[Federal Register Volume 72, Number 32 (Friday, February 16, 2007)]
[Notices]
[Pages 7701-7706]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E7-2792]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-55258; File No. SR-OCC-2006-01]
Self-Regulatory Organizations; The Options Clearing Corporation;
Order Approving Proposed Rule Change as Modified by Amendment No. 1 To
Revise Option Adjustment Methodology
�MDBU�*ERR01*�MDNM�
February 8, 2007.
I. Introduction
On January 12, 2006, The Options Clearing Corporation (``OCC'')
filed with the Securities and Exchange Commission (``Commission'')
proposed rule change SR-OCC-2006-01 pursuant to Section 19(b)(1) of the
Securities Exchange Act of 1934 (``Act'').\1\ On March 9, 2006, the
Commission published notice of the proposed rule
[[Page 7702]]
change to solicit comments from interested parties.\2\ The Commission
received ten comment letters upon publication of the notice.\3\ To
address the concerns raised by the commenters, OCC amended the proposed
rule change on September 25, 2006. On November 21, 2006, the Commission
published notice of the amended proposed rule change to solicit
comments from interested parties.\4\ The Commission received four
additional comment letters.\5\ For the reasons discussed below, the
Commission is approving the proposed rule change.\6\
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\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).
\4\ Securities Exchange Act Release No. 54748 (November 14,
2006), 71 FR 67415.
\5\ James Knight, Vice President, Manager, Options Trading
Strategies, Raymond James Associates, Gary Franklin, Manager of
Option Trading, Managing Director, Senior Options Principal, Morgan
Keegan Co., and Dennis Moorman, Manager-Options Department, J.J.B.
Hilliard, W.L. Lyons, Inc. (December 12, 2006); William H. Navin,
Executive Vice President, General Counsel, and Secretary, The
Options Clearing Corporation (December 21, 2006); Erik A. Hartog,
Operating Manager, Allagash Trading LLC (January 8, 2007); and
William H. Navin, Executive Vice President, General Counsel, and
Secretary, The Options Clearing Corporation (January 9, 2007).
\6\ OCC filed a companion proposed rule change seeking to revise
its stock futures adjustment methodology in a manner consistent with
the revised option adjustment methodology. Securities Exchange Act
Release No. 54898 (December 8, 2006), 71 FR 75287 (December 14,
2006) (File No. SR-OCC-2006-08).
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II. Description
OCC is amending Article VI (Clearance of Exchange Transactions),
Section 11A of its 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) 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 also adds a $12.50 per contract threshold amount for cash
dividends and distributions to trigger application of OCC's adjustment
rules.
A. Changes Relating to Adjustments for Certain Stock Dividends,
StockDistributions, and Stock Splits
Prior to this rule change, OCC's By-Laws specified 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.\7\ In all other cases, the number of shares to
be delivered under the option contract is increased and the strike
price is reduced proportionately.\8\
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\7\ 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.
\8\ 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.
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Although these two methods have been used for many years, in
certain circumstances either method can produce a windfall profit for
one side and a corresponding loss for the other side 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 and 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
would have 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., a 4-for-3 split produces a deliverable of
133.3333 shares). In those cases, OCC's By-Laws required 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 often remain.
The windfall profits and correspondent losses resulting from the
rounding process have historically been accepted as immaterial.
However, due to recent substantial increases in trading volume and
position size, 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 rounding strike prices can be
eliminated by using a different adjustment method whereby the
deliverable is adjusted but the strike prices or the values used to
calculate aggregate exercise prices and premiums are not. As an
illustration of the new 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 $5,000 ($50 times 100) but would receive 150 shares of XYZ stock
instead of 100.\9\ 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. \10\
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\9\ The same adjustment methodology will 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.
\10\ The adjustment methodology used for spin-offs, mergers, and
special cash dividends is to adjust the unit of trading while
leaving the strike price unchanged.
