[Federal Register Volume 69, Number 209 (Friday, October 29, 2004)]
[Notices]
[Pages 63188-63190]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E4-2907]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-50585; File No. SR-OCC-2004-18]


Self-Regulatory Organizations; The Options Clearing Corporation; 
Notice of Filing and Immediate Effectiveness of a Proposed Rule Change 
Relating to OCC's Adjustment Policies for Options and Stock Futures on 
Fund Shares

October 25, 2004.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ notice is hereby given that on September 27, 2004, The 
Options Clearing Corporation (``OCC'') filed with the Securities and 
Exchange Commission (``Commission'') the proposed rule change as 
described in Items I, II, and III below, which items have been prepared 
primarily by OCC. The Commission is publishing this notice to solicit 
comments on the proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The proposed rule change codifies exceptions for options and stock 
futures on ``fund shares'' to OCC's adjustment policies recently made 
by panels of OCC's Securities Committee.

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

    In its filing with the Commission, OCC 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 IV below. OCC has prepared summaries, set forth in sections (A), 
(B), and (C) below, of the most significant aspects of such 
statements.\2\
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    \2\ The Commission has modified parts of these statements.
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(A) Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

(1) Background
    Article VI, Clearance of Exchange Transactions, Section 11, 
Adjustments, Paragraph (c) of OCC's By-Laws states:
    It shall be the general rule that there will be no adjustments to 
reflect ordinary cash dividends or distributions * * * by the issuer of 
the underlying security.
    Interpretation .01 of Article VI, Section 11 (sometimes referred to 
as the ``10% rule'') provides:
    Dividends or distributions by the issuer of the underlying security 
in an aggregate amount per dividend or distribution which does not 
exceed 10% of the market value (as of the close of trading on the 
declaration date) of the underlying security outstanding will, as a 
general rule, be deemed to be `ordinary dividends or distributions' 
within the meaning of paragraph (c) of Section 11.
    However, Article VI, Section 11(j) provides:
    Notwithstanding the general rules set forth in paragraphs (c) 
through (j) of this Section 11 or which may be set forth as 
interpretations and policies under this Section 11, the Securities 
Committee shall have the power to make exceptions in those cases or 
groups of cases * * * in which, applying the standards set forth in 
paragraph (b) hereof, the Securities Committee shall determine such 
exceptions to be appropriate. * * *
    Panels of OCC's Security Committee recently determined to exercise 
their authority under Article VI, Section 11(j) to make exceptions to 
the 10% rule and adjust options on exchange traded funds (``ETFs'') and 
Holding Company Depository Receipts (``HOLDRs'') (collectively referred 
to in OCC's Rules

[[Page 63189]]

