[Federal Register Volume 63, Number 132 (Friday, July 10, 1998)]
[Notices]
[Pages 37430-37433]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-18413]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-40166; File No. SR-CBOE-97-03]


Self-Regulatory Organizations; Order Granting Approval of a 
Proposed Rule Change and Notice of Filing and Order Granting 
Accelerated Approval of Amendment Nos. 2 and 3 to the Proposed Rule 
Change by the Chicago Board Options Exchange, Inc. Relating to Options 
on Interests in Listed, Open-End, Indexed Investment Companies

July 2, 1998.

I. Introduction

    On January 22, 1997, the Chicago Board Options Exchange, Inc. 
(``CBOE'' or ``Exchange''), pursuant to Section 19(b)(1) of the 
Securities Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 
thereunder,\2\ filed with the Securities and Exchange Commission 
(``SEC'' or ``Commission'') a proposed rule change to adopt rules to 
permit the trading of options on securities representing interest in 
open-end, exchange-listed investment companies that hold a portfolio of 
securities comprising or based on a broad-based stock index 
(``Exchange-Traded Fund Shares'' or ``Fund Shares''). Notice of the 
proposal appeared in the Federal Register on March 5, 1997.\3\ No 
comment letters were received on the proposed rule change.\4\ On 
January 12, 1998, the Exchange filed Amendment No. 2 to the 
proposal.\5\ On May 18, 1998, the CBOE

[[Page 37431]]

filed Amendment No. 3 to the proposed rule change.\6\ Finally, on June 
24, 1998, the Exchange filed a technical amendment to the filing.\7\ 
This order approves the Exchange's proposal, and Amendment Nos. 2 and 3 
on an accelerated basis.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 38342 (February 26, 
1997), 62 FR 10098.
    \4\ On May 2, 1997, the CBOE filed an amendment to the proposed 
rule change. See Letter from Michael L. Meyer, Esq., Schiff Hardin & 
Waite, to Howard L. Kramer, Senior Associate Director, Office of 
Market Supervision (``OMS''), Division of Market Regulation 
(``Division''), Commission, dated May 2, 1997 (``Amendment No. 1''). 
Amendment No. 1 made no changes to the proposal, but merely 
clarified the Exchange's original filing. Amendment No. 1 is no 
longer relevant, and has been replaced and superseded by Amendment 
Nos. 2 and 3.
    \5\ See Letter from Michael L. Meyer, Esq., Schiff Hardin & 
Waite to Howard L. Kramer, Senior Associate Director, OMS, Division, 
Commission, dated January 9, 1998 (``Amendment No. 2''). In 
Amendment No. 2 the Exchange proposes to revise the listing 
standards for Fund Shares set forth in Interpretation and Policy .06 
under Rule 5.3 to require, in addition to other criteria, either: 
(1) that the underlying Fund Shares or units must satisfy the same 
criteria and guidelines under CBOE rules that apply to determine the 
eligibility for listing options on underlying equity securities; or 
(2) that the issuer is obligated to issue Fund Shares in a specified 
aggregate number in return for a cash deposit in an amount equal to 
the value of the securities that comprise the index or portfolio 
represented by the Fund Shares. In addition, Amendment No. 2 
provides that the same tiered position and exercise limits that 
apply to options on individual equity securities will apply to 
options on Fund Shares. Finally, Amendment No. 2 removed certain 
continued listing standards that were in the original filing.
    \6\ See Letter form Joseph Levin, Vice President, Research, 
CBOE, to Howard L. Kramer, Senior Associate Director, OMS, Division, 
Commission, dated May 14, 1998 (``Amendment No. 3''). In Amendment 
No. 3 the Exchange proposes a new surveillance sharing standard for 
options on Fund Shares that include non-U.S. stocks in the index or 
portfolio upon which Fund Shares are based. In addition, Amendment 
No. 3 includes continued listing standards for options on Fund 
Shares, which are discussed herein.
    \7\ See Letter from Michael L. Meyer, Esq., Schiff Hardin & 
Waite, to James T. McHale, Special Counsel, OMS, Division, 
Commission, dated June 23, 1998 (``Amendment No. 4''). Amendment No. 
4 merely corrects an erroneous cross-reference in Interpretation and 
Policy .08 to Rule 5.4.
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II. Description of the Proposal

