[Federal Register Volume 65, Number 166 (Friday, August 25, 2000)]
[Notices]
[Pages 51880-51884]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-21741]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-43186; File No. SR-CBOE-99-37]


Self-Regulatory Organizations; Chicago Board Options Exchange, 
Inc.; Order Approving Proposed Rule Change and Notice of Filing and 
Order Granting Accelerated Approval to Amendment Nos. 2 and 3 to the 
Proposed Rule Change Establishing a Membership Ownership Requirement 
and a Capitalization Transfer Fee Applicable to Designated Primary 
Market Makers

August 21, 2000.

I. Introduction

    On July 9, 1999, the Chicago Board Options Exchange, Inc. (``CBOE'' 
or ``Exchange'') submitted to the Securities and Exchange Commission 
(``SEC'' or ``Commission''), pursuant to Section 19(b)(1) of the 
Securities Exchange Act

[[Page 51881]]

of 1934 (``Act''),\1\ and Rule 19b-4 thereunder,\2\ a proposed rule 
change adding provisions to the designated primary market maker 
(``DPM'') program. On July 13, 1999, the Exchange submitted Amendment 
No. 1 to the proposed rule change.\3\ The proposed rule change was 
published in the Federal Register on September 21, 1999.\4\ The 
Commission received 19 comment letters on the proposed rule change.\5\ 
On December 20, 1999, the CBOE submitted Amendment No. 2 to the 
proposed rule change.\6\ On August 9, 2000, the CBOE submitted 
Amendment No. 3 to the proposed rule change.\7\ This order approves the 
proposed rule change and approves Amendment Nos. 2 and 3 to the 
proposed rule change on an accelerated basis. The Commission is also 
soliciting comment on Amendment Nos. 2 and 3 to the proposed rule 
change.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Letter from Arthur B. Reinstein, Assistant General Counsel, 
CBOE, to Kelly Riley, Attorney, Division of Market Regulation 
(``Division''), SEC, dated July 12, 1999 (``Amendment No. 1'').
    \4\ Securities Exchange Act Release No. 41872 (September 13, 
1999), 64 FR 51158.
    \5\ See note 8 infra.
    \6\ Letter from Arthur B. Reinstein, Assistant General Counsel, 
CBOE, to Kelly Riley, Attorney, Division, SEC, dated December 17, 
1999 (``Amendment No. 2''). In Amendment No. 2, the Exchange amended 
the proposed transfer fee to provide that options traded on other 
exchanges before June 29, 1999 that have been allocated to DPMs will 
not be considered when determining whether the proposed transfer fee 
applies to a capitalization transfer. In addition, the Exchange 
clarified its use of the multiplier of two in one of the proposed 
transfer fee formulas. Finally, the CBOE committed that it would not 
consider financial information that relates to a DPM's non-DPM 
business activities in the calculation of the capitalization 
transfer fee.
    \7\ See letter from Arthur B. Reinstein, Associate General 
Counsel, CBOE, to Kelly Riley, Division, SEC, dated August 8, 2000 
(``Amendment No. 3''). In Amendment No. 3, the CBOE proposed to 
renumber the proposed rules so that they are consistent with the 
current CBOE rules.
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II. Description of the Proposed Rule Change

    The CBOE proposes two new requirements for DPMs. The first will 
require that each DPM own at least one Exchange membership. The second 
will assess a transfer fee on a DPM that undergoes a change in its 
capitalization during a set period of time.

A. Requirement That a DPM Own an Exchange Membership

    The Exchange proposes to add paragraph (e) to CBOE Rule 8.85, which 
is the current rule governing the Modified Trading System. This new 
proposal would require DPMs to own at least one Exchange membership. 
Each current DPM would have 18 months from the proposal's effective 
date to satisfy the ownership requirement. The ownership requirement 
may be satisfied either by owning a transferable regular CBOE 
membership, or a Chicago Board of Trade full membership that is 
effectively exercised pursuant to Article Fifth of the CBOE's 
Certificate of Incorporation. A single membership, however, may not be 
used to satisfy the ownership requirement for more than one DPM. The 
ownership requirement would be satisfied if a senior principal of a DPM 
owns the membership.