as ``fund shares'') for dividends reflecting special one-time 
distributions on portfolio securities notwithstanding that the amounts 
of the dividends were not expected to exceed 10% of the market value of 
the fund shares themselves.\3\ The proposed rule change amends 
Interpretation .08 under Article VI, Section 11 of OCC's By-Laws to 
call for such adjustments as a matter of course.
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    \3\ In accordance with a preexisting commitment to report 
exercises of the Securities Committee's exception-making authority, 
these actions were reported to the Division of Market Regulation by 
letter dated August 9, 2004.
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    (a) The TRLY Decision. On July 20, 2004, Terra Networks S.A. 
(``TRLY'') announced a cash return of capital distribution of $2.48 per 
share, which represented approximately 42% of the stock price, payable 
to holders of record on July 27, 2004. Because the amount of the 
distribution exceeded 10% of the stock price, the 10% rule did not 
apply. On July 23, 2004, a panel of OCC's Securities Committee 
determined to adjust options on TRLY stock effective on the ex-date for 
the distribution by adjusting the underlying to include the amount of 
the distribution.\4\
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    \4\ OCC Information Memo 19875 (July 20, 2004).
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    The American Stock Exchange (``Amex'') trades options on HOLDRs 
issued by the Europe 2001+ HOLDRS Trust (``Trust''). The Trust's 
portfolio includes TRLY American Depository Shares. In order to pass 
through the TRLY distribution, as it was obligated to do, the Trust 
declared its own distribution of approximately $0.37 per HOLDR. This 
was less than 10% of the market price of the HOLDRs. Nevertheless, on 
July 26, 2004, a panel of the Securities Committee consisting of two 
representatives of the Amex and one non-voting representative of OCC 
determined to make an exception to the 10% rule and adjust for the 
Trust's distribution.\5\
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    \5\ OCC Information Memo 19877 (July 26, 2004).
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    The panel's decision was based on the special characteristics of 
HOLDRs. A HOLDR is a trust-issued receipt representing beneficial 
ownership of a basket of stocks. The owner of a HOLDR has the right to 
vote the shares in the basket, to receive dividends and other 
distributions on those shares, and to exchange the HOLDR at any time 
for the underlying basket of stocks. Given the purely derivative nature 
of HOLDRs, which are intended to function as exact surrogates for the 
underlying basket of stocks, the Securities Committee was of the view 
that it would be inappropriate to apply the 10% rule to a distribution 
on a HOLDR caused by a one-time distribution on a portfolio security of 
sufficient size to cause options on the latter to be adjusted.\6\
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    \6\ The 10% rule does not apply to regular quarterly dividends 
on HOLDRs because adjusting for recurring dividends would require 
repeated readjustments of previously adjusted series, which would 
cause a proliferation of outstanding options series that would not 
be in the best interest of investors. Making a one-time adjustment 
for a one-time distribution does not have that effect.
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    Existing Interpretation .08 of Article VI, Section 11 recognizes 
the special characteristics of HOLDRs and other fund shares by 
excluding capital gain distributions on fund shares from the 10% rule. 
Had the draftsmen of that Interpretation anticipated the possibility of 
distributions on fund shares reflecting on-time return of capital 
distributions on portfolio securities, they would have excluded those 
distributions as well. The Securities Committee concluded that 
adjusting for the Trust's distribution was consistent with the spirit 
of Interpretation .08.
    (b) The MSFT Decision. On July 20, 2004, Microsoft Corporation 
(``MSFT'') declared a special one-time cash dividend of $3.00 per 
share, payable December 2, 2004, to holders of record on November 17, 
2004, subject to approval of related amendments to MSFT's employee 
stock plans at its annual meeting in November. Because the amount of 
the dividend exceeded 10% of the market value of MSFT, the 10% rule did 
not apply and on July 20, 2004 a panel of OCC's Securities Committee 
determined to adjust options on MSFT stock effective on the ex-date by 
reducing stock prices by $3.00 per share.\7\
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    \7\ OCC Information Memo 19872 (July 20, 2004).
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    Options are traded on a total of 19 ETFs and HOLDRs whose 
portfolios include MSFT stock. When the MSFT special dividend is paid, 
it is anticipated that it will be passed through to holders of those 
fund shares in the form of dividends. The amounts of any such dividends 
are expected to be less than 10% of the funds' respective stock prices. 
Panels of OCC's Securities Committee nevertheless determined on July 
27, 2004, to make an exception to the 10% rule and to adjust for fund 
share dividends reflecting the MSFT special dividend in those cases 
where the impact on the ETF or HOLDR equals or exceeds the de minimus 
amount of an eighth, or $0.125 per share.\8\
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    \8\ OCC Information Memos 19883 (July 27, 2004) and 
19892 (July 29, 2004).
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    There were a number of reasons for the decision to adjust. First, 
Nasdaq, Standard & Poor's, and Dow Jones had all announced that they 
intended to adjust the divisors of their respective indexes to 
compensate for the MSFT special dividend. As Dow Jones explained in its 
press release, ``Divisor adjustments nullify the effect on the index 
values of the stock price being lowered by the value of the dividend.'' 
\9\ A number of underlying ETFs, including the widely traded QQQ which 
tracks the Nasdaq-100 index, were designed to track indexes that will 
be adjusted for the MSFT special dividend. The effect of adjusting 
those indexes would be to nullify the effect of the special dividend 
not only on the indexes themselves but also on options overlying those 
indexes. Failing to adjust options on ETFs that track those indexes 
would have created an unfair and inequitable disconnect between the 
values of ETF options and the values of index options based on the same 
index.
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    \9\ Dow Jones Indexes press release dated July 22, 2004.
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    Although this rationale applied only to some ETFs (i.e., those that 
tracked indexes that were being adjusted), it would have been 
inconsistent and potentially confusing not to adjust options on other 
ETFs that also hold MSFT stock in their portfolios. Moreover, a 
precedent for adjusting options on fund shares for distributions 
reflecting special one-time distributions on portfolio securities 
notwithstanding the 10% rule had been set just the day before by the 
TRLY decision.
(2) The Proposed Rule Change
    The proposed rule change codifies the TRLY and MSFT decisions by 
revising Interpretation .08 under Article VI, Section 11 to exclude 
from the 10% rule distributions on fund shares other than capital gains 
distributions, which are currently excluded, if:
    (i) The fund tracks the performance of an index that underlies a 
class of index options or index futures, and the distribution on the 
fund shares includes or reflects a dividend or other distribution on a 
portfolio security that resulted in an adjustment of the index divisor; 
or
    (ii) The distribution in the fund shares includes or reflects a 
dividend or other distribution on a portfolio security:
    (x) That results in an adjustment of options on other fund shares; 
\10\ or
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    \10\ This would cover the situation, perhaps unlikely, where two 
ETFs, one of which tracks an index, hold the same portfolio security 
and a distribution of less than 10% of the value of the portfolio 
security nevertheless causes an adjustment of the index divisor. If 
options on the ETF that tracks the index are adjusted, this 
provision would allow options on the other to be adjusted as well.
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    (y) In an aggregate amount exceeding 10% of the market value of the 
portfolio security.