    The purpose of the proposed rule change is to provide for the 
trading of options on Fund Shares. As noted above, Fund Shares are 
exchange-listed securities representing interests in open-end unit 
investment trusts or open-end management investment companies 
(``Funds'') that hold securities based on an index or a portfolio of 
securities. Fund Shares are issued in exchange for an ``in kind'' 
deposit of a specified portfolio of securities, together with a cash 
payment, in minimum size aggregations or multiples thereof (``Creation 
Units''). The size of the applicable Creation Unit size aggregation is 
set forth in the Fund's prospectus, and varies from one series of Fund 
Shares to another, but generally is of a substantial size (e.g., value 
in excess of $450,000 per creation unit). A fund, generally, will issue 
and sell Fund Shares in Creation Unit size through a principal 
underwriter on a continuous basis at the net asset value per share next 
determined after an order to purchase Fund Shares and the appropriate 
securities are received. Following issuance, Fund Shares are traded on 
an exchange like other equity securities, and equity trading rules 
apply. Likewise, redemption of Fund Shares is made in Creation Unit 
size and ``in kind,'' with a portfolio of securities and cash exchanged 
for Fund Shares that have been tendered for redemption.
    The CBOE proposes to trade options on Fund Shares pursuant to the 
same rules and procedures that apply generally to trading in options on 
equity securities, except that some special listing criteria are 
proposed to apply to this category of options. Options on Fund Shares 
will be physically-settled and will have either the European-style or 
American-style exercise feature, as specified.\8\
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    \8\ Telephone conversation between Michael L. Meyer, Esq., 
Schiff Hardin & Waite, and James T. McHale, Special Counsel, OMS, 
Division, Commission, on June 30, 1998.
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    The listing and maintenance standards proposed for options on Fund 
Shares are set forth in proposed Interpretation and Policy .06 under 
CBOE Rule 5.3 and in Interpretation .10 under CBOE Rule 5.4, 
respectively. Pursuant to the proposed initial listing standards, CBOE 
only will list options on Fund Shares that are principally traded on a 
national securities exchange or through the facilities of a national 
securities association and reported as national market securities. In 
addition, the initial listing standards require that either: (1) the 
Fund Shares meet the uniform options listing standards in CBOE Rule 5.3 
and Interpretation and Policy .01 thereunder, which include minimum 
public float, trading volume, and share price of the underlying 
security in order to list the option;\9\ or (2) the Exchange-Traded 
Fund Shares must be available for creation or redemption each business 
day in cash or in kind from the Fund at a price related to the net 
asset value, and the Exchange will require that the Fund is obligated 
to issue Fund Shares in a specified aggregate number even though some 
or all of the securities needed to be deposited have not been received 
by the Fund.\10\
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    \9\ Specifically, Interpretation and Policy .01 to Rule 5.3 
requires the underlying security to have a public float of 7,000,000 
shares, 2000 holders, trading volume of 2,400,000 shares in the 
preceding 12 months, a share price of $7.50 for the majority of the 
business days during the three calendar months preceding the date of 
the selection, and that the issuer of the underlying security is in 
compliance with the Act.
    \10\ Provided the person obligated to deposit the securities has 
undertaken to deliver the securities as soon as possible and such 
undertaking has been secured by the delivery and maintenance of 
collateral consisting of cash or cash equivalents satisfactory to 
