[Federal Register Volume 61, Number 15 (Tuesday, January 23, 1996)]
[Notices]
[Pages 1791-1796]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-835]



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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-36710; File Nos. SR-Amex-94-56, SR-CBOE-95-14, and SR-
PSE-95-01]


Self-Regulatory Organizations; American Stock Exchange, Inc.; 
Chicago Board Options Exchange, Inc.; and Pacific Stock Exchange, Inc.; 
Order Approving Proposed Rule Changes and Notice of Filing and Order 
Granting Accelerated Approval of Amendments Thereto Relating to Buy-
Write Option Unitary Derivatives (``BOUNDs'')

January 11, 1996.
    Pursuant to Section 19(b) of the Securities Exchange Act of 1934 
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ the American Stock 
Exchange, Inc. (``Amex''), Pacific Stock Exchange, Inc. (``PSE''), and 
Chicago Board Options Exchange, Inc. (``CBOE'') (collectively, the 
``Exchanges'') submitted to the Securities and Exchange Commission 
(``SEC'' or ``Commission''), proposed rule changes (``proposals'') to 
permit trading in Buy-Write Options Unitary Derivatives 
(``BOUNDs'').\3\

    \1\ 15 U.S.C. Sec. 78s(b)(1) (1988 & Supp. V 1993).
    \2\ 17 CFR 240.19b-4 (1994).
    \3\ The Amex, CBOE, and PSE rule filings were submitted on 
December 12, 1994, February 1, 1995, and February 6, 1995, 
respectively. On December 23, 1994, the Amex submitted Amendment No. 
1 (``Amex Amendment No. 1'') to its filing to provide that BOUNDs 
will be listed with a maximum expiration date corresponding to the 
longest prescribed long-term equity options (``LEAPs'') then 
available for trading, which is currently 39 months. See Letter from 
William Floyd-Jones, Jr., Assistant General Counsel, Amex, to 
Michael Walinskas, Derivative Products Regulation, SEC, dated Dec. 
23, 1994. The Amex originally proposed listing BOUNDs with 60 month 
expirations and extending the maximum duration of LEAPs from 39 
months to 60 months.
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    Notice of the proposed rule changes and Amex Amendment No. 1 were 
published for comment and appeared in the Federal Register.\4\ Two 
comment letters were received in response to the Amex proposal,\5\ and 
one letter was submitted in response to the CBOE and PSE proposals.\6\ 
The Amex responded to both comment letters.\7\

    \4\ See Securities Exchange Act Release Nos. 35327 (Feb. 3, 
1995), 60 FR 7805 (Feb. 9, 1995) (Amex); 35430 (March 2, 1995), 60 
FR 12991 (March 9, 1995) (CBOE); and 35436 (March 2, 1995), 60 FR 
12998 (March 9, 1995) (PSE).
    \5\ See Letters to Jonathan G. Katz, Secretary, SEC, from James 
E. Buck, Senior Vice President and Secretary, NYSE, dated February 
27, 1995; and Carl F. Koenemann, Executive Vice President and Chief 
Financial Officer, Motorola, Inc., dated March 1, 1995.
    \6\ See Letter from James E. Buck, Senior Vice President and 
Secretary, NYSE, dated March 15, 1995 to Jonathan G. Katz, 
Secretary, SEC. This letter incorporates the same comments raised by 
the NYSE in response to the Amex proposal.
    \7\ See Letter from William Floyd-Jones, Jr., Assistant General 
Counsel, Amex, to Stephen Youhn, Esq., Derivative Products 
Regulation, SEC, dated March 21, 1995.
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    The Amex subsequently submitted Amendments No. 2 and 3 to the 
proposal on December 19, 1996 (``Amex Amendment No. 2'') and January 
11, 1995 (``Amex Amendment No. 3'').\8\ The CBOE subsequently submitted 
Amendment No. 1 (``CBOE Amendment No. 1'') to the proposal on January 
4, 1996.\9\ The PSE subsequently submitted Amendments No. 1, 2, and 3 
to the proposal on June 27, 1995 (``PSE Amendment No. 1''), January 2, 
1996 (``PSE Amendment No. 2''), and January 4, 1996, respectively 
(``PSE Amendment No. 3'') (collectively, with all of the Exchanges' 
amendments, the ``Amendments'').\10\

