Self-Regulatory Organizations; The Options Clearing Corporation; Order Approving Proposed Rule Change as Modified by Amendment No. 1 To Revise Option Adjustment Methodology, 7701-7706 [E7-2792]
Download as PDF
<![CDATA[
Federal Register / Vol. 72, No. 32 / Friday, February 16, 2007 / Notices
not edit personal identifying
information from submissions. You
should submit only information that
you wish to make available publicly. All
submissions should refer to File
Number SR–ISE–2007–08 and should be
submitted on or before March 9, 2007.
For the Commission, by the Division of
Market Regulation, pursuant to delegated
authority.13
Florence E. Harmon,
Deputy Secretary.
[FR Doc. E7–2793 Filed 2–15–07; 8:45 am]
BILLING CODE 8010–01–P
SECURITIES AND EXCHANGE
COMMISSION
[Release No. 34–55264; File No. SR-NYSE–
2006–45]
Self-Regulatory Organizations; New
York Stock Exchange LLC.; Order
Approving Proposed Rule Change
Relating to Amendments to Exchange
Rule 638 Concerning Mediation
February 9, 2007.
I. Introduction
On June 22, 2006, the New York Stock
Exchange LLC (‘‘NYSE’’ or the
‘‘Exchange’’) filed 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 a proposed rule change
relating to amendments to Exchange
Rule 638 concerning mediation. The
proposed rule change was published for
comment in the Federal Register on
December 21, 2006,3 and the
Commission received one comment on
the proposal.4 This order approves the
proposed rule change.
II. Description
The proposal would delete references
in NYSE Rule 638 to the mediation pilot
program that expired on January 31,
2003. The proposed amendments would
also codify or, in some cases, recodify
certain existing mediation procedures,
including that: (1) The mediator’s fees
and method of payment are subject to
agreement of the parties and the
mediator, and all such fees and costs
incurred in mediation are the parties’
responsibility; (2) an adjournment fee
will be assessed if an arbitration hearing
is adjourned for purposes of the parties
pursuing mediation unless the fee is
waived under Exchange Rule 617; (3) a
mediator may not represent a party or
act as an arbitrator in an arbitration
relating to the matter mediated, nor be
called to testify regarding the mediation
in any proceeding;5 and (4) the
mediation is confidential and no record
is kept of the proceeding,6 and, except
as may be required by law, the parties
and mediator agree not to disclose the
substance of the mediation without the
prior written authorization of all parties
to the mediation.
In addition, the proposed rule change
would clarify that any party may
withdraw from mediation at any time
prior to the execution of a settlement
agreement upon written notification to
all other parties, the mediator, and the
Director of Arbitration. It also would
clarify that parties may select a mediator
on their own or request a list of
potential mediators from the Exchange,
and that, upon request of any party, the
Director of Arbitration would send the
parties a list of five potential mediators
together with the mediators’
biographical information described in
Rule 608.7
Finally, the proposed rule change
would provide that the parties will
advise the Exchange as to the name of
the agreed-upon mediator. In addition,
it would clarify that once the parties
agree to mediate, the Exchange would
facilitate the mediation, if requested, by
contacting the mediator selected and by
assisting in making necessary
arrangements, as well as that parties to
mediation may use the Exchange
meeting facilities in New York, when
available, without charge.
III. Summary of Comment
The Commission received one
comment on the proposal.8 The
commenter objected to the provision of
the proposed rule change that would
prohibit a mediator from acting as an
arbitrator in an arbitration related to the
matter mediated.9 The NYSE responded
that because the provision is
substantially the same as in the current
rule this comment is outside the scope
of this rule filing.10 The Commission
finds the NYSE’s determination that
these comments are beyond the scope of
the rule filing to be reasonable because
they suggest substantive changes from
5 See
current NYSE Rule 638(a)(4).
sroberts on PROD1PC70 with NOTICES
6 Id.
13 17
7 See
1 15
CFR 200.30–3(a)(12).
U.S.C. 78s(b)(1).
2 17 CFR 240.19b–4.
3 See Exchange Act Release No. 54917 (Dec. 11,
2006), 71 FR 76714 (Dec. 21, 2006).
4 See letter from Stephen A. Hochman to Nancy
Morris, dated January 16, 2007 (‘‘Hochman’’).
8 Hochman.
VerDate Aug<31>2005
19:03 Feb 15, 2007
Jkt 211001
current NYSE Rule 638(a)(2).
9 Id.
10 See letter from Mary Yeager, Assistant
Secretary, NYSE, to Katherine A. England, Assistant
Director, Division of Market Regulation, dated
February 7, 2007.
PO 00000
Frm 00111
Fmt 4703
Sfmt 4703
7701
the current mediation rules that were
not intended to be addressed by this
rule filing. Thus, the Commission finds
the NYSE’s determination not to amend
the proposed rule change in connection
with this comment at this time to be
reasonable.
IV. Discussion and Findings
After careful review, the Commission
finds that the proposed rule change is
consistent with the Act and, in
particular, with Section 6(b)(5) of the
Act, which requires, among other
things, that the NYSE’s rules be
designed to promote just and equitable
principles of trade, and, in general, to
protect investors and the public
interest.11 The Commission believes
that the proposed rule change will bring
greater clarity to the mediation process
by deleting outdated references to the
expired mediation pilot program and
codifying certain existing mediation
procedures.
V. Conclusion
It is therefore ordered, pursuant to
Section 19(b)(2) of the Act 12 that the
proposed rule change (SR–NYSE–2006–
45), be, and hereby is, approved.
For the Commission, by the Division of
Market Regulation, pursuant to delegated
authority.13
Florence E. Harmon,
Deputy Secretary.
[FR Doc. E7–2721 Filed 2–15–07; 8:45 am]
BILLING CODE 8010–01–P
SECURITIES AND EXCHANGE
COMMISSION
[Release No. 34–55258; File No. SR–OCC–
2006–01]
Self-Regulatory Organizations; The
Options Clearing Corporation; Order
Approving Proposed Rule Change as
Modified by Amendment No. 1 To
Revise Option Adjustment
Methodology
February 8, 2007.
I. Introduction
On January 12, 2006, The Options
Clearing Corporation (‘‘OCC’’) filed with
the Securities and Exchange
Commission (‘‘Commission’’) proposed
rule change SR–OCC–2006–01 pursuant
to Section 19(b)(1) of the Securities
Exchange Act of 1934 (‘‘Act’’).1 On
March 9, 2006, the Commission
published notice of the proposed rule
11 15
U.S.C. 78f(b)(5).
U.S.C. 78s(b)(2).
13 17 CFR 200.30–3(a)(12).
1 15 U.S.C. 78s(b)(1).
12 15
E:\FR\FM\16FEN1.SGM
16FEN1
7702
Federal Register / Vol. 72, No. 32 / Friday, February 16, 2007 / Notices
change to solicit comments from
interested parties.2 The Commission
received ten comment letters upon
publication of the notice.3 To address
the concerns raised by the commenters,
OCC amended the proposed rule change
on September 25, 2006. On November
21, 2006, the Commission published
notice of the amended proposed rule
change to solicit comments from
interested parties.4 The Commission
received four additional comment
letters.5 For the reasons discussed
below, the Commission is approving the
proposed rule change.6
II. Description
sroberts on PROD1PC70 with NOTICES
OCC is amending Article VI
(Clearance of Exchange Transactions),
Section 11A of its By-Laws to (1)
Eliminate the need to round strike
prices and/or units of trading in the
event of certain stock dividends, stock
distributions, and stock splits and (2)
provide for the adjustment of
outstanding options for special
dividends (i.e., cash distributions not
declared pursuant to a policy or practice
of paying such distributions on a
quarterly or other regular basis). The
proposed rule change also adds a $12.50
per contract threshold amount for cash
dividends and distributions to trigger
application of OCC’s adjustment rules.
2 Securities Exchange Act Release No. 53400
(March 2, 2006), 71 FR 12226.
3 Joseph Haggenmiller (March 8, 2006); Erik A.
Hartog, Operating Manager, Allagash Trading LLC
(March 21, 2006); Jeffrey Woodring (March 22,
2006); Adam Besch-Turner (March 23, 2006);
Christopher Nagy, Chairman, Options Committee,
Securities Industry Association (March 24, 2006);
Mike Ianni (April 5, 2006); Mike Ianni (April 5,
2006); Peter van Dooijeweert, President, Alopex
Capital Management, LLC (April 26, 2006); Bob
Linville and Deborah Mittelman, Service Bureau
Committee Co-Chairs, Financial Information Forum
(May 2, 2006); and William H. Navin, Executive
Vice President, General Counsel, and Secretary, The
Options Clearing Corporation (September 29, 2006).
4 Securities Exchange Act Release No. 54748
(November 14, 2006), 71 FR 67415.
5 James Knight, Vice President, Manager, Options
Trading Strategies, Raymond James Associates,
Gary Franklin, Manager of Option Trading,
Managing Director, Senior Options Principal,
Morgan Keegan Co., and Dennis Moorman,
Manager-Options Department, J.J.B. Hilliard, W.L.
