[Federal Register Volume 64, Number 26 (Tuesday, February 9, 1999)]
[Notices]
[Pages 6410-6413]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-3031]



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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-41009; File No. SR-CBOE-98-49]


Self-Regulatory Organizations; Chicago Board Options Exchange, 
Incorporated; Order Granting Approval to Proposed Rule Change and 
Notice of Filing and Order Granting Accelerated Approval of Amendment 
No. 1 to Proposed Rule Change Relating to Trading and Listing Options 
on the Dow Jones Equity REIT Index

February 1, 1999.

I. Introduction

    On November 5, 1998 the Chicago Board Options Exchange, 
Incorporated (``CBOE'' or ``Exchange'') submitted to the Securities and 
Exchange Commission (``Commission'' or ``SEC''), 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 provide for the listing 
and trading of options on the Dow Jones Equity Real Estate Investment 
Trust Index (``Index'' or ``REITS Index''). The Commission published 
the proposed rule change for comment in the Federal Register on 
December 22, 1998.\3\ No comments were received.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Securities Exchange Act Release No. 40794 (December 15, 
1998), 63 FR 70816.
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    On January 28, 1999, the CBOE submitted Amendment No. 1 to the 
proposed rule change.\4\ This order approves the proposed rule change, 
and also approves Amendment No. 1 on an accelerated basis.
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    \4\ See letter, dated January 27, 1999, from Eileen Smith, 
Director, Product Development, CBOE, to Marianne Duffy, Special 
Counsel, Division of Market Regulation, Commission (``Amendment No. 
1''). Among other things, Amendment No. 1 clarified that the Dow 
Jones' internal surveillance procedures apply to the Index as well, 
included the full list of the Index components, amended Rule 
24.4.01(e) to include a hedge exemption of 625,000 contracts on the 
Index and clarified that the maintenance standard of 80% is by 
weight.
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II. Description of the Proposal

A. Index Design

    The proposed rule change would permit the Exchange to list and 
trade cash-settled, European-style,\5\ A.M.-settled stock index 
options. The Index is a broad-based, capitalization-weighted index 
currently composed of 116 equity real estate investment trusts 
(``REITs'').\6\ The Index was designed by Dow Jones & Company. The 
Index has been designed to measure the performance of REITs that 
comprise 95% of the market capitalization of the domestic equity REIT 
investable universe, which includes equity REITs that are listed on the 
New York Stock Exchange (``NYSE''), the American Stock Exchange 
(``Amex'') and the Nasdaq National Market (``NNM'').
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    \5\ A European-style option is one that may be exercised only 
during a limited period of time prior to expiration of the option.
    \6\ REITs, created by the U.S. Congress to facilitate small 
investor participation in real estate on a wholesale scale, pool 
capital from multiple investors like mutual funds.
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    The Index components are subject to a screening process that: (1) 
eliminates REITs that have more than 10 no-trading days over the past 
quarter; (2) eliminates REITs that comprise the bottom 1% of the 
aggregate REIT market capitalization; and (3) eliminates REITs that 
comprise the bottom 0.01% of the average dollar-trading volume. All of 
the component REITs are ``reported securities,'' as that term is 
defined in Rule 11Aa3-1 under the Act.\7\ All but one REIT in the Index 
are eligible for options trading.
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    \7\ See 17 CFR 240.11Aa3-1. A ``reported security'' is defined 
as ``any security or class of securities for which transaction 
reports are collected, processed and made available pursuant to an 
effective transaction reporting plan.'' A ``transaction reporting 
plan'' is in turn defined in paragraph (a)(2) of this rule as ``any 
plan for collecting, processing, making available or disseminating 
transaction reports with respect to transactions in reported 
securities filed with the Commission pursuant to, and meeting the 
requirements of this section.''
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    On October 20, 1998, the 116 components ranged in capitalization 
from $207 million to $6.13 billion. The largest component accounted for 
5.08% of the total weighting of the Index, while the smallest accounted 
for 0.17%. The total capitalization of the REITs in the Index was 
$120.4 billion. The average capitalization was $1.04 billion, and the 
median capitalization was $655 million. Also, as of October 20, 1998, 
the Index components represented eleven distinct property 
classifications: office property (21.01%), apartments (19.31%), 
shopping centers (12.27%), hotels/restaurants (9.33%), regional malls 
(9.17%), diversified (8.56%), warehouses/industrial (7.53%), healthcare 
(5.35%), self-storage (4.99%), manufactured homes (1.65%) and outlet 
centers (0.83%). In addition, the Index components are diversified by 
geographic region, representing real estate investments throughout much 
of the United States.