    \8\ See Letters from William Floyd-Jones, Jr., Assistant General 
Counsel, Amex, to Michael Walinskas, Derivative Products Regulation, 
SEC dated December 15, 1995 and to Stephen Youhn, SEC, dated January 
11, 1996, respectively.
    \9\ See Letter from Janet Angstadt, Schiff Hardin & Waite, to 
Michael Walinskas, SEC, dated January 4, 1996.
    \10\ See Letters from Michael Pierson, Senior Attorney, PSE, to 
Stephen M. Youhn, SEC, dated June 20, 1995, December 29, 1995, and 
January 3, 1996, respectively.
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    Amex and PSE Amendments No. 2 and CBOE Amendment No. 1 primarily 
relate to the elimination of certain spread margin treatment provisions 
and the conforming of the Exchanges' rules to those of the Options 
Clearing Corporation (``OCC'') in order to avoid potential conflict. In 
addition, Amex Amendment No. 2 and CBOE Amendment No. 1 also clarify 
that their respective ``ten-up rules'' (Amex Rule 958A and CBOE Rule 
8.51) will not be applicable to the trading of BOUNDs. Amex and PSE 
Amendments No. 3 and CBOE Amendment No. 1 eliminate the use of escrow 
receipts and letters of guarantee as adequate margin cover for short 
BOUNDs positions. Finally, PSE Amendment No. 1 establishes that BOUNDs 
are designated as Tier I securities for purposes of PSE Rule 3. This 
order approves the proposals, as amended.

I. Description of the Proposal

    The Exchanges, for some time, have sought a replacement for the 
expired Americus Trust PRIMEs and SCOREs (``PRIMEs and SCOREs'').\11\ 
During this process, the Exchanges began to list and trade a 
standardized option product called LEAPs. Like SCOREs, LEAPs enable 
investors to receive the benefits of a stock's price appreciation above 
a fixed dollar amount over a long period of time. Currently, however, 
there is no generally available replacement for the PRIMEs component.

    \11\ PRIMEs and SCOREs were unit investment trusts that allowed 
investors to separate their common stock securities holdings into 
distinct trading components representing discrete interests in the 
income and capital appreciation potential of the securities 
deposited in the trust. See Securities Exchange Act Release No. 
21863 (March 18, 1985), 50 FR 11972 (March 26, 1985) (``PRIMEs 
Adopting Release'').
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    The Exchanges, accordingly, propose to list BOUNDs as a replacement 
for PRIMEs. BOUNDs will offer essentially the same economic 
characteristics as covered calls with the added benefits that BOUNDs 
can be traded in a single transaction and are not subject to early 
exercise. BOUND holders will profit from appreciation in the underlying 
stock's price up to the strike price until expiration and will receive 
payments equivalent to any cash dividends declared on the underlying 
stock. As with PRIMEs, the strike price will serve as a ``cap'' to 
effectively limit the amount of upside appreciation an investor may 
receive.
    OCC will be the issuer of all BOUNDs traded on the Exchanges, which 
are proposed to be treated as standardized options pursuant to Rule 9b-
1 of the Act (``Rule 9b-1'').\12\ As with all OCC issued options, 
BOUNDs will be created when an opening buy or an opening sell order are 
executed and the execution of such orders will increase the open 
interest in BOUNDs. On the dividend payable date for the underlying 
stock, OCC will debit all accounts with short positions in BOUNDs and 
credit all accounts with long positions in BOUNDs with an amount equal 
to the cash dividend on the underlying stock.\13\ Except as described 
herein, BOUNDs will be subject to the rules governing standardized 
options.

    \12\ 17 CFR 240.9b-1 (1994).
    \13\ See Amex and PSE Amendments No. 2 and CBOE Amendment No. 1.
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    The Exchanges anticipate listing BOUNDs on those underlying 
securities that have listed LEAPs. The criteria for stocks underlying 
BOUNDs will be same 

[[Page 1792]]
as the criteria for stocks underlying LEAPs.\14\

    \14\ See, e.g., Amex Rule 915.
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    The Exchanges also anticipate that the sum of the market prices of 
a LEAP and a BOUND on the same underlying stock with the same 
expiration and exercise price will closely approximate the market price 
for the underlying stock. The Exchanges further believe that certain 
BOUNDs-related arbitrage strategies will help to ensure this price 
relationship with the underlying security. Nevertheless, the Exchanges 
will conduct surveillance of BOUNDs in the same manner it surveils 
listed equity options.\15\

    \15\ See Amex and PSE Amendments No. 2 and CBOE Amendment No. 1.
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    BOUNDs will have the same expiration dates as their respective 
LEAPs, however, the Exchanges will list only strike prices that are the 
same or very close to the price of the underlying stock at the time of 
listing, or that are below the price of the stock at that time. For 
example, at the time of initial listing, the strike prices for a BOUND 
with the underlying stock trading at $50 per share, would be set at $40 
and $50. An Exchange would not list a BOUND with a strike price of $60 
in this example.
    The Exchanges anticipate listing new complementary LEAPs and BOUNDs 
on the same underlying securities annually, or at more frequent 
intervals, depending on market demand. The Exchanges have the current 
authority to list LEAPs with up to 39 months until expiration and, 
therefore, seek to introduce BOUNDs with up to the same 39 month 
duration.\16\

