[Federal Register Volume 62, Number 205 (Thursday, October 23, 1997)]
[Notices]
[Pages 55289-55293]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-28027]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-39244; File No. SR-CBOE-97-25]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Change by the Chicago Board Options Exchange, Incorporated, Relating to 
the Listing and Trading of Options on the Lipper Analytical/Salomon 
Brothers Growth and Growth & Income Fund Indexes

October 15, 1997.

I. Introduction

    On June 4, 1997, the Chicago Board Options Exchange, Incorporated 
(``CBOE'' or ``Exchange'') filed a proposed rule change 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\ to list and trade options 
on two mutual fund indexes designed by Lipper Analytical Services, Inc. 
in conjunction with Salomon Brothers Inc.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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    Notice of the proposal was published for comment and appeared in 
the Federal Register on June 17, 1997.\3\ No comment letters were 
received on the proposed rule change. This order approves the 
Exchange's proposal.
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    \3\ See Securities Exchange Act Release No. 38730 (June 10, 
1997), 62 FR 32846.
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II. Description of the Proposal

    The Exchange is proposing to list and trade cash-settled, European-
style options on two mutual fund indexes designed by Lipper Analytical 
Services, Inc. (``Lipper Analytical'' or LAS<SUP></SUP>) \4\ in 
conjunction with Salomon Brothers Inc.--the Lipper Analytical/Salomon 
Brothers Growth Fund Index (``Growth Fund Index'') and the Lipper 
Analytical/Salomon Brothers Growth & Income Fund Index (``Growth & 
Income Fund Index'').
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    \4\ Lipper Analytical is a major provider of mutual fund 
information and currently calculates approximately 100 other mutual 
fund indexes designed to track specific investment objectives.
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A. Index Design

    The Indexes are composed of the 30 largest U.S. funds in each 
investment

[[Page 55290]]

objective (i.e., Growth or Growth & Income), based on their total net 
assets as of the close on the last trading day of December. The Indexes 
include only those funds that report net asset values (``NAV'') through 
the facilities of the National Association of Securities Dealers 
Automated Quotation System (``Nasdaq''). Some mutual funds are composed 
of more than one class which have different fees and expenses. If there 
is more than one class of a specific mutual fund, only the class with 
the highest total net assets will be included. As of December 31, 1996, 
the Growth Fund Index had total net assets (``TNA'') of $218.6 billion, 
an average TNA per component of $7.3 billion and a median TNA per 
component of $4.2 billion. The TNAs ranged from $2.5 billion to $54.0 
billion. As of the same date, the Growth & Income Fund Index had a TNA 
of $241.2 billion, an average TNA per component of $8.0 billion and a 
median TNA per component of $5.0 billion. The TNAs ranged from $2.5 
billion to $30.9 billion.
    Lipper Analytical determines the investment objective of each fund 
by reviewing both the language in the prospectus and the fund's 
investment characteristics as shown in the Lipper-Equity Analysis 
Report on the Weighted Average Holdings of Large Investment Companies. 
A Growth Fund is described as a fund that normally invests in companies 
whose long-term earnings are expected to grow significantly faster than 
earnings of the stocks represented in the major unmanaged stock 
indexes. A Growth & Income Fund is described as a fund that combines a 
growth of earnings orientation and an income requirement for level and/
or rising dividends.

B. Calculation

    The Indexes are equal-dollar weighted and re-balanced quarterly 
after the close on expiration Fridays in March, June, September, and 
December. The Index value is calculated in essentially the same manner 
as other equal-dollar weighted indexes. The total number of shares for 
each component is calculated by dividing $1,000 by the closing NAV, 
adjusted for distributions, of the component on the re-balancing date 
and rounding to two decimal places. The share amount is held constant 
throughout the quarter. The Indexes are calculated by summing the 
product of the current NAV adjusted for distributions and the share 
amount for each component and then dividing by the index divisor. The 
divisors were calculated to produce a value of 150.00 for the Growth 
Fund Index and 250.00 for the Growth and Income Fund Index as of 
December 31, 1996, the base date. The Indexes are calculated once per 
day as soon as the NAVs for each of the components are available.\5\ 
The Index values will be disseminated by CBOE through the facilities of 
the Options Price Reporting Authority (``OPRA'') prior to the opening 
on the next business day.
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    \5\ The Exchange represents that Index values are updated only 
at the close of trading each day because that is the only time when 
the fund net asset values comprising the Indexes are determined and 
disseminated. The Exchange believes that this should not pose an 
obstacle to options trading, any more than it prevents investors 
from entering intra-day orders to purchase or redeem shares of the 
funds themselves at closing net asset values that are unknown at the 
time the orders are entered.
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    Lipper has informed the Exchange that it has not had any difficulty 
in obtaining net asset values for the funds in the Indexes. The funds 
comprising the Indexes are among the largest funds in existence. In the 
unlikely event that any of these funds do not comply with Rule 22c-1 
under the Investment Company Act of 1940, which requires daily 
computation of a fund's current net asset value, the Exchange would 
follow the same procedure it uses for dissemination of standard indexes 
when a component price is unavailable; it will use the last available 
price.\6\
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    \6\ The Commission notes that pursuant to Article XVII, Section 
4 of the OCC by-laws, OCC is empowered to fix an exercise settlement 
amount in the event it determines a current index value is 
unreported or otherwise unavailable. See Securities Exchange Act 
Release No. 37315 (June 17, 1996), 61 FR 42671 (order approving SR-
OCC-95-19).
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C. Maintenance