Lyons, Inc. (December 12, 2006); William H. Navin,
Executive Vice President, General Counsel, and
Secretary, The Options Clearing Corporation
(December 21, 2006); Erik A. Hartog, Operating
Manager, Allagash Trading LLC (January 8, 2007);
and William H. Navin, Executive Vice President,
General Counsel, and Secretary, The Options
Clearing Corporation (January 9, 2007).
6 OCC filed a companion proposed rule change
seeking to revise its stock futures adjustment
methodology in a manner consistent with the
revised option adjustment methodology. Securities
Exchange Act Release No. 54898 (December 8,
2006), 71 FR 75287 (December 14, 2006) (File No.
SR–OCC–2006–08).
VerDate Aug<31>2005
19:03 Feb 15, 2007
Jkt 211001
A. Changes Relating to Adjustments for
Certain Stock Dividends,
StockDistributions, and Stock Splits
Prior to this rule change, OCC’s ByLaws specified two alternative methods
of adjusting for stock dividends, stock
distributions, and stock splits. In cases
where one or more whole shares are
issued with respect to each outstanding
share, the number of outstanding option
contracts is correspondingly increased
and strike prices are proportionally
reduced.7 In all other cases, the number
of shares to be delivered under the
option contract is increased and the
strike price is reduced proportionately.8
Although these two methods have
been used for many years, in certain
circumstances either method can
produce a windfall profit for one side
and a corresponding loss for the other
side due to rounding of adjusted strike
prices. These profits and losses, while
small on a per contract basis, can be
significant for large positions. Because
equity option strike prices are currently
stated in eighths, OCC’s By-Laws
require adjusted strike prices to be
rounded to the nearest eighth. For
example, if an XYZ $50 option for 100
shares were to be adjusted for a 3-for2 split, the deliverable would be
increased to 150 shares, and the strike
price would be adjusted to $33.33 and
then be rounded up to $333⁄8. Prior to
the adjustment, a call holder would
have had to pay $5,000 to exercise ($50
× 100 shares). After the adjustment, the
caller would have to pay $5,006.25 for
the equivalent stock position ($33.375 ×
150 shares). Conversely, an exercising
put holder would receive $5,006.25
instead of $5,000. The $6.25 difference
represents a loss for call holders and put
writers and a windfall for put holders
and call writers.
A loss/windfall can also occur when
the split results in a fractional
deliverable (e.g., a 4-for-3 split produces
a deliverable of 133.3333 shares). In
those cases, OCC’s By-Laws required
that the deliverable be rounded down to
eliminate the fraction, and if
appropriate, the strike price be further
adjusted to the nearest eighth to
compensate for the diminution in the
value of the contract resulting from the
elimination of the fractional share.
However, even if these steps are taken,
small rounding inequities often remain.
7 For example, in the event of a 2-for-1 split, an
XYZ $60 option calling for the delivery of 100
shares of XYZ stock would be subdivided into two
XYZ $30 options, each calling for the delivery of
100 shares of XYZ stock.
8 For example, in a 3-for-2 split, an XYZ $60
option calling for the delivery of 100 shares would
be adjusted to call for the delivery of 150 shares and
the strike price would be reduced to $40.
PO 00000
Frm 00112
Fmt 4703
Sfmt 4703
The windfall profits and
correspondent losses resulting from the
rounding process have historically been
accepted as immaterial. However, due to
recent substantial increases in trading
volume and position size, they have
become a source of concern to
exchanges and market participants. In
addition, OCC has been informed that
some traders may be exploiting
announcements of splits and similar
events by quickly establishing positions
designed to capture rounding windfalls
at the expense of other market
participants.
The inequity that results from
rounding strike prices can be eliminated
by using a different adjustment method
whereby the deliverable is adjusted but
the strike prices or the values used to
calculate aggregate exercise prices and
premiums are not. As an illustration of
the new adjustment methodology, in the
XYZ $50 option 3-for-2 split example
described above, the resulting
adjustment would be a deliverable of
150 shares of XYZ stock while the strike
price would remain at $50. In this case,
the presplit multiplier of 100, used to
extend aggregate strike price and
premium amounts, is unchanged. For
example, a premium of 1.50 would
equal $150 ($1.5 × 100) both before and
after the adjustment. An exercising call
holder would continue to pay $5,000
($50 times 100) but would receive 150
shares of XYZ stock instead of 100.9
This is the method currently used for
property distributions such as spin-offs
and special dividends large enough to
require adjustments under OCC’s ByLaws. 10
The inequity that results from the
need to eliminate fractional shares from
the deliverable and to compensate by
further reducing the strike price to the
nearest eighth can be eliminated by
adjusting the deliverable to include cash
in lieu of the fractional share. As an
illustration, consider a 4-for-3 split of
the stock underlying an XYZ $80 option
with a 100 share deliverable. Employing
the new adjustment method, the
deliverable would be adjusted to
133.3333 shares, which would be
rounded down to 133 shares, and the
strike price would remain $80.
However, instead of compensating for
the elimination of the .3333 share by
9 The same adjustment methodology will apply to
reverse stock splits or combination of shares. For
example, in a 3-for-4 reverse stock split on a XYZ
$50 option calling for the delivery of 100 shares, the
resulting adjustment would be a deliverable of 75
shares of XYZ stock while the strike price would
remain at $50.
10 The adjustment methodology used for spinoffs, mergers, and special cash dividends is to
adjust the unit of trading while leaving the strike
price unchanged.
E:\FR\FM\16FEN1.SGM
16FEN1
Federal Register / Vol. 72, No. 32 / Friday, February 16, 2007 / Notices
reducing the strike prices, the strike
prices would remain unchanged, and
the cash value of the eliminated
fractional share (.3333 x the post-split
value of a share of XYZ stock as
determined by OCC) would be the
deliverable along with the 133 shares.
The adjusted option would also
continue to use 100 as the multiplier to
calculate aggregate strike and premium
amounts.
The revised adjustment methodology
will not be applied to 2-for-1 or 4-for1 stock distributions or splits (since
such distributions or splits normally
result in strike prices that do not require
rounding to the nearest eighth) unless
the split requires rounding of the strike
price, which may occur where the strike
price was previously adjusted due to an
earlier stock distribution or split. In
addition, the revised adjustment
methodology will not generally be used
for stock dividends, stock distributions,
or stock splits with respect to any series
of options having exercise prices stated
in decimals.11 For those options, the
existing adjustment rules will continue
to apply. The reason for this is that once
the market has converted to decimal
strikes, the rounding errors created by
rounding to the nearest cent would be
immaterial even given the larger
positions taken in today’s markets and
the other factors discussed above.
Because conversion to decimal strikes
might be phased in rather than applied
to all series of equity options
simultaneously, the rule has been
drafted to cover both methods of
expressing exercise prices.
The changes in adjustment
methodology will not be implemented
until the exchanges have conducted
appropriate educational efforts and
definitive copies of an appropriate
supplement to the options disclosure
document, Characteristics and Risks of
Standardized Options, are available for
distribution.12
sroberts on PROD1PC70 with NOTICES
B. Changes to the Definition of
‘‘Ordinary Dividends and Distributions’’
Currently, Article VI, Section 11A(c)
of OCC’s By-Laws provides that as a
general rule, outstanding options will
not be adjusted to compensate for
ordinary cash dividends. Interpretation
and Policy .01 under Section 11A of
Article VI provides that a cash dividend
will generally be deemed to be
11 Although there are currently no decimal strikes
for equity options, OCC wants to avoid the need for
further amendments to its By-Laws and the options
disclosure document in the event that such strikes
are introduced in the future.
12 OCC will notify the Commission and issue an
Important Notice when the new adjustment
methodology is implemented.
VerDate Aug<31>2005
19:03 Feb 15, 2007
Jkt 211001
‘‘ordinary’’ if the amount does not
exceed 10% of the value of the
underlying stock on the declaration date
(‘‘10% Rule’’). The OCC Securities
Committee is authorized to decide on a
case-by-case basis whether to adjust for
dividends exceeding that amount. As a
result, OCC historically has not adjusted
for special cash dividends unless the
amount of the dividend was greater than
10% of the stock price at the close of
trading on the declaration day.
The 10% Rule predated a number of
significant developments, including the
introduction of Long-term Equity
AnticiPation Security (‘‘LEAPS’’)
options, the sizeable open interest seen
today, the large contract volume
associated with trading and spreading
strategies, and the modern option
pricing models that take dividends into
account. When open interests and
individual positions were smaller, not
adjusting for dividends of less than 10%
did not have the pronounced impact it
does today. Additionally, changes to the
tax code which now tax dividends more
favorably have provided an incentive for
companies to pay more dividends,
including special dividends. In light of
these considerations, OCC believes it is
appropriate to now revise the 10% Rule.