B. Index Value Calculation

    The methodology used to calculate the value of the Index is similar 
to the methodology used to calculate the value of other well-known 
broad-based indices. The level of the Index reflects the total market 
value of the component REITs relative to a particular base period. The 
Index base date is January 2, 1990, when the Index value was set to 
100. The Index had a closing value of 131.44 on October 19, 1998. The 
daily calculation of the Index is computed by dividing the total market 
value of the companies in the Index by the Index divisor. The divisor 
keeps the Index comparable over time and is adjusted periodically to 
maintain the Index. The values of the Index will be calculated by Dow 
Jones & Company, Inc. or its designee and disseminated at 15-second 
intervals during regular CBOE trading hours to market information 
vendors via the Options Price Reporting Authority (``OPRA'').

C. Index Maintenance

    Dow Jones or its designee is responsible for the maintenance of the 
Index. Index maintenance includes monitoring and completing the 
adjustments for company additions and deletions, share changes, stock 
splits, stock dividends (other than an ordinary cash dividend), and 
stock price adjustments due to company restructuring or spin-offs. Some 
corporate actions, such as stock splits and stock dividends, require 
simple changes in the common shares outstanding and the stock prices of 
the companies in the Index. Other corporate actions, such as share 
issuances or component changes, may change the market value of the 
Index and require an index divisor adjustment as well.
    The Index is reviewed on a quarterly basis by adding or deleting 
REITs using end-of-quarter market capitalization values. If any 
component REIT fails to meet the targeted threshold or the investable 
universe cutoff rules, it will be deleted from the Index. Non-component 
REITs that become eligible for inclusion are added, largest to 
smallest, until the 95% threshold is attained. In order to preserve the 
continuity of the Index, the actual threshold may be slightly higher or 
lower than the targeted 95%. An annual review is performed to update 
any changes in an issue's investment structure and/or property type. As 
a result of these periodic reviews, over time the number of component 
REITs in the Index may change.
    The Exchange will notify the Commission if the number of securities 
in the Index drops by 40 or more. In addition, the Exchange will notify 
the Commission if any of the following occurs: 10% or more of the 
weight of the

[[Page 6411]]

Index is represented by component REITs having a market value less than 
$75 million; less than 80% of the weight of the Index is represented by 
component REITs that are eligible for options trading; 10% or more of 
the weight of the Index is represented by component REITs trading less 
than 20,000 shares per day; the largest component REIT accounts for 
more than 15% of the weight of the Index or the largest five components 
in the aggregate account for more than 50% of the weight of the Index.

D. Index Option Trading

    In addition to regular Index options, the Exchange may provide for 
the listing of long-term index option series (``LEAPs'') and reduced-
value LEAPS on the Index. For reduced-value LEAPs, the underlying value 
would be computed at one-tenth of the Index level. The current and 
closing index value of any such reduced-value LEAP will, after such 
initial computation, be rounded to the nearest one-hundredth.
    Strike prices will be set to bracket the Index in 2\1/2\ point 
increments for strikes below 200 and 5 point increments above 200. The 
minimum tick size for series trading below $3 will be \1/16\th and for 
series trading above $3 the minimum tick will be \1/8\th. The trading 
hours for options on the Index will be from 8:30 a.m. to 3:02 p.m. 
(Chicago time).

