[Federal Register Volume 60, Number 203 (Friday, October 20, 1995)]
[Notices]
[Pages 54269-54273]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-26003]



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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-36371; File No. SR-CBOE-95-42]


Self-Regulatory Organizations; Order Granting Approval to 
Proposed Rule Change and Notice of Filing and Order Granting 
Accelerated Approval to Amendment No. 1 to Proposed Rule Change by the 
Chicago Board Options Exchange, Inc., To Add Two Position and Exercise 
Limit Tiers for Qualifying Equity Option Classes and To Expand the 
Equity Option Hedge Exemption

October 13, 1995.

I. Introduction

    On August 7, 1995, the Chicago Board Options Exchange, Inc. 
(``CBOE'' or ``Exchange'') submitted to the Securities and Exchange 
Commission (``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 to amend Rule 4.11 (Position 
Limits) and Rule 4.12 (Exercise Limits) to add two upper position and 
exercise limit \3\ tiers for those equity option classes that meet 
certain criteria for high liquidity in the underlying stocks. In 
addition, the CBOE proposed to expand its current equity option hedge 
exemption from twice to three times the standard or base position 
limit.\4\

    \1\ 15 U.S.C. Sec. 78s(b)(1) (1988).
    \2\ 17 CFR 240.19b-4 (1994).
    \3\ Position limits impose a ceiling on the aggregate number of 
option contracts on the same side of the market that an investor, or 
group of investors acting in concert, may hold or write. Similarly, 
exercise limits impose a ceiling on the aggregate long positions in 
option contracts that an investor, or group of investors acting in 
concert, can or will have exercised within five consecutive business 
days.
    \4\ The equity hedge exemption currently exempts certain 
specified equity options positions from the stated (or base) 
position limits in Exchange Rule 4.11 where the option contracts are 
hedged by 100 shares of stock or securities convertible into such 
stock (or hedged by the same number of shares represented by an 
adjusted option contract), up to a maximum allowable position of 
twice the standard or base limit.
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    Notice of the proposed rule change appeared in the Federal Register 
on 

[[Page 54270]]
August 28, 1995.\5\ Two comment letters were received in response to 
the proposal.\6\ The Exchange subsequently filed Amendment No. 1 to the 
proposed rule change on October 2, 1995.\7\

    \5\ See Securities Exchange Act Release No. 36124 (August 18, 
1995), 60 FR 44524 (August 28, 1995).
    \6\ See Letter from CS First Boston, Goldman, Sachs & Co., J.P. 
Morgan Securities, Lehman Brothers, Merrill Lynch & Co., Morgan 
Stanley & Co., PaineWebber Incorporated, and Salomon Brothers Inc., 
to Jonathan G. Katz, Secretary, Commission, dated September 18, 1995 
(``Working Group Letter''); and letter from Peter A. Ianello, 
President, and Patricia Levy, Executive Director, Swiss Bank 
Corporation Capital Markets, Inc., to Jonathan G. Katz, Secretary, 
Commission, dated September 28, 1995 (supporting views expressed in 
Working Group Letter).
    \7\ In Amendment No. 1, the CBOE stated its intention to 
restrict the use of the new position and exercise limit tiers and 
the expanded hedge exemption to option classes which solely trade on 
the Exchange and are not multiply traded. Implementation of the 
proposed rule change for multiply traded option classes will be 
delayed until the Commission approves similar proposals by the other 
options exchanges or the Commission otherwise determines that 
implementation is appropriate. See letter from Mary L. Bender, 
Senior Vice President, Division of Regulatory Services, CBOE, to 
Holly Smith, Associate Director, Division of Market Regulation 
(``Division''), Office of Market Supervision (``OMS''), Commission, 
dated October 2, 1995 (``Amendment No. 1'').
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II. Background and Description

    Since the inception of standardized options trading, the options 
exchanges have had rules imposing limits on the aggregate number of 
options contracts that a member or customer could hold or exercise. 
These rules are intended to prevent the establishment of large options 
positions that can be used or might create incentives to manipulate or 
disrupt the underlying market so as to benefit the options position. In 
particular, position and exercise limits are designed to minimize the 
potential for mini-manipulations \8\ and for corners or squeezes of the 
underlying market. In addition, they serve to reduce the possibility 
for disruption of the options market itself, especially in illiquid 
options classes.

