Federal Register / Vol. 69, No. 247 / Monday, December 27, 2004 / Notices 77275

1 15 U.S.C. 78s(b)(1).

2 17 CFR 240.19b-4.

3See letter from Richard Lewandowski, Vice 

President, Division of Regulatory Services, CBOE, to 

Michael A. Macchiaroli, Associate Director, 

Division of Market Regulation (‘‘Division’’), 

Commission, dated April 1, 2004 (‘‘Amendment No. 

1’’).

4See Securities Exchange Act Release No. 45630 

(March 22, 2002), 67 FR 15263 (March 29, 2002).

5See E-mail from Mike Ianni, Private Investor to 

rule-comments@sec.gov, dated November 7, 2002 

(‘‘Ianni E-mail’’).

6See Securities Exchange Act Release No. 46576 

(October 1, 2002), 67 FR 62843 (October 8, 2002) 

(File No. SR–NYSE–2002–19) (‘‘NYSE Proposal’’).

Dated: December 17, 2004. 

Jeff Rosen, 

Acting Executive Director and General 

Counsel and Director of Policy.

[FR Doc. 04–28159 Filed 12–23–04; 8:45 am] 

BILLING CODE 6820–MA–M

SECURITIES AND EXCHANGE 

COMMISSION 

[Release No. 34–50886; File No. SR–CBOE–

2002–03] 

Self-Regulatory Organizations; Notice 

of Filing of Proposed Rule Change and 

Amendment No. 1 Thereto by the 

Chicago Board Options Exchange, 

Incorporated Relating to Customer 

Portfolio and Cross-Margining 

Requirements 

December 20, 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 April 2, 

2004, the Chicago Board Options 

Exchange, Incorporated (‘‘CBOE’’ or 

‘‘Exchange’’) filed with the Securities 

and Exchange Commission 

(‘‘Commission’’) Amendment No. 13 to 

the proposed rule change as described 

in Items I, II, and III below, which Items 

have been prepared by the CBOE. The 

CBOE submitted the original proposed 

rule change to the Commission on 

January 15, 2002 (‘‘Original Proposal’’). 

The proposed rule change was 

published in the Federal Register on 

March 29, 2002.4 The Commission 

received one comment letter in response 

to the proposed rule change.5 The CBOE 

is proposing Amendment No. 1 to make 

corrections or clarifications to the 

proposed rule, or to reconcile 

differences between the proposed rule 

and a parallel filing by the NYSE.6 The 

Commission is publishing this notice to 

solicit comments on the proposed rule 

change, as amended, from interested 

persons.

I. Self-Regulatory Organization’s 

Statement of the Terms of Substance of 

the Proposed Rule Change 

The CBOE proposes to amend its 

rules, for certain customer accounts, to 

allow member organizations to margin 

listed, broad-based, market index 

options, index warrants and related 

exchange-traded funds according to a 

portfolio margin methodology as an 

alternative to the current strategy-based 

margin methodology. The proposed rule 

change also will provide for crossmargining by allowing broad-based 

index futures and options on such 

futures to be included with listed, 

broad-based index options, index 

warrants and related exchange-traded 

funds for portfolio margin treatment, in 

a separate cross-margin account. The 

text of the proposed rule change is 

below. Additions are in italics. 

Deletions are in brackets.

* * * * *

Chapter XII Margins 

[Covered Options Contracts] 

Portfolio Margin and Cross-Margin for 

Index Options 

Rule 12.4. [Deleted January 15, 1975.] 

As an alternative to the transaction / 

position specific margin requirements 

set forth in Rule 12.3 of this Chapter 12, 

members may require margin for listed, 

broad-based U.S. index options, index 

warrants and underlying instruments 

(as defined below) in accordance with 

the portfolio margin requirements 

contained in this Rule 12.4.

In addition, members, provided they 

are a Futures Commission Merchant 

(‘‘FCM’’) and are either a clearing 

member of a futures clearing 

organization or have an affiliate that is 

a clearing member of a futures clearing 

organization, are permitted under this 

Rule 12.4 to combine a customer’s 

related instruments (as defined below) 

and listed, broad based U.S. index 

options, index warrants and underlying 

instruments and compute a margin 

requirement (‘‘cross-margin’’) on a 

portfolio margin basis. Members must 

confine cross-margin positions to a 

portfolio margin account dedicated 

exclusively to cross-margining.

Application of the portfolio margin 

and cross-margining provisions of this 

Rule 12.4 to IRA accounts is prohibited.

(a) Definitions.

(1) The term ‘‘listed option’’ shall 

mean any option traded on a registered 

national securities exchange or 

automated facility of a registered 

national securities association.

(2) The term ‘‘unlisted option’’ means 

any option not included in the 

definition of listed option.

(3) The term ‘‘options class’’ refers to 

all options contracts covering the same 

underlying instrument.

(4) The term ‘‘portfolio’’ means 

options of the same options class 

grouped with their underlying 

instruments and related instruments.

(5) The term ‘‘option series’’ relates to 

listed options and means all option 

contracts of the same type (either a call 

or a put) and exercise style, covering the 

same underlying instrument with the 

same exercise price, expiration date, 

and number of underlying units.

(6) The term ‘‘related instrument’’

within an option class or product group 

means futures contracts and options on 

futures contracts covering the same 

underlying instrument.

(7) The term ‘‘underlying instrument’’

means long and short positions in an 

exchange traded fund or other fund 

product registered under the Investment 

Company Act of 1940 that holds the 

same securities, and in the same 

proportion, as contained in a broad 

based index on which options are listed. 

The term underlying instrument shall 

not be deemed to include, futures 

contracts, options on futures contracts, 

underlying stock baskets, or unlisted 

instruments.

(8) The term ‘‘product group’’ means 

two or more portfolios of the same type 

(see subparagraph (a)(9) below) for 

which it has been determined by Rule 

15c3–1a under the Securities Exchange 

Act of 1934 that a percentage of 

offsetting profits may be applied to 

losses at the same valuation point.

(9) The term ‘‘theoretical gains and 

losses’’ means the gain and loss in the 

value of individual option series and 

related instruments at 10 equidistant 

intervals (valuation points) ranging from 

an assumed movement (both up and 

down) in the current market value of the 

underlying instrument. The magnitude 

of the valuation point range shall be as 

follows:

77276 Federal Register / Vol. 69, No. 247 / Monday, December 27, 2004 / Notices 

Portfolio type 

Up/Down market 

move (high & low 

valuation points) 

non-high capitalization, broad based U.S. market index option 1 ........................................................................................... +/¥10%

high capitalization, broad based U.S. market index option 1 .................................................................................................. +6%/¥8%

1 In accordance with sub-paragraph (b)(1)(i)(B) of Rule 15c3–1a under the Securities Exchange Act of 1934.

(b) Eligible Participants. The 

application of the portfolio margin 

provisions of this Rule 12.4, including 

cross-margining, is limited to the 

following:

(1) any broker or dealer registered 

pursuant to Section 15 of the Securities 

Exchange Act of 1934;

(2) any affiliate of a self-clearing 

member organization;

(3) any member of a national futures 

exchange to the extent that listed index 

options hedge the member’s index 

futures; and

(4) any other person or entity not 

included in (b)1 through (b)3 above that 

has or establishes, and maintains, 

equity of at least 5 million dollars. For 

purposes of this equity requirement, all 

securities and futures accounts carried 

by the member for the same customer 

may be combined provided ownership 

across the accounts is identical. A 

guarantee by any other account for 

purposes of the minimum equity 

requirement is not to be permitted.

(c) Opening of Accounts.

(1) Only customers that, pursuant to 

Rule 9.7, have been approved for 

options transactions, and specifically 

approved to engage in uncovered short 

option contracts, are permitted to utilize 

a portfolio margin account.

(2) On or before the date of the initial 

transaction in a portfolio margin 

account, a member shall:

A. furnish the customer with a special 

written disclosure statement describing 

the nature and risks of portfolio 

margining and cross-margining which 

includes an acknowledgement for all 

portfolio margin account owners to sign, 

and an additional acknowledgement for 

owners that also engage in crossmargining to sign, attesting that they 

have read and understood the 

disclosure statement, and agree to the 

terms under which a portfolio margin 

account and the cross-margin account, 

respectively, are provided [see Rule 

9.15(d)], and

B. obtain a signed 

acknowledgement(s) from the customer, 

both of which are required for crossmargining customers, and record the 

date of receipt.

(d) Establishing Account and Eligible 

Positions.

(1) Portfolio Margin Account. For 

purposes of applying the portfolio 

margin requirements provided in this 

Rule 12.4, members are to establish and 

utilize a dedicated securities margin 

account, or sub-account of a margin 

account, clearly identified as a portfolio 

margin account that is separate from 

any other securities account carried for 

a customer.

(2) Cross-Margin Account. For 

purposes of combining related 

instruments and listed, broad-based 

U.S. index options, index warrants and 

underlying instruments and applying 

the portfolio margin requirements 

provided in this Rule 12.4, members are 

to establish and utilize a portfolio 

margin account, clearly identified as a 

cross-margin account, that is separate 

from any other securities account or 

portfolio margin account carried for a 

customer.

A margin deficit in either the portfolio 

margin account or the cross-margin 

account of a customer may not be 

considered as satisfied by excess equity 

in the other account. Funds and/or 

securities must be transferred to the 

deficient account and a written record 

created and maintained.

(3) Portfolio Margin Account—Eligible 

Positions

(i) A transaction in, or transfer of, a 

listed, broad-based U.S. index option or 

index warrant may be effected in the 

portfolio margin account.