B. Assessment of Transfer Fee

    The proposal also adds Interpretation and Policy .02 to CBOE Rule 
8.89. Under this Interpretation, the Exchange proposes to assess a 
transfer fee on DPMs that undergo changes in its capitalization during 
a determined five-year period. The transfer fee would only be assessed 
on those DPMs that have been allocated one or more options classes that 
have traded on the CBOE prior to June 29, 1999. Furthermore, the 
transfer fee would only be imposed on those DPMs that have been 
allocated on pre-June 29, 1999 options class after June 29, 1999. The 
five-year period would begin as of the date of allocation to the DPM of 
the first pre-June 29, 1999 option class.
    The Exchange proposes to define a change in capitalization to 
include any sale, transfer, or assignment of any ownership interest in 
the DPM or any change in the DPM's capital structure, voting authority, 
or distribution of profits or losses.
    As proposed, the transfer fee would generally be equivalent to an 
applicable percentage of the larger of: (1) The dollar amount of the 
change in a DPM's capitalization attributable to pre-June 29, 1999 
option classes allocated to the DPM after June 29, 1999, or (2) the 
value of the change in the DPM's capitalization attributable to the 
business gained because of the pre-June 29, 1999 options class that was 
allocated to the DPM after June 29, 1999, as determined by a formula 
for ascertaining an approximate value of that portion of the 
transaction. The applicable percentage to be applied in determining the 
transfer fee will be: 50% in the first year of the five-year period 
during which the DPM is subject to this transfer fee, 40% in the second 
year, 30% in the third year, 20% in the fourth year, and 10% in the 
fifth year.
III. Summary of Comments
    The Commission received nineteen comment letters opposing the 
proposed rule change. Eighteen were submitted by DPMs, and one by 
members of the Board of the DPM Members Association of the CBOE.\8\ The 
Exchange submitted one letter in response.\9\
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    \8\ See letters to Kelly Riley, Attorney, Division, SEC, from 
Lee E. Tenzer, Chairman, Lee E. Tenzer Trading Company, dated 
January 20, 2000 (``Tenzer Letter''); Thomas Bartlett, Managing 
Partner, Trade Mark Financial Group, dated February 11, 2000 
(``Bartlett Letter''); Jack Callahan, Callahan DPM, LLC, dated 
February 12, 2000 (``Callahan Letter''); John M. Saliba, Managing 
Member, Saliba Partners DPM, dated February 14, 2000 (``Saliba 
Letter''); Ethan Schwartz, Schwartz Trading Group LLC, dated 
February 16, 2000 (``Schwartz Letter''); Keith Hoglung, General 
Partner, Rathunas Trading, L.L.C., dated February 26, 2000 
(``Hoglund Letter''); Thomas M. O'Donnell, Member, Specialist DPM, 
LLC, dated February 17, 2000 (``O'Donnell Letter''); Ed Zareck and 
Michael Hoban, General Partners, ZH Partners, JV, dated February 27, 
2000 (``ZH Partners Letter''); Joseph Feldman, Partner, Bridgeport 
Securities and Bridge port DPM, L.L.C., dated February 17, 2000 
(``Feldman Letter''); Michael R. Benson and Edward V. Dolinar, 
Managing Members, Big Blue Trading LLC, dated February 17, 2000 
(``Big Blue Letter''); Randy Emer, Managing Partner, Eclipe JV, 
dated February 17, 2000 (``Emer Letter''); Jeff Cesarone, Terry 
Herlihy, Robert Maine, Robert Murphy, John Witten and Scott Witten, 
Members, Hiland Capital I, LLC/DPM, dated February 17, 2000 
(``Hiland Letter''); Daniel F. O'Neill and Peter J. Gancer, Managing 
Members, Midway Securities, L.L.C., dated February 17, 2000 
(``Midway Letter''); Timothy J. Werner, Member, RTB Derivates 
L.L.C., undated, received February 18, 2000 (``Werner Letter''); 
William J. Gorman and Orlando Alfonso, Partners, Copper Trading 
J.V., and William Johnson, Partner, Johnson Trading, J.V., dated 
February 18, 2000 (``Cooper-Johnson Letter''); Jim Murphy, Managing 
Partner, Option Funding Group, LP, dated February 18, 2000 (``Murphy 
Letter''); Jeff Melgard, Prime Markets Group, LLC, dated February 
18, 2000 (``Melgard Letter''); Jesse Stamer, TradeNet, LLC, dated 
February 18, 2000 (``Stamer Letter''); and Daniel Koutris, Managing 
Member, KFT DPM, LLC, et al., Members of the Board of the DPM 
Members Association of the CBOE, dated February 15, 2000 (``DPM 
Board Members Letter''); Copies of the comment letters are available 
in the Commission's Public Reference Room in File No. SR-CBOE-99-37.
    \9\ See letter from Arthur B. Reinstein, Assistant General 
Counsel, CBOE, to Kelly Riley, Attorney, Division, SEC, dated April 
18, 2000 (``CBOE Response'').
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    Three of the commenters stated that the proposed rule change had 
not been adequately explained by the CBOE staff, and that it was 
broader in its scope than they had previously understood.\10\ Five 
commenters argued that the rule change was actually meant to mollify or 
protect certain members of the Exchange at the expense of newer or 
smaller DPMs, and not simply to ensure a long-term commitment to the 
CBOE.\11\
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    \10\ See Hoglund Letter; Feldman Letter; and DPM Board Members 
Letter.
    \11\ See Tenzer Letter; Schwartz Letter; Murphy Letter; Stamer 
Letter; and DPM Board Members Letter.
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    In response to these objections, the Exchange stated that the 
proposed rule change was developed as part of an initiative to expand 
its DPM system, after substantial input from the Exchange membership, 
including meetings of each CBOE trading crowd