    Lipper Analytical has the sole responsibility of maintaining the 
Indexes. Salomon Brothers acted as an adviser to provide technical 
support, including advice on index design and the methodology of index 
construction.\7\ Lipper Analytical reviews the components annually 
after the close on the last trading day of December to include the 
thirty largest funds by total net assets. Any component changes 
resulting from the annual review will be announced by LAS and CBOE at 
least two weeks prior to implementation which will occur after the 
close on expiration in March. The index calculation reflects 
reinvestment of all distributions of component funds. Generally, there 
will be no need for any other adjustments intra-quarter.
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    \7\ Because Salomon's only role is to continue to provide 
technical support on such things as index design and the index 
construction methodology, and is not involved in any way with the 
ongoing maintenance of the Indexes, it is not necessary to erect 
informational barriers at Salomon with regard to the Indexes at this 
time. The Commission notes, however, that should Salomon's role 
change so that it is involved, whether through consultation or 
directly, in any maintenance of the Indexes, it may need to erect an 
informational barrier between personnel having access to information 
and Salomon's sales and trading personnel concerning changes and 
adjustments to the Indexes. Accordingly, should Salomon become 
involved in any maintenance of the Indexes, the CBOE should contact 
the Commission's Division of Market Regulation immediately to 
determine if CBOE may continue to list and trade options overlying 
the Indexes until such informational barriers are in place.
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D. Index Option Trading

    The proposed options on the Indexes will be cash-settled, European-
style options.\8\ Standard options trading hours for broad-based index 
options (8:30 a.m. to 3:15 p.m. Chicago time) will apply to the 
contracts. The multiplier for each Index will be 100. The Exchange 
intends to list up to three near-term months plus up to 3 months on a 
quarterly cycle. The Exchange proposes to base trading in options on 
the Lipper Analytical Indexes on the full-value of each Index. Further, 
the exchange also may list full-value long-term index option series 
(``LEAPS''<SUP></SUP>), as provided in Rule 24.9. The Exchange also 
may provide for the listing of reduced-value LEAPS, for which the 
underlying value would be computed at one-tenth of the value of the 
Index. The current and closing index value of any such reduced-value 
LEAP will, after such initial computation, be rounded to the nearest 
one-hundredth.
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    \8\ A European-style option can be exercised only during a 
specified period before the option expires.
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E. Exercise and Settlement

    Options on the Indexes will settle based on the closing NAVs of the 
component funds two business days prior to expiration. The proposed 
options will expire on the Saturday following the third Friday of the 
expiration month. Thus, the last day for trading in an expiring series 
will be two business days (ordinarily a Thursday) preceding the 
expiration date. The settlement value (which is the same as Thursday's 
closing value) will be disseminated prior to the opening on Friday.

F. Exchange Rules Applicable

    Except as modified herein, the Rules in Chapter XXIV will be 
applicable to mutual fund index options. Index option contracts based 
on the Lipper Analytical Indexes will be subject to a position limit 
and exercise limit of 75,000 contracts, with no more than 50,000 
contracts in the nearest expiration month. Ten reduced-value options 
will equal one full-value contract for such purposes. The Exchange 
believes that the proposed position limits are reasonable and