(ii) A transaction in, or transfer of, an 

underlying instrument may be effected 

in the portfolio margin account 

provided a position in an offsetting 

listed, broad-based U.S. index option or 

index warrant is in the account or is 

established in the account on the same 

day.

(iii) If, in the portfolio margin 

account, the listed, broad-based U.S. 

index option or index warrant position 

offsetting an underlying instrument 

position ceases to exist and is not 

replaced within 10 business days, the 

underlying instrument position must be 

transferred to a regular margin account, 

subject to Regulation T initial margin 

and the margin required pursuant to the 

other provisions of this chapter. 

Members will be expected to monitor 

portfolio margin accounts for possible 

abuse of this provision.

(iv) In the event that fully paid for 

long options and/or index warrants are 

the only positions contained within a 

portfolio margin account, such long 

positions must be transferred to a 

securities account other than a portfolio 

margin account or cross-margin account 

within 10 business days, subject to the 

margin required pursuant to the other 

provisions of this chapter, unless the 

status of the account changes such that 

it is no longer composed solely of fully 

paid for long options and/or index 

warrants.

(4) Cross-Margin Account—Eligible 

Positions

(i) A transaction in, or transfer of, a 

related instrument may be effected in 

the cross-margin account provided a 

position in an offsetting listed, U.S. 

broad based index option, index 

warrant or underlying instrument is in 

the account or is established in the 

account on the same day.

(ii) If the listed, U.S. broad-based 

index option, index warrant or 

underlying instrument position 

offsetting a related instrument ceases to 

exist and is not replaced within 10 

business days, the related instrument 

position must be transferred to a futures 

account. Members will be expected to 

monitor cross-margin accounts for 

possible abuse of this provision.

(iii) In the event that fully paid for 

long options and/or index warrants 

(securities) are the only positions 

contained within a cross-margin 

account, such long positions must be 

transferred to a securities account other 

than a portfolio margin account or 

cross-margin account within 10 business 

days, subject to the margin required 

pursuant to the other provisions of this 

chapter, unless the status of the account 

changes such that it is no longer 

composed solely of fully paid for long 

options and/or index warrants.

(e) Initial and Maintenance Margin 

Required. The amount of margin 

required under this Rule 12.4 for each 

portfolio shall be the greater of:

(1) the amount for any of the 10 

equidistant valuation points 

representing the largest theoretical loss 

as calculated pursuant to paragraph (f) 

below or

(2) $.375 for each listed index option 

and related instrument multiplied by 

the contract or instrument’s multiplier, 

not to exceed the market value in the 

case of long positions in listed options 

and options on futures contracts.

Federal Register / Vol. 69, No. 247 / Monday, December 27, 2004 / Notices 77277

(f) Method of Calculation.

(1) Long and short positions in listed 

options, underlying instruments and 

related instruments are to be grouped by 

option class; each option class group 

being a ‘‘portfolio’’. Each portfolio is 

categorized as one of the portfolio types 

specified in paragraph (a)(9) above.

(2) For each portfolio, theoretical 

gains and losses are calculated for each 

position as specified in paragraph (a)(9) 

above. For purposes of determining the 

theoretical gains and losses at each 

valuation point, members shall obtain 

and utilize the theoretical value of a 

listed index option, underlying 

instrument or related instrument 

rendered by a theoretical pricing model 

that, in accordance with paragraph 

(b)(1)(i)(B) of Rule 15c3–1a under the 

Securities Exchange Act of 1934, 

qualifies for purposes of determining the 

amount to be deducted in computing 

net capital under a portfolio based 

methodology.

(3) Offsets. Within each portfolio, 

theoretical gains and losses may be 

netted fully at each valuation point.

Offsets between portfolios within the 

High Capitalization, Broad Based Index 

Option product group and the Non-High 

Capitalization, Broad Based Index 

Option product group may then be 

applied as permitted by Rule 15c3–1a 

under the Securities Exchange Act of 

1934.

(4) After applying paragraph (3) 

above, the sum of the greatest loss from 

each portfolio is computed to arrive at 

the total margin required for the 

account (subject to the per contract 

minimum).

(g) Equity Deficiency. If, at any time, 

equity declines below the 5 million 

dollar minimum required under 

Paragraph (b)(4) of this Rule 12.4 and is 

not brought back up to at least 5 million 

dollars within three (3) business days 

(T+3) by a deposit of funds or securities, 

or through favorable market action; 

members are prohibited from accepting 

opening orders starting on T+4, except 

that opening orders entered for the 

purpose of hedging existing positions 

may be accepted if the result would be 

to lower margin requirements. This 

prohibition shall remain in effect until 

such time as an equity of 5 million 

dollars is established.

(h) Determination of Value for Margin 

Purposes. For the purposes of this Rule 

12.4, all listed index options and related 

instrument positions shall be valued at 

current market prices. Account equity 

for the purposes of this Rule 12.4 shall 

be calculated separately for each 

portfolio margin account by adding the 

current market value of all long 

positions, subtracting the current 

market value of all short positions, and 

adding the credit (or subtracting the 

debit) balance in the account.

(i) Additional Margin.

(1) If at any time, the equity in any 

portfolio margin account, including a 

cross-margin account, is less than the 

margin required, additional margin 

must be obtained within one business 

day (T+1). In the event a customer fails 

to deposit additional margin within one 

business day, the member must 

liquidate positions in an amount 

sufficient to, at a minimum, lower the 

total margin required to an amount less 

than or equal to account equity. 

Exchange Rule 12.9—Meeting Margin 

Calls by Liquidation shall not apply to 

portfolio margin accounts. However, 

members will be expected to monitor the 

risk of portfolio margin accounts 

pursuant to the risk monitoring 

procedures required by Rule 15.8A. 

Guarantees by any other account for 

purposes of margin requirements are not 

to be permitted.

(2) The day trading requirements of 

Exchange Rule 12.3(j) shall not apply to 

portfolio margin accounts, including 

cross-margin accounts.

(j) Cross-Margin Accounts—

Requirement to Liquidate.

(1) A member is required immediately 

either to liquidate, or transfer to another 

broker-dealer eligible to carry crossmargin accounts, all customer crossmargin accounts that contain positions 

in futures and/or options on futures if 

the member is:

(i) insolvent as defined in section 101 

of title 11 of the United States Code, or 

is unable to meet its obligations as they 

mature;

(ii) the subject of a proceeding 

pending in any court or before any 

agency of the United States or any State 

in which a receiver, trustee, or 

liquidator for such debtor has been 

appointed;

(iii) not in compliance with applicable 

requirements under the Securities 

Exchange Act of 1934 or rules of the 

Securities and Exchange Commission or 

any self-regulatory organization with 

respect to financial responsibility or 

hypothecation of customers’ securities; 

or

(iv) unable to make such 

computations as may be necessary to 

establish compliance with such 

financial responsibility or 

hypothecation rules.

(2) Nothing in this paragraph (j) shall 

be construed as limiting or restricting in 

any way the exercise of any right of a 

registered clearing agency to liquidate or 

cause the liquidation of positions in 

accordance with its by-laws and rules.

* * * * *

Chapter XIII—Net Capital 

Customer Portfolio Margin Accounts 

Rule 13.5. (a) No member 

organization that requires margin in any 

customer accounts pursuant to Rule 

12.4—Portfolio Margin and CrossMargin for Index Options, shall permit 

gross customer portfolio margin 

requirements to exceed 1,000 percent of 

its net capital for any period exceeding 

three business days. The member 

organization shall, beginning on the 

fourth business day of any noncompliance, cease opening new 

portfolio margin accounts until 

compliance is achieved.

(b) If, at any time, a member 

organization’s gross customer portfolio 

margin requirements exceed 1,000 

percent of its net capital, the member 

organization shall immediately transmit 

telegraphic or facsimile notice of such 

deficiency to the Securities and 

Exchange Commission, 450 Fifth Street, 

NW., Washington, DC, 20549; to the 

district or regional office of the 

Securities and Exchange Commission 

for the district or region in which the 

member organization maintains its 

principal place of business; and to its 

Designated Examining Authority.

* * * * *

Chapter XV Records, Reports and 

Audits 

Risk Analysis of Portfolio Margin 

Accounts 

Rule 15.8A. (a) Each member 

organization that maintains any 

portfolio margin accounts for customers 

shall establish and maintain written 

procedures for assessing and monitoring 

the potential risk to the member 

organization’s capital over a specified 

range of possible market movements of 

positions maintained in such accounts. 

Current procedures shall be filed and 

maintained with the Department of 

Financial and Sales Practice 

Compliance. The procedures shall 

specify the computations to be made, 

the frequency of computations, the 

records to be reviewed and maintained, 

and the position(s) within the 

organization responsible for the risk 

function.

(b) Upon direction by the Department 

of Financial and Sales Practice 

Compliance, each affected member 

organization shall provide to the 

Department such information as the 

Department may reasonably require 

with respect to the member 

organization’s risk analysis for any or 

all of the portfolio margin accounts it 

maintains for customers.

77278 Federal Register / Vol. 69, No. 247 / Monday, December 27, 2004 / Notices 

(c) In conducting the risk analysis of 

portfolio margin accounts required by 

this Rule 15.8A, each affected member 

organization is required to follow the 

Interpretations and Policies set forth 

under Rule 15.8—Risk Analysis of 

Market-Maker Accounts. In addition, 

each affected member organization 

shall include in written procedures 

required pursuant to paragraph (a) 

above the following:

(1) Procedures and guidelines for the 

determination, review and approval of 

credit limits to each customer, and 

across all customers, utilizing a 

portfolio margin account.