    \16\ The Amex originally proposed listing BOUNDs with 60 month 
expirations and extending the maximum duration of LEAPs from 39 
months to 60 months. See Amex Amendment No. 1.
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    Like regular options, BOUNDs will trade in standardized contract 
units of 100 shares of underlying stock per BOUND so that at 
expiration, BOUND holders will receive 100 shares of the underlying 
stock for each BOUND contract held if, on the last day of trading, the 
underlying stock closes at or below the strike price. However, if at 
expiration the underlying stock closes above the strike price, the 
BOUNDs contract holder will receive a cash payment equal to 100 times 
the BOUND's strike price for each BOUND contract held. BOUND writers, 
depending on the price of the underlying stock at expiration, will be 
required to deliver either 100 shares of the underlying stock for each 
BOUND contract (if the price of the underlying stock is at or less than 
the strike price) or the strike price multiplied by 100 at expiration 
(if the price of the underlying exceeds the strike price). This 
settlement design, from the perspective of the long BOUNDs holder, is 
economically similar to the situation where an investor purchases a 
covered call (i.e., long stock, short call) and holds that position to 
the expiration of the call option.
    For example, if the XYZ BOUND has a strike price of $50 and XYZ 
stock closes at $50 or less at expiration, the holder of the XYZ BOUND 
contract will receive 100 shares of XYZ stock. This is the same result 
as if the call option in a covered call position had expired out of the 
money; i.e., the option would expire worthless and the writer would 
retain the underlying stock. If XYZ closes above $50 per share, then 
the holder of an XYZ BOUND will receive $5,000 in cash (100 times the 
$50 strike price). This mimics the economic result to the covered call 
writer when the call expires in the money.
    The settlement mechanism for the BOUNDs will operate in conjunction 
with that of LEAP calls. For example, if at expiration the underlying 
stock closes at or below the LEAP strike price, the LEAP call will 
expire worthless, and the holder of a corresponding BOUND contract will 
receive 100 shares of stock from the short BOUND. If, on the other 
hand, the LEAP call is in the money at expiration, the holder of the 
LEAP call is entitled to 100 shares of stock from a short LEAP upon 
payment of the proper exercise amount, and the holder of a BOUND 
contract is entitled to the cash equivalent of the strike price times 
100 from the short BOUND. An investor long both a LEAP and a BOUND, 
where XYZ closes above the $50 strike price at expiration, would be 
entitled to receive $5,000 in cash from the short BOUND and, upon 
exercise of the LEAP, would be obligated to pay $5,000 to receive 100 
shares of XYZ stock.
    An investor long the underlying stock, and who writes both a LEAP 
and a BOUND, will be obligated to deliver the stock to the long LEAP 
call if the underlying stock closes above the strike price, in exchange 
for payment of the strike price times 100, which amount will then be 
delivered to the long BOUND. Accordingly, the Exchanges believe a 
covered BOUND/LEAP writer's position is effectively closed upon the 
delivery of the underlying stock. If a writer of both instruments has 
deposited cash or securities other than the underlying stock as margin 
for a short LEAP call and BOUND, then the BOUND/LEAP writer delivers 
100 shares of stock (purchased on the open market) to the long LEAP 
call upon payment of the strike price times 100. The writer of the 
BOUND then delivers the cash value of 100 times the strike price to the 
holder of the long BOUND.
    It should be noted that LEAPs are American-style options whereas 
BOUNDs are European-style.\17\ The Exchanges believe that it would be 
inappropriate for the BOUND holder to have an American-style exercise 
right since the BOUND will tend to trade at a discount to the price of 
the underlying stock and BOUND strike price.

    \17\ A European-style option may only be exercised during a 
limited period of time before the option expires. An American-style 
option may be exercised at any time prior to its expiration.
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Sales Practices

    BOUNDs will be subject to the Exchanges' sales practice and 
suitability rules applicable to standardized options. Accordingly, 
BOUNDs will only be sold to investors whose accounts have been approved 
for options trading.

Adjustments

    BOUNDs will be subject to adjustments for corporate and other 
actions in accordance with the rules of OCC. Furthermore, the Options 
Price Reporting Authority represents that it has the necessary systems 
capacity to accommodate any new series that would result from the 
introduction of BOUNDs.\18\

    \18\ See Memorandums from Joe Corrigan, OPRA, to Michael 
Walinskas, SEC, dated December 26, 1995 (``Amex OPRA Letter''); 
Eileen Smith, CBOE, dated January 3, 1996 (``CBOE OPRA Letter''); 
and Kim Koppien, PSE, dated January 9, 1996 (``PSE OPRA Letter'').
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Position Limits

    BOUNDs will be subject to the position limits for equity 
options.\19\ In addition, BOUNDs will be aggregated with other equity 
options on the same underlying stock for purposes of calculating 
position limits. Since a BOUND to the holder is a bullish position, the 
Exchanges propose that long BOUNDs be aggregated with long call and 
short put positions in the related class of equity options. Similarly, 
since the Exchanges believe the BOUND, from the perspective of the 
seller, is a ``bearish'' position (i.e., it is the equivalent of a long 
put position where the strike price has been prepaid), they propose to 
aggregate short BOUNDs with short call and long put positions in the 
related class of equity options.