Under OCC’s revision, a cash
dividend or distribution would be
considered ordinary (regardless of size)
if the OCC Securities Committee
determines that such dividend or
distribution was declared pursuant to a
policy or practice of paying such
dividends or distributions on a quarterly
or other regular basis. In addition, as a
general rule, a cash dividend or
distribution that is less than $12.50 per
contract would not trigger the
adjustment provisions of Article VI,
Section 11A.
7703
This economic disadvantage is further
magnified if the option position is large,
as is often the case today. Conversely,
put holders often receive a windfall
benefit from the increase in the in-themoney value on the ex date. To the
extent that equity options can be priced
accurately and consistently without
dislocations due to unforeseen special
dividends, these economic
disadvantages can be avoided.
Moreover, because special dividends are
one-off events, adjusting for them
should not cause the proliferation of
outstanding options series and symbols
that would result from adjusting for
regular dividends as explained below.
2. De Minimis Threshold
Adjusting for dividends can cause a
proliferation of outstanding option
symbols and series.14 In the interest of
providing some limit on option symbol
proliferation, the revised adjustment
policy will include a de minimis
threshold of $12.50 per contract. Special
dividends smaller than this amount will
not trigger an adjustment.
OCC believes that a threshold that is
a set dollar amount is preferable to one
that is a percentage of the stock price
(like OCC’s 10% Rule) because there are
operational problems with applying a
percentage threshold. Under the 10%
Rule, in order to determine whether the
threshold is met, the per share dividend
amount is added to the closing price of
the underlying security on the dividend
declaration date. The date the dividend
is announced (by press release or by
some other means) is not normally the
‘‘declaration date’’ when the dividend is
officially declared by an issuer’s board
of directors. Until the actual declaration
date, investors and traders may not
know whether or not an announced
1. No Adjustment for Regularlydividend will trigger an adjustment
Scheduled Dividends Needed
based on the company’s share price. In
Dividends declared by an issuer
the interim, it is difficult for traders and
pursuant to a policy or practice of such
issuer are known and can thus be priced investors to price their options because
they do not know if an adjustment will
into option premiums. By definition,
be made.
however, special dividends cannot be
The advantage of a fixed dollar
anticipated in advance and therefore
cannot be integrated into option pricing threshold is the avoidance of
models.13 If adjustments are not made in uncertainty. The per contract value of
the dividend can be immediately
response to special dividends, call
determined without the need to wait
holders can capture the dividends only
until the declaration date and without
by exercising their options. Often in
the need to do a calculation based on
these cases, especially with LEAPS
the closing price of the underlying
options or FLEX options which can last
shares.
for 5 to 10 years, early exercise would
sacrifice substantial option time value.
13 OCC
has been told that some traders form
judgments as to the likelihood that certain issuers
may declare special cash dividends and factor those
judgments into their pricing models.
PO 00000
Frm 00113
Fmt 4703
Sfmt 4703
14 Symbols proliferate when adjustments are
made because often the dividend amount must be
added to the deliverable yielding a non-standard
option. The exchanges then introduce standard
options with the same strikes.
E:\FR\FM\16FEN1.SGM
16FEN1
7704
Federal Register / Vol. 72, No. 32 / Friday, February 16, 2007 / Notices
3. Consistency Across Relevant
Interpretations
Interpretations and Policies .01 and
.08 under Article VI, Section 11A apply
to cash distributions. Interpretation and
Policy .01 (as amended by this rule
change) will apply in general to all cash
distributions. Interpretation and Policy
.08 currently carves out exceptions for
fund share cash distributions and does
not include a threshold minimum. In
the interest of clarity and consistency
with Interpretation and Policy .01,
Interpretation .08 is being revised to
provide for the same $12.50 per contract
threshold for fund share cash
distributions. Clause (ii) of
Interpretation and Policy .08 sets forth
an exception to the 10% Rule and will
be deleted when the 10% Rule is
abolished.
III. Comment Letters
The Commission received fourteen
comment letters in response to the
proposed rule change.15 Eleven of the
comment letters opposed the rule
change. OCC submitted three letters
responding to the comment letters.
Seven of the comment letters opposed
elimination of the 10% Rule.16 Three of
the comment letters opposed the
adjustment methodology for stock
dividends, stock distributions, and stock
splits.17
sroberts on PROD1PC70 with NOTICES
A. Comments Opposing the 10% Rule
Those commenters opposing
elimination of the 10% Rule did so for
various reasons. First, they felt that
elimination of the 10% Rule for existing
contracts would be unfair to the contract
traders who have priced adjustments
into their pricing models based on their
estimated probability that an issuer will
pay a special dividend with the
15 Supra notes 3 and 5. Joseph Haggenmiller’s
comment letter objected to the entire proposed rule
change but did not state why. Joseph Haggenmiller
(March 8, 2006). The comment letters received after
OCC’s amendment did not comment on the
amendment.
16 Erik A. Hartog, Operating Manager, Allagash
Trading LLC (March 21, 2006); Jeffrey Woodring
(March 22, 2006); Adam Besch-Turner (March 23,
2006); Mike Ianni (April 5, 2006); Mike Ianni (April
5, 2006); Peter van Dooijeweert, President, Alopex
Capital Management, LLC (April 26, 2006); and Erik
A. Hartog, Operating Manager, Allagash Trading
LLC (January 8, 2007).
17 Christopher Nagy, Chairman, Options
Committee, Securities Industry Association (March
24, 2006); Bob Linville and Deborah Mittelman,
Service Bureau Committee Co-Chairs, Financial
Information Forum (May 2, 2006); and James
Knight, Vice President, Manager, Options Trading
Strategies, Raymond James Associates, Gary
Franklin, Manager of Option Trading, Managing
Director, Senior Options Principal, Morgan Keegan
Co., and Dennis Moorman, Manager-Options
Department, J.J.B. Hilliard, W.L. Lyons, Inc.
(December 12, 2006).
VerDate Aug<31>2005
19:03 Feb 15, 2007
Jkt 211001
assumption that OCC would adjust for
special dividends based on the 10%
Rule. OCC responded that it did not
believe special dividends could be
anticipated in advance and therefore
could not be integrated into pricing
models. However, OCC discussed the
matter with market participants and
now understands that some traders do
estimate the probability of special
dividends by selected issuers and do
factor those estimates into their pricing
models. In response, OCC amended the
proposed rule change so that the 10%
Rule would be eliminated and replaced
with the dollar threshold test beginning
with dividends announced on and after
February 1, 2009. The few outstanding
options series with expirations beyond
that date will be grandfathered and will
be assigned separate trading symbols.
Second, some commenters expressed
their concerns that elimination of the
10% Rule would create uncertainty as to
whether OCC would classify particular
vidends as ordinary or special and that
market liquidity for the affected options
would disappear until OCC announced
whether a dividend was ordinary or
special. OCC responded that a dividend
will be classified as ordinary if it is
declared pursuant to a policy or practice
of paying such dividends on a quarterly
or other regular basis. The issue as to
whether a particular dividend or
distribution fits the criteria to be
classified as ordinary or special would
be determined by a panel of the OCC
Securities Committee, which consists of
two representatives of each exchange
that lists options on the underlying
security and one representative of OCC,
who votes only in the event of a tie vote.
OCC contends that most special
dividends are in such amounts and/or
payable on such dates that it will be
immediately obvious to the market that
they are not being declared pursuant to
a policy or a practice of paying such
dividends on a quarterly or other regular
basis. In addition, issuers normally
classify a dividend as special or
ordinary when the dividend is
announced. While this will not control
OCC’s determination of whether a
dividend is ordinary or special, in the
vast majority of cases a dividend
classified by the issuer as special would
not fit OCC’s definition of ordinary cash
dividends or distributions.
In certain cases the OCC Securities
Committee will need to make a
judgment as to whether to classify a
dividend as ordinary or special. The
uncertainty which may exist in such
cases will diminish over time as OCC
publishes interpretations and policies
and a body of precedent develops. OCC
intends to publish informational
PO 00000
Frm 00114
Fmt 4703
Sfmt 4703
material indicating how these situations
will be handled. Pursuant to the
amendment, the elimination of the 10%
Rule will only be effective for dividends
announced on and after February 1,
2009, which should allow ample lead
time for OCC’s educational effort to get
under way.
OCC also responded that a balance
needs to be struck between uncertainty
and fairness in that under the 10% Rule,
market participants incur large losses in
the case of a 9.9% special dividend but
are made whole if the special dividend
exceeds 10% of the closing stock price
on the declaration date.
The commenters’ third major concern
in opposing elimination of the 10%
Rule was that the rule change would
lead to symbol proliferation in that any
special dividend greater than $12.50 per
contract would trigger a contract
adjustment and a new symbol. The
frequency of such adjustments could be
very high, causing a sharp spike in
symbol proliferation. OCC responded by
acknowledging that this is true for the
short term but that the need for
additional symbols would end when the
industry converts to decimal stike
prices.18 Also, OCC believes that the
inequities caused by the 10% Rule
outweigh any operational burdens
associated with symbol proliferation.19
The fourth major concern raised by
the commenters in opposing the 10%
Rule was that the revised rule could
reduce liquidity for adjusted options
because investors are drawn to round
increments in strike prices. The 10%
Rule has always avoided liquidity loss
by only creating odd strike prices when
the dividend is so extraordinarily
disproportionate as to require
adjustment. OCC responded that despite
the thousands of contractual
adjustments made in over 33 years of
options trading on U.S. markets, it
knows of no case where liquidity was
wiped out for an adjusted series.