(2) Procedures and guidelines for 

monitoring credit risk exposure to the 

member organization, including intraday credit risk, related to portfolio 

margin accounts.

(3) Procedures and guidelines for the 

use of stress testing of portfolio margin 

accounts in order to monitor market risk 

exposure from individual accounts and 

in the aggregate.

(4) Procedures providing for the 

regular review and testing of these risk 

analysis procedures by an independent 

unit such as internal audit or other 

comparable group.

* * * * *

Chapter 9 Doing Business With the 

Public 

Delivery of Current Options Disclosure 

Documents and Prospectus 

Rule 9.15. (a) no change 

(b) no change 

(c) no change 

(d) The special written disclosure 

statement describing the nature and 

risks of portfolio margining and crossmargining, and acknowledgement for 

customer signature, required by Rule 

12.4(c)(2) shall be in a format prescribed 

by the Exchange or in a format 

developed by the member organization, 

provided it contains substantially 

similar information as the prescribed 

Exchange format and has received prior 

written approval of the Exchange.

Sample Risk Description for Use by 

Firms to Satisfy Requirements of 

Exchange Rule 9.15(d) 

Portfolio Margining and CrossMargining Disclosure Statement and 

Acknowledgement 

For a Description of the Special Risks 

Applicable to a Portfolio Margin 

Account and its Cross-Margining 

Features, See the Material Under Those 

Headings Below.

Overview of Portfolio Margining 

1. Portfolio margining is a margin 

methodology that sets margin 

requirements for an account based on 

the greatest projected net loss of all 

positions in a ‘‘product class’’ or 

‘‘product group’’ as determined by an 

options pricing model using multiple 

pricing scenarios. These pricing 

scenarios are designed to measure the 

theoretical loss of the positions given 

changes in both the underlying price 

and implied volatility inputs to the 

model. Portfolio margining is currently 

limited to product classes and groups of 

index products relating to broad-based 

market indexes.

2. The goal of portfolio margining is 

to set levels of margin that more 

precisely reflect actual net risk. The 

customer benefits from portfolio 

margining in that margin requirements 

calculated on net risk are generally 

lower than alternative ‘‘position’’ or 

‘‘strategy’’ based methodologies for 

determining margin requirements. 

Lower margin requirements allow the 

customer more leverage in an account.

Customers Eligible for Portfolio 

Margining 

3. To be eligible for portfolio 

margining, customers (other than 

broker-dealers and certain non-brokerdealer affiliates of the carrying brokerdealer) must meet the basic standards 

for having an options account that is 

approved for uncovered writing and 

must have and maintain at all times 

account net equity of not less than $5 

million, aggregated across all accounts 

under identical ownership at the 

clearing broker. The identical ownership 

requirement excludes accounts held by 

the same customer in different 

capacities (e.g., as a trustee and as an 

individual) and accounts where 

ownership is overlapping but not 

identical (e.g., individual accounts and 

joint accounts).

Positions Eligible for a Portfolio Margin 

Account 

4. All positions in broad-based U.S. 

market index options and index 

warrants listed on a national securities 

exchange, and exchange traded funds 

and other fund products registered 

under the Investment Company Act of 

1940 that are managed to track the 

same index that underlies permitted 

index options, are eligible for a portfolio 

margin account.

Special Rules for Portfolio Margin 

Accounts 

5. A portfolio margin account may be 

either a separate account or a 

subaccount of a customer’s regular 

margin account. In the case of a 

subaccount, equity in the regular 

account will be available to satisfy any 

margin requirement in the portfolio 

margin subaccount without transfer to 

the subaccount.

6. A portfolio margin account or 

subaccount will be subject to a 

minimum margin requirement of $.375 

multiplied by the index multiplier for 

every options contract or index warrant 

carried long or short in the account. No 

minimum margin is required in the case 

of eligible exchange traded funds or 

other eligible fund products.

7. Margin calls in the portfolio margin 

account or subaccount, regardless of 

whether due to new commitments or the 

effect of adverse market moves on 

existing positions, must be met within 

one business day. Any shortfall in 

aggregate net equity across accounts 

must be met within three business days. 

Failure to meet a margin call when due 

will result in immediate liquidation of 

positions to the extent necessary to 

reduce the margin requirement. Failure 

to meet an equity call prior to the end 

of the third business day will result in 

a prohibition on entering any opening 

orders, with the exception of opening 

orders that hedge existing positions, 

beginning on the fourth business day 

and continuing until such time as the 

minimum equity requirement is 

satisfied.

8. A position in an exchange traded 

index fund or other eligible fund 

product may not be established in a 

portfolio margin account unless there 

exists, or there is established on the 

same day, an offsetting position in 

securities options or other eligible 

securities. Exchange traded index funds 

and/or other eligible funds will be 

transferred out of the portfolio margin 

account and into a regular securities 

account subject to strategy based margin 

if, for more than 10 business days and 

for any reason, the offsetting securities 

options or other eligible securities no 

longer remain in the account.

9. When a broker-dealer carries a 

regular cash account or margin account 

for a customer, the broker-dealer is 

limited by rules of the Securities and 

Exchange Commission and of The 

Options Clearing Corporation (‘‘OCC’’) 

in the extent to which the broker-dealer 

may permit OCC to have a lien against 

long option positions in those accounts. 

In contrast, OCC will have a lien against 

all long option positions that are carried 

by a broker-dealer in a portfolio margin 

account, and this could, under certain 

circumstances, result in greater losses to 

a customer having long option positions 

in such an account in the event of the 

insolvency of the customer’s broker. 

Accordingly, to the extent that a 

customer does not borrow against long 

option positions in a portfolio margin 

Federal Register / Vol. 69, No. 247 / Monday, December 27, 2004 / Notices 77279

account or have margin requirements in 

the account against which the long 

option can be credited, there is no 

advantage to carrying the long options 

in a portfolio margin account and the 

customer should consider carrying them 

in an account other than a portfolio 

margin account.

Special Risks of Portfolio Margin 

Accounts 

10. Portfolio margining generally 

permits greater leverage in an account, 

and greater leverage creates greater 

losses in the event of adverse market 

movements.

11. Because the time limit for meeting 

margin calls is shorter than in a regular 

margin account, there is increased risk 

that a customer’s portfolio margin 

account will be liquidated involuntarily, 

possibly causing losses to the customer.

12. Because portfolio margin 

requirements are determined using 

sophisticated mathematical calculations 

and theoretical values that must be 

calculated from market data, it may be 

more difficult for customers to predict 

the size of future margin calls in a 

portfolio margin account. This is 

particularly true in the case of 

customers who do not have access to 

specialized software necessary to make 

such calculations or who do not receive 

theoretical values calculated and 

distributed periodically by The OCC.

13. For the reasons noted above, a 

customer that carries long options 

positions in a portfolio margin account 

could, under certain circumstances, be 

less likely to recover the full value of 

those positions in the event of the 

insolvency of the carrying broker.

14. Trading of securities index 

products in a portfolio margin account 

is generally subject to all the risks of 

trading those same products in a regular 

securities margin account. Customers 

should be thoroughly familiar with the 

risk disclosure materials applicable to 

those products, including the booklet 

entitled Characteristics and Risks of 

Standardized Options.

15. Customers should consult with 

their tax advisers to be certain that they 

are familiar with the tax treatment of 

transactions in securities index 

products.

16. The descriptions in this disclosure 

statement relating to eligibility 

requirements for portfolio margin 

accounts, and minimum equity and 

margin requirements for those accounts, 

are minimums imposed under exchange 

rules. Time frames within which margin 

and equity calls must be met are 

maximums imposed under exchange 

rules. Broker-dealers may impose their 

own more stringent requirements.

Overview of Cross-Margining 

17. With cross-margining, index 

futures and options on index futures are 

combined with offsetting positions in 

securities index options and underlying 

instruments, for the purpose of 

computing a margin requirement based 

on the net risk. This generally produces 

lower margin requirements than if the 

futures products and securities products 

are viewed separately, thus providing 

more leverage in the account.

18. Cross-margining must be done in 

a portfolio margin account type. A 

separate portfolio margin account must 

be established exclusively for crossmargining.

19. When index futures and options 

on futures are combined with offsetting 

positions in index options and 

underlying instruments in a dedicated 

account, and a portfolio margining 

methodology is applied to them, crossmargining is achieved.

Customers Eligible for Cross-Margining 

20. The eligibility requirements for 

cross-margining are generally the same 

as for portfolio margining, and any 

customer eligible for portfolio margining 

is eligible for cross-margining.

21. Members of futures exchanges on 

which cross-margining eligible index 

contracts are traded are also permitted 

to carry positions in cross-margin 

accounts without regard to the 

minimum aggregate account equity.

Positions Eligible for Cross-Margining 

22. All securities products eligible for 

portfolio margining are also eligible for 

cross-margining.

23. All broad-based U.S. market index 

futures and options on index futures 

traded on a designated contract market 

subject to the jurisdiction of the 

Commodity Futures Trading 

Commission are eligible for crossmargining.

Special Rules for Cross-Margining 

24. Cross-margining must be 

conducted in a portfolio margin account 

type. A separate portfolio margin 

account must be established exclusively 

for cross-margining. A cross-margin 

account is a securities account, and 

must be maintained separate from all 

other securities accounts.

25. Cross-margining is automatically 

accomplished with the portfolio 

margining methodology. Cross-margin 

positions are subject to the same 

minimum margin requirement for every 

contract, including futures contracts.

