[Federal Register Volume 61, Number 171 (Tuesday, September 3, 1996)]
[Notices]
[Pages 46500-46502]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-22279]


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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-37603; File No. SR-OCC-95-20]


Self-Regulatory Organizations; The Options Clearing Corporation; 
Order Approving a Proposed Rule Change Relating to the Issuance, 
Clearance, and Settlement of Buy-Write Options Unitary Derivatives

August 26, 1996.
    On December 27, 1995, the Options Clearing Corporation (``OCC'') 
filed with the Securities and Exchange Commission (``Commission'') a 
proposed rule change (File No. SR-OCC-95-20) pursuant to Section 
19(b)(1) of the Securities Exchange Act of 1934 (``Act'').\1\ On 
February 5, 1996, OCC filed Amendment No. 1 to the proposed rule 
change.\2\ Notice of the proposed rule change, as amended, was 
published in the Federal Register on March 20, 1996.\3\ No comment 
letters were received. On March 20, 1996, OCC filed Amendment No. 2.\4\ 
Notice of the amendment was published in the Federal Register on May 
15, 1996.\5\ No comment letters were received. For the reasons 
discussed below, the

[[Page 46501]]

Commission is approving the proposed rule change.
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    \1\ 15 U.S.C. Sec. 78s(b)(1) (1988).
    \2\ Letter from James C. Yong, First Vice President and General 
Counsel, OCC, to Jerry W. Carpenter, Assistant Director, Division of 
Market Regulation (``Division''), Commission (February 5, 1996).
    \3\ Securities Exchange Act Release No. 36960 (March 13, 1996), 
61 FR 11458.
    \4\ Letter from James C. Yong, First Vice President and General 
Counsel, OCC, to Jerry W. Carpenter, Esq., Assistant Director, 
Division, Commission (March 19, 1996).
    \5\ Securities Exchange Act Release No. 37203 (May 10, 1996), 61 
FR 24995.
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I. Description of the Proposal