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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 new 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
[[Page 7703]]
reducing the strike prices, the strike prices would remain unchanged,
and the cash value of the eliminated fractional share (.3333 x the
post-split value of a share of XYZ stock as determined by OCC) would be
the deliverable along with the 133 shares. The adjusted option would
also continue to use 100 as the multiplier to calculate aggregate
strike and premium amounts.
The revised adjustment methodology will not be applied to 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) unless the split requires rounding of the strike
price, which may occur where the strike price was previously adjusted
due to an earlier stock distribution or split. In addition, the revised
adjustment methodology will 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.\11\ For those
options, the existing adjustment rules will 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
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.
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\11\ 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.
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The changes in adjustment methodology will 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,
are available for distribution.\12\
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\12\ OCC will notify the Commission and issue an Important
Notice when the new adjustment methodology is implemented.
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B. Changes to the Definition of ``Ordinary Dividends and
Distributions''
Currently, Article VI, Section 11A(c) of OCC's By-Laws 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
the modern option pricing models that take dividends into account. When
open interests 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, OCC believes it is appropriate to now revise the 10%
Rule.
Under OCC's revision, 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.\13\ If
adjustments are not made in response to special dividends, call holders
can capture the dividends only by exercising their options. Often in
these cases, especially with LEAPS options or FLEX options which can
last for 5 to 10 years, early exercise would sacrifice substantial
option time value. This economic disadvantage is 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 should not cause the proliferation of outstanding
options series and symbols that would result from adjusting for regular
dividends as explained below.
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\13\ 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.
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2. De Minimis Threshold
Adjusting for dividends can cause a proliferation of outstanding
option symbols and series.\14\ In the interest of providing some limit
on option symbol proliferation, the revised adjustment policy will
include a de minimis threshold of $12.50 per contract. Special
dividends smaller than this amount will not trigger an adjustment.
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\14\ 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.
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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
10% Rule) because there are operational problems with applying a
percentage threshold. Under the 10% Rule, in order to determine whether
the threshold is met, the per share dividend amount is added 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 the avoidance of
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.
[[Page 7704]]
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
amended by this rule change) will 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 is being revised to
provide for the same $12.50 per contract threshold for fund share cash
distributions. Clause (ii) of Interpretation and Policy .08 sets forth
an exception to the 10% Rule and will be deleted when the 10% Rule is
abolished.
III. Comment Letters
The Commission received fourteen comment letters in response to the
proposed rule change.\15\ Eleven of the comment letters opposed the
rule change. OCC submitted three letters responding to the comment
letters. Seven of the comment letters opposed elimination of the 10%
Rule.\16\ Three of the comment letters opposed the adjustment
methodology for stock dividends, stock distributions, and stock
splits.\17\
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\15\ Supra notes 3 and 5. Joseph Haggenmiller's comment letter
objected to the entire proposed rule change but did not state why.
Joseph Haggenmiller (March 8, 2006). The comment letters received
after OCC's amendment did not comment on the amendment.
\16\ Erik A. Hartog, Operating Manager, Allagash Trading LLC
(March 21, 2006); Jeffrey Woodring (March 22, 2006); Adam Besch-
Turner (March 23, 2006); Mike Ianni (April 5, 2006); Mike Ianni
(April 5, 2006); Peter van Dooijeweert, President, Alopex Capital
Management, LLC (April 26, 2006); and Erik A. Hartog, Operating
Manager, Allagash Trading LLC (January 8, 2007).
\17\ Christopher Nagy, Chairman, Options Committee, Securities
Industry Association (March 24, 2006); Bob Linville and Deborah
Mittelman, Service Bureau Committee Co-Chairs, Financial Information
Forum (May 2, 2006); and James Knight, Vice President, Manager,
Options Trading Strategies, Raymond James Associates, Gary Franklin,
Manager of Option Trading, Managing Director, Senior Options
Principal, Morgan Keegan Co., and Dennis Moorman, Manager-Options
Department, J.J.B. Hilliard, W.L. Lyons, Inc. (December 12, 2006).
