[Federal Register Volume 69, Number 60 (Monday, March 29, 2004)]
[Notices]
[Pages 16299-16305]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-6818]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-49447; File No. SR-ISE-2003-36]


Self-Regulatory Organizations; Notice of Filing and Order 
Granting Accelerated Approval of Proposed Rule Change and Amendment No. 
1 Thereto by the International Securities Exchange, Inc., Relating to 
Trading Options on the Morgan Stanley Technology Index

March 18, 2004.
    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 December 4, 2003, the International Securities Exchange, Inc. 
(``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 Exchange. On February 27, 2004, the Exchange filed Amendment No. 1 
to the proposed rule change.\3\ The Commission is publishing this 
notice to solicit comments on the proposed rule, as amended, from 
interested persons and is approving the proposed rule change, 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 from Joseph W. Ferraro, III, Assistant General 
Counsel, ISE to Nancy Sanow, Assistant Director, Division of Market 
Regulation (``Division''), Commission, dated February 26, 2004, 
enclosing Amendment No. 1, which replaces the original filing in its 
entirety.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The ISE is proposing to trade options on the Morgan Stanley 
Technology Index (``MSH'' or ``Index''), a stock index developed by 
Morgan Stanley & Co. Incorporated (``Morgan Stanley'') and calculated 
and maintained by the American Stock Exchange LLC (``Amex''). The Index 
is comprised of technology sector stocks that currently trade on the 
New York Stock Exchange, Inc. (``NYSE'') or that are National Market 
securities traded through the Nasdaq Stock Market, Inc. (``Nasdaq''). 
The Commission has previously approved the listing of options on the 
Index,\4\ and those options currently are traded on the Amex. In 
addition, the Exchange proposes to amend the Supplementary Material to 
ISE Rule 2001 to include the Index and the Reporting Authority in the 
disclaimer provisions of the rule. The text of the proposed rule 
change, as amended, is below. Proposed new language is in italics; 
proposed deletions are in [brackets].
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    \4\ See Securities Exchange Act Release Nos. 41472 (June 2, 
1999), 64 FR 31331 (June 10, 1999) (SR-Amex-99-14) (approving a 
reduction in the value of the Index); and 36283 (September 26, 
1995), 60 FR 51825 (October 3, 1995) (SR-Amex-95-26) (approving the 
listing of options on the Index on the Amex) (``Amex Approval'').
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* * * * *

Rule 2001. Definitions

Supplementary Material to Rule 2001

    .01 The reporting authorities designated by the Exchange in respect 
of each index underlying an index options contract traded on the 
Exchange are as provided in the chart below.

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             Underlying index                   Reporting  authority
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S&P SmallCap 600 Index....................  Standard & Poor's.
Morgan Stanley Technology Index...........  American Stock Exchange.
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* * * * *

Rule 2009. Terms of Index Options Contracts

    (a) General.
    (4) ``European-Style Exercise.'' The following European-style index 
options, some of which may be A.M.-settled as provided in paragraph 
(a)(5), are approved for trading on the Exchange:
    (i) S&P SmallCap 600 Index..
    (ii) Morgan Stanley Technology Index.
    (5) A.M.-Settled Index Options. The last day of trading for A.M.-
settled index options shall be the business day preceding the last day 
of trading in the underlying securities prior to expiration. The 
current index value at the expiration of an A.M.-settled index option 
shall be determined, for all purposes under these Rules and the Rules 
of the Clearing Corporation, on the last day of trading in the 
underlying securities prior to expiration, by reference to the reported 
level of such index as derived from first reported sale (opening) 
prices of the underlying securities on such day, except that:
    (i) In the event that the primary market for an underlying security 
does not open for trading on that day, the price of that security shall 
be determined, for the purposes of calculating the current index value 
at expiration, as set forth in Rule 2008(g), unless the current index 
value at expiration is fixed in accordance with the Rules and By-Laws 
of the Clearing Corporation; and
    (ii) In the event that the primary market for an underlying 
security is open for trading on that day, but that particular security 
does not open for trading on that day, the price of that security, for 
the purposes of calculating the current index value at expiration, 
shall be the last reported sale price of the security.
    The following A.M.-settled index options are approved for trading 
on the Exchange:
    (i) S&P SmallCap 600 Index.
    (ii) Morgan Stanley Technology Index.
    (b) Long-Term Index Options Series.
    (1) (No change).
    (2) Reduced Value Long Term Options Series.
    (i) Reduced-value long term options series on the following stock 
indices are approved for trading on the Exchange:
    (A) S&P SmallCap 600 Index.
    (B) Morgan Stanley Technology Index
    (ii) Expiration Months. Reduced-value long term options series may 
expire at six-month intervals. When a new expiration month is listed, 
series may be near or bracketing the current index value. Additional 
series may be added when the value of the underlying index increases or 
decreases by ten (10) to fifteen (15) percent.

