[Federal Register Volume 66, Number 49 (Tuesday, March 13, 2001)]
[Notices]
[Pages 14613-14616]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-6190]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-44037; File No. SR-ISE-01-08]


Self-Regulatory Organizations; Notice of Filing and Order 
Granting Accelerated Approval of Proposed Rule Change and Amendment No. 
1 by the International Securities Exchange LLC, Relating to Listing and 
Trading of Options on Exchange-Traded Fund

DATE: March 2, 2001.
    Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'')\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on March 2, 2001, the International Securities Exchange LLC (``ISE'' or 
``Exchange'') filed with the Securities and Exchange Commission 
(``SEC'' or ``Commission'') the proposed rule change as described in 
Items I and II below, which Items have been prepared by the ISE. The 
same day, March 2, 2001, the ISE submitted Amendment No. 1 to the 
proposed rule change.\3\ The Commission is publishing this notice to 
solicit comments on the proposed rule changes from interested persons 
and to approve the proposal, as amended, on an accelerated basis.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See letter to Heather Traeger, Special Counsel, Division of 
Market Regulation (``Division''), SEC, from Katherine Simmons, Vice 
President and Associate General Counsel, ISE, dated March 2, 2001 
(``Amendment No. 1''). In Amendment No. 1, the ISE added proposed 
margin requirements for options on Fund Shares.
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    The Exchange is proposing to amend ISE Rules 502, 503 and 504 to 
adopt listing and maintenance standards for options on Fund Shares (as 
defined below), as well as to permit the Exchange to trade options on 
Fund Shares in various exercise price increments. The text of the 
proposed rule change is available at the ISE or the Commission.

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, the ISE included statements 
concerning the purpose of and basis for the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item III below. The ISE has prepared summaries, set forth in sections 
A, B and C below, of the most significant aspects of such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

1. Purpose
    The purpose of the proposed rule change, as amended, is to provide 
for the trading of options on shares or other securities (``Fund 
Shares'') that represent interests in registered investment companies 
organized as open-end management investment companies, unit investment 
trusts or similar entities that are principally traded on a national 
securities exchange or through the facilieis of a national securities 
association and reported as ``national market'' securities, and that 
hold portfolios of securities comprising or otherwise based on or 
representing investments in broad-based indexes or portfolios of 
securities (``Funds''). Fund Shares are issued in exchange for an ``in 
kind'' deposit of a specified portfolio of securities, together with a 
cash payment, in minimum size aggregations or multiples thereof 
(``Creation Units''). The size of the applicable Creation Unit size 
aggregation is set forth in the Fund's prospectus, and varies from one 
series of Fund Shares to another, but generally is of substantial size 
(e.g., value in excess of $450,000 per creation Unit). A fund, 
generally, will issue and sell Fund Shares in Creation Unit size 
through a principal underwriter on a continuous basis at the net asset 
value per share next determined after an order to purchase Fund Shares 
and the appropriate securities are received. Following issuance, Fund 
Shares are traded on an exchange like other equity securities, and 
equity trading rules apply. Likewise, redemption of Fund Shares is made 
in Creation Unit size and ``in kind,'' with a portfolio of securities 
and cash exchange for the Fund Shares that have been tendered for 
redemption.
    Generally, options on Fund Shares are proposed to be traded on the 
Exchange pursuant to the same rules and procedures that apply to 
trading in options on equity securities.\4\ The position, exercise and 
reporting limits for options on Fund Shares would be the same as those 
established for

[[Page 14614]]