[[Page 51882]]

and general open membership meetings. The CBOE stated that the 
initiative included work by a task force of seventeen members, four of 
whom were among the commenters now opposing the rule. Finally, the CBOE 
noted that the rule change had been approved by its Board of Directors, 
and by its membership by a vote of 654 for, 372 against, and 4 
abstentions. The CBOE further noted that the proposed rule change was 
approved by a vote of its membership before any allocation of the 
subject option classes. The CBOE therefore argued that DPMs that 
accepted such allocations knew or should have known of the rule.\12\
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    \12\ See CBOE Response.
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    In response to the argument that the rule had not been adequately 
explained, the CBOE noted that a circular describing the rule was 
distributed, which clearly stated that the fee would be imposed for 
``any change in capitalization,'' and that the text of the proposed 
rule itself defined what would constitute such a change.\13\
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    \13\ Id.
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    Finally, the Exchange submitted that the rule was not meant to 
disadvantage any particular DPMs. The Exchange stressed that the 
proposed rule was meant to serve three purposes: (1) To provide an 
incentive for owners to sufficiently capitalize their DPMs; (2) to 
ensure a long-term commitment to the CBOE; and (3) to return value to 
the CBOE for any sale of a valuable asset which the DPM received at no 
cost.\14\
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    \14\ Id.
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    Five commenters argued that the proposed rule change was poorly 
drafted and vague. They stated that these deficiencies could lead to 
subjective interpretation, and uneven application of the proposed 
rule.\15\ One letter argued, for example, that it was not clear whether 
a change in capital structure would include, or how the proposed fee 
formula would assess, the conversion of subordinated debt to equity, or 
a change of structure from a partnership to a limited liability 
corporation.\16\
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    \15\ See Tenzer Letter; Emer Letter; Hoglund Letter, Bartlett 
Letter; and DPM Board Members Letter.
    \16\ See DPM Board Members Letter.
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    In response, the Exchange stated that the proposed rule, by its own 
terms, was clear that it would apply to any change in a firm's 
capitalization, including any sale, transfer, or assignment of 
ownership, or any change in its capital structure, voting authority, or 
distribution of its profits or losses. The Exchange specified that the 
proposed rule would, therefore, apply to the conversion of consolidated 
debt to equity, since this would involve a change in ownership. On the 
other hand, so long as the DPM's capital structure, voting, and profit 
and loss distribution remained otherwise the same, the conversion of a 
partnership to a limited liability corporation would not implicate the 
fee, because there would be not be a change in ownership. Finally, the 
Exchange asserted that the methods of calculation of the fee were also 
clear, and noted that a DPM may appeal an assessment of the fee to the 
Exchange's Appeals Committee, and from there to the CBOE's Board of 
Directors.\17\
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    \17\ See CBOE Response.
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    All the commenters asserted that the proposed rule change hindered 
DPMs from changing their business structures in order to remain 
competitive. They argued that the proposed rule would, for example, 
prevent a DPM from acquiring a strategic partner, or from rewarding an 
employee with a share of ownership. Five of the commenters asserted 
that the rule would disadvantage new DPMs relative to older firms, and 
would disadvantage DPMS at the CBOE relative to specialists on other 