[[Page 63190]]

    No adjustment would be made, however, if the adjustment would 
amount to less than $0.125 per share.
    Conforming changes have been made to Interpretation and Policy .08 
of Article XII, Futures and Futures Options, Section 3, which covers 
adjustments to stock futures on fund shares and parallels the 
provisions of Interpretation and Policy .08 of Article VI, Section 11. 
In addition, technical changes have been made to Interpretation .08 of 
Article VI, Section 3 to (i) fix garbled text as originally filed in 
SR-OCC-2001-07 and approved by the Commission \11\ and (ii) delete the 
term ``stock'' as a modifier for ``fund shares'' in order to further 
conform the Interpretation to the changes proposed in SR-OCC-2002-22 
and approved by the Commission.\12\
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    \11\ See Securities Exchange Act Release No. 44727 (August 20, 
2001), 66 FR 45351 (August 28, 2001).
    \12\ See Securities Exchange Act Release No. 46914 (November 26, 
2002), 67 FR 72261 (December 4, 2002).
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    OCC believes that the proposed rule change is consistent with the 
purposes and requirements of Section 17A of the Act, as amended, 
because it codifies exceptions to OCC's adjustment policies made by 
adjustment panels of the Securities Committee that were intended to 
promote fairness to buyers and sellers of options contracts, the 
maintenance of fair and orderly markets, and consistency of 
interpretation and practice.

 (B) Self-Regulatory Organization's Statement on Burden on Competition

    OCC does not believe that the proposed rule change would impose any 
burden on competition.

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

    Written comments were not and are not intended to be solicited with 
respect to the proposed rule change, and none have been received.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    The foregoing rule change has become effective pursuant to section 
19(b)(3)(A)(iii) of the Act \13\ and Rule 19b-4(f)(4) \14\ promulgated 
thereunder because the proposal effects a change in an existing service 
of OCC that (A) does not adversely affect the safeguarding of 
securities or funds in the custody or control of OCC or for which it is 
responsible and (B) does not significantly affect the respective rights 
or obligations of OCC or persons using the service. At any time within 
sixty days of the filing of the proposed rule change, the Commission 
may summarily abrogate such rule change if it appears to the Commission 
that such action is necessary or appropriate in the public interest, 
for the protection of investors, or otherwise in furtherance of the 
purposes of the Act.
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    \13\ 15 U.S.C. 78s(b)(3)(A)(iii).
    \14\ 17 CFR 240.19b-4(f)(4).
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IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act. Comments may be submitted by any of 
the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml) or
     Send an e-mail to [email protected]. Please include 
File Number SR-OCC-2004-18 on the subject line.

Paper Comments

     Send paper comments in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., 
Washington, DC 20549-0609.
    All submissions should refer to File Number SR-OCC-2004-18. This 
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, please use only one method. The Commission will post all 
comments on the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml). 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 Section, 450 Fifth 
Street, NW., Washington, DC 20549. Copies of such filing also will be 
available for inspection and copying at the principal office of OCC and 
on OCC's Web site at http://www.optionsclearing.com. All comments 
received will be posted without change; the Commission does not edit 
personal identifying information from submissions. You should submit 
only information that you wish to make available publicly. All 
submissions should refer to File Number SR-OCC-2004-18 and should be 
submitted on or before November 19, 2004.

    For the Commission by the Division of Market Regulation, 
pursuant to delegated authority.\15\
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    \15\ 17 CFR 200.30-3(a)(12).
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Jill M. Peterson,
Assistant Secretary.
 [FR Doc. E4-2907 Filed 10-28-04; 8:45 am]
BILLING CODE 8010-01-P