26. Margin calls arising in the crossmargin account, and any shortfall in 

aggregate net equity across accounts, 

must be satisfied within the same time 

frames, and subject to the same 

consequences, as in a portfolio margin 

account.

27. A position in a futures product 

may not be established in a crossmargin account unless there exists, or 

there is established on the same day, an 

offsetting position in securities options 

and/or other eligible securities. Futures 

products will be transferred out of the 

cross-margin account and into a futures 

account if, for more than 10 business 

days and for any reason, the offsetting 

securities options and/or other eligible 

securities no longer remain in the 

account. If the transfer of futures 

products to a futures account causes the 

futures account to be undermargined, a 

margin call will be issued or positions 

will be liquidated to the extent 

necessary to eliminate the deficit.

28. According to the rules of the 

exchanges, a broker-dealer is required to 

immediately liquidate, or, if feasible, 

transfer to another broker-dealer eligible 

to carry cross-margin accounts, all 

customer cross-margin accounts that 

contain positions in futures and/or 

options on futures in the event that the 

carrying broker-dealer becomes 

insolvent.

29. Customers participating in crossmargining will be required to sign an 

agreement acknowledging that their 

positions and property in the crossmargin account will be subject to the 

customer protection provisions of Rule 

15c3–3 under the Securities Exchange 

Act of 1934 and the Securities Investor 

Protection Act, and will not be subject 

to the provisions of the Commodity 

Exchange Act, including segregation of 

funds.

30. In signing the agreement referred 

to in paragraph 29 above, a customer 

also acknowledges that a cross-margin 

account that contains positions in 

futures and/or options on futures will be 

immediately liquidated, or, if feasible, 

transferred to another broker-dealer 

eligible to carry cross-margin accounts, 

in the event that the carrying brokerdealer becomes insolvent.

Special Risks of Cross-Margining 

31. Cross-margining must be 

conducted in a portfolio margin account 

type. Generally, cross-margining and the 

portfolio margining methodology both 

contribute to provide greater leverage 

than a regular margin account, and 

greater leverage creates greater losses in 

the event of adverse market movements.

32. As cross-margining must be 

conducted in a portfolio margin account 

type, the time required for meeting 

margin calls is shorter than in a regular 

securities margin account and may be 

shorter than the time ordinarily required 

77280 Federal Register / Vol. 69, No. 247 / Monday, December 27, 2004 / Notices 

by a futures commission merchant for 

meeting margin calls in a futures 

account. As a result, there is increased 

risk that a customer’s cross-margin 

positions will be liquidated 

involuntarily, causing possible loss to 

the customer.

33. As noted above, cross-margin 

accounts are securities accounts and are 

subject to the customer protections setforth in Rule 15c3–3 under the 

Securities Exchange Act of 1934 and the 

Securities Investor Protection Act. 

Cross-margin positions are not subject 

to the customer protection rules under 

the segregation provisions of the 

Commodity Exchange Act and the rules 

of the Commodity Futures Trading 

Commission (‘‘CFTC’’) adopted 

pursuant to the Commodity Exchange 

Act.

34. Trading of index options and 

futures contracts in a cross-margin 

account is generally subject to all the 

risks of trading those same products in 

a futures account or a regular securities 

margin account, as the case may be. 

Customers should be thoroughly 

familiar with the risk disclosure 

materials applicable to those products, 

including the booklet entitled 

Characteristics and Risks of 

Standardized Options and the risk 

disclosure document required by the 

CFTC to be delivered to futures 

customers. Because this disclosure 

statement does not disclose the risks 

and other significant aspects of trading 

in futures and options, customers 

should review those materials carefully 

before trading in a cross-margin 

account.

35. Customers should bear in mind 

that the discrepancies in the cash flow 

characteristics of futures and certain 

options are still present even when those 

products are carried together in a crossmargin account. Both futures and 

options contracts are generally marked 

to the market at least once each 

business day, but the marks may take 

place with different frequency and at 

different times within the day. When a 

futures contract is marked to the 

market, the gain or loss is immediately 

credited to or debited from, respectively, 

the customer’s account in cash. While 

an increase in value of a long option 

contract may increase the equity in the 

account, the gain is not realized until 

the option is sold or exercised. 

Accordingly, a customer may be 

required to deposit cash in the account 

in order to meet a variation payment on 

a futures contract even though the 

customer is in a hedged position and 

has experienced a corresponding (but as 

yet unrealized) gain on a long option. 

On the other hand, a customer who is 

in a hedged position and would 

otherwise be entitled to receive a 

variation payment on a futures contract 

may find that the cash is required to be 

held in the account as margin collateral 

on an offsetting option position.

36. Customers should consult with 

their tax advisers to be certain that they 

are familiar with the tax treatment of 

transactions in index products, 

including tax consequences of trading 

strategies involving both futures and 

option contracts.

37. The descriptions in this disclosure 

statement relating to eligibility 

requirements for cross-margining, and 

minimum equity and margin 

requirements for cross-margin accounts, 

are minimums imposed under exchange 

rules. Time frames within which margin 

and equity calls must be met are 

maximums imposed under exchange 

rules. The broker-dealer carrying a 

customer’s portfolio margin account, 

including any cross-margin account, 

may impose its own more stringent 

requirements.

* * * * *

Acknowledgement for Customers 

Utilizing a Portfolio Margin Account 

—Cross-Margining and Non CrossMargining—

Rule 15c3–3 under the Securities 

Exchange Act of 1934 requires that a 

broker or dealer promptly obtain and 

maintain physical possession or control 

of all fully-paid securities and excess 

margin securities of a customer. Fullypaid securities are securities carried in 

a cash account and margin equity 

securities carried in a margin or special 

account (other than a cash account) that 

have been fully paid for. Excess margin 

securities are a customer’s margin 

securities having a market value in 

excess of 140% of the total of the debit 

balances in the customer’s non-cash 

accounts. For the purposes of Rule 

15c3–3, securities held subject to a lien 

to secure obligations of the brokerdealer are not within the broker-dealer’s 

physical possession or control. The 

Commission staff has taken the position 

that all long option positions in a 

customer’s portfolio-margining account 

(including any cross-margining account) 

may be subject to such a lien by OCC 

and will not be deemed fully-paid or 

excess margin securities under Rule 

15c3–3.

The hypothecation rules under the 

Securities Exchange Act of 1934 (Rules 

8c-1 and 15c2–1), prohibit brokerdealers from permitting the 

hypothecation of customer securities in 

a manner that allows those securities to 

be subject to any lien or liens in an 

amount that exceeds the customer’s 

aggregate indebtedness. However, all 

long option positions in a portfoliomargining account (including any crossmargining account) will be subject to 

OCC’s lien, including any positions that 

exceed the customer’s aggregate 

indebtedness. The Commission staff has 

taken a position that would allow 

customers to carry positions in 

portfolio-margining accounts (including 

any cross-margining account), even 

when those positions exceed the 

customer’s aggregate indebtedness. 

Accordingly, within a portfolio margin 

account or cross-margin account, to the 

extent that you have long option 

positions that do not operate to offset 

your aggregate indebtedness and 

thereby reduce your margin 

requirement, you receive no benefit from 

carrying those positions in your 

portfolio margin account or crossmargin account and incur the 

additional risk of OCC’s lien on your 

long option position(s).

BY SIGNING BELOW, THE 

CUSTOMER AFFIRMS THAT THE 

CUSTOMER HAS READ AND 

UNDERSTOOD THE FOREGOING 

DISCLOSURE STATEMENT AND 

ACKNOWLEDGES AND AGREES THAT 

LONG OPTION POSITIONS IN 

PORTFOLIO-MARGINING ACCOUNTS 

AND CROSS-MARGINING ACCOUNTS 

WILL BE EXEMPTED FROM CERTAIN 

CUSTOMER PROTECTION RULES OF 

THE SECURITIES AND EXCHANGE 

COMMISSION AS DESCRIBED ABOVE 

AND WILL BE SUBJECT TO A LIEN BY 

THE OPTIONS CLEARING 

CORPORATION WITHOUT REGARD 

TO SUCH RULES.

CUSTOMER NAME: lllllllll

BY: llllllllllllllll

(signature/title) 

DATE: lllllllllllllll

* * * * *

Acknowledgement for Customers 

Engaged in Cross-Margining 

As disclosed above, futures contracts 

and other property carried in customer 

accounts with Futures Commission 

Merchants (‘‘FCM’’) are normally subject 

to special protection afforded under the 

customer segregation provisions of the 

Commodity Exchange Act (‘‘CEA’’) and 

the rules of the CFTC adopted pursuant 

to the CEA. These rules require that 

customer funds be segregated from the 

accounts of financial intermediaries and 

be separately accounted for, however, 

they do not provide for, and regular 

futures accounts do not enjoy the 

benefit of, insurance protecting 

customer accounts against loss in the 

event of the insolvency of the 

intermediary carrying the accounts.

Federal Register / Vol. 69, No. 247 / Monday, December 27, 2004 / Notices 77281

7An account dedicated to portfolio margining.

8See NYSE Proposal, supra note 6.

9The NYSE Rule 431 Committee is comprised of 

securities industry representatives, primarily 

representatives of NYSE member organizations. 