    \19\ See, e.g., Amex Rule 904.
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    The Exchanges propose that positions in BOUNDs shall be reported in 
accordance with existing options rules, with the minimum position in an 
account to be reported being 200 

[[Page 1793]]
BOUNDs on the same underlying security. Finally, due to the lack of 
trading experience with BOUNDs, Amex and CBOE will not apply their 
``ten-up'' rules, Amex Rule 958A and CBOE Rule 8.51, to BOUNDs 
transactions.\20\

    \20\ See Amex Amendment No. 2 and CBOE Amendment No. 1.
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Customer Margin

    The Exchanges propose to apply options margin treatment to BOUNDs 
as follows:
    1. Long BOUND Positions: full payment required at the time of 
purchase.
    2. Short BOUND Positions: the BOUND seller receives full payment 
for the BOUND at the time of the initial sale and receives no further 
payment when the contract is settled either by payment of the strike 
price or delivery of the underlying stock. Short BOUND positions, 
therefore, will be margined in an amount equal to the current market 
price of the BOUND plus an amount equal to an ``add-on'' used to margin 
short call options times the market value of the BOUND. Since the 
maximum obligation of the seller of a BOUND cannot exceed the strike 
price, however, the amount of margin will never exceed the strike 
value. For example:
    A. Assume a stock of $50, an exercise price of $50, a margin add-on 
percent of 20% and the BOUND trading at $40. In this case, the short 
seller would have to pay $48 to margin the position, i.e., $40 BOUND 
price plus 20% of $40.
    B. Assume a stock price of $40, an exercise price of $50, a margin 
add-on percent of 20% and the BOUND trading at $35. In this case, the 
margin would be 42, i.e., $35 BOUND price plus 20% of $35.
    3. Covered Positions: Short BOUND positions offset by the 
equivalent number of shares of the underlying stock will not require 
any additional margin since the seller's obligation to the buyer will, 
in all cases, be covered by the position in the underlying stock. 
Further, since it is expected that the sum of the prices of a LEAP and 
a BOUND will be approximately equal to the price of the underlying 
stock, a long stock position is cover for both a short BOUND and a 
short LEAP position, provided the LEAP and BOUND have the same strike 
price and expiration date.\21\

    \21\ See Amex and PSE Amendments No. 2.
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4. Spread Positions
    i. Same Expiration--Different Strike Prices: There will be no 
margin requirement for BOUND positions which are long the higher strike 
price and short the lower strike price since the long BOUND more than 
covers the obligation of the short side of the position. For positions 
short the higher strike price and long the lower strike, a customer 
will be required to post the difference between the strike prices.
    ii. Different Expiration-Same Strike Price: No margin will be 
required for positions long the nearest expiration and short the longer 
expiration since the value of the long BOUND will cover the obligation 
on the short leg of the position.\22\ Positions that are short the near 
expiration and long the distant expiration will require full margin on 
the short position and payment in full on the long position.\23\

    \22\ For positions that are long the nearest expiration, full 
margin will be required on the short position once the long position 
expires.
    \23\ See Amex and PSE Amendments No. 2 and CBOE Amendment No. 1.
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    iii. Different Expiration-Different Strike Prices: There will be no 
margin required for positions that are long the near expiration and 
short the distant expiration when the strike price on the near 
expiration is higher than the strike on the distant expiration. For 
positions which are long the near expiration and short the distant 
expiration where the strike price on the near expiration is lower than 
the strike on the distant contract, the margin will be the difference 
in the strike between the near term and distant strikes. For positions 
which are short the near expiration and long the distant expiration, 
full margin will be required on the short position and payment in full 
on the long position.\24\

    \24\ See Amex and PSE Amendments No. 2 and CBOE Amendment No. 1.
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II. Comments Received

    The Commission received comment letters from the New York Stock 
Exchange (``NYSE Letter'') and Motorola, Inc. (``Motorola Letter'') in 
response to its publication and request for comments on the 
proposals.\25\ The NYSE Letter expresses the belief that BOUNDs should 
be classified an equity product as opposed to a standardized option and 
that BOUNDs raised significant investor protection concerns.