[[Page 16300]]

    (c) Procedures for Adding and Deleting Strike Prices. The 
procedures for adding and deleting strike prices for index options are 
provided in Rule 504, as amended by the following:
    (1) The interval between strike prices will be no less than $5.00; 
provided, that in the case of the following classes of index options, 
the interval between strike prices will be no less than $2.50:
    (i) S&P SmallCap 600, if the strike price is less then $200.00[.]
    (ii) Morgan Stanley Technology Index, if the strike price is less 
than $200.00.
* * * * *

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 Exchange included statements 
concerning the purpose of, and basis for, the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
item III below. The Exchange 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 Exchange proposes to trade standardized options on the Index. 
The Index is an equal-dollar weighted index developed by Morgan 
Stanley, representing a portfolio of large, actively traded technology 
stocks. The Index comprises 35 U.S. public issuers drawn from 11 
technology subsectors, including: Computer and Business Services; Data 
Networking/Internet Infrastructure; Electronics Manufacturing Services; 
Enterprise Software; Internet & PC Software; Server & Enterprise 
Hardware; PC Hardware & Data Storage; Semiconductor Capital Equipment; 
Semiconductors; Technical Software (CAD/CAM, EDA); Telecom Equipment-
Wireline/Wireless.\5\
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    \5\ The specific components of the Index are: Xilinx Inc.; 
Microsoft Corp.; Motorola Inc.; Computer Associates International 
Inc.; Accenture Ltd.; L.M. Ericsson Telephone Co.; Qualcomm Inc.; 
Electronic Data Systems Corp.; First Data Corp.; Veritas Software 
Corp.; Automatic Data Processing Inc.; Nokia Corp.; Juniper Networks 
Inc.; International Business Machines Corp.; Texas Instruments Inc.; 
Amazon.Com Inc.; Stmicroelectronics N.V.; Broadcom Corp.; Emc Corp.; 
Interactivecorp.; Micron Technology Inc.; Flextronics International 
Ltd.; Ebay Inc.; Yahoo! Inc.; Agilent Technologies Inc.; Intel 
Corp.; Hewlett-Packard Co.; Cisco Systems Inc.; Electronic Arts 
Inc.; Oracle Corp.; Intuit Inc.; Peoplesoft Inc.; Applied Materials 
Inc.; Dell Inc.; and Seagate Technology Inc.
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    By way of background, MSH is a narrow-based index, the listing of 
which normally would not require prior Commission approval pursuant to 
Rule 19b-4 under the Act.\6\ However, for the reasons discussed below, 
the listing of MSH options does not squarely fit within the procedures 
in place for the accelerated listing of derivative products, thus 
giving rise to the need for this filing. The Commission amended Rule 
19b-4 in 1998 to eliminate the necessity for self-regulatory 
organizations (``SROs'') to obtain the Commission's permission to list 
and trade new derivative securities products if the Commission has 
approved, pursuant to Rule 19b-4(e), an SRO's trading rules, procedures 
and listing standards for the product class that would include the new 
derivative securities product and the SRO has a surveillance program 
for the product class.\7\ Subsequent to the adoption of this amendment, 
the Commission approved trading rules, procedures and listing standards 
for the trading of narrow-based index options that allow the options 
exchanges to initiate trading in index options pursuant to Rule 19b-
4(e). These trading rules, procedures and listing standards are uniform 
among the options exchanges and are contained in Chapter 20 of the 
ISE's rules and, in particular, ISE Rule 2002.
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    \6\ 17 CFR 240.19b-4.
    \7\ See Securities Exchange Act Release No. 40761 (December 8, 
1998), 63 FR 70952 (December 22, 1998) (File No. S7-13-98) 
(establishing the expedited listing and trading of certain 
derivative products pursuant to Rule 19b-4(e) under the Act).
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    For a derivative product that meets the standards of an exchange's 
rules, an SRO need only complete Form 19b-4(e) at least five business 
days after commencement of trading the new product. However, the 
Commission approved the Amex's trading of options on the MSH in 1995, 
prior to adoption of the Form 19b-4(e) filing process. The Index meets 
all of the requirements of ISE Rule 2002(b), except the requirement 
that an equal dollar-weighted index be rebalanced at least once every 
calendar quarter. Thus, ISE may not list this product pursuant to Rule 
19b-4(e) under the Act.
a. Index Qualification
    ISE Rule 2002(b) contains specific qualification requirements for 
narrow-based index options. Except for the requirement relating to 
quarterly rebalancing of an equal dollar-weighted index (discussed 
below), MSH meets all of those requirements, namely: (1) The index is 
A.M. settled; (2) the index is equal-dollar weighted and has 35 
component securities; (3) each of the component securities has a market 
capitalization of more than $75 million; (4) the trading volume of each 
component security has been over one million shares for each of the 
last six months; (5) each of the component securities represents less 
than 5% of the weight of the index, and the five highest weighted 
component securities in the aggregate account for less than 19% of the 
weight of the index; (6) all of the component securities satisfy the 
requirement of ISE Rule 502 (initial listing standards) applicable to 
individual underlying securities; (7) all component securities are 
``reported securities'' as defined in Rule 11Aa3-1 under the Act; \8\ 
(8) none of the components are non-U.S. securities that are not subject 
to comprehensive surveillance agreements; (9) the underlying index 
value is reported at least once every 15 seconds during the time the 
index options are traded; and (10) the index is calculated by the Amex 
in consultation with Morgan Stanley, which is a broker-dealer that has 
a ``Chinese Wall'' around its personnel who have access to information 
concerning changes in, and adjustments to, the Index.\9\
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    \8\ 17 CFR 240.11Aa3-1.
    \9\ See Amex Approval, supra note 4.
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    In addition, Morgan Stanley has included in the Index only those 
stocks that meet the following standards: (1) A minimum market 
capitalization of $75 million; (2) average monthly trading volume of at 
least one million shares during the preceding six months; (3) each 
component security must be traded on the Amex or the NYSE, or must be a 
National Market security traded through Nasdaq; and (4) upon annual 
rebalancing, at least 90% of the Index's numerical value and at least 
80% of the total number of component securities must meet the then 
current criteria for standardized options trading set forth in Amex 
Rule 915.\10\ Also, because the Index is equal-dollar weighted, no 
component security will represent more than 25% of the weight of the 
Index, nor will the five highest weighted component securities in the 
Index, in the aggregate, account for more than 60% of the weight of the 
Index at each annual rebalancing. Specifically, at each rebalancing, 
each component security will account for approximately 2.86% of the 
weight of the Index.\11\ As of February 18, 2004, all of the Index