Market-makers on U.S. options
exchanges are numerous, highly
competitive, quick to exploit arbitrage
opportunities, and in many cases
obligated by exchange rules to make
18 The current plan is to begin converting
fractional strikes to decimal strikes in November
2009.
19 Since the beginning of 2006, OCC has been
tracking special dividends that were too small to
trigger an adjustment under the 10% Rule but that
would be large enough to cause an adjustment
under the revised rule. Up to September 2006, there
were a total of 22 more dividends which would
have required additional symbols for conventional
equity options. In some cases, new symbols would
also have had to be assigned for LEAP and flex
contracts. According to OCC, the number is not
small but is certainly not large relative to the
hundreds of adjusted and wrap symbols already
assigned.
E:\FR\FM\16FEN1.SGM
16FEN1
Federal Register / Vol. 72, No. 32 / Friday, February 16, 2007 / Notices
markets in every series of every class in
which they quote.20
B. Comments Opposing the Adjustment
Methodology for Stock Dividends, Stock
Distributions, and Stock Splits
The commenters who opposed the
revised adjustment methodology for
stock dividends, stock distributions, and
stock splits did so by suggesting
alternative models such as those
employed by Eurex and other non-U.S.
exchanges.21 OCC responded that while
it has an open mind about making
further changes to its adjustment
methodology, it did not believe it would
be feasible to adopt any of the
alternative models proposed by the
commenters because they would require
extensive and onerous systems changes
by OCC, exchanges, members, and
vendors. One of the commenters who
opposed the adjustment methodology
argued that the adjustment methodology
is new and will result in significant
modifications to the systems which
support the adjustment methodology
OCC seeks to replace.22 In addition, the
commenter argued that if OCC’s
proposed adjustment methodology is
implemented and the strike price does
not change when an adjustment takes
place, some other indicator in the
displays used to trade options must be
changed to somehow alert the investor
that the option represents an adjusted
contract. OCC responded that it is
simply applying to stock dividends,
stock distributions, and stock splits the
same adjustment methodology used for
over thirty years for spin-offs, mergers,
and special cash dividends. In addition,
OCC argued, price vendors, service
bureaus, and securities firms currently
do and have always identified adjusted
contracts through the use of adjusted
symbols.
IV. Amendment
To address certain concerns expressed
in the comment letters and by others,
OCC amended the proposed rule
change. OCC understands that certain
option traders may have integrated into
their pricing models the probability of
special dividends and their being
adjusted based on the OCC rules
20 See,
e.g., CBOE Rules 8.7 and 8.85.
Nagy, Chairman, Options
Committee, Securities Industry Association (March
24, 2006) and James Knight, Vice President,
Manager, Options Trading Strategies, Raymond
James Associates, Gary Franklin, Manager of Option
Trading, Managing Director, Senior Options
Principal, Morgan Keegan Co., and Dennis
Moorman, Manager-Options Department, J.J.B.
Hilliard, W.L. Lyons, Inc. (December 12, 2006).
22 Bob Linville and Deborah Mittelman, Service
Bureau Committee Co-Chairs, Financial Information
Forum (May 2, 2006).
sroberts on PROD1PC70 with NOTICES
21 Christopher
VerDate Aug<31>2005
19:03 Feb 15, 2007
Jkt 211001
currently in effect and that eliminating
the 10% Rule with respect to existing
contracts may unfairly affect these
options traders. To ensure that no
options series that were opened before
approval of the proposed rule change
are affected by elimination of the 10%
Rule, OCC’s elimination of the 10%
Rule and implementation of the fixed
dollar threshold will take effect only for
corporate events announced on or after
February 1, 2009. OCC plans to provide
ODD disclosure of this rule change
before May 29, 2007, (after which date
the exchanges would normally begin
introducing LEAPS expiring in 2010
making a 2009 implementation
impracticable). The delay in
implementation will ensure that all
options series opened before the ODD
disclosure is made available (other than
certain ‘‘flex’’ options that will be
grandfathered under the old rule) will
have expired before the change is
effected.23 While delaying the
implementation until 2009 postpones
the benefit of making this needed
change, it addresses the concerns of
firms that find the operational hurdles
and fairness issues associated with an
earlier implementation onerous.
V. Discussion
After carefully considering the
proposed rule change as amended and
all of the written comments received,
the Commission finds that the proposed
rule change is consistent with the
requirements of the Act and the rules
and regulations thereunder and
particularly with the requirements of
Section 17A(b)(3)(F).24 Section 19(b) 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, in general, to
protect investors and the public interest.
23 OCC intends to take a ‘‘snapshot’’ of flex series
expiring after January 31, 2009, that are outstanding
at the time when ODD disclosure of the rule change
is made. Those series will be assigned distinctive
trading symbols and ‘‘grandfathered’’ under the old
rule. Trading will continue normally in
grandfathered series until their expiration, but the
exchanges would be free to open otherwise
identical non-grandfathered series, which would be
identified by conventional flex trading symbols. If
ODD disclosure is not made until after the
December 2006 expiration, it may also be necessary
to grandfather two classes of LEAPs with December
expirations (SPY and S&P 100 i-Shares) because the
exchanges would ordinarily introduce new series
expiring in December 2009 after the December 2006
expiration.
24 15 U.S.C. 78q–1(b)(3)(F).
PO 00000
Frm 00115
Fmt 4703
Sfmt 4703
7705
The Commission believes that OCC’s
rule change is consistent with this
Section because (1) it is intended to
eliminate inequities that result from
certain rounding practices currently
required by OCC’s By-Laws and thus
should protect investors and (2) it is
intended to make more predictable
when cash distributions by an issuer
will result in an adjustment to an option
contract and thus should make the
process for adjustments more equitable
for all investors.
OCC has amended the rule change in
response to many of the commenters
that opposed various portions of the
rule change for various reasons.
Some commenters expressed concern
that elimination of the 10% Rule would
create uncertainty as to whether OCC
would classify particular dividends as
ordinary or special and that market
liquidity for the affected options would
disappear until OCC made an
announcement whether a dividend is
ordinary or special. The Commission
feels that OCC’s proposed rule is clear
as to the procedure that will be used to
classify a dividend as ordinary or
special. A dividend will be classified as
ordinary if it is declared pursuant to a
policy or practice of paying such
dividends on a quarterly or other regular
basis. The Commission finds persuasive
OCC’s argument that most special
dividends are in such amounts and/or
payable on such dates that it will be
immediately obvious to the market that
they are not being declared pursuant to
a policy or a practice of paying such
dividends on a quarterly or other regular
basis. In addition, issuers normally
classify a dividend as special or
ordinary when the dividend is
announced, and in the vast majority of
cases a dividend classified by the issuer
as special would not fit OCC’s definition
of ordinary cash dividends or
distributions. Any uncertainty which
may exist in cases where the OCC
Securities Committee will need be to
make a judgment as to whether a
dividend is ordinary or special should
diminish over time as OCC publishes
interpretations and policies and a body
of precedent develops. In addition, the
Commission is not convinced,
considering that adjusted options have
shown no lack of liquidity in the past,
that the elimination of the 10% Rule
will wipe out liquidity for adjusted
options.
Some commenters stated that the
elimination of the 10% Rule for existing
contracts would be unfair to those
traders that have built into their pricing
models the possibility that an issuer
would declare a special dividend and
the effect of that dividend under the
E:\FR\FM\16FEN1.SGM
16FEN1
7706
Federal Register / Vol. 72, No. 32 / Friday, February 16, 2007 / Notices
sroberts on PROD1PC70 with NOTICES
10% Rule. In response, OCC amended
the filing so that the 10% Rule will be
eliminated and the new dollar threshold
implemented only for dividends
announced on and after February 1,
2009, so that the majority of existing
options contracts will not be affected.
Some commenters also argued that
elimination of the 10% Rule would lead
to symbol proliferation in that any
special dividend greater than $12.50 per
contract would trigger a contract
adjustment and a new symbol. The
Commission believes that any symbol
proliferation should be short lived as
the industry is planning to convert from
fractional strikes to decimal strikes in
November 2009 and that the benefits of
the change outweigh any burdens.
Of particular concern to the
Commission is the inequitable economic
impact of unanticipated special
dividends on market participants when
the 10% Rule is applied. The
Commission believes that OCC’s rule
change makes appropriate changes to
the way that OCC handles special
dividends to address this problem.
Those commenters that disagreed
with the adjustment methodology for
stock dividends, stock distributions, and
stock splits suggested changes that
would require major systems revisions.
