[Federal Register Volume 71, Number 224 (Tuesday, November 21, 2006)]
[Notices]
[Pages 67415-67418]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E6-19619]
-----------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-54748; File No. SR-OCC-2006-01]
Self-Regulatory Organizations; The Options Clearing Corporation;
Notice of Amended Filing of Proposed Rule Change To Revise Option
Adjustment Methodology
November 14, 2006.
Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Act''),\1\ notice is hereby given that on January 12, 2006, 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
by OCC. On March 9, 2006, the Commission published notice of the
proposed rule change to solicit comments from interested parties.\2\
The Commission received ten comment letters.\3\ To address the concerns
raised by the commenters, OCC amended the proposed rule change on
September 25, 2006. The Commission is publishing this notice to solicit
comments on the proposed rule change, as amended, from interested
parties.
---------------------------------------------------------------------------
\1\ 15 U.S.C. 78s(b)(1).
\2\ Securities Exchange Act Release No. 53400 (March 2, 2006),
71 FR 12226.
\3\ Joseph Haggenmiller (March 8, 2006); Erik A. Hartog,
Operating Manager, Allagash Trading LLC (March 21, 2006); Jeffrey
Woodring (March 22, 2006); Adam Besch-Turner (March 23, 2006);
Christopher Nagy, Chairman, Options Committee, Securities Industry
Association (March 24, 2006); Mike Ianni (April 5, 2006); Mike Ianni
(April 5, 2006); Peter van Dooijeweert, President, Alopex Capital
Management, LLC (April 26, 2006); Bob Linville and Deborah
Mittelman, Service Bureau Committee Co-Chairs, Financial Information
Forum (May 2, 2006); and William H. Navin, Executive Vice President,
General Counsel, and Secretary, The Options Clearing Corporation
(September 29, 2006).
---------------------------------------------------------------------------
I. Self-Regulatory Organization's Statement of the Terms of Substance
of the Proposed Rule Change
OCC is seeking to amend Article VI (Clearance of Exchange
Transactions), Section 11A of OCC's By-Laws to (1) eliminate the need
to round strike prices and/or units of trading in the event of certain
stock dividends, stock distributions, and stock splits and (2)
[[Page 67416]]
provide for the adjustment of outstanding options for special dividends
(i.e., cash distributions not declared pursuant to a policy or practice
of paying such distributions on a quarterly or other regular basis).
The proposed rule change would also add a $12.50 per contract threshold
amount for cash dividends and distributions to trigger application of
OCC's adjustment rules.
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 these
statements.\4\
---------------------------------------------------------------------------
\4\ The Commission has modified the text of the summaries
prepared by OCC.
---------------------------------------------------------------------------
(A) Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change
A. Changes relating to Adjustments for Certain Stock Dividends, Stock
Distributions, and Stock Splits
OCC's By-Laws currently specify two alternative methods of
adjusting for stock dividends, stock distributions, and stock splits.
In cases where one or more whole shares are issued with respect to each
outstanding share, the number of outstanding option contracts is
correspondingly increased and strike prices are proportionally
reduced.\5\ In all other cases, the number of shares to be delivered
under the option contract is increased and the strike price is reduced
proportionately.\6\
---------------------------------------------------------------------------
\5\ For example, in the event of a 2-for-1 split, an XYZ $60
option calling for the delivery of 100 shares of XYZ stock would be
subdivided into two XYZ $30 options, each calling for the delivery
of 100 shares of XYZ stock.
\6\ For example, in a 3-for-2 split, an XYZ $60 option calling
for the delivery of 100 shares would be adjusted to call for the
delivery of 150 shares and the strike price would be reduced to $40.
---------------------------------------------------------------------------
Although these two methods have been used since the inception of
options trading, in certain circumstances either method can produce a
windfall profit for one side and a corresponding loss for the other due
to rounding of adjusted strike prices. These profits and losses, while
small on a per-contract basis, can be significant for large positions.
Because equity option strike prices are currently stated in eighths,
OCC's By-Laws require adjusted strike prices to be rounded to the
nearest eighth. For example, if an XYZ $50 option for 100 shares were
to be adjusted for a 3-for-2 split, the deliverable would be increased
to 150 shares and the strike price would be adjusted to $33.33, which
would then be rounded up to $33-\3/8\. Prior to the adjustment, a call
holder would have had to pay $5,000 to exercise ($50 x 100 shares).