NYSE Rule 431 contains the NYSE’s margin rules. 

the function of the NYSE Rule 431 Committee is to 

assess the adequacy of NYSE Rule 431 on an 

ongoing basis, review proposals for changes to 

Continued

As also has been discussed above, 

cross-margining must be conducted in a 

portfolio margin account dedicated 

exclusively to cross-margining, and 

cross-margin accounts are not treated as 

a futures account with an FCM. Instead, 

cross-margin accounts are treated as 

securities accounts carried with brokerdealers. As such, cross-margin accounts 

are covered by Rule 15c3–3 under the 

Securities Exchange Act of 1934, which 

protects customer accounts. Rule 15c3–

3, among other things, requires a brokerdealer to maintain physical possession 

or control of all fully-paid and excess 

margin securities and maintain a 

special reserve account for the benefit of 

their customers. However, in respect of 

cross-margin accounts, there is an 

exception to the possession or control 

requirement of Rule 15c3–3 that permits 

The Options Clearing Corporation to 

have a lien on long positions. This 

aspect is outlined in a separate 

acknowledgement form that must be 

signed prior to or concurrent with this 

form. Additionally, the Securities 

Investor Protection Corporation 

(‘‘SIPC’’) insures customer accounts 

against the financial insolvency of a 

broker-dealer in the amount of up to 

$500,000 to protect against the loss of 

registered securities and cash 

maintained in the account for 

purchasing securities or as proceeds 

from selling securities (although the 

limit on cash claims is $100,000). 

According to the rules of the exchanges, 

a broker-dealer is required to 

immediately liquidate, or, if feasible, 

transfer to another broker-dealer eligible 

to carry cross-margin accounts, all 

customer cross-margin accounts that 

contain positions in futures and/or 

options on futures in the event that the 

carrying broker-dealer becomes 

insolvent.

BY SIGNING BELOW, THE 

CUSTOMER AFFIRMS THAT THE 

CUSTOMER HAS READ AND 

UNDERSTOOD THE FOREGOING 

DISCLOSURE STATEMENT AND 

ACKNOWLEDGES AND AGREES THAT: 

1) POSITIONS AND PROPERTY IN 

CROSS-MARGINING ACCOUNTS, WILL 

NOT BE SUBJECT TO THE CUSTOMER 

PROTECTION RULES UNDER THE 

CUSTOMER SEGREGATION 

PROVISIONS OF THE COMMODITY 

EXCHANGE ACT (‘‘CEA’’) AND THE 

RULES OF THE COMMODITY 

FUTURES TRADING COMMISSION 

ADOPTED PURSUANT TO THE CEA, 

AND 2) CROSS-MARGINING 

ACCOUNTS THAT CONTAIN 

POSITIONS IN FUTURES AND/OR 

OPTIONS ON FUTURES WILL BE 

IMMEDIATELY LIQUIDATED, OR, IF 

FEASIBLE, TRANSFERED TO 

ANOTHER BROKER-DEALER ELIGIBLE 

TO CARRY CROSS-MARGIN 

ACCOUNTS, IN THE EVENT THAT 

THE CARRYING BROKER-DEALER 

BECOMES INSOLVENT.

CUSTOMER NAME: lllllllll

BY: llllllllllllllll

(signature/title)

DATE: lllllllllllllll

* * * * *

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 

CBOE 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. The CBOE 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 

a. Introduction 

The CBOE proposes to expand its 

margin rules by providing a portfolio 

margin methodology for listed, broadbased market index options, index 

warrants and related exchange-traded 

funds that clearing member 

organizations may extend to eligible 

customers as an alternative to the 

current strategy-based option margin 

requirements. The proposed rule change 

would also allow broad-based index 

futures and options on such futures to 

be included in a separate portfolio 

margin account, thus providing a crossmargin capability. The CBOE seeks to 

introduce the proposed new rule as a 

two-year pilot program that would be 

made available to member organizations 

on a voluntary basis. 

The proposed rule change would 

permit self-clearing member 

organizations to apply a prescribed 

portfolio margin methodology to an 

account 7 of an affiliate, another brokerdealer, and an account of a member of 

a national futures exchange who is a 

futures floor trader. Any other 

customers of the clearing member 

would be required to have account 

equity of at least $5 million to be 

eligible for portfolio margin treatment. 

This circumscribes the number of 

accounts able to participate and adds 

safety in that such accounts are more 

likely to be of significant financial 

means and investment sophistication. 

Further, portfolio margining is most 

effective when applied to larger 

accounts with diverse option positions 

and related securities, and any related 

futures contracts. It is expected that 

institutional customers will be the 

primary participants. Whether the 

account equity requirement should be 

lowered to allow participation of more 

customers will be assessed at the end of 

the pilot program period. Application of 

portfolio margin, including crossmargin, to an IRA account would be 

prohibited under the proposed rule 

change.

A number of revisions contained in 

Amendment No. 1 were deemed 

warranted, or requested or 

recommended by staff of the 

Commission. In either case, the reason 

for these revisions is to make 

corrections or clarifications to the 

proposed rule, or to reconcile 

differences between the proposed rule 

and a parallel filing by the NYSE.8

The proposed portfolio margin and 

cross-margin rules have been developed 

by the CBOE in cooperation with The 

Options Clearing Corporation (‘‘The 

OCC’’), the New York Stock Exchange, 

Inc. (‘‘NYSE’’), the American Stock 

Exchange LLC (‘‘AMEX’’), the Board of 

Trade of the City of Chicago, Inc. 

(‘‘CBOT’’), and the Chicago Mercantile 

Exchange Inc. (‘‘CME’’). The CBOE 

intends to provide a written overview 

describing the operational details of the 

portfolio margin and cross-margin pilot 

program to potential member 

organization participants to introduce 

and explain the pilot program. 

A committee of representatives from 

the member organizations identified as 

potential participants, and staff of the 

sponsoring exchanges and The OCC (the 

‘‘Portfolio Margin Committee’’) was 

formed and met several times in 1999 

and 2000 to refine the portfolio margin 

and cross-margin pilot program. This 

group has recommended adoption of the 

portfolio margin and cross-margin pilot 

program, as finalized by the group, and 

the related rule proposals. In addition, 

the portfolio margin and cross-margin 

pilot program has been presented to the 

NYSE’s Rule 431 Committee 9 on two 

77282 Federal Register / Vol. 69, No. 247 / Monday, December 27, 2004 / Notices 

NYSE Rule 431, and recommend changes that are 

deemed appropriate. 10Under the proposed rule change, the term 

‘‘related instrument’’ would mean, with respect to 

an options class or product group, futures contracts 

and options on futures contracts covering the same 

underlying instrument. 11Under the proposed rule change, the term 

‘‘options class’’ would refer to all options contracts 

covering the same underlying instrument. 12CBOE’s pilot program would permit an 

exchange-traded fund structured to replicate the 

composition of the index to be included; however, 

stock baskets would not be permitted at this time. 13Position values would represent the difference 

between the position closing price and the 

theoretical value at each valuation point. 14Rule 15c3–1a under the Act, 17 CFR 240.15c3–

1a.

15The proposed rules set a per contract minimum 

of $37.50. 16See Rule 15c3–1a(b)(1)(i)(B) under the Act, 17 

CFR 240.15c3–1a(b)(1)(i)(B). 17CBOE believes that it is imperative that these 

market move ranges be competitive with the range 

used in the futures industry for computing margin 

(performance bond) on broad-based index futures. 

The proposed ranges accomplish this goal. 

Customer performance bond in the futures industry 

is computed using a portfolio margining system 

known as the Standard Portfolio Analysis of Risk 

(‘‘SPAN’’). The terms ‘‘high capitalization’’ and 

‘‘non-high capitalization’’ have the same meaning 

as they do for the purposes of risk-based haircuts 

(Rule 15c3–1 under the Act, 17 CFR 240.15c3–1).

occasions, with draft rules included on 

the second occasion, and has received 

the NYSE’s Rule 431 Committee’s 

support.

b. Overview—Portfolio Margin 

Computation 

(1) Portfolio Margin

Under a portfolio margin system, 

margin is required based on the greatest 

loss that would be incurred in a 

portfolio if the value of components 

(underlying instruments in the case of 

options) move up or down by a 

predetermined amount (e.g., ±5%). 

Under the Exchange’s proposed 

portfolio margin rule, listed index 

options and underlying instruments 

(also related instruments 10 in the case 

of a cross-margin account) would be 

grouped by class 11 (e.g., S&P 500, S&P 

100, etc.), each class group being a 

portfolio.12 The gain or loss on each 

position in a portfolio would be 

calculated at each of 10 equidistant 

points (‘‘valuation points’’) set at and 

between the upper and lower market 

range points. A theoretical options 

pricing model would be used to derive 

position values 13 at each valuation 

point for the purpose of determining the 

gain or loss. Gains and losses would 

then be netted for positions within the 

class or portfolio at each valuation 

point. The greatest net loss among the 

10 valuation points would be the margin 

required on the portfolio or class. The 

margin for all other portfolios within an 

account would be calculated in a similar 

manner. Broad-based index classes 

(portfolios) that are highly correlated 

would be allowed offsets such that, at 

the same valuation point, for example, 

90% of a gain in one class may reduce 

or offset a loss in another class. The 

amount of offset allowed between 

portfolios would be the same amount 

that is permitted under the risk-based 

haircut methodology set forth in 

Appendix A of the Commission’s net 

capital rule.14 A per contract minimum 

would be established and would 

override if a lesser requirement is 

rendered by the portfolio margin 

computation.15 Member organizations 

would not be permitted to use any 

theoretical pricing model to generate the 

prices used to calculate theoretical 

profits and losses. Under the proposed 

rule change, the theoretical prices used 

for computing profits and losses must 

come from a theoretical pricing model 

that, pursuant to the Commission’s net 

capital rule,16 qualifies for purposes of 

determining the amount to be deducted 

in computing net capital under a 

portfolio-based methodology. CBOE 

believes that delineating acceptable 

theoretical pricing models is best 

achieved by applying the Commission’s 

net capital rule by reference. In this 

way, consistency with the Commission’s 

net capital rule is maintained. In 

addition, since theoretical pricing 

models must be approved by a 

Designated Examining Authority 

(‘‘DEA’’) and reviewed by the 

Commission to qualify, uniformity 

across models can be assured. As a 

result, portfolio margin and crossmargin requirements will not vary 

materially from firm to firm. Currently, 

the theoretical model used by The OCC 

is the only model qualified pursuant to 

the Commission’s net capital rule. 