Exchanges, which do not have such rules.\18\ Four commenters also 
argued that the proposed rule change would disadvantage the CBOE as 
well, because fewer firms would be willing to become, or could 
effectively complete as, DPMs.\19\
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    \18\ See Tenzer Letter, Hiland Letter; Copper-Johnson Letter, 
Bartlett Letter; and DPM Board Members Letter.
    \19\ See Tenzer Letter; Saliba Letter; Murphy Letter; and DPM 
Board Members Letter.
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    Finally, five commenters argued that the proposed rule change could 
be detrimental to customers. They asserted that DPMs that could not 
acquire capital without incurring the associated fee for a change in 
capital structure might not be able to compete effective with other 
DPMs or specialists on other Exchanges. These commenters stated that 
this would lead to a reduction in competition, increasingly illiquid 
markets, and wider bid-ask spreads.\20\
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    \20\ See Hiland Letter; ZH Partners Letter; Saliba Letter; 
Copper-Johnson Letter; and Stamer Letter.
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    In response to these objections, the CBOE argued that differing 
rules among exchanges reflected competition and ongoing efforts by each 
exchange to better serve its customers. The CBOE stated that the 
proposed rule did not prevent DPMs from raising capital, but merely 
added to the cost of doing so. The Exchange stated that it had 
contemplated the effect of the proposed rule change on business at the 
CBOE, but concluded that its benefits outweighed any potential 
costs.\21\
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    \21\ See CBOE Response.
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    Finally the Exchange noted that changes to the proposed rule could 
be considered in the future, but asserted that it should be approved 
now. The Exchange argued that, with greater experience applying the 
rule, its staff and affected DPMs could later propose changes to the 
appropriate Exchange authorities, if necessary.\22\
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    \22\ Id.
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IV. Discussion

    After careful review, 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.\23\ In particular, the Commission believes that the proposal 
is consistent with Section 6(b)(5) of the Act,\24\ which requires, 
among other things, that the rules of an exchange be designed to 
promote just and equitable principles of trade, to remove impediments 
to and perfect the mechanism of a free and open market, and to protect 
investors and the public interest.
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    \23\ In approving this proposal, the Commission has considered 
its impact on efficiency, competition, and capital formation. 15 
U.S.C. 78c(f).
    \24\ 15 U.S.C. 78f(b)(5).
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A. Membership Requirement

    The proposed rule change will require DPMs to own an Exchange 
membership. The Commission believes that this ownership requirement 
should provide stability in the Exchange's options market. By requiring 
each DPM to own an Exchange membership, the Exchange is seeking to 
ensure that DPMs have a long-term commitment to the Exchange. The 
proposal should discourage entities from seeking short-term DPM 
appointments, which could be disruptive to the trading of allocated 
options classes, because DPMs will be required to make a substantial 
financial commitment to the Exchange. DPMs that own a membership in the 
Exchange should be more willing to invest the time, effort, and funding 
needed to build and foster a stable market place for the trading of 
their allocated options classes. This should provide enhanced trading 
benefits to investors by increasing liquidity and trading stability. 
Moreover, the proposal should help to preserve the integrity of the 
Exchange because DPMs will have a vested interest in ensuring that the 
Exchange maintains high standards.