    \25\ See supra notes 5 and 6 and accompanying text.
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    The NYSE Letter suggests several reasons to categorize BOUNDs as 
equities and not as options. First, the NYSE argues that BOUNDs do not 
perform like an option since they do not confer upon the holder a right 
to buy or sell anything. Second, the NYSE notes that although an option 
may be either ``in'' or ``out of the money'' and may expire worthless, 
BOUNDs are always in the money and cannot expire worthless unless the 
underlying stock expires worthless. Third, they note that while options 
are used to transfer risk, BOUNDs do not transfer risk; instead, they 
believe a BOUND seller only transfers the essential elements of stock 
ownership, i.e., dividend stream and appreciation up to the cap price 
to the buyer.
    With respect to investor protection concerns, the NYSE Letter noted 
that Rule 10a-1 under the Act, the ``short-sale'' rule, would not apply 
to BOUNDs if they were classified as options and that this could lead 
to price manipulation of the underlying stock through unregulated short 
selling of the BOUND. Second, they argue that although position limits 
would impose an overall limit on the amount of BOUNDs that could be 
sold by a single trader, there would be no overall limits on the number 
of LEAPs and BOUNDs that could be sold into the market place, which 
could cause extreme market volatility. Finally, they argue that while 
stock specialists have specific affirmative and negative obligations to 
help ensure orderly markets in the stock, the Commission and the 
options markets traditionally have not applied such obligations in the 
options market due to the derivative nature of the instruments and that 
this creates the potential for market confusion and unequal regulation.
    The Motorola letter expresses concern that LEAPs and BOUNDs may 
allow an investor with no economic interest in a company to maintain 
voting rights. Specifically, an investor could purchase the underlying 
stock and then sell both a LEAP and a BOUND. Motorola argues that this 
division of economic and voting interests is contrary to corporate 
governance and that significant matters, including corporate control, 
could be determined by groups of stockholders with absolutely no stake 
in the outcome. They further state that the ``division of economic and 
voting interests'' could create ``cheap votes'' which could then be 
sold to the highest bidder.
    The Amex submitted a response letter to the Commission, addressing 
the NYSE's and Motorola's concerns.\26\ Amex believes the NYSE and 
Motorola Letters share an unstated premise that BOUNDs are unique in 
allowing the creation of a synthetic position in stock. In this regard, 
Amex notes that investors currently utilize several existing strategies 
to establish synthetic positions, for example, through the use 

[[Page 1794]]
of options and equity linked notes \27\ and over-the-counter 
strategies.

    \26\ See supra note 7.
    \27\ Equity linked notes are hybrid instruments whose value is 
linked to the performance of a highly capitalized, actively traded 
common stock. See, e.g., Securities Exchange Act Release No. 32343 
(May 20, 1993).
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    Amex asserts several arguments in response to the NYSE's investor 
protection/short sale concerns. First, Amex notes that the underlying 
stock will continue to be subject to the short sale rule and that this 
would restrain any downward pressure on the price of the underlying 
stock which might be caused by the BOUNDs. Second, they note that 
several options strategies (i.e., selling an in the money call, buying 
a put and selling a call, or buying an in the money put) currently 
exist for synthetically selling a stock short and that none of these 
strategies is subject to the Rule 10a-1 tick test nor have such 
strategies been utilized to manipulate the underlying. Third, Amex 
believes that the proposed BOUNDs position limit rules will act to 
limit the number of BOUNDs that may be sold short. Fourth, Amex argues 
that BOUNDs, by virtue of their options pricing, are an inefficient 
method of generating selling pressure on the underlying. Fifth, Amex 
does not believe that the type of price manipulation that rule 10a-1 
was intended to prevent can be effected through the derivatives market. 
Furthermore, Amex believes that ongoing surveillance would adequately 
address any manipulative activity affected in the derivatives market 
for the purpose of manipulating the underlying. Finally, Amex argues 
that the options markets are transparent due to the interposition of 
OCC, which records all options positions and establishes reporting 
requirements for options positions of more than 200 equity options 
contracts. Therefore, Amex believes it would be able to detect 
suspicious trading activity in BOUNDs promptly.
    Amex also responded to Motorola's ``cheap vote'' concerns by 
stating that the practical effect of BOUNDs on corporate governance 
issues would be substantially limited by position limit rules and the 
requirement that BOUNDs be aggregated with other options positions on 
the same side of the market. Accordingly, Amex does not believe that 
BOUNDs will have an effect on proxy contests or tender offers. 
Furthermore, Amex points out that BOUNDs are inferior to over-the-
counter derivatives as a means of affecting shareholder votes since 
over-the-counter options positions may be tailored by expiration date 
(e.g., expire the day after a proxy contest) and price (e.g., 
establishment of a zero-cost collar).
    Finally, the Amex has received a letter from the Commodity Futures 
Trading Commission (``CFTC'') expressing the opinion that BOUNDs are 
not futures contracts on a single security.\28\ In reaching this 
conclusion, the CFTC noted that given the restrictions on setting 
strike prices (as discussed above), BOUNDs predominantly exhibit the 
one-way indexing characteristic of stock options.

    \28\ See Letter from Andrea M. Corcoran and Pat G. Nicolette, 
Co-Chairpersons, Off-Exchange Task Force, CFTC, to Nathan Most, New 
Product Development, Amex, dated July 27, 1994. The CFTC letter is 
based upon the assumption that BOUNDs strike prices will be set at-
the-money or out-of-the-money.
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III. Discussion

    After careful consideration of the comments received and the 
applicable statutory provisions, the Commission finds that the proposed 
rule changes are consistent with the requirements of the Act and the 
rules and regulations thereunder applicable to a national securities 
exchange, and, in particular, the requirements of Section 6(b)(5). 
Specifically, the Commission finds that the Exchanges' proposals to 
list and trade BOUNDs strike a reasonable balance between the 
Commission's mandates under Section 6(b)(5) to remove impediments to 
and perfect the mechanism of a free and open market and a national 
market system, while protecting investors and the public interest. The 
Commission believes that BOUNDs will provide a new derivative 
instrument for investors to more closely approximate their desired 
investment objectives. For the reasons discussed below, the Commission 
has concluded that the proposals are consistent with the Act.\29\