    \8\ Mini-manipulation is an attempt to influence, over a 
relatively small range, the price movement in a stock to benefit a 
previously established derivatives position.
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    In establishing position and exercise limits, the Commission has 
been careful to balance two competing concerns. First, the Commission 
has recognized that the limits must be sufficient to prevent investors 
from disrupting the market for the underlying security by acquiring and 
exercising a number of options contracts disproportionate to the 
deliverable supply and average trading volume of the underlying 
security. At the same time, the Commission has realized that limits 
must not be established at levels that are so low as to discourage 
participation in the options market by institutions and other investors 
with substantial hedging needs or to prevent specialists and market 
makers from adequately meeting their obligations to maintain a fair and 
orderly market.\9\

    \9\ See H.R. Rept. No. IFC-3, 96th Cong., 1st Sess. at 189-91 
(Comm. Print 1978) (``Options Study'').
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    In October 1980, the Commission approved proposed rule changes by 
the options exchanges to increase position and exercise limits from 
1,000 to 2,000 contracts for all individual equity options classes.\10\ 
In conjunction with the approval, the Commission received commitments 
from the options exchanges to study the effects of the increased 
limits. The Commission indicated that the experience gained under the 
increased limits, if coupled with adequate monitoring and surveillance 
procedures, could serve as a basis for considering further position and 
exercise limit modifications.

    \10\ See Securities Exchange Act Release No. 17237 (October 22, 
1980), 45 FR 71454 (October 28, 1980) (``1980 Release'').
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    In July 1983, the Commission approved a further increase in 
position and exercise limits for individual stock options based on a 
tiering approach.\11\ Limits for options on stocks with the greatest 
trading volume and public float were increased to 4,000 contracts and 
limits on all other options classes were increased to 2,500 
contracts.\12\ In approving the increased limits under a two-tiered 
framework, the Commission noted that tiering was consistent with the 
gradual, evolutionary approach that the Commission and the exchanges 
have adopted in increasing position and exercise limits.

    \11\ See Securities Exchange Act Release No. 19975 (July 15, 
1983), 48 FR 33389 (July 21, 1983) (``1983 Release'').
    \12\ To be eligible for the 4,000 contract limit an underlying 
security was required to have had either (i) trading volume of at 
least 20 million shares during the most recent six month trading 
period; or (ii) trading volume of at least 15 million shares during 
the most recent six month trading period and at least 60 million 
shares currently outstanding. All other options not meeting these 
requirements were subject to the 2,500 contract limits.
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    In 1985, the Commission approved a further increase in position and 
exercise limits for individual equity options. This approval extended 
the tiering approach commenced by the options exchanges in 1983.\13\ 
The Commission noted in the 1985 Release that liberalizing position and 
exercise limits would further increase the potential depth and 
liquidity of the individual stock options markets without significantly 
increasing concerns regarding intermarket manipulations or disruptions 
of the market for the options or underlying securities.