The Commission believes that such
systems changes would be a tremendous
burden on the industry and the costs
would not outweigh any benefits.
Finally, it was argued that major
systems changes would need to be
undertaken and symbols changed to
somehow alert investors that an option
represents an adjusted contract. The
Commission is not persuaded by this
argument because the adjustment
methodology OCC is going to apply to
stock dividends, stock distributions, and
stock splits is the same adjustment
methodology it has used for over thirty
years for spin-offs, mergers, and
extraordinary cash dividends and
identification of these adjusted contracts
does not appear to have presented a
problem.
VI. 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 Section 17A of the Act and
the rules and regulations thereunder.25
In approving the proposed rule change,
the Commission considered the
proposal’s impact on efficiency,
competition and capital formation.
It is therefore ordered, pursuant to
Section 19(b)(2) of the Act, that the
25 15
U.S.C. 78c(f).
VerDate Aug<31>2005
19:03 Feb 15, 2007
Jkt 211001
proposed rule change (File No. SR–
FICC–2006–01), as modified by
Amendment No. 1, be and hereby is
approved.
For the Commission by the Division of
Market Regulation, pursuant to delegated
authority.26
Florence E. Harmon,
Deputy Secretary.
[FR Doc. E7–2792 Filed 2–15–07; 8:45 am]
BILLING CODE 8011–01–P
SECURITIES AND EXCHANGE
COMMISSION
[Release No. 34–55261; File No. SR–Phlx–
2007–01]
Self-Regulatory Organizations;
Philadelphia Stock Exchange, Inc.;
Notice of Filing and Immediate
Effectiveness of Proposed Rule
Change and Amendment No. 1 Thereto
Relating to Calculation and
Dissemination of PHLX/KBW Bank
Index Values
February 8, 2007.
Pursuant to Section 19(b)(1) of the
Securities Exchange Act of 1934
(‘‘Act’’),1 and Rule 19b–4 thereunder,2
notice is hereby given that on January
18, 2007, the Philadelphia Stock
Exchange, Inc. (‘‘Phlx’’ or ‘‘Exchange’’)
filed with the Securities and Exchange
Commission (‘‘Commission’’) the
proposed rule change as described in
Items I and II below, which Items have
been substantially prepared by the Phlx.
On February 2, 2007, the Phlx filed
Amendment No. 1 to the proposed rule
change. The Phlx filed the proposed
rule change as a ‘‘non-controversial’’
rule change pursuant to Section
19(b)(3)(A) of the Act 3 and Rule 19b–
4(f)(6) thereunder,4 which renders the
proposal effective upon filing with the
Commission. The Commission is
publishing this notice to solicit
comments on the proposed rule change,
as amended, from interested persons.5
I. Self-Regulatory Organization’s
Statement of the Terms of Substance of
the Proposed Rule Change
The Phlx proposes that Dow Jones &
Company, Inc. (‘‘Dow Jones’’) will
26 17
CFR 200.30–3(a)(12).
U.S.C. 78s(b)(1).
2 17 CFR 240.19b–4.
3 15 U.S.C. 78s(b)(3)(A).
4 17 CFR 240.19b–4(f)(6).
5 Certain additions and technical corrections were
made throughout the discussion of the proposed
rule change pursuant to conversations with Phlx
staff. Telephone conversation between Jurij
Trypupenko, Director and Counsel, Phlx, and Kate
Robbins, Attorney, Division of Market Regulation,
Commission, on February 5, 2007.
1 15
PO 00000
Frm 00116
Fmt 4703
Sfmt 4703
replace the Exchange as the party solely
responsible for the calculation and
dissemination of the current index
values 6 of the PHLX/KBW Bank Index
(‘‘Bank Index’’ or ‘‘Index’’).7
II. Self-Regulatory Organization’s
Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule
Change
In its filing with the Commission, the
Phlx included statements concerning
the purpose of and basis for the
proposed rule change and discussed any
comments it received on the proposed
rule change. The text of these statements
may be examined at the places specified
in Item IV below. The Phlx has prepared
summaries, set forth in Sections A, B,
and C below, of the most significant
aspects of such statements.
A. Self-Regulatory Organization’s
Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule
Change
1. Purpose
The purpose of the proposed rule
change is to provide that Dow Jones,
rather than the Exchange, will calculate
and disseminate the current index
values of the Bank Index. No other
changes are proposed in respect of the
Index.
Options on the Bank Index, a narrowbased (industry) index, were originally
listed in 1992.8 The Commission’s
Approval Order regarding the Bank
Index and options on it contains the
following language about the calculation
of the underlying current index value:
Even though the Index will be maintained
by KBW, the Phlx represents that the
Exchange will be solely responsible for the
calculation of the Index and that the Index
value will be calculated and disseminated in
such a way that neither KBW nor any other
party will be in receipt of the Index value
prior to the public dissemination of the
6 Bridge Data, which merged into Reuters, at
various times has calculated and disseminated
relevant index values on behalf of the Exchange.
7 KBW is a registered broker-dealer that, among
other things, specializes in U.S. bank stocks and is
recognized as the ‘‘financial services industry
authority.’’ The Bank Index (BKX), also known as
the KBW Bank Index and as a sector index, is a
European-style modified-capitalization-weighted
index composed of 24 geographically dispersed
companies representing national money center
banks and leading regional institutions. KBW has
informed the Exchange that an independent third
party, Dow Jones, on behalf of KBW will calculate
and publicly disseminate the current values of the
Bank Index and will follow necessary procedures
such as publicly reporting the current underlying
index values at least once every 15 seconds during
the periods that options on the Bank Index are
traded.
8 See Securities Exchange Act Release No. 31145
(September 3, 1992), 57 FR 41531 (September 10,
1992) (SR–Phlx–91–27) (‘‘Approval Order’’).
E:\FR\FM\16FEN1.SGM
16FEN1
]]>Agencies
[Federal Register Volume 72, Number 32 (Friday, February 16, 2007)]
[Notices]
[Pages 7701-7706]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E7-2792]
-----------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-55258; File No. SR-OCC-2006-01]
Self-Regulatory Organizations; The Options Clearing Corporation;
Order Approving Proposed Rule Change as Modified by Amendment No. 1 To
Revise Option Adjustment Methodology
�MDBU�*ERR01*�MDNM�
February 8, 2007.
I. Introduction
On January 12, 2006, The Options Clearing Corporation (``OCC'')
filed with the Securities and Exchange Commission (``Commission'')
proposed rule change SR-OCC-2006-01 pursuant to Section 19(b)(1) of the
Securities Exchange Act of 1934 (``Act'').\1\ On March 9, 2006, the
Commission published notice of the proposed rule
[[Page 7702]]
change to solicit comments from interested parties.\2\ The Commission
received ten comment letters upon publication of the notice.\3\ To
address the concerns raised by the commenters, OCC amended the proposed
rule change on September 25, 2006. On November 21, 2006, the Commission
published notice of the amended proposed rule change to solicit
comments from interested parties.\4\ The Commission received four
additional comment letters.\5\ For the reasons discussed below, the
Commission is approving the proposed rule change.\6\
---------------------------------------------------------------------------
\1\ 15 U.S.C. 78s(b)(1).
\2\ Securities Exchange Act Release No. 53400 (March 2, 2006),
71 FR 12226.
\3\ Joseph Haggenmiller (March 8, 2006); Erik A. Hartog,
Operating Manager, Allagash Trading LLC (March 21, 2006); Jeffrey
Woodring (March 22, 2006); Adam Besch-Turner (March 23, 2006);
Christopher Nagy, Chairman, Options Committee, Securities Industry
Association (March 24, 2006); Mike Ianni (April 5, 2006); Mike Ianni
(April 5, 2006); Peter van Dooijeweert, President, Alopex Capital
Management, LLC (April 26, 2006); Bob Linville and Deborah
Mittelman, Service Bureau Committee Co-Chairs, Financial Information
Forum (May 2, 2006); and William H. Navin, Executive Vice President,
General Counsel, and Secretary, The Options Clearing Corporation
(September 29, 2006).
\4\ Securities Exchange Act Release No. 54748 (November 14,
2006), 71 FR 67415.
\5\ James Knight, Vice President, Manager, Options Trading
Strategies, Raymond James Associates, Gary Franklin, Manager of
Option Trading, Managing Director, Senior Options Principal, Morgan
Keegan Co., and Dennis Moorman, Manager-Options Department, J.J.B.
Hilliard, W.L. Lyons, Inc. (December 12, 2006); William H. Navin,
Executive Vice President, General Counsel, and Secretary, The
Options Clearing Corporation (December 21, 2006); Erik A. Hartog,
Operating Manager, Allagash Trading LLC (January 8, 2007); and
William H. Navin, Executive Vice President, General Counsel, and
Secretary, The Options Clearing Corporation (January 9, 2007).
\6\ OCC filed a companion proposed rule change seeking to revise
its stock futures adjustment methodology in a manner consistent with
the revised option adjustment methodology. Securities Exchange Act
Release No. 54898 (December 8, 2006), 71 FR 75287 (December 14,
2006) (File No. SR-OCC-2006-08).