[[Page 51883]]

B. Capitalization Transfer Fee

    The Commission finds that the proposed capitalization transfer fee 
is consistent with the requirements of the Act because it also seeks to 
provide stability to the DPM program on the CBOE. DPMs will be assessed 
a transfer fee if it seeks to change its capitalization during the 
initial five years after it has been allocated a pre-June 29, 1999 
options class. The transfer fee will only apply to business 
attributable to options classes that have been trading on the CBOE 
before June 29, 1999 that have been allocated to a DPM after June 29, 
1999.
    This proposal should discourage DPMs from seeking allocations in 
established options classes and then quickly seeking to sell its 
interest to other parties. Allowing a DPM to sell the established 
business of an allocated options class may be inequitable to the 
Exchange. Many existing options classes have significant established 
order flow and contract volume that is not attributable to the newly 
appointed DPM's efforts. It may be inequitable to allow a newly 
appointed DPM to profit from this order flow and contract volume 
without having contributed to its development. Moreover, by 
discouraging DPMs from selling its interest in established options 
classes, the transfer fee should encourage long-term commitments to the 
Exchange, which should enhance stability in DPM allocated securities.
    The transfer fee should also serve as an incentive to a DPM to 
ensure its financial well-being. The transfer fee should ensure that a 
DPM has sufficient capital before seeking an allocation of a pre-June 
29, 1999 options class because during the first five years after 
allocation, it will be subject to a significant transfer fee if the DPM 
should require financial restructuring. This should help in providing 
investors with a stable, liquid market in options classes allocated to 
DPMs.
    The Commission notes that the comment letters received regarding 
the transfer fee were all opposed to the proposed transfer fee. The 
Commission has carefully considered the issues raised by the commenters 
but finds that the proposed transfer fee is consistent with the 
requirements of the Act.
    First, the Commission notes that the proposed transfer fee was 
approved by a majority of CBOE's members. The transfer fee was 
developed as a component of the CBOE's DPM expansion initiative. 
According to the CBOE, the transfer fee, as part of the DPM expansion 
initiative, was developed with extensive member input. Member input was 
secured by way of the Floor Directors Committee, which developed the 
initiative to expand the DPM program, as well as general membership 
meetings. In addition, a member task force was convened to further 
consider the DPM expansion, including the transfer fee. Before the 
member vote, the CBOE distributed an Information Circular describing 
the expansion of the DPM program, which included a description of the 
proposed transfer fee and specifically set forth the two proposed 
formulas. Further, the Information Circular stated the proposed 
transfer fee would apply to ``any change in capitalization of the 
firm.'' Therefore, the Commission believes that the members of the 
CBOE, which approved the proposal by a majority vote, were sufficiently 
informed of the proposal and its ramifications.
    Second, the transfer fee will be applied only to options allocated 
to DPMs after June 1999 that have options traded on the CBOE before 
June 29, 1999. Thus, the CBOE has tailored this proposed fee to apply 
only to DPMs that are allocated options classes that have established 
order flow on the CBOE. Further, according to the CBOE, each DPM is 
notified before it is allocated an existing option class. Moreover, a 
DPM can choose not to apply to receive allocations of existing CBOE 
options classes and therefore, to not be subject to the transfer fee.
    Finally, the Commission notes that the Act does not mandate that 
the SROs have the same rules. On the contrary, each SRO is free to 
tailor its own rules to meet the requirements of its individual 
marketplace, so long as its rules are consistent with the requirements 
of the Act. In fact, one of the ways the SROs compete with one another 
for listings and members is by way of their individual business 
structures, which includes trading and membership rules.
    The Commission believes that the proposed transfer fee should 
provide incentives to DPMs that are allocated existing CBOE options to 
maintain sufficient capital to operate as a DPM, which should result in 
greater liquidity and investor protections in those options classes. 
Further, the CBOE has an interest in securing long-term commitments to 
the Exchange because members that are committed to the Exchange should 
have greater incentives to ensure the orderly and effective operation 
of the market. Finally, the Commission recognizes that the existing 
order flow in options classes that have traded on the Exchange for a 
period of time is a valuable commodity for which the Exchange and its 
members are not compensated by the DPMS allocated such classes. Thus, 
the Commission finds that it is reasonable for the Exchange to limit 
the compensation that a DPM may receive by virtue of a capitalization 
change for those options classes that have business that was 
established by a person or entities other than the DPM.