    \13\ See Securities Exchange Act Release No. 21907 (March 29, 
1985), 50 FR 13440 (April 4, 1985) (``1985 Release''). The 1985 
Release created a three-tiered system of position and exercise 
limits of 8,000, 5,500, and 3,000 contracts. To be eligible for the 
8,000 contract limit an underlying security was required to have had 
either (i) trading volume of at least 40 million shares during the 
most recent six month trading period; or (ii) trading volume of at 
least 30 million shares during the most recent six month trading 
period and at least 120 million shares currently outstanding. To be 
eligible for the 5,500 contract limit an underlying security was 
required to have had either (ii) trading volume of at least 20 
million shares during the most recent six month trading period; or 
(ii) trading volume of at least 15 million shares during the most 
recent six month trading period and at least 40 million shares 
currently outstanding. All other options not meeting these 
requirements were subject to the 3,000 contract limits.
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    Lastly, in December 1993, the Commission approved the CBOE's 
existing position and exercise limit framework for individual equity 
options.\14\ Depending on certain criteria related to the trading 
volume of the underlying stock or a combination of both the trading 
volume and the number of shares outstanding of the underlying stock, 
the Exchange's current position and exercise limits were established at 
levels of 10,500 contracts, 7,500 contracts, and 4,500 contracts.\15\

    \14\ See Securities Exchange Act Release No. 33283 (December 3, 
1993), 58 FR 65204 (December 13, 1993) (``1993 Release'').
    \15\ To be eligible for the 10,500 contract limit an underlying 
security must have either (i) trading volume of at least 40 million 
shares during the most recent six month trading period; or (ii) 
trading volume of at least 30 million shares during the most recent 
six month trading period and at least 120 million shares currently 
outstanding. To be eligible for the 7,500 contract limit an 
underlying security must have either (i) trading volume of at least 
20 million shares during the most recent six month trading period; 
or (ii) trading volume of at least 15 million shares during the most 
recent six month trading period and at least 40 million shares 
currently outstanding. All other options not meeting these 
requirements are subject to the 4,500 contract limits.
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    The Exchange proposes to add two position and exercise limit tiers 
at 25,000 and 20,000 contract levels. The criterion to qualify for the 
proposed 25,000 contract limit will require that the underlying 
security must have at least 300 million shares outstanding with 75 
million shares traded in the past six months, or have 100 million 
shares traded in the past six months. To qualify for the proposed 
20,000 contract limit, the underlying security must have at least 240 
million shares outstanding with 60 million shares traded in the past 
six months, or have 80 million shares traded in the past six months.
    According to the Exchange, the number of equity option classes 
currently listed on the CBOE that would qualify for either of these new 
higher position and exercise limit tiers is small. The Exchange 
represents that based on 

[[Page 54271]]
available statistics, as of June 30, 1995, approximately 73 classes 
would qualify for the 25,000 contract tier. Similarly, approximately 22 
classes would satisfy the requirements for the 20,000 contract tier, 
out of approximately 580 equity option classes currently listed on the 
CBOE.
    In addition to the proposed 25,000 and 20,000 contract tiers, the 
CBOE is also proposing to expand the equity hedge exemption in Rule 
4.11, Interpretation and Policy .04. Under this proposal, the maximum 
allowable position, after exempting from the base limit specified 
positions where the option contract is hedged by 100 shares of stock or 
securities convertible into stock, will be three times instead of twice 
the standard or base limit currently provided.\16\

    \16\ The Commission notes that the proposed increase in the 
maximum hedge exemption will apply to all position limit tiers, not 
just to the proposed 25,000 and 20,000 contract tiers.
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    As set forth in greater detail in a recent report prepared by the 
Exchange (``Study''),\17\ the CBOE has represented that position and 
exercise limit tiers can be added and that the equity hedge exemption 
can be expanded to the benefit of investors without increasing the 
potential for market disruption.\18\

    \17\ See Letter from Mary Bender, Senior Vice President, 
Division of Regulatory Services, CBOE, to Holly Smith, Associate 
Director, OMS, Division, Commission, dated April 28, 1995 (market 
analysis of increased limits and expanded hedge exemption).
    \18\ See Securities Exchange Act Release No. 36124 (August 18, 
1995), 60 FR 44524 (August 28, 1995) (notice of File No. SR-CBOE-95-
42) (summarizing findings of Study).
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III. Summary of Comments