[[Page 16301]]

component securities had standardized options trading on them.
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    \10\ Amex Rule 915 is substantively identical to ISE Rule 502.
    \11\ See Securities Exchange Act Release No. 35944 (July 7, 
1995), 60 FR 36167 (July 13, 1995) (SR-Amex-95-26).
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    As of the close of trading on February 18, 2004, the Index was 
valued at 508.78. The market capitalizations of the individual stocks 
in the Index as of the close of trading on February 18, 2004, ranged 
from a high of $283.0 billion to a low of $8.0 billion, with the mean 
and median being $50.9 billion and $26.1 billion, respectively. The 
market capitalization of all the stocks in the Index on that date was 
approximately $1.8 trillion. The total number of shares outstanding for 
the stocks in the Index ranged from a high of 10.8 billion shares to a 
low of 198.5 million shares. In addition, the average daily trading 
volume of the stocks in the Index, for the six-month period from August 
18, 2003, through February 18, 2004, ranged from a high of 64 million 
shares per day to a low of 1.8 million shares per day, with the mean 
and median being 13.6 million and 8.6 million shares, respectively. 
Lastly, as of the close on February 18, 2004, the highest weighted 
component security represents 4.54% of the Index, and the lowest 
weighted component security represents 1.79% of the index.
b. Index Calculation
    The Index is calculated using an ``equal-dollar weighting'' 
methodology designed to ensure that each of the component securities is 
represented in an approximately ``equal'' dollar amount in the Index at 
each rebalancing. The Exchange believes that this method of calculation 
is important because even among the largest companies in the technology 
sector there is great disparity in market value. For example, although 
the stocks included in the Index represent many of the highly 
capitalized companies in the technology sector, the five most highly 
capitalized companies in the Index currently represent approximately 
57% of the aggregate market value of the Index. Since the Index is 
equal dollar weighted, however (as opposed to market capitalization 
weighted), these five most highly capitalized companies have, on 
average, approximately the same weighting in the Index as the five 
least highly capitalized companies in the Index. It has been the 
Exchange's experience that options on market value or capitalization 
weighted indexes dominated by relatively few component stocks are less 
useful to investors because those indexes tend to represent those few 
companies and not the targeted industry as a whole.\12\
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    \12\ See supra note 6.
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    The following is a description of how the equal-dollar weighting 
calculating method works. As of the market close on December 16, 1994, 
a portfolio of technology stocks was established representing an 
investment of $300,000 in the stock (rounded to the nearest whole 
share) of each of the securities represented in the Index. The value of 
the Index equals the current market value (i.e., based on U.S. primary 
market prices) of the sum of the assigned number of shares of each of 
the stocks in the Index divided by the Index divisor. The Index divisor 
was initially determined to yield the benchmark value of 200.00 at the 
close of trading on December 16, 1994. Annually thereafter, following 
the close of trading on the third Friday of December, the Index is 
adjusted by changing the number of whole shares of each component stock 
so that each company is again represented in approximately ``equal'' 
dollar amounts. If necessary, a divisor adjustment is made at the 
rebalancing to ensure continuity of the Index's value.\13\ The newly 
adjusted Index becomes the basis for the Index's value on the first 
trading day following the annual adjustment.
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    \13\ On April 13, 1999, Amex proposed to split the Index to one-
third of its then current value by tripling the divisor used in 
calculating the Index. See Securities Exchange Act Release No. 41472 
(June 2, 1999), 64 FR 31331 (June 10, 1999). However, the Index was 
split 2-for-1 on March 20, 2000. See the American Stock Exchange--
The Morgan Stanley Technology Index Option Specifications on the 
Amex Web site at www.amex.com.
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    As noted above, the number of shares of each component stock in the 
Index remains fixed between annual reviews except in the event of 
certain types of corporate actions, such as the payment of a dividend 
(other than an ordinary cash dividend), stock distribution, stock 
split, reverse stock split, rights offering, distribution, 
reorganization, recapitalization, or similar event with respect to the 
component stocks. In a merger or consolidation of an issuer of a 
component stock, if the stock remains in the Index, the number of 
shares of that security in the Index may be adjusted, to the nearest 
whole share, to maintain the component's relative weight in the Index 
at the level at which it was represented immediately prior to the 
corporate action. In the event of a stock replacement, the average 
dollar value of the remaining Index components is calculated and that 
amount invested in the stock of the new component, rounded to the 
nearest whole share. In all cases, the divisor is adjusted, if 
necessary, to ensure continuity in the value of the Index.
    The value of the Index is calculated continuously and disseminated 
every 15 seconds over the Consolidated Tape Association's Network B and 
to the Options Price Reporting Authority.\14\
c. Maintenance of the Index
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    \14\ See supra note 3.
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    The one requirement for listing and trading of options on the Index 
pursuant to Rule 19b-4(e) under the Act \15\ that the MSH does not 
currently meet is the requirement in ISE Rule 2002(b)(11) that an equal 
dollar-weighted index be rebalanced at least once every calendar 
quarter. The Amex calculates the Index, which is rebalanced annually. 
In its initial approval of the MSH for options trading, the Commission 
included certain specific requirements related to rebalancing of the 
Index in addition to the annual rebalancing.
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    \15\ 17 CFR 240.19b-4(e).
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    The Index is calculated and maintained by the Amex in consultation 
with Morgan Stanley who may, from time to time, suggest changes in the 
technology industry categories represented in the Index or changes in 
the number of component stocks in an industry category to properly 
reflect the changing conditions in the technology sector. Specifically, 
the Amex must maintain the Index so that if at any time between annual 
rebalancings the top five component securities, by weight, account for 
more than one-third of the weight of the Index, the Index is rebalanced 
after the close of the trading on the third Friday (``Expiration 
Friday'') in the next month in the March cycle. The Amex also reviews 
the Index component securities on a quarterly basis and replaces 
component securities that fail to meet the following maintenance 
criteria: (1) A minimum market capitalization of $75 million; (2) 
average monthly trading volume in the component security of at least 
500,000 shares during the preceding six month period; (3) a share price 
greater than $5.00 for a majority of the trading days during the 
preceding three month period; and (4) at least 90% of the component 
securities, by weight, must satisfy the Amex's options eligibility 
requirements. In addition, the Amex must seek approval from the 
Commission pursuant to Section 19(b) of the Act prior to increasing the 
number of components in the Index to more than 46 or decreasing the 
number of components to less than 24.\16\
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    \16\ See Amex Approval, supra note 4, at fn 17.
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    At the beginning of each calendar quarter, Morgan Stanley will 
provide the Amex with a current list of replacement stocks on which to 
draw in