the Fund which underlies the option, as described in the Fund 
prospectus. See Amendment No. 3, supra note 6.
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    In addition, the initial listing standards require that: (1) any 
Fund Share with non-US stocks in the underlying index or portfolio that 
are not subject to comprehensive surveillance agreements do not in the 
aggregate represent more than 50% of the weight of the index or 
portfolio; (2) stocks for which the primary market is in any one 
country that is not subject to a comprehensive surveillance agreement 
do not represent 20% of more of the weight of the index; and (3) stocks 
for which the primary market is in any two countries that are not 
subject to comprehensive surveillance agreements do not represent 33% 
of more of the weight of the index.\11\
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    \11\ See Amendment No. 3, supra note 6.
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    The Exchange's proposed maintenance standards provide that if a 
particular series of Exchange-Traded Fund Shares should cease to trade 
on an exchange or as national market securities in the over-the-counter 
market, there will be no opening transactions in the options on the 
Fund Shares, and all such options will trade on a liquidation-only 
basis. In addition, the CBOE will consider the suspension of opening 
transactions in any series of options of the class covering Fund Shares 
if: (1) the options fail to meet the uniform equity option maintenance 
standards in paragraphs (a), (b), (c), and (d) of Interpretation and 
Policy .01 to Rule 5.4,\12\ when the options were listed pursuant to 
the equity option listing standards of Rule 5.3 and Interpretation and 
Policy .01 thereunder; \13\ (2) following the initial twelve-month 
period beginning upon the commencement of trading of the Fund Shares on 
a national securities exchange or as national market securities through 
the facilities of a national securities association there are fewer 
than 50 record and/or beneficial holders of Fund Shares for 30 or more 
consecutive trading days, when options on Fund Shares were listed 
pursuant to clause (D)(y) under Interpretation and Policy .06 of Rule 
5.3; \14\ or (3) the value of the index or portfolio of securities on 
which the Fund Shares are based is no longer calculated or available.
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    \12\ Specifically, paragraphs (a), (b), (c) and (d) of 
Interpretation and Policy .01 to Rule 5.4 provide that an underlying 
security will not meet the Exchange's requirements for continued 
listing when, among other things: (1) there are fewer than 6,300,000 
publicly-held shares; (2) there are fewer than 1600 holders; (3) 
trading volume was less than 1,800,000 shares in the preceding 
twelve months; and (4) the share price of the underlying security 
closed below $5 on a majority of the business days during the 
preceding 6 months.
    \13\ See Amendment No. 2, supra note 5. The Commission notes 
that even if options on Fund Shares were not listed under the 
uniform equity option listing standards, initial listing standards 
for the underlying Fund Shares typically require a minimum number of 
Fund Shares to be outstanding before trading in a series of Fund 
Shares may commence. In addition, the CBOE has represented that 
although there is no comparable public float maintenance standard 
for the underlying Fund Shares, as a practical matter there can 
never be trading in a series of Fund Shares in which there is less 
than one Creation Unit outstanding, since Fund Shares only may be 
created and redeemed in Creation Unit size, and if the last 
outstanding Creation Unit should ever be redeemed, the series (and 
the options on that series) will cease to trade.
    \14\ See Amendment No. 4, supra note 7.
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    Reflecting the indexed nature of the underlying portfolios of the 
Fund