C. Amendment Nos. 2 and 3

    The Commission finds good cause for approving Amendment Nos. 2 and 
3 to the proposed rule change prior to the thirtieth day after the date 
of publication of notice thereof in the Federal Register. The 
Commission notes that in Amendment No. 2, the CBOE proposed to narrow 
the application of the transfer fee to apply to capitalization changes 
of DPMs that have been allocated options classes traded only on the 
CBOE before June 29, 1999. DPMs that have been allocated options 
classes traded on other options exchanges before June 29, 1999 will not 
be subject to a transfer fee on the business generated by such options. 
\25\ The Commission believes that this amendment is reasonable because 
a DPM that has been allocated an options class that is new to the CBOE 
but that may have traded on another exchange may have to expend 
significant time and resources to establish order flow and contract 
volume on the CBOE. Therefore, applying the transfer fee to options 
classes that have traded on another options exchange does not raise the 
same inequitable concerns that maybe raised by a capitalization 
transfer after an allocation of an established CBOE options class.
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    \25\ The Commission notes that a DPM may still be subject to a 
transfer fee if it also has been allocated an options class that 
traded on the CBOE before June 29, 1999.
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    Amendment No. 2 also clarifies that when calculating the transfer 
fee, the Exchange will not consider financial information that is 
reflected in the FOCUS Data Reports that does not relate to a DPM's 
business as such. The Commission believes that it is appropriate to 
exclude this financial information because it does not relate to the 
DPM's business in allocated options classes or its profitability per 
contract in an allocated options class.
    Finally, Amendment No. 2 clarifies the use of the multiplier of two 
in one of the transfer fee formulas. According to the Exchange, this 
type of multiplier is frequently used in the industry when determining 
the value of a DPM's business. The multiplier is, in essence, an 
multiple of earnings and is intended

[[Page 51884]]

to represent two calendar years of assumed DPM operation. The 
Commission finds that the use of this multiplier to determine the value 
of a DPM's business as such is reasonable because it seeks to 
approximate the multiple of earnings that parties utilize to value DPM 
units in the marketplace.
    Since Amendment No. 2 only modifies that the scope and clarifies 
the application of the proposed rule change, but did not change the 
intent of the proposal, the Commission believes that good cause exists, 
consistent with Sections(b)(5) \26\ and 19(b) of the Act \27\ to 
accelerate approval of Amendment No. 2.
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    \26\ 15 U.S.C. 78f(b)(5).
    \27\ 15 U. S.C. 78s(b).
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    In Amendment No. 3, the CBOE proposed to renumber the proposed 
rules to make them consistent with recently approve changes to the 
CBOE's DPM rules. \28\ The CBOE did not make substantive changes to the 
proposed rules in Amendment No. 3. Therefore, the Commission believes 
that good cause exists, consistent with Sections 6(b)(5) \29\ and 19(b) 
of the Act, \30\ to approve Amendment No. 3 on an accelerated basis.
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    \28\ See Securities Exchange Act Release No. 43004 (June 30, 
2000), 65 FR 43060 (July 12, 2000).
    \29\ 15 U.S.C. 78f(b)(5).
    \30\ 15 U.S.C. 78s(b).
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V. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment Nos. 2 and 3, including whether the 
amendments are consistent with the Act. Persons making written 
submissions should file six copies thereof with the Secretary, 
Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, 
D.C. 20549-0609. 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 Room. Copies of such 
filing will also be available for inspection and copying at the 
principal office of the CBOE. All submissions should refer to File No. 
SR-CBOE-99-37 and should be submitted by September 15, 2000.

VI. Conclusion

    It Is Therefore Ordered, pursuant to Section 19(b)(2) of the Act, 
\31\ that the amended proposed rule change (SR-CBOE-99-37) is approved.
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    \31\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority. \32\
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    \32\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 00-21741 Filed 8-24-00; 8:45 am]
BILLING CODE 8010-01-M