[[Page 16302]]

the event that a component in the Index must be replaced due to merger, 
takeover, or other similar event. The stocks on the replacement list 
will be selected and ranked by Morgan Stanley based on a number of 
criteria, including conformity to Amex Rules 915 and 916, which set 
forth the criteria for the initial and continued listing of 
standardized options on equity securities, trading liquidity, market 
capitalization, ability to borrow shares, and share price. The 
replacement stocks will be categorized by industry within the 
technology sector and ranked within their category based on the 
aforementioned criteria. The replacement stock for a security being 
removed from the Index will be selected by the Amex from the 
replacement list based on industry category and liquidity.\17\
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    \17\ For a more complete discussion of the Replacement list, see 
Amex Approval, supra note 4.
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    In addition, Morgan Stanley will advise Amex regarding the handling 
of unusual corporate actions which may arise from time to time. Routine 
corporate actions (e.g., stock splits, routine spinoffs, etc.) which 
require straightforward index divisor adjustments will be handled by 
Amex staff without consultation with Morgan Stanley. All stock 
replacements and unusual divisor adjustments caused by the occurrence 
of extraordinary events such as dissolution, merger, bankruptcy, non-
routine spin-offs, or extraordinary dividends will be made by Amex 
staff in consultation with Morgan Stanley. All stock replacements and 
the handling of non-routine corporate actions will be announced at 
least ten business days in advance of such effective change, whenever 
practicable. As with all options currently trading on the Exchange, the 
Exchange will make this information available to the public through the 
dissemination of an information circular.\18\
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    \18\ See supra note 4.
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    The Commission concluded in approving the Amex's trading of options 
on the MSH that the composition and maintenance criteria for the Index 
were appropriate to minimize the possibility that the Index could be 
manipulated, and options on the Index continue to trade on the Amex 
today under these standards. The Exchange believes that these standards 
continue to be adequate to protect investors. The Exchange shall notify 
the Market Regulation Division of the Commission immediately in the 
event Amex determines to cease maintaining or calculating the Index. In 
the event the Index ceases to be maintained or calculated, the Exchange 
may determine not to list any additional series for trading or limit 
all transactions in such options to closing transactions only for the 
purpose of maintaining a fair and orderly market and protecting 
investors.
d. Expiration and Settlement, Position and Exercise Limits; Margin 
Requirements, and Trading Halts
    The product specifications of the options on the Index proposed to 
be traded on the Exchange will be identical to the product 
specifications of the options on the Index traded on Amex. 
Specifically, options on the Index are European-style \19\ and cash-
settled. The Exchange's standard trading hours for index options (9:30 
a.m. to 4:15 p.m., New York time), as set forth in ISE Rule 2008(a), 
will apply to MSH options. MSH options listed on Amex also trade from 
9:30 a.m. to 4:15 p.m., New York time. The options on the Index will 
expire on the Saturday following the third Friday of the expiration 
month (``Expiration Friday''). The last trading day in an expiring 
Index option series will normally be the second to last business day 
preceding the Saturday following Expiration Friday (normally a 
Thursday). Trading in expiring Index options will cease at the close of 
trading on the last trading day.
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    \19\ European-style options may only be exercised during a 
specified time period immediately prior to expiration.
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    The Exchange plans to list Index options series with expirations in 