E. Exercise and Settlement

    The proposed options on the Index will expire on the Saturday 
following the third Friday of the expiration month. Trading in the 
expiring contract month will normally cease at 3:02 p.m. (Chicago time) 
on the business day preceding the last day of trading in the component 
securities of the Index (ordinarily the Thursday before expiration 
Saturday, unless there is an intervening holiday). The exercise 
settlement value of the Index at option expiration will be calculated 
by Dow Jones or its' designee based on the opening prices of the 
component securities on the business day prior to expiration. If a REIT 
fails to open for trading, the last available price will be used in the 
calculation of the Index, as is done for currently listed indices.\8\ 
When the last trading day is moved because of Exchange holidays (such 
as when the CBOE is closed on the Friday before expiration), the last 
trading day for expiring options will be Wednesday and the exercise 
settlement value of Index options at expiration will be determined at 
the opening of regular Thursday trading.
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    \8\ The Commission notes that pursuant to Article XVII, Section 
4 of the by-laws of the Options Clearing Corporation (``OCC''), OCC 
is empowered to fix an exercise settlement amount in the event it 
determines a current index value is unreported or otherwise 
unavailable. Further, OCC has the authority to fix an exercise 
settlement amount whenever the primary market for the securities 
representing a substantial part of the value of an underlying index 
is not open for trading at the time when the current index value 
(i.e., the value used for exercise settlement purposes) ordinarily 
would be determined. See Securities Exchange Act Release No. 37315 
(June 17, 1996), 61 FR 42671 (Commission order approving SR-OCC-95-
19).
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F. Surveillance and Position Limits

    The Exchange will use the same surveillance procedures currently 
utilized for each of the Exchanges' other index options to monitor 
trading on options and LEAPs on the Index. For surveillance purposes, 
the Exchange will have complete access to information regarding trading 
activity in the underlying securities.
    The Exchange proposes to establish position limits for options on 
the Index at 250,000 contracts on either side of the market. These 
limits are roughly equivalent, in dollar terms, to the limits 
applicable to options on other indices.

G. Exchange Rules Applicable

    As modified by this proposal, the Rules in Chapter XXIV will be 
applicable to the Index options. Broad-based margin rules will apply to 
the Index. In addition, the Index will have a broad-based index hedge 
exemption of 625,000 contracts. CBOE is proposing to amend Rule 24.14 
in order to include specific reference to Dow Jones & Company, Inc. as 
being entitled to the benefit of the disclaimer of liability in respect 
of the Index.

H. Systems Capacity

    CBOE believes it has the necessary systems capacity to support new 
series that would result from the introduction of the Index options. 
CBOE also has been assured that the OPRA has the capacity to support 
the new series.

III. Discussion

    The Commission finds that the proposed rule change is 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).\9\ Specifically, 
the Commission finds that the trading of options on the REIT Index, 
including LEAPs and reduced-value LEAPs, will serve to promote the 
public interest as well as to help remove impediments to a free and 
open securities market. The Commission also believes that the trading 
of options on the Index will allow investors holding positions in some 
or all of the securities underlying the Index to hedge the risks 
associated with their portfolios. Accordingly, the Commission believes 
that the Index options will provide investors with an important trading 
and hedging mechanism.\10\ By broadening the hedging and investment 
opportunities of investors, the Commission believes that the trading of 
options on the REIT Index will serve to protect investors, promote the 
public interest, and contribute to the maintenance of fair and orderly 
markets.\11\
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    \9\ 15 U.S.C. 78f(b)(5).
    \10\ Pursuant to Section 6(b)(5) of the Act, the Commission must 
predicate approval of any new securities product upon a finding that 
the introduction of such product is in the public interest. Such a 
finding would be difficult with respect to a product 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. In 
this regard, the trading of listed Index options will provide 
investors with a hedging vehicle that should reflect the overall 
market of stocks representing a substantial segment of the U.S. 
securities market.
    \11\ In approving this proposed rule change, the Commission 
notes that is has considered the proposed rule's impact on 
efficiency, competition, and capital formation. 15 U.S.C. 78c(f).
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    Nevertheless, the trading of options on the REIT Index raises 
several issues related to the design and structure of the Index, 
customer protection, surveillance, and market impact. The Commission 
believes, however, for the reasons discussed below, that the CBOE has 
adequately addressed these issues.\12\
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    \12\ The Commission notes that it did not object to the 
designation of the Chicago Mercantile Exchange as a contract market 
to trade futures and futures options on the Standard and Poor's REIT 
Composite Index. See letter, dated November 23, 1998, from Richard 
R. Lindsey, Director, Division of Market Regulation, Commission, to 
Steven Manaster, Director, Division of Economic Analysis, Commodity 
Futures Trading Commission. This index consisted of 105 REIT stocks, 
most of which also are the components of the Index, and had a 
similar market capitalization.
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A. Index Design and Structure
    The Commission believes that it is appropriate for the Exchange to 
designate the Index as a broad-based index for purposes of index option 
trading because the REIT segment of the U.S. equities market 
constitutes a substantial segment of the overall public U.S. equities 
market and the Index reflects the REIT market.\13\ First, the