After the adjustment, the caller has to pay $5,006.25 for the
equivalent stock position ($33.375 x 150 shares). Conversely, an
exercising put holder would receive $5,006.25 instead of $5,000. The
$6.25 difference represents a loss for call holders and put writers and
a windfall for put holders and call writers.
A loss/windfall can also occur when the split results in a
fractional deliverable (e.g., when a 4-for-3 split produces a
deliverable of 133.3333 shares). In those cases, OCC's By-Laws
currently require that the deliverable be rounded down to eliminate the
fraction, and if appropriate, the strike price be further adjusted to
the nearest eighth to compensate for the diminution in the value of the
contract resulting from the elimination of the fractional share.
However, even if these steps are taken, small rounding inequities may
remain.
The windfall profits and correspondent losses resulting from the
rounding process have historically been accepted as immaterial. Due to
recent substantial increases in trading volume and position size,
however, they have become a source of concern to exchanges and market
participants. In addition, OCC has been informed that some traders may
be exploiting announcements of splits and similar events by quickly
establishing positions designed to capture rounding windfalls at the
expense of other market participants.
The inequity that results from the need to round strike prices can
be eliminated by using a different adjustment method: namely, adjusting
the deliverable but not the strike prices or the values used to
calculate aggregate exercise prices and premiums. As an illustration of
the proposed adjustment methodology, in the XYZ $50 option 3-for-2
split example described above, the resulting adjustment would be a
deliverable of 150 shares of XYZ stock while the strike price would
remain at $50. In this case, the presplit multiplier of 100, used to
extend aggregate strike price and premium amounts, is unchanged. For
example, a premium of 1.50 would equal $150 ($1.5 x 100) both before
and after the adjustment. An exercising call holder would continue to
pay $50 times 100 (for a total of $5,000) but would receive 150 shares
of XYZ stock instead of 100.\7\ This is the method currently used for
property distributions such as spin-offs and special dividends large
enough to require adjustments under OCC's By-Laws.
---------------------------------------------------------------------------
\7\ The same adjustment methodology would apply to reverse stock
splits or combination of shares. For example, in a 3-for-4 reverse
stock split on a XYZ $50 option calling for the delivery of 100
shares, the resulting adjustment would be a deliverable of 75 shares
of XYZ stock while the strike price would remain at $50.
---------------------------------------------------------------------------
The inequity that results from the need to eliminate fractional
shares from the deliverable and to compensate by further reducing the
strike price to the nearest eighth can be eliminated by adjusting the
deliverable to include cash in lieu of the fractional share. As an
illustration, consider a 4-for-3 split of the stock underlying an XYZ
$80 option with a 100 share deliverable. Employing the proposed
adjustment method, the deliverable would be adjusted to 133.3333
shares, which would be rounded down to 133 shares, and the strike price
would remain $80. However, instead of compensating for the elimination
of the .3333 share by reducing the strike prices, the strike prices
would be left unchanged, and the deliverable would be adjusted to 133
shares plus the cash value of the eliminated fractional share (.3333 x
the post-split value of a share of XYZ stock as determined by OCC). The
adjusted option would also continue to use 100 as the multiplier to
calculate aggregate strike and premium amounts.
The proposed revised adjustment methodology would not generally be
used for 2-for-1 or 4-for-1 stock distributions or splits (since such
distributions or splits normally result in strike prices that do not
require rounding to the nearest eighth). In addition, the revised
adjustment methodology would not generally be used for stock dividends,
stock distributions, or stock splits with respect to any series of
options having exercise prices stated in decimals.\8\ For those
options, the existing adjustment rules would continue to apply. The
reason for this is that once the market has converted to decimal
strikes, the rounding errors created by rounding to the nearest cent
would be immaterial even given the larger positions taken in today's
markets and the other factors discussed above. Because conversion to
[[Page 67417]]
decimal strikes might be phased in rather than applied to all series of
equity options simultaneously, the rule has been drafted to cover both
methods of expressing exercise prices, applying the appropriate rule to
each.
---------------------------------------------------------------------------
\8\ Although there are currently no decimal strikes for equity
options, OCC wants to avoid the need for further amendments to its
By-Laws and the options disclosure document in the event that such
strikes are introduced in the future.