the three near-term calendar months and in two additional calendar 
months in the March cycle. In addition, longer term option series 
having up to thirty-six months to expiration may be traded. In lieu of 
such long-term options based on the full-value of the Index, the 
Exchange may instead list long-term, reduced-value put and call options 
based on one-tenth (\1/10\th) of the Index's full value. In either 
event, the interval between expiration months for either a full-value 
or reduced-value long-term Index option will not be less than six 
months. The trading of any long-term Index options will be subject to 
the same rules which govern the trading of all the Exchange's index 
options, including sales practice rules, margin requirements, and 
trading rules.
    Because the Index is a narrow-based index, position and exercise 
limits on full-value and reduced-value long-term Index options will be 
equivalent to the position and exercise limits for narrow-based indexes 
established pursuant to Exchange rules.\20\ For aggregation purposes, 
ten contracts of a reduced-value index series will be equivalent to one 
full-value contract.\21\ For example, since the position limit for the 
full-value options on the Index is 31,500 contracts on the same side of 
the market (as they currently are on Amex), then the position limit for 
the reduced-value options will be 315,000 contracts on the same side of 
the market.
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    \20\ Conversation between Joseph W. Ferraro, III, Assistant 
General Counsel, ISE, and Tim Fox, Attorney, Division, Commission on 
March 18, 2004. Pursuant to ISE Rules 2005 and 2007, the position 
and exercise limits for the MSH options will be 31,500 contracts on 
the same side of the market.
    \21\ See ISE Rule 2004(c).
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    Similarly, the margin requirement for the MSH options will be 
equivalent to those applied to narrow-based index options.\22\ In 
addition, Exchange rules governing and trading halt procedures that are 
applicable to the trading of narrow-based index options will apply to 
options traded on the Index.\23\
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    \22\ The ISE represents that the minimum customer margin for 
uncovered writers of Index contracts will be 100% of the market 
value of the option plus 20% of the aggregate Index value less any 
out-of-the-money amount, subject to a minimum of 100% of the market 
value of the option plus 10% of the aggregate Index value. See email 
from Joseph Ferraro, Assistant General Counsel, ISE to Tim Fox, 
Attorney, Commission, dated March 10, 2004.
    \23\ Trading on the Exchange MSH options will be halted or 
suspended whenever trading in underlying securities whose weighted 
value represents more than ten percent of the index value is halted 
or suspended. See ISE Rule 2008(c). Conversation between Joseph 
Ferraro, Assistant General Counsel, ISE and Tim Fox, Attorney, ISE 
on March 18, 2004.
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    The exercise settlement value for expiring Index options is 
calculated based upon the primary exchange regular way opening sale 
prices for the component stocks, except in the case of Nasdaq National 
Market System (``Nasdaq/NMS'') components of the Index. Amex revised 
the settlement value calculation methodology for Nasdaq/NMS component 
stocks in the Index.\24\ Prior to that revision, the Index's settlement 
value was determined by using the regular-way opening sale price for 
each of the Index's component stocks in its primary market on the last 
trading day prior to expiration. Upon that revision, the Index's 
settlement value calculation is determined by using the volume weighted 
average price for each Nasdaq/NMS listed Index component, as calculated 
during the first five minutes of trading immediately following the 
first reported trade for such component. If no other trades are 
executed in a Nasdaq/NMS listed Index component during the five minutes 
following the first reported trade, Amex will use the price of the 
first reported trade in

[[Page 16303]]