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A. Comments Opposing the 10% Rule
Those commenters opposing elimination of the 10% Rule did so for
various reasons. First, they felt that elimination of the 10% Rule for
existing contracts would be unfair to the contract traders who have
priced adjustments into their pricing models based on their estimated
probability that an issuer will pay a special dividend with the
assumption that OCC would adjust for special dividends based on the 10%
Rule. OCC responded that it did not believe special dividends could be
anticipated in advance and therefore could not be integrated into
pricing models. However, OCC discussed the matter with market
participants and now understands that some traders do estimate the
probability of special dividends by selected issuers and do factor
those estimates into their pricing models. In response, OCC amended the
proposed rule change so that the 10% Rule would be eliminated and
replaced with the dollar threshold test beginning with dividends
announced on and after February 1, 2009. The few outstanding options
series with expirations beyond that date will be grandfathered and will
be assigned separate trading symbols.
Second, some commenters expressed their concerns that elimination
of the 10% Rule would create uncertainty as to whether OCC would
classify particular vidends as ordinary or special and that market
liquidity for the affected options would disappear until OCC announced
whether a dividend was ordinary or special. OCC responded that a
dividend will be classified as ordinary if it is declared pursuant to a
policy or practice of paying such dividends on a quarterly or other
regular basis. The issue as to whether a particular dividend or
distribution fits the criteria to be classified as ordinary or special
would be determined by a panel of the OCC Securities Committee, which
consists of two representatives of each exchange that lists options on
the underlying security and one representative of OCC, who votes only
in the event of a tie vote. OCC contends that most special dividends
are in such amounts and/or payable on such dates that it will be
immediately obvious to the market that they are not being declared
pursuant to a policy or a practice of paying such dividends on a
quarterly or other regular basis. In addition, issuers normally
classify a dividend as special or ordinary when the dividend is
announced. While this will not control OCC's determination of whether a
dividend is ordinary or special, in the vast majority of cases a
dividend classified by the issuer as special would not fit OCC's
definition of ordinary cash dividends or distributions.
In certain cases the OCC Securities Committee will need to make a
judgment as to whether to classify a dividend as ordinary or special.
The uncertainty which may exist in such cases will diminish over time
as OCC publishes interpretations and policies and a body of precedent
develops. OCC intends to publish informational material indicating how
these situations will be handled. Pursuant to the amendment, the
elimination of the 10% Rule will only be effective for dividends
announced on and after February 1, 2009, which should allow ample lead
time for OCC's educational effort to get under way.
OCC also responded that a balance needs to be struck between
uncertainty and fairness in that under the 10% Rule, market
participants incur large losses in the case of a 9.9% special dividend
but are made whole if the special dividend exceeds 10% of the closing
stock price on the declaration date.
The commenters' third major concern in opposing elimination of the
10% Rule was that the rule change would lead to symbol proliferation in
that any special dividend greater than $12.50 per contract would
trigger a contract adjustment and a new symbol. The frequency of such
adjustments could be very high, causing a sharp spike in symbol
proliferation. OCC responded by acknowledging that this is true for the
short term but that the need for additional symbols would end when the
industry converts to decimal stike prices.\18\ Also, OCC believes that
the inequities caused by the 10% Rule outweigh any operational burdens
associated with symbol proliferation.\19\
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\18\ The current plan is to begin converting fractional strikes
to decimal strikes in November 2009.
\19\ Since the beginning of 2006, OCC has been tracking special
dividends that were too small to trigger an adjustment under the 10%
Rule but that would be large enough to cause an adjustment under the
revised rule. Up to September 2006, there were a total of 22 more
dividends which would have required additional symbols for
conventional equity options. In some cases, new symbols would also
have had to be assigned for LEAP and flex contracts. According to
OCC, the number is not small but is certainly not large relative to
the hundreds of adjusted and wrap symbols already assigned.