    The Commission received two comment letters on the proposed rule 
change.\19\ The commenters, in general, expressed support for the 
proposed changes noting that there is a demonstrated need for the 
higher tiers and that the higher tiers and expanded hedge exemption 
will not increase market disruptions. Although believing that the 
proposals are a ``good first step'' in reducing the undue constraints 
imposed by position limits, the commenters state that further expansion 
of position limits is required. Specifically, the commenters note that 
the depth and liquidity of the markets for many of the most highly 
capitalized and actively traded stocks support the allowance of large 
options positions and that increased levels will not raise concerns 
about manipulation or disruption of the market for the underlying 
stock. Moreover, the commenters state that due to the sophisticated 
surveillance systems currently in place in the markets, any efforts to 
manipulate the market with large positions in options would be readily 
detectable. In this light, the commenters believe that further 
increases in tier size are warranted.

    \19\ See supra note 6.
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    In addition, the commenters stated that any limitation on the 
ability of market participants to use options to hedge their positions 
exposes participants to unnecessary risk on the unhedged portion of 
their portfolios. In this regard, the commenters believe that the 
adoption of an uncapped hedge exemption (i.e., the ability to 
accumulate an unlimited number of options contracts provided that such 
contracts are properly hedged) is appropriate.\20\

    \20\ The Commission notes that prior to the CBOE submitting its 
proposed rule change, the Exchange received six letters from member 
firms supporting an increase in the current position limit levels. 
Further, the CBOE received comments from member firm representatives 
and customers who stated that they did not have adequate hedging 
capabilities under the current position limit tiers. Lastly, the 
CBOE received comment from money managers who believed that the 
current equity option position limits were too restrictive with 
respect to the size of assets managed.
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IV. Discussion

    The Commission finds that the proposed rule changes are consistent 
with the requirements of the Act and the rules and regulations 
thereunder applicable to a national securities exchange, and, in 
particular, with the requirements of Section 6(b)(5).\21\ Specifically, 
the Commission believes that the proposed addition of position and 
exercise limit tiers of 25,000 contracts and 20,000 contracts for 
qualifying equity options, and the proposed expansion of the equity 
hedge exemption to three times the standards or base limit will 
accommodate the needs of investors and market participants. The 
Commission also believes that the proposed rule changes will increase 
the potential depth and liquidity of the equity options market as well 
as the underlying cash market without significantly increasing concerns 
regarding intermarket manipulations or disruptions of the market for 
the options or underlying securities. Accordingly, as discussed below, 
the rule proposal is consistent with the requirements of Section 
6(b)(5) that Exchange rules facilitate transactions in securities while 
continuing to further investor protection and the public interest.

    \21\ 15 U.S.C. 78f(b)(5) (1988).
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    In approving the increased limits, the Commission recognizes that 
securities with active and deep trading markets, as well as with broad 
public ownership, are more difficult to manipulate or disrupt than 
securities having less active and deep markets and having smaller 
public floats.\22\ The proposed additional position and exercise limit 
tiers recognize this by seeking to minimize the restraints on those 
options classes that can accommodate larger limits without 
significantly increasing manipulation concerns.\23\ In particular, the 
proposed limit of 25,000 contracts and 20,000 contracts for options on 
the most actively traded, widely held securities, permits the 
Commission to avoid placing unnecessary restraints on those options 
where the manipulative potential is the least and the need for 
increased positions likely is the greatest. Accordingly, the Commission 
believes that the additional position and exercise limit tiers and the 
expanded equity hedge exemption is warranted.