calculating the settlement value for the Index.\25\
e. Exchange Rules Applicable to Stock Index Options
    Exchange Rules 2000 through 2012 will apply to the trading of 
option contracts based on the Index. The Commission has approved ISE 
maintenance standards and trading rules applicable to narrow-based 
index options pursuant to which options on MSH will be traded. These 
rules, by virtue of their incorporation of other Exchange rules by 
reference, cover issues such as surveillance and exercise prices.
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    \24\ See Securities Exchange Act Release No. 41775 (August 20, 
1999), 64 FR 47206 (August 30, 1999) (SR-Amex-99-28).
    \25\ Id.
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    The Exchange believes that it has an adequate surveillance program 
in place for index options and intends to use those same program 
procedures that it applies to the Exchange's other index options (at 
present, options on the S&P SmallCap 600 Index). Additionally, the 
Exchange is a member of the Intermarket Surveillance Group (``ISG'') 
under the Intermarket Surveillance Group Agreement.\26\
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    \26\ The ISE is a member of the Intermarket Surveillance Group 
(``ISG'') under the ISG Agreement, as amended. The members of the 
ISG include all of the U.S. registered stock and options markets: 
the Amex, the Boston Stock Exchange (``BSE''), the Chicago Board 
Options Exchange (``CBOE''), the Chicago Stock Exchange (``CHX''), 
the National Stock Exchange ``NSX''), National Association of 
Securities Dealers, Inc. (``NASD''), the NYSE, the Pacific Exchange 
(``PCX'') and the Philadelphia Stock Exchange (``Phlx''). The ISE 
members work together to coordinate surveillance and investigative 
information sharing in the stock and options markets. In addition, 
the major futures exchanges are affiliated members of the ISG, which 
allows for the sharing of surveillance information for potential 
intermarket trading abuses. See Securities Exchange Act Release No. 
48587 (October 2, 2003), 68 FR 58514 (October 8, 2003) (SR-ISE-2003-
18) (approval of trading options on the S&P Small Cap 600 Index on 
ISE).
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    The Exchange notes that the Commission's Order granting approval to 
Amex to trade options on the Index \27\ provides that Morgan Stanley 
has also adopted special procedures to prevent the potential misuses of 
material, non-public information by the research, sales and trading 
divisions of the firm in connection with the maintenance of the Index. 
As discussed in that Order, the stocks on each Replacement List are not 
eligible to be added to the Index by Amex for a period of three months 
after receipt of the Replacement List by Amex. Moreover, the Amex 
publicly disseminates each Replacement List by issuing information 
circulars so that investors will know in advance which securities will 
be considered as replacements for the Index. In addition, Morgan 
Stanley will have a limited role in the stock replacement selection and 
substitution process. First, when a stock in the Index no longer meets 
the published criteria as determined following a quarterly review of 
the components by the Exchange, the Amex will determine, without 
consultation with Morgan Stanley, which security from the applicable 
Replacement List will be selected for addition to the Index. Second, 
the Amex will also make adjustments as a result of stock splits, spin-
offs, and otherwise, without consultation with Morgan Stanley. Finally, 
even in those situations where the Amex consults with Morgan Stanley, 
upon the occurrence of certain events, the actual replacement stock 
will be selected solely by Amex from the 45 stocks on the replacement 
list.
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    \27\ See Amex Approval, supra note 4.
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    The Index is a narrow-based index, as defined in Exchange Rule 
2001(i). The Exchange proposes to set exercise (strike) prices at $5.00 
intervals, bracketing the current value of the Index when the Index is 
above 200. If the Index is below 200, the interval will be $2.50. 
Pursuant to ISE Rule 2009(b), strike price interval, bid/ask 
differential and price continuity rules will not apply to the trading 
of LEAPS on the Index until their time to expiration is less than 
twelve months. The strike price interval for the reduced-value Index 
LEAPS will be no less than $2.50 instead of $5.00. In addition, ISE 
Rule 2009(b) provides that full-value or reduced-value LEAPS on the 
Index will be issued at no less than six-month intervals and that new 
strike prices will either be near or bracketing the current Index 
value. These strike prices intervals are the same intervals used by 
Amex.\28\
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    \28\ See Amex Web site at www.amex.com.
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2. Statutory Basis
    The Exchange believes that the proposed rule change, as amended, is 
consistent with section 6(b) of the Act \29\ in general, and furthers 
the objectives of section 6(b)(5),\30\ in particular, in that it is 
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, in general, 
to protect investors and the public interest.
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    \29\ 15 U.S.C. 78f(b).
    \30\ 15 U.S.C. 78f(b)(5).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    The Exchange does not believe that the proposed rule change, as 
amended, will impose any burden on competition.

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

    The Exchange did not receive any written comments on the proposed 
rule change, as amended.

III. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning the foregoing, including whether the proposal 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. Comments 
may also be submitted electronically at the following e-mail address: 
[email protected]. All comment letters should refer to File No. SR-
ISE-2003-36. The file number should be included on the subject line if 
e-mail is used. To help the Commission process and review your comments 
more efficiently, comments should be sent in hardcopy or by e-mail but 
not by both methods. 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 Exchange. All 
submissions should refer to the File No. SR-ISE-2003-36 and should be 
submitted by April 19, 2004.

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

    After careful consideration, 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,\31\ and, in particular, with the requirements of 
Section 6(b) of the Act \32\ and the rules and regulations thereunder. 
The Commission finds that the proposed rule change, as amended,

[[Page 16304]]

is consistent with Section 6(b)(5) of the Act,\33\ which requires, 
among other things, that the rules of the 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, in general, 
protect investors and the public interest. Specifically, the Commission 
finds that the trading of options on the Index, including full-value 
and reduced-value Index LEAPS, will serve to promote the public 
interest and help to remove impediments to a free and open securities 
market by providing investors with an additional means to hedge 
exposure to market risk associated with stocks in the various high 
technology industries.
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    \31\ In approving this rule, the Commission notes that it has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. 15 U.S.C. 78c(f).
    \32\ 15 U.S.C. 78f(b).
    \33\ 15 U.S.C. 78f(b)(5).
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    The trading of options on the Index and on a reduced-value Index, 
however, raises several issues relating to index design, customer 
protection, surveillance, and market impact. The Commission believes, 
for the reasons discussed below, that the ISE adequately has addressed 
these issues.