---------------------------------------------------------------------------
The proposed changes in adjustment methodology would not be
implemented until the exchanges have conducted appropriate educational
efforts and definitive copies of an appropriate supplement to the
options disclosure document, Characteristics and Risks of Standardized
Options, were available for distribution.\9\
---------------------------------------------------------------------------
\9\ OCC will notify the Commission and issue an Important Notice
when the proposed adjustment methodology is implemented.
---------------------------------------------------------------------------
B. Changes to the Definition of ``Ordinary Dividends and
Distributions''
Article VI, Section 11A(c) of OCC's By-Laws currently provides that
as a general rule, outstanding options will not be adjusted to
compensate for ordinary cash dividends. Interpretation and Policy .01
under Section 11A of Article VI provides that a cash dividend will
generally be deemed to be ``ordinary'' if the amount does not exceed
10% of the value of the underlying stock on the declaration date (``10%
Rule''). The OCC Securities Committee is authorized to decide on a
case-by-case basis whether to adjust for dividends exceeding that
amount. As a result, OCC historically has not adjusted for special cash
dividends unless the amount of the dividend was greater than 10% of the
stock price at the close of trading on the declaration day.
The 10% Rule predated a number of significant developments,
including, the introduction of Long-term Equity AnticiPation Security
(``LEAPS'') options, the sizeable open interest seen today, the large
contract volume associated with trading and spreading strategies, and
modern option pricing models that take dividends into account. When
open interest and individual positions were smaller, not adjusting for
dividends of less than 10% did not have the pronounced impact it does
today. Additionally, changes to the tax code which now tax dividends
more favorably have provided an incentive for companies to pay more
dividends, including special dividends. In light of these
considerations, it is appropriate that the 10% Rule now be revised.
Under the revision proposed by OCC, a cash dividend or distribution
would be considered ordinary (regardless of size) if the OCC Securities
Committee determines that such dividend or distribution was declared
pursuant to a policy or practice of paying such dividends or
distributions on a quarterly or other regular basis. In addition, as a
general rule, a cash dividend or distribution that is less than $12.50
per contract would not trigger the adjustment provisions of Article VI,
Section 11A.
1. No Adjustment for Regularly-Scheduled Dividends Needed
Dividends declared by an issuer pursuant to a policy or practice of
such issuer are known and can thus be priced into option premiums. By
definition, however, special dividends cannot be anticipated in advance
and therefore cannot be integrated into option pricing models.\10\ If
adjustments are not made in response to special dividends (i.e., by
calling for the delivery of the dividend) call holders can capture the
dividends only by exercising their options. Often in these cases,
especially with LEAPS options or FLEX options which can exist for 5 to
10 years, early exercise would sacrifice substantial option time value.
This economic disadvantage would be further magnified if the option
position is large, as is often the case today. Conversely, put holders
often receive a windfall benefit from the increase in the in-the-money
value on the ex date. To the extent that equity options can be priced
accurately and consistently without dislocations due to unforeseen
special dividends, these economic disadvantages can be avoided.
Moreover, because special dividends are one-off events, adjusting for
them would not cause the proliferation of outstanding series that would
result from adjusting for regular dividends as explained below.
---------------------------------------------------------------------------
\10\ OCC has been told that some traders form judgments as to
the likelihood that certain issuers may declare special cash
dividends and factor those judgments into their pricing models.
However, that is clearly not the case with all traders or all
issues.
---------------------------------------------------------------------------
2. De Minimis Threshold
Adjusting for dividends can cause a proliferation of outstanding
option symbols and series.\11\ In the interest of providing some limit
on option symbol proliferation, the proposed rule change includes a de
minimis threshold of $12.50 per contract. Special dividends smaller
than these amounts would not trigger an adjustment.
---------------------------------------------------------------------------
\11\ Symbols proliferate when adjustments are made because often
the dividend amount must be added to the deliverable yielding a non-
standard option. The exchanges then introduce standard options with
the same strikes.
---------------------------------------------------------------------------
OCC believes that a threshold that is a set dollar amount is
preferable to one that is a percentage of the stock price (like OCC's
existing 10% Rule) because there are operational problems with applying
a percentage threshold. Under the existing 10% Rule, in order to
determine whether this threshold is met, the per share dividend amount
is applied to the closing price of the underlying security on the
dividend declaration date. The date the dividend is announced (by press
release or by some other means) is not normally the ``declaration
date'' when the dividend is officially declared by an issuer's board of
directors. Until the actual declaration date, investors and traders may
not know whether or not an announced dividend will trigger an
adjustment based on the company's share price. In the interim, it is
difficult for traders and investors to price their options because they
do not know if an adjustment will be made.