---------------------------------------------------------------------------
II. Description
OCC is amending Article VI (Clearance of Exchange Transactions),
Section 11A of its By-Laws to (1) Eliminate the need to round strike
prices and/or units of trading in the event of certain stock dividends,
stock distributions, and stock splits and (2) provide for the
adjustment of outstanding options for special dividends (i.e., cash
distributions not declared pursuant to a policy or practice of paying
such distributions on a quarterly or other regular basis). The proposed
rule change also adds a $12.50 per contract threshold amount for cash
dividends and distributions to trigger application of OCC's adjustment
rules.
A. Changes Relating to Adjustments for Certain Stock Dividends,
StockDistributions, and Stock Splits
Prior to this rule change, OCC's By-Laws specified two alternative
methods of adjusting for stock dividends, stock distributions, and
stock splits. In cases where one or more whole shares are issued with
respect to each outstanding share, the number of outstanding option
contracts is correspondingly increased and strike prices are
proportionally reduced.\7\ In all other cases, the number of shares to
be delivered under the option contract is increased and the strike
price is reduced proportionately.\8\
---------------------------------------------------------------------------
\7\ For example, in the event of a 2-for-1 split, an XYZ $60
option calling for the delivery of 100 shares of XYZ stock would be
subdivided into two XYZ $30 options, each calling for the delivery
of 100 shares of XYZ stock.
\8\ For example, in a 3-for-2 split, an XYZ $60 option calling
for the delivery of 100 shares would be adjusted to call for the
delivery of 150 shares and the strike price would be reduced to $40.
---------------------------------------------------------------------------
Although these two methods have been used for many years, in
certain circumstances either method can produce a windfall profit for
one side and a corresponding loss for the other side due to rounding of
adjusted strike prices. These profits and losses, while small on a per
contract basis, can be significant for large positions. Because equity
option strike prices are currently stated in eighths, OCC's By-Laws
require adjusted strike prices to be rounded to the nearest eighth. For
example, if an XYZ $50 option for 100 shares were to be adjusted for a
3-for-2 split, the deliverable would be increased to 150 shares, and
the strike price would be adjusted to $33.33 and then be rounded up to
$33\3/8\. Prior to the adjustment, a call holder would have had to pay
$5,000 to exercise ($50 x 100 shares). After the adjustment, the caller
would have to pay $5,006.25 for the equivalent stock position ($33.375
x 150 shares). Conversely, an exercising put holder would receive
$5,006.25 instead of $5,000. The $6.25 difference represents a loss for
call holders and put writers and a windfall for put holders and call
writers.
A loss/windfall can also occur when the split results in a
fractional deliverable (e.g., a 4-for-3 split produces a deliverable of
133.3333 shares). In those cases, OCC's By-Laws required that the
deliverable be rounded down to eliminate the fraction, and if
appropriate, the strike price be further adjusted to the nearest eighth
to compensate for the diminution in the value of the contract resulting
from the elimination of the fractional share. However, even if these
steps are taken, small rounding inequities often remain.
The windfall profits and correspondent losses resulting from the
rounding process have historically been accepted as immaterial.
However, due to recent substantial increases in trading volume and
position size, they have become a source of concern to exchanges and
market participants. In addition, OCC has been informed that some
traders may be exploiting announcements of splits and similar events by
quickly establishing positions designed to capture rounding windfalls
at the expense of other market participants.
The inequity that results from rounding strike prices can be
eliminated by using a different adjustment method whereby the
deliverable is adjusted but the strike prices or the values used to
calculate aggregate exercise prices and premiums are not. As an
illustration of the new adjustment methodology, in the XYZ $50 option
3-for-2 split example described above, the resulting adjustment would
be a deliverable of 150 shares of XYZ stock while the strike price
would remain at $50. In this case, the presplit multiplier of 100, used
to extend aggregate strike price and premium amounts, is unchanged. For
example, a premium of 1.50 would equal $150 ($1.5 x 100) both before
and after the adjustment. An exercising call holder would continue to
pay $5,000 ($50 times 100) but would receive 150 shares of XYZ stock
instead of 100.\9\ This is the method currently used for property
distributions such as spin-offs and special dividends large enough to
require adjustments under OCC's By-Laws. \10\
---------------------------------------------------------------------------
\9\ The same adjustment methodology will apply to reverse stock
splits or combination of shares. For example, in a 3-for-4 reverse
stock split on a XYZ $50 option calling for the delivery of 100
shares, the resulting adjustment would be a deliverable of 75 shares
of XYZ stock while the strike price would remain at $50.
\10\ The adjustment methodology used for spin-offs, mergers, and
special cash dividends is to adjust the unit of trading while
leaving the strike price unchanged.
---------------------------------------------------------------------------
The inequity that results from the need to eliminate fractional
shares from the deliverable and to compensate by further reducing the
strike price to the nearest eighth can be eliminated by adjusting the
deliverable to include cash in lieu of the fractional share. As an
illustration, consider a 4-for-3 split of the stock underlying an XYZ
$80 option with a 100 share deliverable. Employing the new adjustment
method, the deliverable would be adjusted to 133.3333 shares, which
would be rounded down to 133 shares, and the strike price would remain
$80. However, instead of compensating for the elimination of the .3333
share by
[[Page 7703]]
reducing the strike prices, the strike prices would remain unchanged,
and the cash value of the eliminated fractional share (.3333 x the
post-split value of a share of XYZ stock as determined by OCC) would be
the deliverable along with the 133 shares. The adjusted option would
also continue to use 100 as the multiplier to calculate aggregate
strike and premium amounts.
The revised adjustment methodology will not be applied to 2-for-1
or 4-for-1 stock distributions or splits (since such distributions or
splits normally result in strike prices that do not require rounding to
the nearest eighth) unless the split requires rounding of the strike
price, which may occur where the strike price was previously adjusted
due to an earlier stock distribution or split. In addition, the revised
adjustment methodology will not generally be used for stock dividends,
stock distributions, or stock splits with respect to any series of
options having exercise prices stated in decimals.\11\ For those
options, the existing adjustment rules will continue to apply. The
reason for this is that once the market has converted to decimal
strikes, the rounding errors created by rounding to the nearest cent
would be immaterial even given the larger positions taken in today's
markets and the other factors discussed above. Because conversion to
decimal strikes might be phased in rather than applied to all series of
equity options simultaneously, the rule has been drafted to cover both
methods of expressing exercise prices.
---------------------------------------------------------------------------
\11\ Although there are currently no decimal strikes for equity
options, OCC wants to avoid the need for further amendments to its
By-Laws and the options disclosure document in the event that such
strikes are introduced in the future.
---------------------------------------------------------------------------
The changes in adjustment methodology will not be implemented until
the exchanges have conducted appropriate educational efforts and
definitive copies of an appropriate supplement to the options
disclosure document, Characteristics and Risks of Standardized Options,
are available for distribution.\12\
---------------------------------------------------------------------------
\12\ OCC will notify the Commission and issue an Important
Notice when the new adjustment methodology is implemented.
---------------------------------------------------------------------------
B. Changes to the Definition of ``Ordinary Dividends and
Distributions''
Currently, Article VI, Section 11A(c) of OCC's By-Laws provides
that as a general rule, outstanding options will not be adjusted to
compensate for ordinary cash dividends. Interpretation and Policy .01
under Section 11A of Article VI provides that a cash dividend will
generally be deemed to be ``ordinary'' if the amount does not exceed
10% of the value of the underlying stock on the declaration date (``10%
Rule''). The OCC Securities Committee is authorized to decide on a
case-by-case basis whether to adjust for dividends exceeding that
amount. As a result, OCC historically has not adjusted for special cash
dividends unless the amount of the dividend was greater than 10% of the
stock price at the close of trading on the declaration day.
The 10% Rule predated a number of significant developments,
including the introduction of Long-term Equity AnticiPation Security
(``LEAPS'') options, the sizeable open interest seen today, the large
contract volume associated with trading and spreading strategies, and
the modern option pricing models that take dividends into account. When
open interests and individual positions were smaller, not adjusting for
dividends of less than 10% did not have the pronounced impact it does
today. Additionally, changes to the tax code which now tax dividends
more favorably have provided an incentive for companies to pay more
dividends, including special dividends. In light of these
considerations, OCC believes it is appropriate to now revise the 10%
Rule.
Under OCC's revision, a cash dividend or distribution would be
considered ordinary (regardless of size) if the OCC Securities
Committee determines that such dividend or distribution was declared
pursuant to a policy or practice of paying such dividends or
distributions on a quarterly or other regular basis. In addition, as a
general rule, a cash dividend or distribution that is less than $12.50
per contract would not trigger the adjustment provisions of Article VI,
Section 11A.