    \29\ Pursuant to Section 6(b)(5) of the Act, the Commission is 
required to find, among other things, that trading in BOUNDs will 
serve to protect investors and contribute to the maintenance of fair 
and orderly markets. In this regard, the Commission must predicate 
approval of any new derivative product upon a finding that the 
introduction of the derivative instrument is in the public interest. 
Such a finding would be difficult for a derivative instrument that 
served no hedging or other economic function, because any benefits 
that might be derived by market participants likely would be 
outweighed by the potential for manipulation, diminished public 
confidence in the integrity of the markets, and other valid 
regulatory concerns. As discussed below, the Commission believes 
BOUNDs will serve an economic purpose by providing an alternative 
product that will allow a BOUND holder to forego some of the 
potential for upside appreciation in return for enhanced income.
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    As an initial matter, the Commission must determine whether it is 
appropriate for the Exchanges to regulate BOUNDs as standardized 
options. The Commission is authorized pursuant to Rule 9b-1(a)(4) under 
the Act to include within the definition of standardized options ``* * 
* such other securities as the Commission may, buy order, designated.'' 
\30\ The proposed classification of BOUNDs as standardized options 
presents certain difficult and unique issues. As discussed above, 
BOUNDs are intended as a replacement product to the expired PRIMEs. 
PRIMEs (and SCOREs) were subject to separate unit trust listing 
standards specifically designed to accommodate their listing and were 
not treated as standardized options within the meaning of Rule 9b-1. 
Nevertheless, the Commission believes that BOUNDs, despite possessing 
some attributes of PRIMEs, can be designated as standardized options 
for purposes of Rule 9b-1 under the Act.

    \30\ 17 CFR 240.9b-1(a)(4) (1988). In amending the definition of 
the term standardized option to include ``such other securities as 
the Commission may, by order, designate'' the Commission noted that 
it added the new language ``to authorize the Commission, by order, 
to allow the use of Rule 9b-1 for new investment vehicles that the 
Commission believes should be included within the new disclosure 
framework.'' See also Securities Exchange Act Release No. 19055 
(Sept. 16, 1982), 47 FR 41950, 41954.
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    In this respect, the Commission notes that the value of a 
particular BOUNDs is derivative of the value of its underlying stock. 
Moreover, its terms are standardized in the same manner as option 
contracts, with an underlying security, standardized expiration dates 
and strike prices. Second, BOUNDs will be subject to options margin 
treatment. Third, because long BOUNDs positions have the same economic 
attributes present when a market participant implements a covered call 
writing strategy, they constitute an aggregation of a synthetic long 
stock position and short call option position in a single transaction. 
Accordingly, BOUNDs possess a significant options component. Fourth, 
while not necessarily determinative of whether a product is an option, 
BOUNDs, like all other options traded on national securities exchanges, 
will be issued and cleared by OCC, a registered clearing agency. Fifth, 
BOUNDs open interest will be created in a manner similar to options. 
Finally, like a long options position, a long BOUNDs position is 
created by the deposit of a fully paid for premium, which is the 
maximum loss on the position.
    The Commission recognizes that, as the NYSE letter indicates, 
BOUNDs differ in several respects from traditional options. 
Nevertheless, for the reasons stated above, the Commission does not 
believe it is unreasonable to treat BOUNDs as standardized options. 

[[Page 1795]]
Indeed, options treatment may provide a more tailored trading and 
disclosure regime to the products.\31\ Therefore, the Commission has 
determined the BOUNDs are a type of security that falls into the 
category of ``other security'' under Rule 9b-1(a)(4) which the 
Commission should treat as standardized options for purposes of Rule 
9b-1 under the Act.