[[Page 37432]]

Shares on which options are proposed to be traded, the Exchange 
proposes to amend Interpretation and Policy .01 under Exchange Rule 5.5 
to provide that the minimum strike price intervals for these options 
will be $2.50 where the strike price is $200 or less, and $5.00 where 
the strike price is over $200. These are comparable to the strike price 
intervals provided in Interpretation and Policy .01 under Exchange Rule 
24.9, as applicable to broad-based index options having strike prices 
at about the level expected for options on Fund Shares.
    Margin requirements are proposed for options on Fund Shares at the 
same levels that apply to options generally under Exchange Rule 12.3, 
except that, reflecting the broad-based nature of the index or 
portfolio underlying Fund Shares, minimum margin must be deposited and 
maintained equal to 100% of the current market value of the option plus 
15% (instead of 20%) of the market value of equivalent units of the 
underlying security value. In this respect, the margin requirements 
proposed for options on Fund Shares are comparable to margin 
requirements that currently apply to broad-based index options under 
Exchange Rule 24.11(b)(i).\15\
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    \15\ The Commission notes that the CBOE's proposal is limited to 
trading options on Fund Shares comprising or based on a broad-based 
index or portfolio.
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    CBOE believes it has the necessary systems capacity to support the 
additional series of options that would result from the introduction of 
options on Fund Shares, and it has been advised that the Option Price 
Reporting Authority (``OPRA'') also has the capacity to support these 
additional series.\16\
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    \16\ See memorandum from Joseph Corrigan, Executive Director, 
OPRA, to Eileen Smith, CBOE, dated January 21, 1997.
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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)(15).\17\ Specifically, the 
Commission believes that providing for the listing and trading of 
standardized options on Exchange-Traded Fund Shares should give 
investors a better means to hedge their positions in the underlying 
Fund Shares. Further, the Commission believes that pricing of the 
underlying Fund Shares may become more efficient and market makers in 
these shares, by virtue of enhanced hedging opportunities, may be able 
to provide deeper and more liquid markets. In sum, the Commission 
believes that options on Fund Shares likely will engender the same 
benefits to investors and the market place that exist with respect to 
options on common stock,\18\ thereby serving to promote the public 
interest, remove impediments to a free and open securities market, and 
promote efficiency, competition, and capital formation.\19\
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    \17\ 15 U.S.C. 78f(b)(5).
    \18\ 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 new product is in the public interest. Such 
a finding would be difficult for a derivative instrument that served 
no hedging or 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.
    \19\ 15 U.S.C. 78c(f).
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    As a general matter, 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 Fund 
Shares, can commence trading 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 costumers; (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. With 
regard to position and exercise limits, the Commission finds that it is 
appropriate to adopt the tiered approach used in setting position and 
exercise limits for standardized stock options. This approach should 
serve to minimize potential manipulation and market impact concerns. 
Accordingly, because options on Fund Shares 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 Fund Shares.
    The Commission also believes that it is appropriate to permit the 
CBOE to list and trade options on Exchange-Traded Fund Shares given 
that these options must meet specific requirements related to the 
protection of investors.\20\ First, the Exchange's listing and 
delisting criteria for options on Fund Shares are adequate. With regard 
to initial listing, the proposal requires that either: (1) The 
underlying Fund Shares meet the CBOE's uniform options listing 
standards; or (2) the Exchange-Traded Fund Shares must be available for 
creation or redemption each business day in cash or in kind from the 
Fund at a price related to the net asset value, and the Exchange will 
require that the Fund is obligated to issue Fund Shares in a specified 
aggregate number even though some or all of the securities needed to be 
deposited have not been received by the Fund.\21\ This listing 
requirement should ensure that there exists sufficient supply of the 
underlying Fund Shares so that a short call writer, for example, will 
have the ability to secure delivery of the Fund Shares upon exercise of 
the option.
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    \20\ The Commission notes, and CBOE has verified, that holders 
of options on Fund Shares who exercise and receive the underlying 
Fund Shares must receive, like any purchaser of Fund Shares, a 
product description or prospectus, as appropriate. Telephone 
Conservation between Michael L. Meyer, Esq., Schiff Hardin & Waite, 
and James T. McHale, Special Counsel, OMS, Division, Commission, on 
June 30, 1998.
    \21\ Provided the person obligated to deposit the securities has 
undertaken to deliver the securities as soon as possible and such 
undertaking has been secured by the delivery and maintenance of 
collateral consisting of cash or cash equivalents satisfactory to 
the Fund which underlies the option, as described in the Fund 
prospectus.
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    In reviewing the CBOE's proposal, as originally submitted, the 
Commission had been concerned with the ability to produce Fund Shares 
upon exercise of the option. The Commission believes the CBOE has 
adequately addressed these concerns through the adoption of the listing 
standards set forth above. In particular, options listed pursuant to 
the uniform options listing standards will have to meet the options 
maintenance listing standards which require, among other things, that a 
minimum number of Fund Shares be outstanding to continue trading the 
options.\22\ The alternative listing criteria, noted above, should also 
help to ensure that the underlying Fund Shares will be available upon 
exercise by requiring the Fund to allow market participants to create 
Fund Shares even though some or all of the necessary securities needed 
to be deposited are not available.\23\ Although there is no absolute 
assurance that market participants will go ahead and create Fund Shares 
in the event a short call writer needs to purchase Fund Shares to meet 
an exercise notice, it is likely that arbitrage opportunities will 
create an incentive to do so. Further, in the event there are not 
enough Fund Shares to meet exercise requirements, as with other 
physically-settled equity options, the Options Clearing Corporation

[[Page 37433]]