A. Index Design and Structure

    The Commission believes it is appropriate for the Exchange to 
designate the Index as a narrow-based index for purposes of index 
options trading. The Index is comprised of a limited number (35) of 
stocks intended to track a limited range of the technology sector of 
the stock market. Accordingly, the Commission believes it is 
appropriate for the ISE to apply its rules governing narrow-based index 
options to trading in the Index options. The Commission also believes 
that the large capitalizations, liquid markets, and relative weightings 
of the Index's component stocks significantly minimize the potential 
for manipulation of the Index. First, the stocks that comprise the 
Index are actively traded, with a mean and median average monthly 
trading volume for the period between August 18, 2003, and February 18, 
2004, of 13.6 million and 8.6 million shares, respectively. Second, the 
market capitalizations of the stocks in the Index are very large, 
ranging from a high of $283.0 billion to a low of $8.0 billion as of 
February 18, 2004, with the mean and median being $50.9 billion and 
$26.1 billion, respectively. Third, because the index is equal dollar-
weighted, no one particular stock or group of stocks dominates the 
Index. Specifically, as of February 18, 2004, no one stock accounted 
for more than 4.54% of the Index's total value and the percentage 
weighting of the five highest weighted stocks in the Index accounted 
for less than 19% of the Index's value. Fourth, the Index will be 
maintained so that in addition to the other maintenance criteria 
discussed above, at each quarterly review and rebalancing (annual or 
otherwise), at least 90% of the weight of the Index will be composed of 
securities eligible for standardized options trading. Currently, all of 
the component stocks in the Index have standardized options trading on 
them. Fifth, Morgan Stanley and the Amex are required to ensure that 
each component of the Index is subject to last sale reporting 
requirements in the U.S. pursuant to Rule 11Aa3-1 under the Act.\34\ 
The Commission believes that this further reduces the potential for 
manipulation of the value of the Index. Finally, the Commission 
believes that the existing mechanisms to monitor trading activity in 
the component stocks of the Index, or options on those stocks, will 
help deter as well as detect any illegal activity.
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    \34\ 17 CFR 240.11Aa3-1.
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    In addition, even though the Index is only scheduled to be 
rebalanced annually, the Commission believes that the Amex and Morgan 
Stanley have developed several composition and maintenance criteria for 
the Index that will minimize the possibility that the Index could be 
manipulated through trading in less actively traded securities or 
securities with smaller prices or floats. First, if at any time during 
the year the top five components in the Index, by weight, account for 
more than one-third of the weight of the Index, the Exchange will 
rebalance the Index following the close of trading on Expiration Friday 
in the next month in the March cycle. These rebalancing requirements 
will serve to ensure that any ``overweight'' stock \35\ will be brought 
back into line with the other stocks, thus ensuring that less 
capitalized stocks do not become excessively weighted in the Index. 
Second, after each quarterly review and each rebalancing (annual or 
otherwise), at least 90% of the weight of the Index will be comprised 
of stocks that are eligible for standardized options trading. The 
Commission believes that this requirement will ensure that the Index 
will be almost entirely made up of stocks with large public floats that 
are actively traded, thus reducing the likelihood that the Index could 
be easily manipulated by abusive trading in the smaller stocks 
contained in the Index. Third, at each quarterly review of the Index, a 
component may only remain in the Index if it satisfies the maintenance 
requirements discussed above.\36\ These requirements are similar to the 
continued listing requirements for options on individual equity 
securities.\37\ Lastly, because the Index is narrow-based, the 
applicable position and exercise limits \38\, margin requirements,\39\ 
and trading halts \40\ will further reduce the susceptibility of the 
Index to manipulation.\41\
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    \35\ A stock would be ``overweight'' if its weight in the Index 
were greater than the average weight of all of the stocks in the 
Index. This would occur, for example, if the price of a component 
stock significantly increased relative to the other stocks in the 
Index during a particular quarter and prior to the rebalancing.
    \36\ See supra section II (A)(1)(c).
    \37\ See ISE Rule 2002(b).
    \38\ See supra note 20.
    \39\ See supra note 22.
    \40\ See supra note 23.
    \41\ The ISE represents that the minimum customer margin for 
uncovered writers is 100% of the market value of the option plus 20% 
of the aggregate Index value less any out-of-the-money amount, 
subject to a minimum of 100% of the market value of the option plus 
10% of the aggregate Index value. See e-mail from Joseph Ferraro, 
Assistant General Counsel, ISE to Tim Fox, Attorney, Commission, 
dated March 10, 2004, see also ISE Rule 2005.
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    The Commission notes that certain concerns are raised when a 
broker-dealer, such as Morgan Stanley, is involved in the development 
and maintenance of a stock index that underlies an exchange-traded 
derivative product. For several reasons, however, the Commission 
believes that this concern has been adequately addressed with respect 
to options on the Index. First, the value of the Index is to be 
calculated and disseminated by the Amex so that unless a party 
independently calculates the Index value, neither Morgan Stanley nor 
any other party will be in receipt of the values prior to the public 
dissemination of the Index value. Second, routine corporate actions 
(e.g., stock splits, routine spinoffs, etc.) will be handled by the 
Amex without consultation with Morgan Stanley. Third, although stock 
replacements and unusual divisor adjustments caused by the occurrence 
of extraordinary events, such as dissolution, merger, bankruptcy, non-
routine spinoffs, or extraordinary dividends, will be made by Amex 
staff in consultation with Morgan Stanley, Amex alone ultimately will 
select the actual replacement stock from the Replacement List without 
Morgan Stanley's assistance. Such replacements will be announced 
publicly at least 10 business days in advance of the effective change 
by the Amex through the dissemination of an information circular, 
whenever practicable. Fourth, each Replacement List submitted to the 
Amex by Morgan Stanley will be published by the Amex and securities 
cannot be selected from a Replacement