options on single stocks.\5\ The Exchange will list option contracts 
covering either 100 or 1000 Fund Shares, or both, depending on the 
price and volatility of the underlying Fund Shares and the popularity 
of the options.\6\ Options on Fund Shares will be physically-settled 
and will have the American-style exercise feature used on all 
standardized equity options.\7\ The Exchange is not proposing at this 
time to list FLEX options on Fund Shares.
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    \4\ Fund Shares are a type of security. The Exchange's proposed 
change to Rule 502, discussed infra, states: ``securities deemed 
appropriate for options trading shall include [Fund Shares].'' 
Accordingly, all of the Exchange's rules referring to ``securities'' 
would cover Fund Shares unless they were specifically excluded.
    \5\ The Exchange's rules in these areas contain requirements 
with respect to ``any option contract'' and ``any options class'' 
traded on the Exchange, and therefore options on Fund Shares would 
be subject to such requirements.
    \6\ In the event the Exchange lists options covering both 100 
and 1000 of the same underlying Fund Shares, the Exchange will 
assign separate trading symbols to the options and will issue an 
Information Circular to all its members advising of the trading 
symbols.
    \7\ An American-style option may be exercise at any time prior 
to its expiration.
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    The proposed margin requirements for options on fund shares are at 
the same levels that apply to options generally under ISE Rule 1202,\8\ 
except, with respect to Fund Shares based on a broad-based index or 
portfolio, minimum margin must be deposited and maintained equal to 
100% of the current market value of the option plus 15% of the market 
value of equivalent units of the underlying security value. Fund Shares 
that hold securities based upon a narrow-based index or portfolio must 
have options margin that equals at least 100% of the current market 
value of the contract plus 20% of the market value of equivalent units 
of the underlying security value. In this respect, the margin 
requirements that currently apply to broad-based and narrow-based index 
options on the NYSE and CBOE.\9\
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    \8\ The Exchange's margin rules cross reference the rules of the 
Chicago Board Options Exchange (``CBOE'') and New York Stock 
Exchange (``NYSE'').
    \9\ The Exchange agrees to modify its margin rules to reflect 
the proposed margin requirements for options on fund Shares based on 
broad-based and narrow-based indexes, if necessary. See Amendment 
No. 1, supra note 3.
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    To accommodate the listing of Fund Shares, the Exchange proposes 
changes to rule 502 (Criteria for Underlying Securities). The Exchange 
proposes to list options only on Fund Shares that are principally 
traded on a national securities exchange or through the facilities of a 
national securities association and reported as national market 
securities. In addition, the initial listing standards will require 
that Fund Shares either: (1) meet the uniform options listing standards 
currently contained in Rule 502, which include minimum public float, 
trading volume, and share price of the underlying security,\10\ or (2) 
be available for creation or redemption each business day from or 
through the Fund in cash or in kind at a price related to net asset 
value, and the Fund is obligated to issue Fund Shares in a specified 
aggregate number even if some or all of the securities required to be 
deposited have not been received by the Fund.\11\
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    \10\ Specifically, Rule 502 requires the underlying security to 
have a public float of 7,000,000 shares, 2,000 holders, trading 
volume of 2,400 holders, trading volume of 2,400,000 shares in the 
preceding 12 months, a share price of $7.50 for the majority of the 
business days during the three calendar months preceding the date of 
the selection, and that the issuer of the underlying security is in 
compliance with the Exchange Act.
    \11\ This assumes that the authorized creation participant has 
undertaken to deliver the shares as soon as possible and such 
undertaking has been secured by the delivery and maintenance of 
collateral consisting of cash or cash equivalent satisfactory to the 
fund which underlies the option, as described in the fund 
prospectus.
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    In addition, the proposed initial listing standards require that: 
(1) Any non-U.S. component stocks of the index or portfolio on which 
the Fund Shares are based that are not subject to comprehensive 