1. No Adjustment for Regularly-Scheduled Dividends Needed
Dividends declared by an issuer pursuant to a policy or practice of
such issuer are known and can thus be priced into option premiums. By
definition, however, special dividends cannot be anticipated in advance
and therefore cannot be integrated into option pricing models.\13\ If
adjustments are not made in response to special dividends, call holders
can capture the dividends only by exercising their options. Often in
these cases, especially with LEAPS options or FLEX options which can
last for 5 to 10 years, early exercise would sacrifice substantial
option time value. This economic disadvantage is further magnified if
the option position is large, as is often the case today. Conversely,
put holders often receive a windfall benefit from the increase in the
in-the-money value on the ex date. To the extent that equity options
can be priced accurately and consistently without dislocations due to
unforeseen special dividends, these economic disadvantages can be
avoided. Moreover, because special dividends are one-off events,
adjusting for them should not cause the proliferation of outstanding
options series and symbols that would result from adjusting for regular
dividends as explained below.
---------------------------------------------------------------------------
\13\ OCC has been told that some traders form judgments as to
the likelihood that certain issuers may declare special cash
dividends and factor those judgments into their pricing models.
---------------------------------------------------------------------------
2. De Minimis Threshold
Adjusting for dividends can cause a proliferation of outstanding
option symbols and series.\14\ In the interest of providing some limit
on option symbol proliferation, the revised adjustment policy will
include a de minimis threshold of $12.50 per contract. Special
dividends smaller than this amount will not trigger an adjustment.
---------------------------------------------------------------------------
\14\ Symbols proliferate when adjustments are made because often
the dividend amount must be added to the deliverable yielding a non-
standard option. The exchanges then introduce standard options with
the same strikes.
---------------------------------------------------------------------------
OCC believes that a threshold that is a set dollar amount is
preferable to one that is a percentage of the stock price (like OCC's
10% Rule) because there are operational problems with applying a
percentage threshold. Under the 10% Rule, in order to determine whether
the threshold is met, the per share dividend amount is added to the
closing price of the underlying security on the dividend declaration
date. The date the dividend is announced (by press release or by some
other means) is not normally the ``declaration date'' when the dividend
is officially declared by an issuer's board of directors. Until the
actual declaration date, investors and traders may not know whether or
not an announced dividend will trigger an adjustment based on the
company's share price. In the interim, it is difficult for traders and
investors to price their options because they do not know if an
adjustment will be made.
The advantage of a fixed dollar threshold is the avoidance of
uncertainty. The per contract value of the dividend can be immediately
determined without the need to wait until the declaration date and
without the need to do a calculation based on the closing price of the
underlying shares.
[[Page 7704]]
3. Consistency Across Relevant Interpretations
Interpretations and Policies .01 and .08 under Article VI, Section
11A apply to cash distributions. Interpretation and Policy .01 (as
amended by this rule change) will apply in general to all cash
distributions. Interpretation and Policy .08 currently carves out
exceptions for fund share cash distributions and does not include a
threshold minimum. In the interest of clarity and consistency with
Interpretation and Policy .01, Interpretation .08 is being revised to
provide for the same $12.50 per contract threshold for fund share cash
distributions. Clause (ii) of Interpretation and Policy .08 sets forth
an exception to the 10% Rule and will be deleted when the 10% Rule is
abolished.
III. Comment Letters
The Commission received fourteen comment letters in response to the
proposed rule change.\15\ Eleven of the comment letters opposed the
rule change. OCC submitted three letters responding to the comment
letters. Seven of the comment letters opposed elimination of the 10%
Rule.\16\ Three of the comment letters opposed the adjustment
methodology for stock dividends, stock distributions, and stock
splits.\17\
---------------------------------------------------------------------------
\15\ Supra notes 3 and 5. Joseph Haggenmiller's comment letter
objected to the entire proposed rule change but did not state why.
Joseph Haggenmiller (March 8, 2006). The comment letters received
after OCC's amendment did not comment on the amendment.
\16\ Erik A. Hartog, Operating Manager, Allagash Trading LLC
(March 21, 2006); Jeffrey Woodring (March 22, 2006); Adam Besch-
Turner (March 23, 2006); Mike Ianni (April 5, 2006); Mike Ianni
(April 5, 2006); Peter van Dooijeweert, President, Alopex Capital
Management, LLC (April 26, 2006); and Erik A. Hartog, Operating
Manager, Allagash Trading LLC (January 8, 2007).
\17\ Christopher Nagy, Chairman, Options Committee, Securities
Industry Association (March 24, 2006); Bob Linville and Deborah
Mittelman, Service Bureau Committee Co-Chairs, Financial Information
Forum (May 2, 2006); and James Knight, Vice President, Manager,
Options Trading Strategies, Raymond James Associates, Gary Franklin,
Manager of Option Trading, Managing Director, Senior Options
Principal, Morgan Keegan Co., and Dennis Moorman, Manager-Options
Department, J.J.B. Hilliard, W.L. Lyons, Inc. (December 12, 2006).
---------------------------------------------------------------------------
A. Comments Opposing the 10% Rule
Those commenters opposing elimination of the 10% Rule did so for
various reasons. First, they felt that elimination of the 10% Rule for
existing contracts would be unfair to the contract traders who have
priced adjustments into their pricing models based on their estimated
probability that an issuer will pay a special dividend with the
assumption that OCC would adjust for special dividends based on the 10%
Rule. OCC responded that it did not believe special dividends could be
anticipated in advance and therefore could not be integrated into
pricing models. However, OCC discussed the matter with market
participants and now understands that some traders do estimate the
probability of special dividends by selected issuers and do factor
those estimates into their pricing models. In response, OCC amended the
proposed rule change so that the 10% Rule would be eliminated and
replaced with the dollar threshold test beginning with dividends
announced on and after February 1, 2009. The few outstanding options
series with expirations beyond that date will be grandfathered and will
be assigned separate trading symbols.
Second, some commenters expressed their concerns that elimination
of the 10% Rule would create uncertainty as to whether OCC would
classify particular vidends as ordinary or special and that market
liquidity for the affected options would disappear until OCC announced
whether a dividend was ordinary or special. OCC responded that a
dividend will be classified as ordinary if it is declared pursuant to a
policy or practice of paying such dividends on a quarterly or other
regular basis. The issue as to whether a particular dividend or
distribution fits the criteria to be classified as ordinary or special
would be determined by a panel of the OCC Securities Committee, which
consists of two representatives of each exchange that lists options on
the underlying security and one representative of OCC, who votes only
in the event of a tie vote. OCC contends that most special dividends
are in such amounts and/or payable on such dates that it will be
immediately obvious to the market that they are not being declared
pursuant to a policy or a practice of paying such dividends on a
quarterly or other regular basis. In addition, issuers normally
classify a dividend as special or ordinary when the dividend is
announced. While this will not control OCC's determination of whether a
dividend is ordinary or special, in the vast majority of cases a
dividend classified by the issuer as special would not fit OCC's
definition of ordinary cash dividends or distributions.
In certain cases the OCC Securities Committee will need to make a
judgment as to whether to classify a dividend as ordinary or special.
The uncertainty which may exist in such cases will diminish over time
as OCC publishes interpretations and policies and a body of precedent
develops. OCC intends to publish informational material indicating how
these situations will be handled. Pursuant to the amendment, the
elimination of the 10% Rule will only be effective for dividends
announced on and after February 1, 2009, which should allow ample lead
time for OCC's educational effort to get under way.
OCC also responded that a balance needs to be struck between
uncertainty and fairness in that under the 10% Rule, market
participants incur large losses in the case of a 9.9% special dividend
but are made whole if the special dividend exceeds 10% of the closing
stock price on the declaration date.
The commenters' third major concern in opposing elimination of the
10% Rule was that the rule change would lead to symbol proliferation in
that any special dividend greater than $12.50 per contract would
trigger a contract adjustment and a new symbol. The frequency of such
adjustments could be very high, causing a sharp spike in symbol
proliferation. OCC responded by acknowledging that this is true for the
short term but that the need for additional symbols would end when the
industry converts to decimal stike prices.\18\ Also, OCC believes that
the inequities caused by the 10% Rule outweigh any operational burdens
associated with symbol proliferation.\19\
---------------------------------------------------------------------------
\18\ The current plan is to begin converting fractional strikes
to decimal strikes in November 2009.
\19\ Since the beginning of 2006, OCC has been tracking special
dividends that were too small to trigger an adjustment under the 10%
Rule but that would be large enough to cause an adjustment under the
revised rule. Up to September 2006, there were a total of 22 more
dividends which would have required additional symbols for
conventional equity options. In some cases, new symbols would also
have had to be assigned for LEAP and flex contracts. According to
OCC, the number is not small but is certainly not large relative to
the hundreds of adjusted and wrap symbols already assigned.