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Index consists of 116 component REITs, and incorporates approximately 
95% of the REIT industry measured by capitalization. These 116 
securities are diverse, representing a broad cross-section of the REIT 
segment of the U.S. market. Second, all of the component REITs are 
reported securities, and all but one REIT in the Index are eligible for 
options trading.\14\ Third, no stock or group of stocks dominates the 
Index. Specifically, no single REIT accounted for more than 5.08% of 
the total weighting of the Index, and the five highest weighted 
securities accounted for 19.02%. Accordingly, the Commission believes 
that it is appropriate for the Exchange to classify the Index as broad-
based and apply its rules governing broad-based index options.
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    \13\ The REIT segment is recognized as a discernible, unique 
segment of the overall market that operates, in part, as a vehicle 
for equity market participants to hold indirect interests in real 
estate. During this decade, the REIT segment of the U.S. equities 
market has grown to 210 REITs with a market capitalization of 
approximately $140 billion as of October 30, 1998. See National 
Association of Real Estate Investment Trusts (http://
www.nareit.com). The REIT segment has also evolved into a diverse 
segment, with numerous REITs holding a variety of investments 
including healthcare, office, residential, retail, self-storage, 
hotel/restaurants, shopping centers and diversified use properties.
    \14\ The Exchange's option listing standards, which are uniform 
among the options exchanges, provide that a security underlying an 
option must, among other things, meet the following requirements: 
(1) the public float must be at least 7 million shares; (2) there 
must be a minimum of 2,000 stockholders; (3) trading volume must 
have been at least 2.4 million shares over the preceding twelve 
months; and (4) the market price per share must have been at least 
$7.50 for a majority of business days during the preceding three 
calendar months. See Interpretations and Policies .01 to Exchange 
Rule 5.3.
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B. Potential for Manipulation

    The Commission also believes that the large number of components, 
the capitalization and weighting methodology of the Index, and the 
depth and liquidity of the securities comprising the Index 
significantly minimize the potential for manipulation of the Index. 
First, the Commission notes that the REIT Index is composed of 116 
securities which represent a broad cross-section of the REIT segment of 
the U.S. market. Second, the Commission notes that the Index is a 
capitalization-weighted index whose value is more difficult to affect 
than that of a price-weighted index. Third, CBOE has represented that 
it will notify the Commission when: (1) the number of securities in the 
Index drops by 40 or more; (2) 10% or more of the weight of the Index 
is represented by component REITs having a market value less than $75 
million; (3) less than 80% of the weight of the Index is represented by 
component REITs that are eligible for options trading; (4) 10% or more 
of the weight of the Index is represented by component REITs trading 
less than 20,000 shares per day; or (5) the largest component REIT 
accounts for more than 15% of the weight of the Index or the largest 
five components in the aggregate account for more than 50% of the 
weight of the Index.\15\ Fourth, the Exchange has proposed reasonable 
position and exercise limits for the Index options that will serve to 
minimize potential manipulation and other market impact concerns. 
Accordingly, the Commission believes that these factors minimize the 
potential for manipulation because it is unlikely that attempted 
manipulations of the prices of the Index components would affect 
significantly the Index's value. Moreover, the surveillance procedures 
discussed below should detect as well as deter potential manipulation 
and other trading abuses.
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    \15\ If the composition of the Index was to substantially 
change, the Commission may reevaluate its decision regarding the 
appropriateness of the Index's current maintenance standards and may 
consider whether additional approval under Section 19(b) of the Act 
is necessary to continue to trade the Index options.
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C. Customer Protection

    The Commission believes that a regulatory system designed to 
protect public customers must be in place before the trading of 
sophisticated financial instruments, such as options on the Index 
including LEAPS and reduced-value LEAPs, can commence on a national 
securities exchange. The Commission notes that the trading of 
standardized, exchange-traded options occurs in an environment that is 
designed to ensure, among other things, that: (1) the special risks of 
options are disclosed to public customers; (2) only investors capable 
of evaluating and bearing the risks of options trading are engaged in 
such trading; and (3) special compliance procedures are applicable to 
options accounts. Accordingly, because the Index options, including 
LEAPS, will be subject to the same regulatory regime as the other 
standardized options currently traded on the CBOE, the Commission 
believes that adequate safeguards are in place to ensure the protection 
of investors in options on the Index.

