02-23310. Self-Regulatory Organizations; The Options Clearing Corporation; Order Granting Approval of a Proposed Rule Change Relating to Providing Clearing Services to Options Exchanges That Are Not Stockholders

September 6, 2002.

I. Introduction

On January 25, 2002, The Options Clearing Corporation (“OCC”) filed with the Securities and Exchange Commission (“Commission”) a proposed rule change (File No. SR-OCC-2002-02) pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 (“Act”).^[1] On July 9, 2002, OCC amended the proposed rule change. Notice of the proposal was published in the Federal Register on July 31, 2002.^[2] No comment letters were received. For the reasons discussed below, the Commission is approving the proposed rule change.

II. Description

The proposed rule change amends OCC by-laws and rules so that OCC can provide clearing services to new options exchanges without having those exchanges become stockholders of OCC. Under OCC's existing by-laws, any new options market desiring to clear options transactions through OCC is required to purchase common stock in OCC and to execute the Stockholders Agreement to which the existing stockholder exchanges are parties. Management of OCC has concluded that the practice of issuing new equity to each market for which OCC provides clearing services is no longer either necessary or appropriate. Indeed, the practice has already been abandoned with respect to providing clearing services to markets trading only security futures or commodity futures.^[3] OCC will now be able to clear options transactions for new options exchanges on a similar basis. OCC believes that there is no more reason to permit or require new options exchanges to become OCC stockholders than to permit or require those other markets to do so.

Exchange ownership of clearing organizations is not required under section 17A of the Act or under any other provision of the federal securities laws. State law at one time made such ownership necessary. Article VIII of the Uniform Commercial Code (“UCC”), as in effect in Illinois prior to the 1973 amendment, defined a “clearing corporation” as “a corporation all of the capital stock of which is held by or for a national securities exchange or association registered under a statute of the United States such as the Securities Exchange Act of 1934.” ^[4] The UCC as now in effect in all U.S. jurisdictions no longer defines “clearing organization” in terms of ownership, and therefore, the UCC is no longer a constraint in determining the ownership of OCC.

Not only is there no continuing need to have new markets seeking clearing services become stockholders, there are a number of reasons not to do so. First, increasing the number of stockholders could adversely affect OCC's ability to pursue new business opportunities. Stock ownership gives the existing participant exchanges the right to a representative on OCC's board of directors and veto rights over certain significant transactions (e.g., a merger) or amendments to certain provisions of the constituent documents (e.g., Article VII of the by-laws regarding exchange qualifications).^[5] The participant exchanges have divergent and sometimes conflicting interests, and this will only become more prevalent as the number and types of options exchanges proliferates. Expanding the number of stockholders with veto rights increases the likelihood that a single stockholder might block action that is in the best interests of OCC and its other stockholders. Second, continuing to add stockholders could soon result in substantial increases in the size of the OCC board. After the number of exchange directors reaches seven, each addition of an exchange director would require the addition of another member director in order to maintain the allocation between member directors and exchange directors called for under OCC's constituent documents. Ultimately, the OCC board could reach an unwieldy size. Finally, issuing additional common stock for each new market would continually dilute the interests of the existing participant exchanges.

OCC is creating a new category of “non-equity exchange” to which markets that desire options clearing services from OCC will be admitted. In lieu of purchasing common stock of OCC, new participant exchanges will be required to enter into a Noteholders Agreement and to purchase a promissory note from OCC in the principal amount of $1 million, which was the amount specified in Article VII, Section 2 of the by-laws as the maximum purchase price for additional equity required to be purchased by a new equity exchange. Instead of the equity interest received by such equity exchanges, non-equity exchanges will receive promissory notes bearing an interest rate return on their investments as described below.

Non-equity exchanges will be subject to admission requirements identical to those imposed on the current participant exchanges that hold equity. Among other things, new participant exchanges must be registered under the Act, must be in compliance with the rules promulgated thereunder by the Commission, and must furnish information to OCC concerning such things as the exchange's operations, management, rules and membership.

OCC will provide clearing services to non-equity exchanges on the same basis that it provides services to the equity exchanges. Non-equity exchanges will become parties to the existing Restated Participant Exchange Agreement in the same way that new participant exchanges have done in the past. No modification to the agreement is necessary because it does not address matters relating to an exchange's role as stockholder, which are confined to the Stockholders Agreement.

The rights of the existing participant exchanges as stockholders, including their rights to representation on OCC's board and their veto rights, have been preserved in Article VIIA, “Equity Exchanges.” Although non-equity exchanges will not have representation on OCC's board, their members that are clearing members of OCC will be “participants” in OCC within the meaning of section 17A(b)(3)(C) of the Act and will be entitled under that provision to “fair representation * * * in the selection of (OCC's) directors and administration of its affairs.” Fair representation will be assured because participants that are members of non-equity exchanges will participate in the selection of OCC's member directors on the same basis as members of the equity exchanges.^[6]

The Noteholders Agreement in this rule filing contains restrictions on the transfer of promissory notes issued to non-equity exchanges and provides for the repurchase of the notes by OCC under certain circumstances parallel to the provisions applicable to the repurchase by OCC of its stock.^[7] These provisions are designed to ensure that the promissory notes remain in the hands of participant exchanges of OCC and to give withdrawing exchanges the right to “put” the notes back to OCC. The promissory notes will bear interest at a rate determined by reference to provisions of the Internal Revenue Code.^[8] The interest rate will be reset annually. Interest will be payable annually in arrears on the promissory note's anniversary date. If a promissory note is repurchased by OCC in less than six years from the date of the initial sale of the note, the purchase price of the note will be the principal amount plus any accrued and unpaid interest less a reduction based on the length of time since initial sale.^[9] After six years, there would be no reduction, and a promissory note would be redeemable at its aggregate principal amount plus any accrued and unpaid interest. Under the terms of Section VIII of the Noteholders Agreement, OCC's obligations to a noteholder are subordinated to the claims of all other creditors of OCC except that the obligation to repurchase a note from any noteholder ranks pari passu with OCC's obligations to repurchase notes from any other noteholders and to repurchase its common stock from any stockholder. The provisions of the Noteholders Agreement are generally parallel to corresponding provisions of the Stockholders Agreement.