    The purpose of the proposed rule change is to amend certain OCC By-
Laws and Rules and to add new sections to OCC's By-Laws and Rules to 
provide for the issuance, clearance, and settlement of a new equity 
derivatives product referred to as Buy-Write Options Unitary 
Derivatives (``BOUNDs''). The Commission recently approved proposed 
rule changes filed by the American Stock Exchange (``Amex''), the 
Chicago Board Options Exchange (``CBOE''), and the Pacific Stock 
Exchange (``PSE'') (collectively referred to as the ``exchanges'') to 
list and trade BOUNDs.\6\
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    \6\ For a complete description of the characteristics of BOUNDs, 
refer to Securities Exchange Act Release No. 36710 (January 11, 
1996), 61 FR 1791 [File Nos. SR-AMEX-94-56, SR-CBOE-95-14, and SR-
PSE-95-01] (order approving proposed rule changes relating to 
BOUNDs).
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    The purchase of a BOUND is intended to be substantially equivalent 
to a buy-write transaction (i.e., the simultaneous writing of a call 
option and purchase of the underlying stock). However, unlike an actual 
buy-write transaction, the purchase of a BOUND is effected in a single 
exchange transaction. As with all OCC issued options, BOUNDs will be 
created when an opening buy and an opening sell order are executed. The 
execution of every such order will increase the open interest in 
BOUNDs.\7\
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    \7\ Open interest refers to the total number of contracts that 
have neither been closed out nor been allowed to expire.
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    The exchanges have indicated that BOUNDs will be listed on the same 
securities on which Long-Term Equity Options Series (``LEAPS'') \8\ are 
listed because the criteria used for stocks underlying BOUNDs will be 
the same criteria that is used for stocks underlying LEAPS. The 
exchanges expect that BOUNDs will be listed with a duration equal to 
that of LEAPS, which is currently thirty-nine months from the date of 
issuance.
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    \8\ Generally, LEAPS are long-term equity option securities that 
expire up to 39 months from the date of issuance. For a complete 
description of LEAPS, refer to Securities Exchange Act Release No. 
28890 (February 15, 1991), 56 FR 7439 [File No. SR-CBOE-90-32] 
(order approving proposed rule change regarding the listing of 
LEAPS).
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    A BOUND holder will be in essentially the same economic position as 
a covered writer of a European-style call option. BOUND holders will 
profit from the stock's movement up to the strike price and will 
receive payments equivalent to any cash dividends paid on the 
underlying stocks (``dividend equivalent''). Non-cash distributions may 
be reflected either through the delivery of the distributed property or 
by means of adjustments in the terms of the BOUNDs. The right of a 
BOUND holder to receive and the obligation of a BOUND writer to pay or 
deliver a dividend equivalent will be fixed at the close of trading on 
the business day preceding the ex dividend date. The actual payment of 
the dividend equivalent may occur days or weeks later to coincide with 
the payable date for the corresponding dividend on the underlying 
stock.\9\
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    \9\ It is possible that an obligation to pay or a right to 
receive a dividend equivalent that accrued prior to the expiration 
date of a BOUND will remain outstanding after the expiration date 
and even after expiration settlement has been completed. OCC simply 
will continue to carry the dividend equivalent right or obligation 
in a manner similar to a settlement obligation of an exercised 
option. It will be margined and marked to the market each day 
similar to other settlement obligations.
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    BOUNDs are European style options because the holder cannot 
exercise a BOUND prior to expiration. In contrast, LEAPS are American 
style options, which can be exercised at any time prior to expiration. 
At the expiration of a BOUND, either delivery of the underlying stock 
or payment of the strike price is always required, and notice of 
exercise is not required. Therefore, the concepts of exercise and 
assignment are not used in relation to BOUNDs.
    Under the proposed rule change, the expiration settlement date of a 
BOUND contract is the third business day following the expiration date. 
The expiration settlement date for a particular BOUND contract will not 
depend on whether the contract is to be settled by cash or by the 
delivery of stock. BOUNDs to be settled in cash will be settled through 
OCC's cash settlement system. BOUNDs that are to be settled by delivery 
of stock ordinarily will be settled in the same manner that exercised 
stock options are settled (i.e., through stock clearing 
corporations).\10\
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    \10\ In the event the BOUND transaction cannot be settled 
through regular-way settlement (i.e., on the third business day 
following the expiration date), the contract will be settled on a 
broker-to-broker basis.
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    Like put and call stock options, BOUNDs ordinarily will trade in 
standardized contract units of one hundred shares of underlying stock 
per BOUND contract. Positions in BOUNDs will be included in the formula 
to determine a clearing member's stock clearing fund contribution, and 
BOUNDs will be included with stock options for purposes of margin 
calculations. The clearing fund pool for BOUNDs will be the same fund 
pool used for stock options, and the rule change amends the definition 
of a ``stock clearing member'' to be a clearing member approved to 
clear transactions in stock options and BOUNDs. Accordingly, stock 
clearing members will be qualified automatically to engage in 
transactions in BOUNDs without any additional qualification.
    At expiration, if on the last day of trading the underlying stock 
closes at or below the strike price, BOUND holders will receive one 
hundred shares of the underlying stock for each BOUND contract held, 
and BOUND writers will be required to deliver one hundred shares of the 
underlying stock for each BOUND contract written. If at expiration the 
underlying stock closes above the strike price, the BOUND holder will 
receive a payment equal to one hundred times the BOUND's strike price 
for each BOUND contract held, and BOUND writers will be required to 
make payment equal to one hundred times the BOUND's strike price for 
each BOUND contract written. In either case, the BOUND holder 
ordinarily will be left in the same economic position as a covered call 
writer that holds the position until the expiration of the call option.
    Technically, there is no premium in a BOUND transaction because 
that term generally is used to denote the purchase price of an option. 
However, in order to accommodate transactions in BOUNDs, the proposed 
rule change amends the definition of the term ``premium'' to permit the 
term to include the trade price with respect to BOUNDs.
    Pursuant to the rule change, OCC will margin BOUNDs as part of the 
stock option product group and will include BOUNDs in the same class 
group with put and call options on the same underlying stock. Special 
provisions have been added to the definition of ``premium margin'' to 
provide an appropriate definition of the term when applied to an 
expired but unsettled BOUND contract. The added provisions reflect that 
premium margin with respect to an expired long or short position in a 
BOUND may call for either the marking price of such underlying security 
due to be settled by delivery or the payment of the strike price 
depending upon the closing price of the underlying stock when the BOUND 
expires. The definition of the term ``marking price'' with respect to 
margins on options and BOUNDs has been changed to reflect that OCC will 
use the highest reported asked quotation in valuing an underlying 
security if no last sale price is available. The minimum margin 
required for the stock option product group includes protection against 
the bid/ask spread; therefore, it is not necessary to use a different

[[Page 46502]]