    \31\ This determination does not preclude another market from 
trading a PRIME-like product under stock or hybrid product trading 
rules. It may be appropriate to use a different regulatory structure 
than that applicable to BOUNDs for a product that combines equity 
and derivative features. For BOUNDs, the Commission merely is 
determining that it is consistent with the Act for the Amex, CBOE, 
and PSE to apply their options rules and to treat the product as a 
standardized option.
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    In treating BOUNDs as options, the Commission must ensure that the 
Exchanges' proposed regulatory requirements provide for adequate sales 
practice requirements, position and exercise limits, margin 
requirements and disclosure. These rules minimize the potential for 
manipulation and help to address any prudential concerns from a 
derivative product. In addition, these standards should address the 
special risks to customers arising from transactions in BOUNDs. For the 
reasons discussed below, the Commission believes the proposals will 
provide significant flexibility to list BOUNDs without compromising the 
effectiveness of the Exchanges' regulatory programs for standardized 
options.
    First, the Exchanges' options sales practice and suitability rules 
apply to transactions in BOUNDs. The Commission believes it appropriate 
to apply the heightened requirements of options account opening and 
suitability rules to BOUNDs transactions because of the significant 
derivative characteristics of the product. Thus, no member or member 
organization of any of the Exchanges may accept an order from a 
customer to purchase, or recommend to any customer any BOUND 
transaction, unless the account has been approved for options trading 
and the member or member organization has reasonable grounds to believe 
that any recommended transaction is not unsuitable for such customer.
    Second, the Exchanges propose that equity option position and 
exercise limit rules be applicable to transactions in BOUNDs and that 
BOUNDs be aggregated with other equity options on the same underlying 
stock for the purpose of calculating position limits. The Commission 
believes that since BOUNDs are standardized options which replicate a 
covered call writing strategy, it is appropriate to apply equity 
options position limits to BOUNDs transactions. The Commission believes 
it is appropriate to aggregate BOUNDs with equity options (including 
LEAPs) on the same side of the market on the same underlying stock 
(i.e., long BOUNDs with long calls and short puts). This will ensure 
that the protection afforded by options position limits (e.g., 
prevention of manipulation of the underlying security) will apply to 
BOUNDs.
    As discussed above, the NYSE and Motorola Comment Letters raise 
short sale and ``cheap vote'' concerns, respectively. With respect to 
the ``cheap vote'' concerns, the Commission agrees with Amex's response 
and notes that there are several existing strategies whereby an 
investor can synthetically divest the economic attributes of common 
stock from actual ownership. As to NYSE's short sale concerns, in light 
of the fact that BOUNDs will be regulated as standardized options, it 
is appropriate to grant them the same treatment under Rule 10a-1 of the 
Act as existing options. Moreover, the Commission notes a BOUNDs' 
underlying stock will remain subject to Rule 10a-1 at all times. 
Furthermore, the Commission believes that the proposed position limit 
and aggregation rules (in addition to margin requirements) should 
adequately protect against BOUNDs short selling any potential concern 
over the division of economic and voting interests.
    Third, the Exchanges propose that their options margin rules be 
applicable to transactions in BOUNDs. The initial sale of a BOUND, by 
definition, will require the seller to go short. In this regard, the 
Exchanges have submitted proposed rules establishing margin levels for 
the purchase and sale of BOUNDs, for covered positions (e.g., long 
stock, short BOUND), and for spread positions involving BOUNDs (e.g., 
long and short BOUND with same expiration date but different strike 
prices). The Commission believes that the options-like margin treatment 
for BOUNDs, as amended, provides for adequate margin coverage for long, 
short, covered, and spread positions.\32\

    \32\ The Commission staff consulted with staff of the Federal 
Reserve Board in reaching this determination.
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    The Commission notes that strike price interval, bid/ask 
differential and continuity rules will not apply to transactions in 
BOUNDs until the time to expiration is less than nine months. This 
approach is consistent with the approach currently being taken by the 
Exchanges with regard to their long-term equity and index options. The 
Commission notes that although specific bid/ask differential and 
continuity rules do not apply to BOUNDs with over nine months to 
expiration, the Exchanges' general rules that obligate registered 
options traders, specialists, and market makers to maintain a fair and 
orderly market will continue to apply.\33\ The Commission believes that 
the requirements of these rules are broad enough, even in the absence 
of bid/ask differential and continuity requirements, to provide the 
Exchanges with the authority to make a finding of inadequate registered 
option trader, specialist, or market maker performance should these 
market participants enter into transactions or make bids or offers (or 
fail to do so) in BOUNDs that are inconsistent with the maintenance of 
a fair and orderly market.

    \33\ See, e.g., Amex Rules 950 and 958 and CBOE Rule 8.7.
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    In order to promote investor protection and to ensure adequate 
disclosure in connection with BOUNDs, the rules pertaining to 
standardized options and the requirements of Exchange Act Rule 9b-1 
will apply to trading in BOUNDs. As with other securities issued by 
OCC, the clearing corporation interposes itself between BOUND buyers 
and sellers, and is technically the ``issuer'' of each contract. 
Moreover, just as with other OCC issued securities, the Commission 
believes providing investors with information regarding the rights and 
characteristics of BOUNDs would provide more useful information to 
investors than additional information on the issuers underlying the 
BOUNDs.\34\ In this regard, BOUNDs investors will receive a special 
supplement to the ODD (``BOUNDs supplement'') explaining in detail the 
economic and risk characteristics of BOUNDs, the mechanism of buying, 
selling and exercising BOUNDs and the market in which BOUNDs will 
trade.\35\ In addition, the Exchanges will require that every exchange 
member and member organization deliver to each customer a current ODD 
and BOUNDs supplement at or prior to the time such 

[[Page 1796]]
customer's account is approved for BOUNDs trading.