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The fourth major concern raised by the commenters in opposing the
10% Rule was that the revised rule could reduce liquidity for adjusted
options because investors are drawn to round increments in strike
prices. The 10% Rule has always avoided liquidity loss by only creating
odd strike prices when the dividend is so extraordinarily
disproportionate as to require adjustment. OCC responded that despite
the thousands of contractual adjustments made in over 33 years of
options trading on U.S. markets, it knows of no case where liquidity
was wiped out for an adjusted series. Market-makers on U.S. options
exchanges are numerous, highly competitive, quick to exploit arbitrage
opportunities, and in many cases obligated by exchange rules to make
[[Page 7705]]
markets in every series of every class in which they quote.\20\
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\20\ See, e.g., CBOE Rules 8.7 and 8.85.
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B. Comments Opposing the Adjustment Methodology for Stock Dividends,
Stock Distributions, and Stock Splits
The commenters who opposed the revised adjustment methodology for
stock dividends, stock distributions, and stock splits did so by
suggesting alternative models such as those employed by Eurex and other
non-U.S. exchanges.\21\ OCC responded that while it has an open mind
about making further changes to its adjustment methodology, it did not
believe it would be feasible to adopt any of the alternative models
proposed by the commenters because they would require extensive and
onerous systems changes by OCC, exchanges, members, and vendors. One of
the commenters who opposed the adjustment methodology argued that the
adjustment methodology is new and will result in significant
modifications to the systems which support the adjustment methodology
OCC seeks to replace.\22\ In addition, the commenter argued that if
OCC's proposed adjustment methodology is implemented and the strike
price does not change when an adjustment takes place, some other
indicator in the displays used to trade options must be changed to
somehow alert the investor that the option represents an adjusted
contract. OCC responded that it is simply applying to stock dividends,
stock distributions, and stock splits the same adjustment methodology
used for over thirty years for spin-offs, mergers, and special cash
dividends. In addition, OCC argued, price vendors, service bureaus, and
securities firms currently do and have always identified adjusted
contracts through the use of adjusted symbols.
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\21\ Christopher Nagy, Chairman, Options Committee, Securities
Industry Association (March 24, 2006) and James Knight, Vice
President, Manager, Options Trading Strategies, Raymond James
Associates, Gary Franklin, Manager of Option Trading, Managing
Director, Senior Options Principal, Morgan Keegan Co., and Dennis
Moorman, Manager-Options Department, J.J.B. Hilliard, W.L. Lyons,
Inc. (December 12, 2006).
\22\ Bob Linville and Deborah Mittelman, Service Bureau
Committee Co-Chairs, Financial Information Forum (May 2, 2006).
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IV. Amendment
To address certain concerns expressed in the comment letters and by
others, OCC amended the proposed rule change. OCC understands that
certain option traders may have integrated into their pricing models
the probability of special dividends and their being adjusted 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
approval of the proposed rule change are affected by elimination of the
10% Rule, OCC's elimination of the 10% Rule and implementation of the
fixed dollar threshold will take effect 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 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.\23\ While delaying the implementation until
2009 postpones the benefit of making this needed change, it addresses
the concerns of firms that find the operational hurdles and fairness
issues associated with an earlier implementation onerous.
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\23\ 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.
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V. Discussion
After carefully considering the proposed rule change as amended and
all of the written comments received, the Commission finds that the
proposed rule change is consistent with the requirements of the Act and
the rules and regulations thereunder and particularly with the
requirements of Section 17A(b)(3)(F).\24\ Section 19(b) of the Act
directs the Commission to approve a proposed rule change of a self-
regulatory organization if it finds that such proposed rule change is
consistent with the requirements of the Act and the rules and
regulations thereunder applicable to such organization. Section
17A(b)(3)(F) of the Act requires that the rules of a clearing agency be
designed, in general, to protect investors and the public interest. The
Commission believes that OCC's rule change is consistent with this
Section because (1) it is intended to eliminate inequities that result
from certain rounding practices currently required by OCC's By-Laws and
thus should 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 should make the process for
adjustments more equitable for all investors.
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\24\ 15 U.S.C. 78q-1(b)(3)(F).