---------------------------------------------------------------------------
The fourth major concern raised by the commenters in opposing the
10% Rule was that the revised rule could reduce liquidity for adjusted
options because investors are drawn to round increments in strike
prices. The 10% Rule has always avoided liquidity loss by only creating
odd strike prices when the dividend is so extraordinarily
disproportionate as to require adjustment. OCC responded that despite
the thousands of contractual adjustments made in over 33 years of
options trading on U.S. markets, it knows of no case where liquidity
was wiped out for an adjusted series. Market-makers on U.S. options
exchanges are numerous, highly competitive, quick to exploit arbitrage
opportunities, and in many cases obligated by exchange rules to make
[[Page 7705]]
markets in every series of every class in which they quote.\20\
---------------------------------------------------------------------------
\20\ See, e.g., CBOE Rules 8.7 and 8.85.
---------------------------------------------------------------------------
B. Comments Opposing the Adjustment Methodology for Stock Dividends,
Stock Distributions, and Stock Splits
The commenters who opposed the revised adjustment methodology for
stock dividends, stock distributions, and stock splits did so by
suggesting alternative models such as those employed by Eurex and other
non-U.S. exchanges.\21\ OCC responded that while it has an open mind
about making further changes to its adjustment methodology, it did not
believe it would be feasible to adopt any of the alternative models
proposed by the commenters because they would require extensive and
onerous systems changes by OCC, exchanges, members, and vendors. One of
the commenters who opposed the adjustment methodology argued that the
adjustment methodology is new and will result in significant
modifications to the systems which support the adjustment methodology
OCC seeks to replace.\22\ In addition, the commenter argued that if
OCC's proposed adjustment methodology is implemented and the strike
price does not change when an adjustment takes place, some other
indicator in the displays used to trade options must be changed to
somehow alert the investor that the option represents an adjusted
contract. OCC responded that it is simply applying to stock dividends,
stock distributions, and stock splits the same adjustment methodology
used for over thirty years for spin-offs, mergers, and special cash
dividends. In addition, OCC argued, price vendors, service bureaus, and
securities firms currently do and have always identified adjusted
contracts through the use of adjusted symbols.
---------------------------------------------------------------------------
\21\ Christopher Nagy, Chairman, Options Committee, Securities
Industry Association (March 24, 2006) and James Knight, Vice
President, Manager, Options Trading Strategies, Raymond James
Associates, Gary Franklin, Manager of Option Trading, Managing
Director, Senior Options Principal, Morgan Keegan Co., and Dennis
Moorman, Manager-Options Department, J.J.B. Hilliard, W.L. Lyons,
Inc. (December 12, 2006).
\22\ Bob Linville and Deborah Mittelman, Service Bureau
Committee Co-Chairs, Financial Information Forum (May 2, 2006).
---------------------------------------------------------------------------
IV. Amendment
To address certain concerns expressed in the comment letters and by
others, OCC amended the proposed rule change. OCC understands that
certain option traders may have integrated into their pricing models
the probability of special dividends and their being adjusted based on
the OCC rules currently in effect and that eliminating the 10% Rule
with respect to existing contracts may unfairly affect these options
traders. To ensure that no options series that were opened before
approval of the proposed rule change are affected by elimination of the
10% Rule, OCC's elimination of the 10% Rule and implementation of the
fixed dollar threshold will take effect only for corporate events
announced on or after February 1, 2009. OCC plans to provide ODD
disclosure of this rule change before May 29, 2007, (after which date
the exchanges would normally begin introducing LEAPS expiring in 2010
making a 2009 implementation impracticable). The delay in
implementation will ensure that all options series opened before the
ODD disclosure is made available (other than certain ``flex'' options
that will be grandfathered under the old rule) will have expired before
the change is effected.\23\ While delaying the implementation until
2009 postpones the benefit of making this needed change, it addresses
the concerns of firms that find the operational hurdles and fairness
issues associated with an earlier implementation onerous.
---------------------------------------------------------------------------
\23\ OCC intends to take a ``snapshot'' of flex series expiring
after January 31, 2009, that are outstanding at the time when ODD
disclosure of the rule change is made. Those series will be assigned
distinctive trading symbols and ``grandfathered'' under the old
rule. Trading will continue normally in grandfathered series until
their expiration, but the exchanges would be free to open otherwise
identical non-grandfathered series, which would be identified by
conventional flex trading symbols. If ODD disclosure is not made
until after the December 2006 expiration, it may also be necessary
to grandfather two classes of LEAPs with December expirations (SPY
and S&P 100 i-Shares) because the exchanges would ordinarily
introduce new series expiring in December 2009 after the December
2006 expiration.
---------------------------------------------------------------------------
V. Discussion
After carefully considering the proposed rule change as amended and
all of the written comments received, the Commission finds that the
proposed rule change is consistent with the requirements of the Act and
the rules and regulations thereunder and particularly with the
requirements of Section 17A(b)(3)(F).\24\ Section 19(b) 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, in general, to protect investors and the public interest. The
Commission believes that OCC's rule change is consistent with this
Section because (1) it is intended to eliminate inequities that result
from certain rounding practices currently required by OCC's By-Laws and
thus should protect investors and (2) it is intended to make more
predictable when cash distributions by an issuer will result in an
adjustment to an option contract and thus should make the process for
adjustments more equitable for all investors.
---------------------------------------------------------------------------
\24\ 15 U.S.C. 78q-1(b)(3)(F).
---------------------------------------------------------------------------
OCC has amended the rule change in response to many of the
commenters that opposed various portions of the rule change for various
reasons.
Some commenters expressed concern that elimination of the 10% Rule
would create uncertainty as to whether OCC would classify particular
dividends as ordinary or special and that market liquidity for the
affected options would disappear until OCC made an announcement whether
a dividend is ordinary or special. The Commission feels that OCC's
proposed rule is clear as to the procedure that will be used to
classify a dividend as ordinary or special. A dividend will be
classified as ordinary if it is declared pursuant to a policy or
practice of paying such dividends on a quarterly or other regular
basis. The Commission finds persuasive OCC's argument that most special
dividends are in such amounts and/or payable on such dates that it will
be immediately obvious to the market that they are not being declared
pursuant to a policy or a practice of paying such dividends on a
quarterly or other regular basis. In addition, issuers normally
classify a dividend as special or ordinary when the dividend is
announced, and in the vast majority of cases a dividend classified by
the issuer as special would not fit OCC's definition of ordinary cash
dividends or distributions. Any uncertainty which may exist in cases
where the OCC Securities Committee will need be to make a judgment as
to whether a dividend is ordinary or special should diminish over time
as OCC publishes interpretations and policies and a body of precedent
develops. In addition, the Commission is not convinced, considering
that adjusted options have shown no lack of liquidity in the past, that
the elimination of the 10% Rule will wipe out liquidity for adjusted
options.
Some commenters stated that the elimination of the 10% Rule for
existing contracts would be unfair to those traders that have built
into their pricing models the possibility that an issuer would declare
a special dividend and the effect of that dividend under the
[[Page 7706]]
10% Rule. In response, OCC amended the filing so that the 10% Rule will
be eliminated and the new dollar threshold implemented only for
dividends announced on and after February 1, 2009, so that the majority
of existing options contracts will not be affected.
Some commenters also argued that elimination of the 10% Rule would
lead to symbol proliferation in that any special dividend greater than
$12.50 per contract would trigger a contract adjustment and a new
symbol. The Commission believes that any symbol proliferation should be
short lived as the industry is planning to convert from fractional
strikes to decimal strikes in November 2009 and that the benefits of
the change outweigh any burdens.
Of particular concern to the Commission is the inequitable economic
impact of unanticipated special dividends on market participants when
the 10% Rule is applied. The Commission believes that OCC's rule change
makes appropriate changes to the way that OCC handles special dividends
to address this problem.
Those commenters that disagreed with the adjustment methodology for
stock dividends, stock distributions, and stock splits suggested
changes that would require major systems revisions. The Commission
believes that such systems changes would be a tremendous burden on the
industry and the costs would not outweigh any benefits.
Finally, it was argued that major systems changes would need to be
undertaken and symbols changed to somehow alert investors that an
option represents an adjusted contract. The Commission is not persuaded
by this argument because the adjustment methodology OCC is going to
apply to stock dividends, stock distributions, and stock splits is the
same adjustment methodology it has used for over thirty years for spin-
offs, mergers, and extraordinary cash dividends and identification of
these adjusted contracts does not appear to have presented a problem.
VI. 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 Section 17A of the Act and the rules and regulations
thereunder.\25\ In approving the proposed rule change, the Commission
considered the proposal's impact on efficiency, competition and capital
formation.
---------------------------------------------------------------------------
\25\ 15 U.S.C. 78c(f).
---------------------------------------------------------------------------
It is therefore ordered, pursuant to Section 19(b)(2) of the Act,
that the proposed rule change (File No. SR-FICC-2006-01), as modified
by Amendment No. 1, be and hereby is approved.
For the Commission by the Division of Market Regulation,
pursuant to delegated authority.\26\
---------------------------------------------------------------------------
\26\ 17 CFR 200.30-3(a)(12).
---------------------------------------------------------------------------
Florence E. Harmon,
Deputy Secretary.
[FR Doc. E7-2792 Filed 2-15-07; 8:45 am]
BILLING CODE 8011-01-P