[[Page 55291]]

appropriate for this product, and are consistent with the position and 
exercise limits that apply to other index options.
    The Exchange is proposing to amend Rule 24.9 Interpretation and 
Policy .01(a) to include 2\1/2\ point strike price intervals for mutual 
fund indexes with strike prices less than $200. Broad-based margins 
will apply to mutual fund index options. CBOE is also amending Rule 
24.1(e) to reflect the fact that mutual funds can underlie indexes. 
CBOE is also proposing to amend Exchange Rule 24.14 in order to include 
specific reference to Lipper Analytical Services as entitled to the 
benefit of the disclaimer of liability in respect of the Indexes.
    Exchange rules applicable to options on both Indexes will be 
identical to the rules applicable to other broad-based index options 
for purposes of trading rotations, halts, and suspension,\9\ and margin 
treatment.\10\
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    \9\ See CBOE Rule 24.7
    \10\ See CBOE Rule 24.11
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G. Surveillance

    As with any other option product, the CBOE will closely monitor 
activity in these options and therefore, should be able to identify any 
potentially unusual activity in the options. It should be noted that 
with respect to the component funds that comprise the Indexes, trading 
in the funds themselves has no effect on the value of the Indexes. 
Instead, the value of the Indexes depends entirely on the net asset 
values of the component funds, which in turn depends on the values of 
the stocks held in the portfolios of the various funds. The Exchange 
believes that the concerns with manipulative activity are not as great 
with respect to options on these Indexes as they are on stock index 
options. First, the Indexes are equal-dollar weighted, thus no single 
component dominates the Index. Therefore any person attempting to 
manipulate the Indexes would have to manipulate the NAVs of a majority 
of the Index components. Second, in order to manipulate the NAVs of the 
component funds, a person would have to have knowledge of the component 
securities held by the funds. This information is not disseminated to 
the public until after the fact (generally only quarterly);\11\ thus 
the Exchange believes that it would be difficult for any individual to 
know, with any degree of certainty, the components of enough of the 
funds to make any manipulative efforts worthwhile. The CBOE also states 
that if it became necessary, the CBOE could examine the activity in the 
underlying stocks being held by various funds if it detects unusual 
activity in the Index options.
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    \11\ Section 13(f) of the Act requires institutional investment 
managers to file reports with the Commission, generally quarterly, 
that disclose each equity security held on the last day of the 
reporting period by accounts with respect to which the institutional 
investment manager exercises investment discretion, the name of the 
issuer and the title, class, CUSIP number, number of shares or 
principal amount, and aggregate fair market value of each such 
security. 15 U.S.C. 78m(f).
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H. Capacity

    CBOE has the necessary systems capacity to support new series that 
would result from the introduction of the Lipper Analytical/Salomon 
Brothers Index options. CBOE has also been informed that OPRA has the 
capacity to support such new series.

III. Commission Findings and Conclusions

    The Commission finds that the proposed rule change is consistent 
with the requirements of the Act and the rules and regulations 
thereunder applicable to a national securities exchange, and, in 
particular, the requirements of Section 6(b)(5) of the Act.\12\ 
Specifically, the Commission finds that the trading of options based on 
the Lipper Analytical/Salomon Brothers Growth and Growth & Income Fund 
Indexes, including full-value and reduced-value LEAPS, will serve to 
protect investors, promote the public interest, and help to remove 
impediments to a free and open securities market by providing investors 
with a means to hedge exposure to market risk associated with some of 
the largest U.S. mutual funds holding securities representing the 
growth and growth & income portion of the U.S. equity market.\13\
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    \12\ 15 U.S.C. 78f(b)(5). In approving this rule, the Commission 
notes that it has considered the proposed rule's impact on 
efficiency, competition, and capital formation. 15 U.S.C. 78c(f).
    \13\ Pursuant to Section 6(b)(5) of the Act, the commission must 
predicate approval of any new securities product upon a finding that 
the introduction of such product is in the public interest. Such a 
finding would be difficult with respect to a warrant that served no 
hedging or other economic function, because any benefits that might 
be derived by market participants likely would be outweighed by the 
potential for manipulation, diminished public confidence in the 
integrity of the markets, and other valid regulatory concerns.
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    The Commission believes that the Indexes are broad-based, and the 
proposed options are designed to reduce the potential for manipulation, 
and is consistent with the CBOE's obligation to promote investor 
protection.\14\ Moreover, the Commission believes, for the reasons 
discussed below, that the CBOE has adequately addressed issues related 
to customer protection, index design, surveillance, and market impact 
of options based on the Lipper Analytical/Salomon Brothers Growth and 
Growth & Income fund Indexes.
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    \14\ The CBOE is a member of the Intermarket Surveillance Group 
(``ISG'') which was formed on July 14, 1983 to, among other things, 
coordinate more effectively surveillance and investigative 
information sharing arrangements in the stock and options markets. 
See Intermarket Surveillance Group Agreement, July 14, 1983. The 
most recent amendment to the ISG Agreement, which incorporates the 
original agreement and all amendments made thereafter, was signed by 
ISG members on January 29, 1990. See Second Amendment to the 
Intermarket Surveillance Group Agreement, January 29, 1990. The 
members of the ISG are: the Amex; the Boston Stock Exchange, Inc.; 
the CBOE; the Chicago Stock Exchange, Inc.; the National Association 
of Securities Dealers, Inc. (``NASD'') the NYSE; the Pacific 
Exchange, Inc.; and the Philadelphia Stock Exchange, Inc. Because of 
potential opportunities for trading abuses involving stock index 
futures, stock options, and the underlying stock and the need for 
greater stock options, and the underlying stock and the need for 
greater sharing of surveillance information for these potential 
intermarket trading abuses, the major stock index futures exchanges 
(e.g., the Chicago Mercantile Exchange and the Chicago Board of 
Trade) joined the ISG as affiliate members in 1990.
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A. Index Design and Structure