[[Page 16305]]

List for three months after receipt by the Amex. Fifth, the Commission 
believes that the procedures Morgan Stanley has established to detect 
and prevent material non-public information concerning the Index from 
being improperly used by the person or persons responsible for 
compiling the Replacement Lists, as well as other persons within Morgan 
Stanley, as discussed above, adequately serve to minimize the 
susceptibility to manipulation of the Index, the securities in the 
Index, and securities added to and deleted from any Replacement List. 
Finally the ISE's existing surveillance procedures for stock index 
options will apply to the options on the Index and should provide the 
ISE with adequate information to detect and deter trading abuses that 
may occur. In summary, the Commission believes that the procedures 
outlined above help to ensure that Morgan Stanley will not have any 
informational advantages concerning modifications to the composition of 
the Index due to its limited role in consulting with Amex on the 
maintenance of the Index under certain circumstances.

B. 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 Index options, 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 and Index LEAPS will be subject to the same regulatory 
regime as the other index options currently traded on the ISE, the 
Commission believes that adequate safeguards are in place to ensure the 
protection of investors in the Index options and full-value or reduced 
value Index LEAPS. Finally, the Amex has stated that it will distribute 
information circulars to members following rebalancings and prior to 
component changes to notify members of changes in the composition of 
the Index. Additionally, the Amex will publicly disseminate each 
Replacement List by means of information circulars. The Commission 
believes this should help to protect investors and avoid investor 
confusion.

C. Surveillance

    The Commission believes that a surveillance sharing agreement 
between an exchange proposing to list a stock index derivative product 
and the exchange(s) trading the stocks underlying the derivative 
product is an important measure for surveillance of the derivative and 
underlying securities markets. Such agreements ensure the availability 
of information necessary to detect and deter potential manipulations 
and other trading abuses, thereby making the stock index product less 
readily susceptible to manipulation. In this regard, the Amex, NYSE, 
and the NASD are all members of the ISG, which provides for the 
exchange of all necessary surveillance information.\42\
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    \42\ See supra note 26.
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D. Market Impact

    The Commission believes that the listing and trading of Index 
options, including full-value and reduced-value Index LEAPS on the ISE 
will not adversely impact the underlying securities markets. First, as 
described above, due to the ``equal dollar-weighting'' method, no one 
stock or group of stocks dominates the Index. Second, because at each 
quarterly review and each rebalancing of the Index, at least 90% of the 
weight of the Index must be accounted for by stocks that meet the 
Amex's options listing standards, the component stocks generally will 
be actively-traded, highly-capitalized stocks. Third, the currently 
applicable 31,500 contract position and exercise limits will serve to 
minimize potential manipulation and market impact concerns. Fourth, the 
risk to investors of contra-party non-performance will be minimized 
because the Index options and Index LEAPS will be issued and guaranteed 
by the Options Clearing Corporation just like any other standardized 
option traded in the United States. Lastly, the Commission believes 
that settling expiring Index options (including full-value and reduced-
value Index LEAPS) 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 closing prices may help reduce adverse effects on 
markets for stocks underlying options on the Index.
    The Commission finds good cause, pursuant to section 19(b)(2) of 
the Act,\43\ for approving the proposed rule change, as amended, prior 
to the 30th day after the date of publication of the notice of the 
filing thereof in the Federal Register. The Commission previously 
addressed the issues raised by the trading of the Index on an exchange 
when the Commission approved this product for trading on the Amex,\44\ 
and accelerated approval of the proposal will allow investors to begin 
trading the options promptly. Moreover, the index meets all of the 
requirements of ISE Rule 2002(b) except for quarterly rebalancing, 
which the Commission has previously determined was appropriate given 
the specific procedures in place for quarterly review and maintenance 
of the Index. Accordingly, the Commission finds that there is good 
cause, consistent with section 6(b)(5) and 19(b)(2) of the Act,\45\ to 
approve the proposed rule change, as amended, on an accelerated basis.
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    \43\ 15 U.S.C. 78s(b)(2).
    \44\ See Amex Approval, supra note 4.
    \45\ 15 U.S.C. 78f(b)(5) and 78s(b)(2).
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V. Conclusion

    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\46\ that the proposed rule change (SR-ISE-2003-36), as amended, is 
hereby approved on an accelerated basis.
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    \46\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\47\
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    \47\ 17 CFR 200.30-3(a)(12).
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Jill M. Peterson,
Assistant Secretary.
[FR Doc. 04-6818 Filed 3-26-04; 8:45 am]
BILLING CODE 8010-01-P