds that
the proposed changes relating to the listing and trading of Growth and
Growth & Income Fund Index options are consistent with the requirements
of Section 6(b)(5) and the rules and regulations thereunder. The
initiation of Growth and Growth & Income Fund Index options trading,
however, is conditioned upon the issuance of an order approving an ODD
Supplement, pursuant to Rule 9b-1 of the Act.
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It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\19\ that the proposed rule change (File No. SR-CBOE-97-25) is
approved.
\19\ 15 U.S.C. 78s(b)(2).
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For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\20\
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\20\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-28027 Filed 10-22-97; 8:45 am]
BILLING CODE 8010-01-M