III. Discussion

Section 19(b)(2) of the Act directs the Commission to approve a proposed rule change of a self-regulatory organization if it finds that such proposed rule change is consistent with the requirements of the Act and the rules and regulations thereunder applicable to such organization. section 17A(b)(3)(F) of the Act requires that the rules of a clearing agency be designed to remove impediments to and perfect the mechanism of a national system for the prompt and accurate clearance and settlement of securities transactions.^[10] The Commission believes that by allowing OCC to amend its by-laws and rules so that they limit the number of OCC's stockholders and in turn the size of OCC's board, OCC will be better able to continue to work to remove impediments to and perfect the mechanism of the national clearance and settlement system. Accordingly, the Commission finds that the proposal is consistent with Section 17A(b)(3)(F).

Sections 17A(b)(3)(C) and (I) of the Act require that the rules of a clearing agency assure fair representation of its shareholders and participants in the selection of its directors and administration of its affairs and that the rules of a clearing agency do not impose any burden on competition that is not necessary or appropriate in furtherance of the Act.^[11] The fact that members of non-equity exchanges that are also members of OCC will participate in the selection of OCC member directors should help to assure fair representation of all OCC's members. OCC's representations to the Commission that OCC's management will provide non-equity exchanges with the opportunity to make presentations to the OCC board and will promptly pass on to non-equity exchanges any information disclosed at or in connection with OCC board meetings that management considers to be of competitive significance should help to ensure that no burden on competition that is not necessary or appropriate in furtherance of the Act will occur.^[12] Therefore, the Commission also finds that OCC's rule change is consistent with the requirements of Section 17A(b)(3)(C) and (I).

IV. Conclusion

On the basis of the foregoing, the Commission finds that the proposed rule change is consistent with the requirements of the Act and in particular with the requirements of section 17A of the Act and the rules and regulations thereunder applicable.

It is therefore ordered, pursuant to section 19(b)(2) of the Act, that the proposed rule change (File No. SR-OCC-2002-02) be, and hereby is, approved.

For the Commission by the Division of Market Regulation, pursuant to delegated authority.^[13]

Margaret H. McFarland,

Deputy Secretary.

Footnotes

1.  15 U.S.C. 78s(b)(1).

2.  Securities Exchange Act Release No. 46257 (July 25, 2002), 67 FR 49729.

3.  Article XII of the by-laws permits OCC to clear “security futures” for “security futures exchanges” without issuing equity to such exchanges and permits OCC to provide clearing services for other futures products on the same basis (Securities Exchange Act Release Nos. 44434 (June 15, 2001), 66 FR 33283 [File No. SR-OCC-2001-05] and 45946 (May 16, 2002), 67 FR 36056 [File No. SR-OCC-2001-16]).

4.  The 1973 amendment identified certain other entities that could be owners of a clearing corporation while retaining securities exchanges or associations among the permitted owners.

5.  Holders of OCC Class A common stock have the right, by majority vote, to elect member directors of OCC. Holders of Class B common stock vote on the election of the management director and exchange directors of OCC. In addition, the votes of Class B common stock holders are required to amend OCC's certificate of incorporation, to adopt an agreement of merger or consolidation of OCC with or into any other corporation, to authorize or consent to the sale, lease, or exchange of all or substantially all of the property and assets of OCC, to authorize or consent to the dissolution of OCC, to receive dividends, and to receive assets upon partial or final liquidation or dissolution of OCC. All OCC Class A and Class B common stock is owned by its current participant options exchanges.

6.  OCC has represented to the Commission that OCC management will (1) provide non-equity exchanges with the opportunity to make presentations to the OCC board or the appropriate board committee upon request and (2) will promptly pass on to non-equity exchanges any information that management considers to be of competitive significance to such exchanges disclosed to exchange directors at or in connection with any meeting or action of the OCC board or any board committee. Letter from William H. Navin, Executive Vice President, General Counsel, and Secretary, OCC (July 8, 2002).

7.  The Noteholders Agreement is attached as Exhibit I to OCC's filing.

8.  The interest rate for the promissory notes will be equal to the short-term applicable federal rate for purposes of Section 1274(d) of the Internal Revenue Code of 1986.

9.  The amount of the reduction, which is set forth in the Noteholders Agreement, would be $300,000 if the note is purchased by OCC within two years of its original sell date, $240,000 if more than two years but less than three years, $180,000 if more than three years but less than four years, $120,000 if more than four years but less than five years, and $60,000 if more than five years but less than six years.

10.  15 U.S.C. 78q-1(b)(3)(F).

11.  15 U.S.C. 78q-1(b)(3)(C) and (I).

12.  Id.

13.  17 CFR 200.30-3(a)(12).