Consequently, all member organizations 

participating in the pilot program 

would, at least for the foreseeable 

future, obtain their theoretical values 

from The OCC.

The Exchange’s proposed rule would 

propose a market range of ±10% for 

computing theoretical gains and losses 

in broad-based, non-high capitalization 

index portfolios. A market range of 

+6%/¥8% is proposed for broad-based, 

high capitalization index portfolios.17

These are the same ranges currently 

applied to options market makers for the 

purpose of computing portfolio or riskbased haircuts. On a historical basis, 

these ranges cover one day moves at a 

very high level of confidence, and 

would be competitive with the market 

range coverage applied for performance 

bond (margin) purposes in the futures 

industry on comparable index futures. 

The proposed rule change requires that 

a separate securities margin account (or 

subaccount of a securities margin 

account) be used for portfolio 

margining.

Amendment No. 1 to the proposed 

rule change also adds rule language that 

requires fully paid for long options 

(and/or index warrants) to be transferred 

out of the portfolio margin account and/

or cross-margin account and into a 

securities account that is not a portfolio 

margin account, in the event that such 

long positions are the only components. 

(2) Cross-Margining 

The proposed rule permits related 

index futures and options on such 

futures to be carried in a separate 

portfolio margin account, thus affording 

a cross-margin capability. Amendment 

No. 1 contains changes that primarily 

relate to the addition of rule language 

(i.e., Rule 12.4(j)) that, pursuant to 

agreement between Commission staff, 

the Exchange and The Options Clearing 

Corporation, requires cross-margin 

positions to be liquidated or transferred 

in the event the carrying broker-dealer 

becomes insolvent. The Original 

Proposal allowed cross-margining to be 

commingled with other, non-cross 

margin portfolio margin positions in the 

same account. However, the proposal of 

Amendment No. 1 to require liquidation 

or transfer of the cross-margin account 

necessitates that cross-margining be 

conducted in an account separate from 

non-cross-margining activity. Therefore, 

Amendment No. 1 contains a number of 

proposed revisions that relate to 

isolation of cross-margin positions in a 

separate account.

In a portfolio margin account, 

including one that is used exclusively 

for cross-margining, constituent 

portfolios may be formed containing 

index options, index warrants and 

exchange-traded funds structured to 

replicate the composition of the index 

underlying a particular portfolio, as well 

as related index futures and options on 

such futures. Cross-margining would 

operate similar to the cross-margin 

program that was approved by the 

Commission and the Commodity 

Futures Trading Commission (‘‘CFTC’’) 

for listed options market-makers and 

proprietary accounts of clearing member 

organizations. For determining 

theoretical gains and losses, and 

resultant margin requirements, the same 

portfolio margin computation program 

will be applied to portfolio margin 

accounts, as well as cross-margin 

accounts. 

Federal Register / Vol. 69, No. 247 / Monday, December 27, 2004 / Notices 77283

18Even a customer that engages exclusively in 

cross-margining is a portfolio margin customer, as 

the proposed rule change permits cross-margining 

to be conducted only by applying the portfolio 

margin methodology.

19As disclosed in the general acknowledgement 

form (required of any portfolio or cross-margin 

customer), portfolio margin and cross-margin 

accounts operate pursuant to an exception to the 

customer protection rules in that fully paid long 

positions will not be segregated.

c. Margin or Minimum Equity 

Deficiency 

Under proposed CBOE Rule 12.4(h), 

positions in a portfolio margin account 

would be valued at current market 

prices, as currently defined in the 

Exchange’s margin rules. Under the 

proposed rule change, account equity 

would be calculated and maintained 

separately for each portfolio margin 

account. For purposes of the $5 million 

minimum account equity requirement, 

all accounts owned by an individual or 

entity may be combined. Proposed 

CBOE Rule 12.4(i) requires that 

additional margin must be obtained 

within one business day (T+1) 

whenever equity is below the margin 

required, regardless of whether the 

deficiency is caused by the addition of 

new positions, the effect of unfavorable 

market movement on existing positions, 

or a combination of both. The portfolio 

margin requirement, therefore, would be 

both the initial and maintenance margin 

requirement, and no differentiation 

would be necessary. In addition, 

proposed CBOE Rule 12.4(g) would 

require that, in the event account equity 

falls below the $5 million minimum, 

additional equity must be deposited 

within 3 business days (T+3). If the 

deficiency were not resolved within 3 

business days, the carrying member 

organization would be prohibited under 

the proposed rule change from 

accepting any new opening orders 

beginning on T+4, with the exception of 

opening orders that hedge existing 

positions. This prohibition would 

remain in effect until a $5 million 

equity was established. 

d. Risk Disclosure Statement and 

Acknowledgement 

In addition, the Exchange proposes 

that member organizations provide 

every portfolio margin customer with a 

written risk disclosure statement at or 

prior to the initial opening of a portfolio 

margin account.18 This disclosure 

statement highlights the risks and 

operation of portfolio margin accounts, 

including cross-margining, and the 

differences between portfolio margin 

and strategy-based margin requirements. 

The disclosure statement is divided into 

two sections, one dealing with portfolio 

margining and the other with crossmargining. The disclosure statement 

clearly notes that additional leverage is 

possible in an account margined on a 

portfolio basis in relation to strategybased margin. Among other things, the 

disclosure statement covers who is 

eligible to open a portfolio margin 

account, the instruments that are 

allowed, and when deposits to meet 

margin and minimum equity are due. 

The fact that long option positions held 

in a portfolio margin account are not 

segregated, as they generally would be 

in the case of a regular margin account 

under the Commission’s customer 

protection rules, is explained. Also 

included within the portfolio margin 

section is a summary list of the special 

risks of portfolio margin accounts, such 

as: increased leverage; shorter time for 

meeting margin; involuntary liquidation 

if margin not received; inability to 

calculate future margin requirements 

because of the data and calculations 

required; and that long positions are 

subject to a lien. The risks and operation 

of a cross-margin feature are outlined in 

the cross-margin section of the 

disclosure statement, and a summary 

list of the special risks associated with 

cross-margining is included.

Further, at or prior to the time a 

portfolio margin account is initially 

opened, member organizations would be 

required to obtain a signed 

acknowledgement concerning portfolio 

margining in general from the customer. 

In addition, prior to accommodating 

cross-margining, member organizations 

would be required to obtain a second 

signed acknowledgement within the 

same time frame that pertains to crossmargin. 

By signing the general 

acknowledgement required of all 

customers, the customer would attest to 

having read the disclosure statement 

and being aware of the fact that long 

option positions in a portfolio margin 

account (which includes cross-margin 

accounts) are not subject to the 

segregation requirements under the 

customer protection rules of the 

Commission, and would be subject to a 

lien by the OCC. In signing the 

additional acknowledgement applicable 

to cross-margining, the customer would 

attest to having read the disclosure 

statement and being aware of the fact 

that futures positions are being carried 

in a securities account, are subject to the 

Commission’s customer protection 

rules,19 and fall under the authority of 

the SIPC in the event the carrying 

broker-dealer becomes financially 

insolvent. Within Chapter 9 of the 

Exchange’s rules (‘‘Doing Business with 

the Public’’), the Exchange would 

prescribe the format of the written 

disclosure statement and 

acknowledgements in proposed 

Exchange Rule 9.15(d)—Delivery of 

Current Options Disclosure Documents 

and Prospectus. Like a current Exchange 

rule that prescribes the format for a 

Special Statement for Uncovered 

Options Writers (CBOE Rule 9.15(c)), 

proposed Exchange Rule 9.15(d) would 

allow member organizations to develop 

their own format, provided it contains 

substantially similar information and it 

is approved in advance by the 

Exchange.

e. Net Capital 

The Exchange also proposes to add a 

new requirement in CBOE Rule 13.5 to 

mandate that the gross customer 

portfolio margin requirements of a 

broker-dealer may at no time exceed 

1,000 percent of a carrying brokerdealer’s net capital (a 10:1 ratio). This 

requirement is intended to place a 

ceiling on the amount of margin a 

broker-dealer can extend to its 

customers in relation to its net capital.

f. Internal Risk Monitoring Procedures 

The Exchange further proposes a 

separate, related rule that would require 

member organizations that carry 

portfolio margin or cross-margin 

accounts to establish and maintain 

written procedures for assessing and 

monitoring the potential risks to their 

capital. Specifically, proposed CBOE 

Rule 15.8A (Risk Analysis of Portfolio 

Margin and Cross-Margin Accounts) 

would require that the member 

organization file and maintain its 

current procedures with its DEA, and 

provide the DEA with such information 

as the DEA may reasonably require 

regarding the member organization’s 

risk analysis of any and all portfolio 

margin and cross-margin accounts 

carried for customers. Proposed CBOE 

Rule 15.8A would incorporate current 

Exchange Rule 15.8—Risk Analysis of 

Market-Maker Accounts—by reference 

to require that the risk analysis be 

conducted in the same manner as 

prescribed in Exchange Rule 15.8. 