    \22\ The Commission notes that the quantitative options listing 
and maintenance standards require: (1) A minimum of 7 and 6.3 
million shares outstanding, respectively, which are owned by persons 
other than ``insiders,'' as defined in Section 16 of the Act; (2) a 
minimum of 2,000 and 1,600 shareholders, respectively; (3) trading 
volume of at least 2.4 and 1.8 million shares, respectively, during 
the past twelve months; (4) for an original listing, the market 
price per share of the underlying security must have closed at or 
above $7.50 during the majority of business days over the preceding 
three months; and (5) to maintain its listing, the market price per 
share of the underlying security must have closed at or above $5 
during the majority of business days over the preceding six months. 
See CBOE Rule 5.4, Interpretation and Policy .01.
    \23\ The Commission continues to believe that proposals to 
increase position and exercise limits must be justified and 
evaluated separately. After reviewing the proposed exercise limits, 
along with the eligibility criteria for the two new tiers, the 
Commission has concluded that the proposed exercise limit additions 
do not raise manipulation problems or increase concerns over market 
disruption in the underlying securities.
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    The Commission believes that the proposed additions to the CBOE's 
position and exercise limit tiers and increased hedge exemption appear 
to be both appropriate and consistent with the Commission's gradual, 
evolutionary approach. There are no ideal limits in the sense that 
options positions of any given size can be stated conclusively to be 
free of any manipulative concerns. The Commission, however, is relying 
on the absence of discernible manipulation problems under the current 
framework as an indicator that the proposed additional limit tiers and 
expanded hedge exemption is justified.
    The Commission does not believe that the addition of the two new 
higher limit tiers and the expanded hedge exemption will have any 
adverse effects on the options markets. In approving the two-tiered 
system in 1983, the Commission stated that it did not believe that 
requiring traders to keep track of two 

[[Page 54272]]
limits rather than one was burdensome or confusing or would lead to 
accidental violations.\24\ The Commission does not believe that a 
change from the current three tiers to five tiers should change this 
conclusion. Similarly, as the Commission views the expansion of the 
equity hedge exemption as consistent with its steady progression in 
this area, the enactment of the proposed rule change should not prove 
difficult to implement or cumbersome to monitor.

    \24\ In this regard, the Commission notes that the CBOE 
routinely, and on a continuous basis, reviews the trading 
characteristics of the underlying stocks to determine the 
appropriate position and exercise limit tiers for the option 
classes.
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    The Commission believes that although position and exercise limits 
for options must be sufficient to protect the options and related 
markets from disruptions by manipulations, the limits must not be 
established at levels that are so low as to discourage participation in 
the options market by institutions and other investors with substantial 
hedging needs or to prevent market makers from adequately meeting their 
obligations to maintain a fair and orderly market. In this regard, the 
CBOE has noted that customers and member firms view the current 
position and exercise limits for certain options classes as too low. 
The Commission believes that the CBOE's proposal is a reasonable and 
appropriately tailored effort to accommodate the identified needs of 
options market participants.\25\ In this regard it is important to note 
that the proposal only adds higher position and exercise limit tiers 
for classes of options overlying the most liquid stocks. As a result, 
the proposal currently affects only 95 of the existing 580 classes of 
equity options that are traded on the CBOE.

    \25\ See Study, supra note 17, at 3, and Comment Letters, supra 
note 6.
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    In 1988, the Commission approved a pilot program proposed by the 
CBOE which provided exemptions from position limits for certain fully 
hedged equity option positions.\26\ The pilot program created an 
exemption from equity option position and exercise limits for accounts 
that had established one of the four most commonly used hedged 
positions.\27\ Under this exemption, the maximum position limit 
(including the allowable exemptions) could not exceed twice the 
established option position limit.\28\

    \26\ See Securities Exchange Act Release No. 25738 (May 24, 
1988), 53 FR 20201 (June 2, 1988) (``Pilot Approval Order'').
    \27\ The four hedged positions are: (1) long stock and short 
call; (2) long stock and long put; (3) short stock and long call; 
and (4) short stock and short put.
    \28\ In May 1995, after several extensions, the Commission 
granted permanent approval to the CBOE's hedge exemption pilot 
program. See Securities Exchange Release No. 35738 (May 18, 1995), 
60 FR 27573 (May 24, 1995).
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    The Exchange currently proposes to increase the hedge exemption to 
three times the applicable position limits. According to the CBOE, as 
institutional accounts are unable to fully hedge their stock holdings 
due to the restrictive limits, investors are unnecessarily forced to 
keep a portion of their portfolio at risk.
    The Commission believes that the CBOE's proposal to expand the 
hedge exemption is an appropriate method to accommodate the identified 
needs of options market participants.\29\ By increasing the hedge 
exemption, the Commission believes, large hedge funds and institutional 
accounts will be provided with the means necessary to adequately hedge 
their stock holdings without adding risk to the options market.