    The Commission finds that it is appropriate and consistent with the 
Act for the CBOE to designate the Indexes as broad-based. Specifically, 
the Commission believes the Indexes, representing the growth and growth 
& income portion of the U.S. equity market, are broad-based for the 
following reasons. First, the indexes each consist of the 30 largest 
U.S. funds in each investment objective, based on their total net 
assets as of the close on the last trading day of December. The Indexes 
include only those funds that report net asset values (``NAV'') through 
the facilities of the National Association of Securities Dealers 
Automated Quotation System (``Nasdaq''). Second, the total net assets 
of the mutual funds comprising the Indexes are very large. As of 
December 31, 1996, the Growth Fund Index had total net assets (''TNA'') 
of $218.6 billion, an average TNA per component of $7.3 billion and a 
median TNA per component of $4.2 billion. The TNAs ranged from $2.5 
billion to $54.0 billion. As of the same date, the Growth & Income Fund 
Index had a TNA of $241.2 billion, an average TNA per component of $8.0 
billion and median TNA per component of $5.0 billion. The TNAs ranged 
from $2.5 billion to $30.9 billion. Third, no one particular mutual 
fund or group of mutual funds dominates the weight of the Index. As 
noted above, each Index value is calculated using an equal-dollar 
weighting methodology. Specifically,

[[Page 55292]]

each component will account for approximately 3.33% of its respective 
Index, and the Exchange will re-balance to equal-dollar weighting 
quarterly. Accordingly, the Commission believes it is appropriate to 
classify the Index as broad-based.

B. Customer Protection

    The Commission believes that a regulatory system designed to 
protect public customers must be in place before the trading of 
sophisticated financial instruments, such as options on the Lipper 
Analytical/Salomon Brothers Growth and Growth & Income Fund Indexes 
(including full-value and reduced value LEAPS), can commence on a 
national securities exchange. The Commission notes that the trading of 
standardized, exchange-traded options occurs in an environment that is 
designed to ensure, among other things, that: (1) The special risks of 
options are disclosed to public customers;\15\ (2) only investors 
capable of evaluating and bearing the risks of options trading are 
engaged in such trading; and (3) special compliance procedures are 
applicable to options accounts. Accordingly, because options on both 
Indexes will be subject to the same regulatory regime as the other 
standardized options currently traded on the CBOE, the Commission 
believes that adequate safeguards are in place to ensure the protection 
of investors in options on the Lipper Analytical/Salomon Brothers 
Growth and Growth & Income Fund Indexes.
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    \15\ The Commission notes that in order to promote investor 
protection and to ensure adequate disclosure in connection with 
Mutual Fund Index options, the rules pertaining to standardized 
options and the requirements of Exchange Act Rule 9b-1 will apply to 
trading in Growth and Growth & Income Fund Index Options. The 
Commission believes it is important to provide investors with 
information regarding the rights and characteristics of these 
options. In this regard, Growth and Growth & Income Fund Index 
options investors will receive a special supplement to The Options 
Clearing Corporation's (``OCC'') Options Disclosure Document (``ODD 
Supplement'') explaining in detail the risks and characteristics of 
Packaged Spreads. In reviewing any disclosure materials submitted, 
the Commission intends to assure that the materials specifically 
describe the risks and characteristics associated with trading 
Mutual Fund Index Options. The CBOE's trading of Growth and Growth & 
Income Fund Index options is expressly contingent upon the 
Commission's approval of such an ODD supplement.
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C. Surveillance