surveillance agreements do not in the aggregate represent more than 50% 
of the weight of the index or portfolio; (2) stocks for which the 
primary market is in any one country that is not subject to a 
comprehensive surveillance agreement do not represent 20% or more of 
the weight of the index; and (3) stocks for which the primary market is 
in any two countries that are not subject to comprehensive surveillance 
agreements do not represent 33% or more of the weight of the index or 
portfolio.
    The Exchange also proposes to amend Rule 503 (Withdrawal of 
Approval of Underlying Securities) to establish maintenance standards 
for Fund Shares. The proposed maintenance standards provide that if a 
particular series of Fund Shares should cease to trade on an exchange 
or as national market securities traded through the facilities of a 
national securities association, there will be no opening transactions 
in the options on the Fund shares, and all such options will trade on a 
liquidation-only basis. In addition, the Exchange will consider the 
suspension of opening transactions in any series of options on Fund 
Shares if: (1) The options on the Fund Shares fail to meet the uniform 
equity maintenance standards contained in ISE Rule 503 when the Fund 
Shares were approved pursuant to the uniform initial listing standards 
for equities options in ISE Rule 502;\12\ (2) following the initial 
twelve-month period beginning upon the commencement of trading in the 
Fund Shares on a national securities association there were fewer than 
50 record and/or beneficial holders of such Fund Shares for 30 or more 
consecutive trading days; (3) the value of the index or portfolio of 
securities on which the Fund Shares are based is no longer calculated 
or available; or (4) such other event occurs or condition exists that 
in the opinion of the Exchange makes further dealing in such options on 
the Exchange inadvisable.
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    \12\ Specifically, Rule 503 provides that an underlying security 
will not meet the Exchange's requirements for continued listing 
when, among other things: (1) there are fewer than 6,300,000 public-
held shares; (2) there were fewer than 1,600 holders; (3) trading 
volume was less than 1,800,000 shares in the preceding twelve 
months; or (4) the share price of the underlying security closed 
below $5 on a majority of the business days during the preceding 6 
months.
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    Finally, the Exchange proposes to amend Rule 504 (Series of Options 
Contracts Open for Trading). Rule 504 specifies the uniform minimum 
strike price intervals for options on single stock, which are $2.50 
where the strike price is $25 or less, $5 where the strike price is 
greater than $25 and $10 where the strike price is greater than $200. 
Options on some Fund Shares, however, currently trade at lesser 
intervals on other options exchanges. Accordingly, the Exchange 
proposes to adopt language similar to that contained in Rules of the 
American Stock Exchange (``Amex'') stating that the interval between 
strike prices of series of options on Fund Shares will be fixed at a 
price per share which is reasonably close to the price per share at 
which the underlying security is traded in the primary market at or 
about the same time such series of options in first open for trading on 
the Exchange, or at such intervals as may have been established on 
another options exchange with respect to options on a particular Fund 
Share prior to the initiation of trading of such options on the 
Exchange.\13\ This change is necessary to allow the ISE to trade the 
same options classes as are traded on other options exchanges.
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    \13\ The Amex currently trades options on a Fund Share called 
QQQ with a $1.00 interval between strike prices. The release 
approving the Amex to trade options on Fund Shares states that 
strike prices ``will be set to bracket the Fund Shares at one point 
intervals up to a share price of $200.'' See Securities Exchange Act 
Release No. 40157 (July 1, 1998), 63 FR 37426 (July 10, 1998). In 
contrast, CBOE Rule 5.5, Interpretations and Policies .01 sets the 
minimum strike interval for Fund Shares at $2.50 where the strike 
price is $200 or less and at $5 where the strike price is more than 
$200. See Securities Exchange Act Release No. 40166 ((July 2, 1998), 
63 FR 37430 (July 10, 1998). Finally, the recent release approving 
Philadelphia Stock Exchange (``PHLX'') to trade options on Fund 
Shares does not discuss trading intervals. See Securities Exchange 
Act Release No. 43921 (February 2, 2001), 66 FR 9739 (February 9, 
2001).
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    The Exchange believes it has the necessary systems capacity to 
support