    \29\ See Study, supra note 17, at 4 and 6.
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    Lastly, the Commission notes that despite an appreciable growth in 
equity options trading and the sophisticated and automated surveillance 
procedures employed by the Exchange, the last change in position limits 
occurred in 1993. Based on the CBOE's experience, the Commission 
believes that the proposed increased hedge exemption and additional 
limit tiers should result in little or no additional risk to the 
marketplace.\30\

    \30\ The Commission notes that to the extent the potential for 
manipulation increases because of the additional tiers and expanded 
hedge exemption, the Commission believes the Exchange's surveillance 
programs will be adequate to detect as well as to deter attempted 
manipulative activity. The Commission will, of course, continue to 
monitor the Exchange's surveillance programs to ensure that problems 
do not arise.
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    As noted above, Amendment No. 1 states that the CBOE will only 
initially implement the changes being approved in this order for those 
classes of options solely traded on the CBOE and that the revised 
limits for multiply traded classes will only be effected uniformly on 
all the options exchanges at an agreed upon date after Commission 
approval of all necessary rule filing. The Commission believes this 
approach is reasonable and balances the market need to expand position 
and exercise limits and the hedge exemption, while continuing to ensure 
that uniform position and exercise limits will exist among the options 
exchanges for multiply traded classes.\31\

    \31\ See supra note 7.
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    The Commission finds good cause to approve Amendment No. 1 to the 
proposed rule change prior to the thirtieth day after the date of 
publication of notice of filing thereof in the Federal Register. 
Specifically, by limiting the implementation of the increase in 
position and exercise limits and the expanded hedge exemption to only 
qualifying non-multiply traded options, pending approval of similar 
proposals by the other options markets, Amendment No. 1 will ensure 
that uniform position and exercise limits among the options exchanges 
will exist for all multiply traded classes. Accordingly, the Commission 
believes that it is consistent with Section 6(b)(5) of the Act to 
approve Amendment No. 1 to the proposal on an accelerated basis.
    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment No. 1 to the rule proposal. Persons 
making written submissions should file six copies thereof with the 
Secretary, Securities and Exchange Commission, 450 Fifth Street NW., 
Washington, DC 20549. Copies of the submission, all subsequent 
amendments, all written statements with respect to the proposed rule 
change that are filed with the Commission, and all written 
communications relating to the proposed rule change between the 
Commission and any person, other than those that may be withheld from 
the public in accordance with the provisions of 5 U.S.C. Sec. 552, will 
be available for inspection and copying at the Commission's Public 
Reference Section, 450 Fifth Street NW., Washington, DC 20549. Copies 
of such filing also will be available for inspection and copying at the 
principal office of the CBOE. All submissions should refer to File No. 
SR-CBOE-95-42 and should be submitted by November 13, 1995.

V. Conclusion

    For the foregoing reasons, the Commission finds that the CBOE's 
proposal to add two position and position and exercise limit tiers for 
qualifying equity option classes and to expand the equity option hedge 
exemption, as well as to delay the implementation of the proposal for 
multiply traded options classes, is consistent with the requirements of 
the Act and the rules and regulations thereunder.
    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\32\ that the proposed rule change (SR-CBOE-95-

[[Page 54273]]
42), including Amendment No. 1, is approved.

    \32\ 15 U.S.C. 78s(b)(2) (1988).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\33\

    \33\ 17 CFR 200.30-3(a)(12) (1994).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 95-26003 Filed 10-19-95; 8:45 am]
BILLING CODE 8010-01-M