D. Surveillance

    The Commission generally believes that a surveillance sharing 
agreement between an exchange proposing to list a stock index 
derivative and the exchange(s) trading the stocks underlying the 
derivative product is an important measure for the surveillance of the 
derivatives and underlying securities markets. Such agreements ensure 
the availability of information necessary to detect and to deter 
potential manipulations and other trading abuses, thereby making the 
stock index product less readily susceptible to manipulation.\16\ In 
this regard, the markets upon which all of the Index component stocks 
trade, the NYSE, Amex and NNM, are members of the ISG. In addition, the 
Exchange will apply the same surveillance procedures as those used for 
existing broad-based index option trading on the CBOE. Furthermore, Dow 
Jones & Company also has a policy in place to prevent the potential 
misuse of material, non-public information by members of the Wall 
Street Journal managerial and editorial staff in connection with the 
maintenance of the Index.\17\
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    \16\ See e.g., Securities Exchange Act Release No. 31243 
(September 28, 1992), 57 FR 45849 (October 5, 1992) (order approving 
the listing of options on the CBOE Biotech Index).
    \17\ See Amendment No. 1, supra note 4.
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E. Market Impact

    The commission believes that the listing and trading of options, 
including LEAPS and reduced-value LEAPs, on the Index will not 
adversely affect the underlying securities markets.\18\ First, as 
described above, the Index is broad-based and constituted of 116 REIT 
stocks, with no one stock dominating the Index. Second, the position 
limit of 250,000 contracts on either side of the market and exercise 
limit of 250,000 contracts based on the value of the Index will serve 
to minimize potential manipulation and market impact concerns. Third, 
currently all components except one REIT comprising the Index are 
options eligible and CBOE will notify the Commission if less than 80% 
of the Index continues to be eligible for options trading. Fourth, the 
risk to investors of contra-party one-performance will be minimized 
because the Index options and LEAPS will be issued and guaranteed by 
the OCC, similar to all other standardized options traded in the United 
States. Lastly, the Commission believes that settling expiring Index 
options based on the opening prices of component securities is 
reasonable and consistent with the Act. As noted in other contexts, 
valuing options for exercise settlement on expiration based on opening 
prices rather than on closing prices may help reduce adverse effects on 
markets for

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stocks underlying options on the Index.\19\
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    \18\ In addition, the CBOE has represented that it and OPRA have 
the necessary systems capacity to support those new series of index 
options that would result from the introduction of Index options.
    \19\ See e.g., Securities Exchange Act Release No. 30944 (July 
21, 1992), 57 FR 33376 (July 28, 1992) (order approving position 
limits for European-style Standard & Poor's 500 Stock Index options 
settled based on the opening prices of component securities).
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F. Accelerated Approval of Amendment No. 1

    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. The 
Commission notes that Amendment No. 1 does not change, but rather 
clarifies, the proposed rule change, and thus does not raise any new 
regulatory issues. Specifically, among other things, Amendment No. 1 
clarified that the Dow Jones' internal surveillance procedures apply to 
the Index as well, included the full list of the Index components, 
amended Rule 24.4.01(e) to include a hedge exemption of 625,000 
contracts on the Index, and clarified that the maintenance standard of 
80% is by weight. In addition, the Commission notes that no comments 
were received on the original CBOE proposal, which was subject to the 
full 21-day notice and comment period. Accordingly, the Commission 
believes that it is consistent with Sections 6(b)(5) and 19(b)(2) of 
the Act to approve Amendment No. 1 to the proposal on an accelerated 
basis.

IV. Solicitation of Comments

    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, 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 at the Commission's Public 
Reference Room. Copies of such filing also will be available for 
inspection and copying at the principal office of the Exchange. All 
submissions should refer to File No. SR-CBOE-98-49 and should be 
submitted by March 2, 1999.

V. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\20\ that the proposed rule change (SR-CBOE-98-49), including 
Amendment No. 1, is approved.

    \20\ 15 U.S.C. 78s(b)(2).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\21\
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    \21\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 99-3031 Filed 2-8-99; 8:45 am]
BILLING CODE 8010-01-M