The advantage of a fixed dollar threshold is avoiding uncertainty.
The per contract value of the dividend can be immediately determined
without the need to wait until the declaration date and without the
need to do a calculation based on the closing price of the underlying
shares.
3. Consistency Across Relevant Interpretations
Interpretations and Policies .01 and .08 under Article VI, Section
11A apply to cash distributions. Interpretation and Policy .01 (as
proposed to be amended) would apply in general to all cash
distributions. Interpretation and Policy .08 currently carves out
exceptions for fund share cash distributions and does not include a
threshold minimum. In the interest of clarity and consistency with
Interpretation and Policy .01, Interpretation .08 would be revised to
provide for the same $12.50 per contract threshold. Clause (ii) of
Interpretation and Policy .08 would be deleted because it is an
exception to the 10% Rule and would no longer be needed when the 10%
Rule is abolished.
4. The Amendment
OCC understands that certain option traders may have integrated
into their pricing models the probability of special dividends based on
the OCC rules currently in effect and that eliminating the 10% Rule
with respect to existing contracts may unfairly affect these options
traders. To ensure that no options series that were opened before
disclosure of the rule change are affected by elimination of the 10%
Rule, OCC will delay eliminating the 10% Rule and replacing it with the
fixed dollar threshold so that these changes will be implemented only
for corporate events announced on or after February 1, 2009. OCC plans
to provide ODD disclosure of this rule change before May 29, 2007
(after which date the
[[Page 67418]]
exchanges would normally begin introducing LEAPS expiring in 2010
making a 2009 implementation impracticable). The delay in
implementation will ensure that all options series opened before the
ODD disclosure is made available (other than certain ``flex'' options
that will be grandfathered under the old rule) will have expired before
the change is effected.\12 \While delaying the implementation until
2009 postpones the benefit of making this needed change, it
accommodates the many firms that find the operational hurdles and
fairness issues associated with an earlier implementation onerous.
---------------------------------------------------------------------------
\12\ OCC intends to take a ``snapshot'' of flex series expiring
after January 31, 2009, that are outstanding at the time when ODD
disclosure of the rule change is made. Those series will be assigned
distinctive trading symbols and ``grandfathered'' under the old
rule. Trading will continue normally in grandfathered series until
their expiration, but the exchanges would be free to open otherwise
identical non-grandfathered series, which would be identified by
conventional flex trading symbols. If ODD disclosure is not made
until after the December 2006 expiration, it may also be necessary
to grandfather two classes of LEAPs with December expirations (SPY
and S&P 100 i-Shares) because the exchanges would ordinarily
introduce new series expiring in December 2009 after the December
2006 expiration.
---------------------------------------------------------------------------
OCC believes that the proposed rule change is consistent with the
requirements of Section 17A of the Act \13\ and the rules and
regulations thereunder applicable to OCC because (1) it is intended to
eliminate inequities that result from certain rounding practices
currently required by OCC's By-Laws and thus protect investors and (2)
it is intended to make more predictable when cash distributions by an
issuer will result in an adjustment to an option contract and thus make
the process for adjustments more equitable for all investors.
---------------------------------------------------------------------------
\13\ 15 U.S.C. 78q-1.
---------------------------------------------------------------------------
(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
Within thirty-five days of the date of publication of this notice
in the Federal Register or within such longer period (i) as the
Commission may designate up to ninety days of such date if it finds
such longer period to be appropriate and publishes its reasons for so
finding or (ii) as to which the self-regulatory organization consents,
the Commission will:
(A) By order approve such proposed rule change or
(B) Institute proceedings to determine whether the proposed rule
change should be disapproved.
IV. 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. 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-2006-01 on the subject line.
Paper Comments
Send paper comments in triplicate to Nancy M. Morris,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-1090.
All submissions should refer to File Number SR-OCC-2006-01. 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, 100 F Street,
NE., 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 www.theocc.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-2006-01 and should be submitted on or before
December 12, 2006.
---------------------------------------------------------------------------
\14\ 17 CFR 200.30-3(a)(12).
For the Commission by the Division of Market Regulation,
pursuant to delegated authority.\14\
Nancy M. Morris,
Secretary.
[FR Doc. E6-19619 Filed 11-20-06; 8:45 am]
BILLING CODE 8011-01-P