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OCC has amended the rule change in response to many of the
commenters that opposed various portions of the rule change for various
reasons.
Some commenters expressed concern that elimination of the 10% Rule
would create uncertainty as to whether OCC would classify particular
dividends as ordinary or special and that market liquidity for the
affected options would disappear until OCC made an announcement whether
a dividend is ordinary or special. The Commission feels that OCC's
proposed rule is clear as to the procedure that will be used to
classify a dividend as ordinary or special. A dividend will be
classified as ordinary if it is declared pursuant to a policy or
practice of paying such dividends on a quarterly or other regular
basis. The Commission finds persuasive OCC's argument that most special
dividends are in such amounts and/or payable on such dates that it will
be immediately obvious to the market that they are not being declared
pursuant to a policy or a practice of paying such dividends on a
quarterly or other regular basis. In addition, issuers normally
classify a dividend as special or ordinary when the dividend is
announced, and in the vast majority of cases a dividend classified by
the issuer as special would not fit OCC's definition of ordinary cash
dividends or distributions. Any uncertainty which may exist in cases
where the OCC Securities Committee will need be to make a judgment as
to whether a dividend is ordinary or special should diminish over time
as OCC publishes interpretations and policies and a body of precedent
develops. In addition, the Commission is not convinced, considering
that adjusted options have shown no lack of liquidity in the past, that
the elimination of the 10% Rule will wipe out liquidity for adjusted
options.
Some commenters stated that the elimination of the 10% Rule for
existing contracts would be unfair to those traders that have built
into their pricing models the possibility that an issuer would declare
a special dividend and the effect of that dividend under the
[[Page 7706]]
10% Rule. In response, OCC amended the filing so that the 10% Rule will
be eliminated and the new dollar threshold implemented only for
dividends announced on and after February 1, 2009, so that the majority
of existing options contracts will not be affected.
Some commenters also argued that elimination of the 10% Rule would
lead to symbol proliferation in that any special dividend greater than
$12.50 per contract would trigger a contract adjustment and a new
symbol. The Commission believes that any symbol proliferation should be
short lived as the industry is planning to convert from fractional
strikes to decimal strikes in November 2009 and that the benefits of
the change outweigh any burdens.
Of particular concern to the Commission is the inequitable economic
impact of unanticipated special dividends on market participants when
the 10% Rule is applied. The Commission believes that OCC's rule change
makes appropriate changes to the way that OCC handles special dividends
to address this problem.
Those commenters that disagreed with the adjustment methodology for
stock dividends, stock distributions, and stock splits suggested
changes that would require major systems revisions. The Commission
believes that such systems changes would be a tremendous burden on the
industry and the costs would not outweigh any benefits.
Finally, it was argued that major systems changes would need to be
undertaken and symbols changed to somehow alert investors that an
option represents an adjusted contract. The Commission is not persuaded
by this argument because the adjustment methodology OCC is going to
apply to stock dividends, stock distributions, and stock splits is the
same adjustment methodology it has used for over thirty years for spin-
offs, mergers, and extraordinary cash dividends and identification of
these adjusted contracts does not appear to have presented a problem.
VI. Conclusion
On the basis of the foregoing, the Commission finds that the
proposed rule change is consistent with the requirements of the Act and
in particular Section 17A of the Act and the rules and regulations
thereunder.\25\ In approving the proposed rule change, the Commission
considered the proposal's impact on efficiency, competition and capital
formation.
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\25\ 15 U.S.C. 78c(f).
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It is therefore ordered, pursuant to Section 19(b)(2) of the Act,
that the proposed rule change (File No. SR-FICC-2006-01), as modified
by Amendment No. 1, be and hereby is approved.
For the Commission by the Division of Market Regulation,
pursuant to delegated authority.\26\
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\26\ 17 CFR 200.30-3(a)(12).
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Florence E. Harmon,
Deputy Secretary.
[FR Doc. E7-2792 Filed 2-15-07; 8:45 am]
BILLING CODE 8011-01-P