[[Page 14615]]

the additional series of options that would result from the 
introduction of options on Fund Shares, and it has been advised that 
the Options Price Reporting Authority also will have the capacity to 
support these additional series.

2. Statutory Basis

    The ISE believes that the basis under the Act for this proposed 
rule change is the requirement under Section 6(b)(5) \14\ that an 
exchange have rules that are designed to prevent fraudulent and 
manipulative acts and practices, to promote just and equitable 
principles of trade, to remove impediments to and perfect the mechanism 
of a free and open market and a national market system, and, in 
general, to protect investors and the public interest.
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    \14\ 15 U.S.C. 78f(b)(5).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    The ISE does not believe that the proposed rule change will place 
any burdens on competition.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received from Members, Participants or Others

    The ISE has not solicited, and does not intend to solicit, comments 
on this proposed rule change. The ISE has not received any unsolicited 
written comments from members or other interested parties.

III. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning the foregoing, including whether the proposed rule 
change, as amended, is consistent with the Act. Persons making written 
submissions should file six copies thereof with the Secretary, 
Securities and Exchange Commission, 450 Fifth Street, NW, Washington, 
DC 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 ISE. All submissions should refer to File No. 
SR-ISE-01-08 and should be submitted by April 3, 2001.

IV. Commission's Findings and Order Granting Accelerated Approval 
of Proposed Rule Change

    The Commission finds that the proposed rule change, as amended, 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).\15\ 
Specifically, the Commission believes that providing for the listing 
and trading of options on Fund Shares should give investors a better 
means to hedge their positions in the underlying Fund Shares. Further, 
the Commission believes that pricing of the underlying Fund Shares may 
become more efficient and market makers in these shares, by virtue of 
enhanced hedging opportunities, may be able to provide deeper and more 
liquid markets. In sum, the Commission believes that options on Fund 
Shares likely will engender the same benefits to investors and the 
market place that exist with respect to options on common stock, 
thereby serving to promote the public interest and remove impediments 
to a free and open securities market.\16\
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    \15\ 15 U.S.C. 78f(b)(5).
    \16\ In approving this rule, the Commission notes that it has 
also considered the proposed rule's impact on efficiency, 
competition, and capital formation. 15 U.S.C. 78c(f).
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    As a general matter, 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 Fund 
Shares, can commence trading 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. With 
regard to position and exercise limits, the Commission finds that it is 
appropriate to adopt the tiered approach used in setting position and 
exercise limits for standardized stock options. This approach should 
serve to minimize potential manipulation and market impact concerns. 
Accordingly, because options on Fund Shares will be subject to the same 
regulatory regime as the other options currently traded on the ISE, the 
Commission believes that adequate safeguard are in place to ensure the 
protection of investors in options on Fund Shares.
    The Commission also believes that it is appropriate to permit the 
ISE to list and trade options on Fund Shares given that these options 
must meet specific requirements related to the protection of 
investors.\17\ First, the Exchange's listing and delisting criteria for 
options on Fund Shares are adequate. With regard to initial listing, 
the proposal requires that either: (1) The underlying Fund Shares meet 
the ISE's uniform options listing standards; or (2) the Fund Shares 
must be available for creation or redemption each business day in cash 
or in kind from the Fund at a price related to the net asset value, and 
the Exchange will require that the underlying Fund Shares may be 
created even though some or all of the securities needed to be 
deposited have not been received by the Fund.\18\ This listing 
requirement should ensure that there exists sufficient supply of the 
underlying Fund Shares so that a short call writer, for example, will 
have the ability to secure delivery of the Fund Shares upon exercise of 
the option.
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    \17\ The Commission notes, and ISE has verified, that holders of 
options on Fund Shares who exercise and receive the underlying Fund 
Shares must receive, like any purchaser of Fund Shares, a product 
description or prospectus, as appropriate. Telephone conversation 
between Katherine Simmons, Vice President and Associate General 
Counsel, ISE, and Heather Traeger, Special Counsel, Division of 
Market Regulation, SEC, on March 2, 2001.
    \18\ See supra note 9.
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    The Commission believes the ISE has adequately addressed potential 
concerns about the ability to produce Fund Shares upon exercise of the 
option through the adoption of the listing standards set forth above. 
In particular, options listed pursuant to the uniform options listing 
standards will have to meet the options maintenance listing standards 
that require, among other things, that minimum number of Fund Shares be 
outstanding to continue trading the options. The alternative listing 
criteria, noted above, should also help to ensure that the underlying 
Fund Shares will be available upon exercise by requiring the Fund to 
allow market participants to create Fund Shares even though some or all 
of the necessary securities needed to be deposited are not available. 
Although there is no absolute assurance that market participants will 
go ahead and create Fund Shares in the event a short call writer needs 
to purchase Fund Shares to meet an exercise notice, it is likely that 
arbitrage opportunities will create an incentive to do so. Further, in 
the event there are not enough Fund Shares to meet exercise 
requirement, as with other

[[Page 14616]]