Additionally, proposed CBOE Rule 

15.8A would set forth certain 

undertakings that must be included in 

the written procedures (e.g., review and 

approval of credit limits for each 

customer and across all accounts). 

Because member organizations would 

be required under the proposed rule 

change to have risk monitoring 

procedures, proposed CBOE Rule 12.4(i) 

states that the current CBOE Rule 12.9—

Meeting Margin Calls by Liquidation 

Prohibited—prohibiting excessive 

77284 Federal Register / Vol. 69, No. 247 / Monday, December 27, 2004 / Notices 

20The Commission anticipates that the clearing 

arrangements described in this section will be the 

subject of a separate proposed rule change filed by 

the OCC.

21On March 15, 1994, the Commission issued a 

no-action letter allowing the implementation of a 

risk-based haircut pilot program. See letter from 

Brandon Becker, Director, Division, Commission, to 

Mary Bender, First Vice President, Division of 

Regulatory Services, CBOE, and Timothy Hinkes, 

Vice President, The OCC, dated March 15, 1994. 

The risk-based haircut program took full effect on 

September 1, 1997. See ‘‘Net Capital Rule,’’

Securities Exchange Act Release No. 38248 

(February 6, 1997), 62 FR 6474 (February 12, 1997).

22See Federal Reserve System, ‘‘Securities Credit 

Transactions; Borrowing by Brokers and Dealers’; 

Regulations G, T, U and X; Docket Nos. R–0905, R–

0923 and R–0944, 63 FR 2806 (January 16, 1998).

23See letter from the FRB to James E. Newsome, 

Acting Chairman, CFTC, and Laura S. Unger, Acting 

Chairman, Commission, dated March 6, 2001.

liquidations to meet margin 

requirements will not apply to portfolio 

margin and cross-margin accounts. 

Furthermore, given the proposed risk 

monitoring procedures, CBOE proposes 

that day trading margin requirements 

would not apply to portfolio margin and 

cross-margin accounts. Through these 

risk-monitoring procedures, member 

organizations will be expected to 

oversee portfolio margin and crossmargin accounts for excessive 

liquidations and day trading and take 

appropriate action according to their 

procedures. 

It should be noted that the disclosure 

statement delivery requirement, the $5 

million minimum equity requirement, 

and the next day deposit condition for 

additionally required margin were all 

added by the Portfolio Margin 

Committee. The Portfolio Margin 

Committee deemed these requirements 

prudent given that less margin is 

generally required under a portfolio 

margining approach than under the 

current strategy-based methodology, and 

these measures made the plan entirely 

acceptable to the member firm 

representatives. 

g. Margin at the Clearing House Level 20

The Exchange proposes that all 

customer portfolio margin account 

transactions not involving a futures 

transaction (e.g., cross-margin) be 

cleared in one special omnibus account 

for the clearing firm at The OCC. In 

addition, the Exchange proposes that all 

transactions involving cross-margining, 

both the security and futures products, 

be cleared in one of two additional 

special omnibus accounts for crossmargining, depending on the entity that 

clears the futures product being crossmargined. One cross-margin omnibus 

account corresponds to a crossmargining agreement between The OCC, 

the CME and the New York Clearing 

Corporation. The other omnibus account 

corresponds to a cross-margining 

agreement between The OCC and the 

Board of Trade Clearing Corporation. 

The OCC will compute margin for the 

special omnibus accounts using the 

same portfolio margin methodology 

applied at the customer level. The OCC 

will continue to require full payment 

from the clearing firm for all long option 

positions. However, as previously 

noted, long positions will not be 

segregated like they are in the firm’s 

regular customer range account at The 

OCC. This is necessary and preferred 

with a portfolio margining methodology 

because all long positions must be 

available for margin offset. Margin relief 

is based on a dollar offset basis as 

opposed to identifying specific contract 

to contract offsets under a strategy-based 

methodology. This may result in 

situations where the long positions of a 

given customer could serve to offset the 

risk in another customer’s short 

position. Long positions would, 

therefore, be subject to The OCC lien. 

An OCC clearing member currently has 

the ability to unsegregate a long position 

in order to pair it with a short position 

(contract to contract basis) and form a 

qualified spread. Under the proposed 

treatment of long positions in a portfolio 

margin omnibus account at The OCC, all 

long positions would be unsegregated, 

freeing The OCC clearing member from 

the task of determining which long 

positions offset risk and from specifying 

each position to be unsegregated. 

h. Rationale For Portfolio Margin 

Portfolio margining brings a modern 

approach to quantifying risk and offers 

a number of efficiencies. It eliminates 

the task of analyzing the portfolio and 

sorting it according to currently 

recognized strategies (e.g., spreads), and 

computing a margin requirement for 

each individual position or strategy. 

This process becomes quite 

cumbersome in an account with 

multiple positions and complex 

strategies. More importantly, for a given 

market move, up or down, in a diverse 

portfolio there will be listed option 

positions that appreciate and other 

option positions that will depreciate. 

Under a portfolio margin system, offsets 

are fully realized, whereas, under the 

current strategy-based system, positions 

and/or a group of positions comprising 

a single strategy are margined 

independent of each other and offsets 

between them do not figure into the 

total margin requirement as efficiently. 

In addition, under a portfolio margin 

system, the volatility of an individual 

listed option series is used in the 

theoretical pricing model that renders 

the price used to compute a gain/loss on 

that option position at each valuation 

point. This links the margin required to 

the risk in each particular position in 

contrast to the strategy-based margin. 

Strategy-based margin applies a 

universal percentage requirement (of the 

underlying index value) to all short 

option positions in the same category 

(e.g., broad-based), irrespective of the 

fact that all options prices do not change 

equally (in percentage terms) with a 

change in the price or level of the 

underlying instrument. 

Theoretical options pricing models 

have become widely accepted and 

utilized since Fischer Black and Myron 

Scholes first introduced a formula for 

calculating the value of a European style 

option in 1973. Other formulas, such as 

the Cox-Ross-Rubinstein model have 

since been developed. Option pricing 

formulas are now used routinely by 

option market participants to analyze 

and manage risk and have proven to be 

highly effective and preferred. In 

addition, essentially the same portfolio 

methodology described above has been 

used successfully by broker-dealers 

since 1994 to calculate haircuts on 

option positions for net capital 

purposes.21

The Board of Governors of the Federal 

Reserve System (the ‘‘Federal Reserve 

Board’’ or ‘‘FRB’’) in its amendments to 

Regulation T in 1998 permitted SROs to 

implement portfolio margin rules, 

provided they are approved by the 

Commission.22 A portfolio margin 

system recognizes the offsetting gains 

from positions that react favorably in 

market declines, while market rises are 

tempered by offsetting losses from 

positions that react negatively. A 

portfolio margin approach can thus have 

a neutralizing effect on option portfolio 

volatility. In times of market stress, the 

current strategy-based margin can result 

in margin calls and forced liquidations, 

thus contributing to the selling pressure 

in the market. The offset ability of 

portfolio margining can alleviate the 

need for liquidations, slowing 

acceleration of volatility in a crisis.

More recently, the FRB encouraged 

the development of a portfolio margin 

approach in a letter to the Commission 

and the CFTC delegating authority to 

the agencies to jointly prescribe margin 

regulations for security futures 

products.23 In that letter, the FRB wrote 

that it ‘‘has encouraged the development 

of [portfolio margin approaches] by, for 

example, amending its Regulation T so 

that portfolio margining systems 

approved by the Commission can be 

used in lieu of the strategy-based system 

Federal Register / Vol. 69, No. 247 / Monday, December 27, 2004 / Notices 77285

24See ‘‘The Brady Report,’’ Report of the 

Presidential Task Force on Market Mechanisms, 

January 1988, p. 59 and pp. 65–66.

25See ‘‘The October 1987 Market Break: Report 

by the Division,’’ Commission, February 1988, pp. 

10–57. See also the interim report of the ‘‘Working 

Group on Financial Markets,’’ (Department of the 

Treasury, CFTC, Commission and FRB), May 1988, 

Appendix D III A.

26See ‘‘OTC Derivatives Dealers,’’ Securities 

Exchange Act Release No. 40594, (October 23, 

1998), 63 FR 59362 (November 3, 1998).

27 15 U.S.C. 78f(b).

28 15 U.S.C. 78f(b)(5).

embodied in the Board’s regulation.’’

The FRB concluded that letter by 

writing ‘‘The Board anticipates that the 

creation of security future products will 

provide another opportunity to develop 

more risk sensitive, portfolio-based 

approaches for all securities, including 

security options and security futures 

products.’’

An ability to cross-margin listed index 

options with index futures, and options 

on such futures, is critical because many 

professional investors hedge their listed 

index options with futures. Although 

haircuts assessed on broker-dealers with 

respect to computing their net capital 

requirement recognize offsets between 

securities index options and index 

futures, current margin practice does 

not allow these offsets. Cross-margin 

benefits the financial markets and 

clearing system in general, not just 

individual investors. Cross-margin 

would reduce the number of forced 

liquidations. Currently, an option 

(securities) account and futures account 

of the same customer are viewed as 

separate and unrelated. In addition, 

currently an option account must be 

liquidated if the risk in the positions has 

increased dramatically or margin calls 

cannot be met, even if gains in the 

customer’s futures account offset the 

losses in the options account. If the 

accounts can be combined (i.e., crossmargined), there is little or no net 

change in risk and unnecessary 

liquidation can be avoided. The severity 

of a period of high volatility in the 

market is lessened if the number of 

liquidations is reduced because, for 

example, liquidating into a declining 

market exacerbates the decline. A 

capability to cross-margin listed index 

options and index futures would further 

alleviate excessive margin calls, 

improve cash flows and liquidity, and 

reduce volatility, particularly in times of 

market downturns. Various government 

agencies and task groups have 

previously advocated implementation of 

a cross-margin system. Those groups 

include the Presidential Task Force on 

Market Mechanics (also know as the 

Brady Commission) 24 and the 

Commission.25

Listed index options are now at a 

disadvantage to economically 

equivalent derivative products traded 

on futures exchanges in terms of margin 

requirements. Since 1988, index futures 

and options have been margined under 

a portfolio margin system known as 

SPAN. While the risks of listed index 

options are no greater than an 

equivalent position in an index future or 

option on the future, margin required on 

listed securities index options is 

significantly higher in many cases. 