    The Commission believes that is important to ensure the 
availability of information necessary to detect and deter potential 
manipulation and other trading abuses, thereby making the mutual fund 
index product less likely to be manipulated. Further, the Commission 
believes that an exchange proposing to list a mutual fund index 
derivative where the mutual fund components themselves are not traded 
in the secondary market, must have in place appropriate surveillance 
procedures for the derivative product and the markets trading the 
underlying securities that comprise the mutual fund components. In this 
regard, the Commission notes that the CBOE will closely monitor 
activity in these options and should be able to identify any 
potentially unusual activity in the options. Moreover, the CBOE 
represents that if it became necessary, the CBOE could examine the 
activity in the underlying stocks if it detects unusual activity in the 
Index options. The Commission believes that this arrangement ensures 
the availability of information necessary to detect and deter potential 
manipulations and other trading abuses, thereby making the Index 
options and full-value and reduced-value Index LEAPS less susceptible 
to manipulation.

D. Market Impact

    The Commission believes that the listing and trading of Growth and 
Growth & Income Fund Index options on the CBOE will not adversely 
impact the securities markets in the United States.\16\ First, the 
Commission notes that the Indexes are broad-based and diversified and 
include component mutual funds that comprise the 30 largest U.S. funds 
in each investment objective. Second, the 75,000 contract position and 
exercise limit, with no more than 50,000 contracts in the nearest 
expiration month, will serve to minimize potential manipulation and 
other market impact concerns. Third, the risk to investors of contra-
party non-performance will be minimized because the Index options, and 
full-value and reduced-value LEAPS, will be issued and guaranteed by 
The Options Clearing Corporation, similar to all other standardized 
options traded in the United States.
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    \16\ In addition, the CBOE has represented that it and OPRA have 
the necessary systems capacity to support those new series of index 
options that would result from the introduction of options and LEAPS 
based on both Indexes.
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E. Index Calculation and Dissemination

    As discussed above, the CBOE is proposing to update the Indexes' 
values at the close of trading each day when the net asset values of 
the component funds of the Indexes are determined and disseminated. The 
result of this is that the disseminated value during the trading day is 
based on the prior day net asset value established at the prior day 
close.
    Generally, the Commission believes that continually updated index 
values on a real-time basis are essential to the trading of any index 
product. The Commission has only allowed exceptions to this for certain 
indexes composed of foreign securities where the primary market for the 
component securities are closed during the U.S. trading hours for the 
overlying options and thus the value of the components are generally 
not changing during the U.S. trading day. In contrast, in the case of 
the Growth Fund Index and the Growth Fund Index, the Index values are 
based on closing NAVs, even though the component funds' portfolio 
securities are themselves trading during the same trading hours as the 
Index options thereby causing the value of the portfolio to fluctuate 
throughout the trading day.
    Nevertheless, the Commission has determined to allow the CBOE to 
trade options overlying the Indexes using the Indexes' values 
established at the prior day close because only the fund manager will 
have knowledge of the funds' portfolio securities and their values on a 
regular basis throughout the trading day. Information regarding the 
component funds' portfolios will only be generally available to the 
public on a quarterly basis as required under Section 13(f) of the Act 
and all investors should have equal access to this information when it 
is disseminated.\17\ Further, CBOE surveillance should also help to 
detect and deter manipulation through the misuse of such intra-day 
information available only to the component fund managers. Finally, 
there are other widely published resources and indexes available that 
track growth and growth & income stocks which investors may use to 
determine an indicative value for the Growth and the Growth & Income 
Fund Indexes.\18\
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    \17\ See supra note 11.
    \18\ If any one of these factors were not present, the 
Commission may have determined it was not appropriate to allow the 
product to trade without real-time dissemination of Index values.
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IV. Conclusion

    Based upon the aforementioned factors, the Commission finds that 
the proposed changes relating to the listing and trading of Growth and 
Growth & Income Fund Index options are consistent with the requirements 
of Section 6(b)(5) and the rules and regulations thereunder. The 
initiation of Growth and Growth & Income Fund Index options trading, 
however, is conditioned upon the issuance of an order approving an ODD 
Supplement, pursuant to Rule 9b-1 of the Act.

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    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\19\ that the proposed rule change (File No. SR-CBOE-97-25) is 
approved.

    \19\ 15 U.S.C. 78s(b)(2).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\20\
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    \20\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-28027 Filed 10-22-97; 8:45 am]
BILLING CODE 8010-01-M