physically-settled equity options, the options Clearing Corporation has 
rules that would apply to such situation. In addition, the Commission 
believes it is appropriate for the ISE to set strike prices for both 
100 and 1000 shares contracts to bracket the Fund Shares price at one 
point intervals up to a share price of $200.
    Second, the Commission believes that the surveillance standard 
developed by the ISE for options on Fund Shares is adequate to address 
the concerns associated with the listing and trading of such 
securities. Specifically, the ISE has proposed that: (1) Any Fund Share 
with non-US stocks in the underlying index or portfolio that are not 
subject to comprehensive surveillance agreements do not in the 
aggregate represent more than 50% of the weight of the index or 
portfolio; (2) stocks for which the primary market is in any one 
country that is not subject to a comprehensive surveillance agreement 
do not represent 20% or more of the weight of the index or portfolio; 
and (3) stocks for which the primary market is in any two countries 
that are not subject to comprehensive surveillance agreements do not 
represent 33% or more of the weight of the index or portfolio.
    As a general matter, the Commission believes that comprehensive 
surveillance agreements provide an important deterrent to manipulation 
because they facilitate the availability of information needed to fully 
investigate a potential manipulation if it were to occur. These 
agreements are especially important in the content of derivative 
products based on foreign securities because they facilitate the 
collection of necessary regulatory, surveillance and other information 
from foreign jurisdictions. In evaluating the current proposal, the 
Commission believes that requiring comprehensive surveillance 
agreements to be in place between the ISE and the primary markets for 
foreign securities that comprise 50% or more of the weight of the 
underlying index or portfolio upon which Fund Shares are based, as well 
as the other conditions discussed above, provides an adequate mechanism 
for the exchange of surveillance sharing information necessary to 
detect and deter possible market manipulations. Although the Commission 
recognizes that up to 50% of the portfolio's value may not be covered 
by comprehensive surveillance agreements, the other requirements will 
ensure that a significant percentage of the portfolio is not made up of 
securities form uncovered countries. Further, as to the domestically-
traded Fund Shares themselves and the domestic stocks in the underlying 
index or portfolio upon which Fund Shares are based, the Intermarket 
Surveillance Group Agreement will be applicable to the trading of 
options on Fund Shares.
    Finally, the Commission believes that it is appropriate to require 
minimum margin of 100% of the current market value of the option plus 
15% of the market value of the underlying security value (``broad-based 
margin'') for options on Fund Shares based on a broad-based index or 
portfolio and for options on Fund Shares which have been approved to 
date. Moreover, the Commission believes that requiring minimum margin 
of 100% of the current market value of the option plus 20% of the 
market value of the underlying security value (``narrow-based margin'') 
for options on Fund Shares based on a narrow-based index or portfolio 
is appropriate. The Commission notes that these margin requirements for 
options on Fund Shares are comparable to margin requirements that 
currently apply to broad-based and narrow-based index options on the 
CBOE and NYSE.\19\
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    \19\ The Commission also notes the ISE will file a proposed rule 
change to amend its margin rules, if necessary. See Amendment No. 1, 
supra note 3.
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    The Commission finds good cause for approving the proposed rule 
change, as amended, (SR-ISE-01-08) prior to the thirtieth day after the 
date of publication of notice thereof in the Federal Register. The 
Commission notes that the proposed rule change, as amended, is similar 
to rules previously approved by the Commission for the Amex, CBOE, 
PHLX, and Pacific Exchange.\20\ The Commission also observes that the 
proposed rule change concerns issues that previously have been the 
subject of a full comment period pursuant to section 19(b) of the 
Act.\21\ The Commission does not believe that the proposed rule change 
raises novel regulatory issues that were not addressed in the previous 
filings. Moreover, the Commission believes that approving the listing 
and trading of Fund Shares on the ISE will increase industry 
competitiveness by providing an additional venue for the trading of 
such issues, to the benefit of the investor. Accordingly, the 
Commission finds that there is good cause, consistent with section 
6(b)(5) of the Act, to approve the proposal, as amended, on an 
accelerated basis.
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    \20\ See Securities Exchange Act Release No. 40157 (July 1, 
1998), 63 FR 37426 (July 10, 1998) (SR-Amex-96-44); Securities 
Exchange Act Release No. 43921 (February 2, 2001), 66 FR 9739 
(February 9, 2001) (SR-Phlx-00-107); Securities Exchange Act Release 
No. 40166 (July 2, 1998), 63 FR 37430 (July 10, 1998) (SR-CBOE-97-
03); and Securities Exchange Act Release No. 44025 (February 28, 
2001).
    \21\ 15 U.S.C. 78s(b).
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    It is Therefore Ordered, pursuant to section 19(b)(2) of the 
Act,\22\ that the proposed rule change, as amended, (SR-ISE-01-08) is 
hereby approved on an accelerated basis.
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    \22\ 15 U.S.C. 78s(b)(2).
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    For the Commission, by the Division of Market Regulation, pursuant 
to delegated authority.\23\
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    \23\ 17 CFR 200.30-3(a)(12).

Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 01-6190 Filed 3-12-01; 8:45 am]
BILLING CODE 8010-01-M