Currently, listed index options margin 

(excluding the option premium) for a 

short at-the-money contract 

approximates 15% of the underlying 

index value while SPAN margin on a 

comparable futures index option 

contract is approximately 6% of the 

index value. When faced with such a 

disparity, investment managers 

discerningly choose futures products 

over listed index options for their 

hedging to reduce their costs. A 

portfolio style margin application for 

listed index options will reduce 

disparities between securities index 

options and futures products, thus 

making listed index products more 

competitive and more effective tools for 

investors.

Relief provided by a portfolio margin 

system is also needed so that listed 

index options can compete with overthe-counter derivatives, which can be 

margined on a good faith basis if hedged 

with a listed option.26

2. Statutory Basis 

The Exchange believes the proposed 

rule change, as amended, is consistent 

with Section 6(b) of the Act 27 in 

general, and furthers the objectives of 

Section 6(b)(5) of the Act 28 in 

particular, in that it is designed perfect 

the mechanism of a free and open 

market and to protect investors and the 

public interest. The proposed portfolio 

margin rule change is intended to 

promote greater reasonableness, 

accuracy and efficiency in respect of 

Exchange margin requirements for 

complex, multiple position listed index 

option strategies, and to offer a crossmargin capability with related index 

futures positions in eligible accounts.

B. Self-Regulatory Organization’s 

Statement on Burden on Competition 

The Exchange does not believe that 

the proposed rule change will impose 

any burden on competition that is not 

necessary or appropriate in the 

furtherance of the purposes of the Act. 

C. Self-Regulatory Organization’s 

Statement on Comments on the 

Proposed Rule Change Received from 

Members, Participants, or Others 

No written comments were either 

solicited or received. 

III. Date of Effectiveness of the 

Proposed Rule Change and Timing for 

Commission Action 

Within 35 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 

90 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 Exchange consents, 

the Commission will: 

(A) By order approve such proposed 

rule change, as amended, 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 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 rulecomments@sec.gov. Please include File 

Number SR–CBOE–2002–03 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–CBOE–2002–03. 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 

77286 Federal Register / Vol. 69, No. 247 / Monday, December 27, 2004 / Notices 

29 17 CFR 200.30–3(a)(12).

1 15 U.S.C. 78s(b)(1).

2 17 CFR 240.19b–4.

3See letter from Patrice Gliniecki, Senior Vice 

President and Deputy General Counsel, NASD, to 

Katherine England, Assistant Director, Division of 

Market Regulation, Commission, dated September 

16, 2004.

4Securities Exchange Act Release No. 50611 (Oct. 

29, 2004 ), 69 FR 64609 (Nov. 5, 2004) (‘‘Notice’’).

5See letter to Jonathan G. Katz, Secretary, 

Commission from Amy B.R. Lancellotta, Senior 

Counsel, Investment Company Institute, dated 

November 24, 2004 (‘‘ICI letter’’). The comment 

letter is available online at http://www.sec.gov/

rules/sro/nasd/nasd2004027.shtml.

6See NASD Rule 2830(k)(1).

7See Notice 69 FR at 64609.

8See Notice, 69 FR 64609, 64610 n. 5.

9See note 4, supra.

10See note 5, supra.

11 ICI letter. See Prohibition on the Use of 

Brokerage Commissions to Finance Distribution,

Investment Company Act Release No. 26591 (Sept. 

2, 2004) 69 FR 54728 (Sept. 9, 2004) (adopting 

amendments to Rule 12b–1 [17 CFR 270.12b–1] 

under the Investment Company Act of 1940 [15 

U.S.C. 80a] to prohibit investment companies from 

paying for the distribution of their shares with 

brokerage commissions).

12 ICI letter.

13 Id.

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 the CBOE. 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–CBOE–

2002–03 and should be submitted on or 

before January 18, 2005.

For the Commission, by the Division of 

Market Regulation, pursuant to delegated 

authority.29

Margaret H. McFarland, 

Deputy Secretary.

[FR Doc. 04–28184 Filed 12–23–04; 8:45 am] 

BILLING CODE 8010–01–P

SECURITIES AND EXCHANGE 

COMMISSION 

[Release No. 34–50883; File No. SR–NASD–

2004–027] 

Self-Regulatory Organizations; Order 

Approving Proposed Rule Change by 

NASD, Inc., Relating to Investment 

Company Portfolio Transactions 

December 20, 2004. 

I. Introduction 

On February 10, 2004, the National 

Association of Securities Dealers, Inc. 

(‘‘NASD’’) filed with the Securities and 

Exchange Commission (‘‘SEC’’ or 

‘‘Commission’’), pursuant to Section 

19(b)(1) of the Securities Exchange Act 

of 1934 (‘‘Act’’) 1 and Rule 19b–4 

thereunder,2 a proposed rule change 

relating to investment company 

portfolio transactions. On September 17, 

2004, NASD filed Amendment No. 1 to 

the proposed rule change.3 The 

proposed rule change, as amended, was 

published for comment in the Federal 

Register on November 5, 2004.4 The 

Commission received one comment 

letter in response to the proposed rule 

change.5 For the reasons discussed 

below, the Commission is approving the 

proposed rule change.

II. Description of the Proposed Rule 

Change 

A. Description of the Proposal 

NASD Rule 2830(k) governs NASD 

members’ execution of investment 

company portfolio transactions. In 

general, the rule prohibits NASD 

members from favoring the sale of 

shares of any investment company on 

the basis of brokerage commissions 

received or expected to be received from 

any source, including the investment 

company.6 However, subparagraph 

(7)(B) of the rule allows an NASD 

member, subject to the requirements of 

best execution, to sell the shares of, or 

act as an underwriter for, an investment 

company where that investment 

company ‘‘follows a policy, disclosed in 

its prospectus, of considering sales of 

shares of the investment company as a 

factor in the selection of broker/dealers 

to execute portfolio transactions * * *.’’

NASD now proposes to strike 

subparagraph (k)(7)(B) from Rule 2830 

and add a new subparagraph, 

designated (k)(2), that would prohibit 

NASD members from selling the shares 

of, or acting as underwriter for, any 

investment company:

if the member knows or has reason to know 

that such investment company, or an 

investment adviser or principal underwriter 

of the company, has a written or oral 

agreement or understanding under which the 

company directs or is expected to direct 

portfolio securities transactions (or any 

commission, markup or other remuneration 

resulting from any such transaction) to a 

broker or a dealer in consideration for the 

promotion or sale of shares issued by the 

company or any other registered investment 

company.7

As NASD noted in its description of 

the proposed rule change, proposed new 

subparagraph (k)(2) ‘‘would add an 

objective proscription, in that the 

broker-dealer’s intent to favor or 

disfavor a particular fund would not be 

relevant to that prohibition. The existing 

proscription of paragraph (k)(1), in 

contrast, turns upon the question of 

whether a broker-dealer favors or 

disfavors a fund based on receipt or 

expected receipt of brokerage 

commissions.’’ 8 The proposed 

prohibition would apply not only to the 

distribution of shares of the fund that 

directs portfolio transaction 

commissions to the distributing broker, 

but also to the distribution of the shares 

of any other registered investment 

company. Further, the rule would 

continue to provide that an NASD 

member will not violate Rule 2830(k) 

solely because it promotes or sells the 

shares of an investment company that 

directs fund portfolio transactions to the 

member, so long as the member does not 

engage in conduct otherwise prohibited 

by the rule.

B. Comment Summary 

The proposal was published for 

comment in the Federal Register on 

November 5, 2004.9 The SEC received 

one comment letter, from the 

Investment Company Institute (‘‘ICI’’), 

in response to the proposed rule 

change.10 The ICI expressed support for 

the proposed rule change, asserting that 

it ‘‘would complement the 

Commission’s recent amendment to 

Rule 12b–1 under the Investment 

Company Act of 1940, which prevents 

funds from paying for the distribution of 

their shares with brokerage 

commissions.’’ 11 The ICI stated that 

NASD’s proposal, ‘‘coupled with the 

Commission’s amendment to Rule 12b–

1, would make it clear to both fund 

advisers and broker-dealers that 

distribution considerations have no 

appropriate role in the allocation of 

fund brokerage.’’ 12 The ICI also 

supported NASD’s retention of Rule 

2830(k)(7)(A) (to be re-designated 

(8)(A)), which provides that an NASD 

member would not violate the rule 

solely because it sells shares of an 

investment company for which it also 

executes transactions, because NASD 

members might otherwise ‘‘be 

improperly discouraged from 

performing both execution and sales 

functions for a particular fund.’’ 13

III. Discussion and Findings 

The Commission finds the proposed 

rule change is consistent with the Act, 

and in particular with Section 15A(b)(6) 

of the Act, which requires, among other 

things, that NASD’s rules be designed to 

prevent fraudulent and manipulative 

acts and practices, to promote just and 

equitable principles of trade, and, in