quotation for puts than for calls (i.e., highest reported ask quotation 
for call options and the lowest reported bid quotation for put 
options).
    The term ``closing price'' is defined under the rule change to mean 
the closing price for the underlying security on the primary market on 
the business day prior to the expiration date of the BOUND contract. 
However, the exchange(s) on which any series of BOUNDs trades may 
provide that the closing price of a BOUND be based on an average of 
prices of the underlying security near the close of trading on such 
business day.\11\ The rule change also sets forth the steps OCC may 
take in the event the closing price for an underlying security is 
unreported or otherwise unavailable. In addition to any other actions 
OCC may be entitled to take under its By-Laws and Rules, OCC may 
suspend settlement obligations for the affected BOUNDs until a closing 
price is available or until OCC determines the closing price. OCC has 
the authority to determine the closing price for BOUNDs by means of a 
panel consisting of two designated representatives of each exchange on 
which the affected series is open for trading and OCC's Chairman.
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    \11\ The exchange(s) must specify that an average of prices will 
be used prior to the opening of trading in any BOUNDs series.
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    The rule change adds a provision to OCC's By-Laws to specify that 
the closing price for the underlying security of a BOUND is 
conclusively presumed to be accurate and shall be final for purposes of 
determining settlement rights and obligations with respect to a BOUND. 
The rule change also adds an Interpretation to OCC's By-Laws to provide 
that except in extraordinary circumstances OCC will not adjust an 
officially reported closing price for exercise settlement purposes even 
if the closing price is subsequently found to have been erroneous.
    OCC's Securities Committee shall have the authority to make 
adjustments in BOUNDs contracts through the same procedures as in the 
case of option adjustments.\12\ BOUNDs ordinarily will be adjusted 
according to existing adjustment rules, and adjustments are expected to 
ordinarily conform to adjustments made with respect to LEAPs on the 
same underlying stock. Whenever additional shares or other property are 
distributed with respect to shares of an underlying security (i.e., a 
stock split or stock dividend) and the number of BOUND contracts 
outstanding is adjusted to reflect the number of shares distributed or 
the unit of trading for such BOUND contract is adjusted to include the 
distributed property, then such adjustment will not include the 
obligation to pay and received a dividend equivalent. However, when the 
strike price of a BOUND is reduced to reflect the value of a 
distribution, the writer of the BOUND will be obligated to pay a 
dividend equilvant to the holder of the BOUND. This will occur because, 
unlike in the case of adjusting an option, lower the strike price of a 
BOUND will not give the holder the benefit of the distribution because 
the holder does not pay the strike price (The strike price of a BOUND 
caps the value that the holder will receive upon expiration of the 
BOUND.) Therefore, it is appropriate to give the holder the benefit of 
certain extraordinary distributions through a dividend equivalent at 
the time the distribution is made and also to reduce the strike price 
so that the BOUND holder cannot again receive the benefit of the 
distribution when the BOUND expires.
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    \12\ OCC's Securities Committee consists of one designated 
representative of each exchange and the Chairman of OCC.
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    In the case of a cash-out merger of similar transaction, a BOUND 
will be adjusted to require the writer to pay expiration an amount 
equal to the lesser of the price paid for the underlying security in 
the merger or the strike price of the BOUND. Because there no longer 
will be an underlying security, the expiration date of the BOUND will 
be accelerated so that the cash will be paid to the BOUND holder at or 
about the same time that payment of the cash-out value is paid to 
holders of the underlying security. While the mechanics are somewhat 
different from the adjustment ordinarily made for the same event in the 
case of an option, the economic result is quite similar. Because the 
value of an option because fixed as the result of adjusting for a cash-
out merger, in-the-money options are effectively terminated because 
they have no time value and because holders have every incentive to 
exercise them immediately to receive the cash. The expiration date of 
the BOUND will be accelerated because BOUNDs are European style and 
cannot be exercised prior to expiration.

II. Discussion

    Section 17A(b)(3)(F) \13\ requires that the rules of a clearing 
agency be designed to assure the safeguarding of securities and funds 
in the custody or control of the clearing agency or for which it is 
responsible. The Commission believes that OCC's proposal is consistent 
with OCC's obligations under Section 17A(3)(F) to assure the 
safeguarding of securities and funds in its custody or control because 
the proposal provides that OCC will process BOUNDs transactions in 
accordance with its existing risk-reduction methodology. For example, 
under the proposal, BOUNDs will be included with stock options for 
purposes of margin calculations, and positions in BOUNDs will be 
included in the formula to determine a clearing member's proportionate 
share of contribution to the clearing fund. Therefore, a clearing 
member's activity in BOUNDs will be reflected in the amount of funds 
collected (e.g., margin and clearing fund deposits) by OCC to safeguard 
it against losses resulting from a clearing member's failure to settle.
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    \13\  15 U.S.C. Sec. 78q-1(b)(3)(F) (1988).
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III. Conclusion

    On the basis of the foregoing, the Commission finds that the 
proposal is consistent with the requirements of Section 71A(b)(3)(F) of 
the Act and the rules and regulations thereunder.
    It is therefore ordered, pursuant to Section 19(b)(2) of the Act, 
that the proposed rule change (File No. SR-OCC-95-20) be, and hereby 
is, approved.

    For the Commission by the Division of Market Regulation, 
pursuant to delegated authority.\14\
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    \14\ 17 CFR 200.30-3(a)(12) (1996).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 96-22279 Filed 8-30-96; 8:45 am]
BILLING CODE 8010-01-M