    \34\ The Commission notes that standardized options are 
registered with the Commission on Form S-20 Registration Statement 
under the Securities Act of 1933. This information includes the 
prospectus and financial statements of OCC, which is the issuer of 
all standardized options.
    \35\ In reviewing any disclosure materials submitted, the 
Commission intends to assure that the materials specifically 
describe BOUNDs, explain their uses, detail the special risks 
associated with BOUNDs trading, and emphasize that BOUNDs contracts, 
unlike other standardized options, subject a writer to dividend-
equivalent payment obligations. The trading of BOUNDs is expressly 
contingent upon the Commission's approval of such an ODD supplement.
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    As discussed above, the Exchanges propose to have BOUNDs issued, 
cleared and settled by OCC. In this regard, on December 27, 1995, OCC 
filed with the Commission a proposed rule change to enable it to issue, 
clear, and settle BOUNDs.\36\ The OCC proposal, when approved, should 
allow OCC to process BOUNDs transactions in accordance with procedures 
that are substantially similar to its existing well-established systems 
and procedures for the clearance and settlement of exchange-traded 
options.\37\ In this respect, the Commission notes that the initiation 
of trading of BOUNDs is conditioned upon Commission approval of OCC's 
proposal to issue, clear and settle BOUNDs, as well as a Commission 
order approving the BOUNDs ODD supplement.

    \36\ See SR-OCC-95-20.
    \37\ The Commission has not yet approved OCC's proposed rule 
filing to issue, clear, and settle BOUNDs (SR-OCC-95-20).
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    The Commission finds good cause for approving the Amendments to the 
proposed rule changes prior to the thirtieth day after the date of 
publication of notice of filing thereof in the Federal Register.\38\ 
The Commission notes that the Amendments bring the BOUNDs margin rules 
applicable to spread positions into conformity with the margin 
treatment currently applicable to other standardized options. 
Furthermore, the Amendments also bring the Exchanges' rules into 
conformity with those of OCC which, the Commission notes, reduces the 
potential for conflict between an Exchanges' and OCC's rules.\39\ Also, 
the Commission believes it is appropriate for Amex and CBOE to not 
apply their ``ten-up'' rules to BOUNDs transactions (i.e., the minimum 
size guarantee for BOUNDs quotes). In the absence of trading experience 
or other indication of adequate market liquidity, the Commission 
believes it is reasonable for the Amex and CBOE to determine that 
specialists or market makers should not be required to make ten-up 
markets for transactions in BOUNDs. The Amendments also eliminate the 
use of escrow receipts and letters of guarantee as adequate margin 
cover for BOUNDs. The Commission notes that because it is unknown 
whether BOUNDs will be settled in cash of the underlying stock until 
expiration of the BOUNDs position, this raises issues as to whether 
such instruments serve as adequate cover for short BOUNDs positions. 
Accordingly, the Commission believes this issue is better addressed in 
the context of a separate OCC filing. Finally, the Commission notes 
that PSE's designation of BOUNDs as a Tier I security is consistent 
with the treatment afforded standardized equity options and, therefore, 
does not raise any new or unique issues. Accordingly, the Commission 
believes it is consistent with Sections 6(b)(5) and 19(b)(2) of the Act 
to approve the Amendment on an accelerated basis.

    \38\ Amex Amendment No. 1 was noticed and published for comment 
with the original filing. The Commission, therefore, is not seeking 
comment on Amex Amendment No. 1.
    \39\ For example, one of the changes alters the timing of the 
payment of the BOUNDs dividends equivalent. The Commission notes 
that this change, which brings the Exchanges' rules into conformity 
with the rules of OCC, will harmonize the payment date for BOUNDs 
with that of the underlying stock, and that this should make trading 
strategies involving both the BOUNDs and underlying stock more 
efficient.
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IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning the Amendments. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549. 
Copies of the submission, all subsequent amendments, all written 
statements with respect to the proposed rule change that are filed with 
the Commission, and all written communications relating to the proposed 
rule change between the Commission and any person, other than those 
that may be withheld from the public in accordance with the provisions 
of 5 U.S.C. 552, will be available for inspection and copying in the 
Commission's Public Reference Section, 450 Fifth Street, N.W., 
Washington, D.C. Copies of such filing will also be available for 
inspection and copying at the principal office of the above-mentioned 
self-regulatory organization. All submissions should refer to the file 
numbers in the caption above and should be submitted by February 13, 
1996.
    Based upon the aforementioned factors, the Commission finds that 
the proposed rule changes relating to the listing and trading of BOUNDs 
are consistent with the requirements of Section 6(b)(5) and the rules 
and regulations thereunder. The initiation of BOUNDs trading, however, 
is conditioned upon the issuance of an order approving the OCC's 
proposed rule change to issue, clear, and settle BOUNDs and also upon 
the Commission's review and approval of an ODD BOUNDs supplement, 
pursuant to Rule 9b-1 of the Act.
    It therefore is ordered, pursuant to Section 19(b)(2) of the 
Act,\40\ that the proposed rule changes (SR-Amex-94-56, SR-CBOE-05-14, 
and SR-PSE-95-01) are approved, as amended.

    \40\ 15 U.S.C. Sec. 78s(b)(2) (1988).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\41\

    \41\ 17 CFR 200.30-3(a)(12) (1994).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 96-835 Filed 1-22-96; 8:45 am]
BILLING CODE 8010-01-M