(``OCC'') has rules that would apply to such situations.
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    \22\ See supra note 12.
    \23\ See supra note 21.
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    Second, the Commission believes that the surveillance standard 
developed by the CBOE for options on Fund Shares is adequate to address 
the concerns associated with the listing and trading of such 
securities. Specifically, the CBOE has proposed that: (1) Any Fund 
Share with non-US stocks in the underlying index or portfolio that are 
not subject to comprehensive surveillance agreements do not in the 
aggregate represent more than 50% of the weight of the index or 
portfolio; (2) stocks for which the primary market is in any one 
country that is not subject to a comprehensive surveillance agreement 
do not represent 20% or more of the weight of the index; and (3) stocks 
for which the primary market is in any two countries that are not 
subject to comprehensive surveillance agreements do not represent 33% 
or more of the weight of the index.\24\
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    \24\ The Exchange uses the term ``comprehensive surveillance 
agreement'' to mean an agreement which requires that the parties 
provide each other, upon request, information about market trading, 
clearing activity and the identity of the ultimate purchasers and 
sellers of securities. Telephone conversation between Michael L. 
Meyer, Esq., Schiff Hardin & Waite, and James T. McHale, Special 
Counsel, OMS, Division, Commission, on June 30, 1998.
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    As a general matter, the Commission believes that comprehensive 
surveillance agreements provide an important deterrent to manipulation 
because they facilitate the availability of information needed to fully 
investigate a potential manipulation if it were to occur. These 
agreements are especially important in the context of derivative 
products based on foreign securities because they facilitate the 
collection of necessary regulatory, surveillance and other information 
from foreign jurisdictions. In evaluating the current proposal, the 
Commission believes that requiring comprehensive surveillance 
agreements to be in place between the CBOE and the primary markets for 
foreign securities that represent 50% or more of the weight of the 
underlying index or portfolio upon which Fund Shares are based, as well 
as the other conditions discussed above, provides an adequate mechanism 
for the exchange of surveillance sharing information necessary to 
detect and deter possible market manipulations. Although the Commission 
recognizes that up to 50% of the portfolio's value may not be covered 
by comprehensive surveillance agreements, the other requirement will 
ensure that a significant percentage of the portfolio is not made up of 
securities from uncovered countries.
    Further, as to the domestically-traded Fund Shares themselves and 
the domestic stocks in an underlying index or portfolio upon which Fund 
Shares are based, the Intermarket Surveillance Group (``ISG'') \25\ 
Agreement will be applicable to the trading of options on Fund Shares.
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    \25\ ISG 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 
members of ISG include all of the registered National Securities 
Exchanges and the National Association of Securities Dealers, Inc. 
(``NASD''). In addition, the major stock index futures exchanges 
(e.g., the Chicago Mercantile Exchange and the Chicago Board of 
Trade) are affiliate members of ISG.
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    Finally, the Commission believes that requiring minimum margin of 
100% of the current market value of the option plus 15% of the market 
value of the underlying security value (``broad-based margin'') for 
options on Fund Shares is appropriate. The Commission notes that this 
margin requirement is comparable to margin requirements that currently 
apply to broad-based index options, and that the CBOE's proposal is 
limited to trading options on Fund Shares comprising or based on a 
broad-based index or portfolio. Accordingly, the Commission believes 
that broad-based margin is appropriate for options on Fund Shares.
    The Commission finds good cause for approving Amendment Nos. 2, and 
3 to the proposed rule change prior to the thirtieth day after the date 
of publication of notice thereof in the Federal Register. Amendment No. 
2 strengthens the proposal by: (1) providing that either the Fund 
Shares underlying the options satisfy the listing standards for options 
on underlying equity securities or the Fund has agreed to issue Fund 
Shares even though some or all of the securities needed to be deposited 
have not been received, thus ensuring a minimum level of liquidity; and 
(2) adopting standardized equity option position and exercise limits. 
Amendment No. 2 also removed certain continued maintenance standards, 
but these requirements were added back to CBOE's rules with Amendment 
No. 3.
    The Commission also believes that Amendment No. 3, concerning 
surveillance requirements, strengthens the CBOE's proposal. Amendment 
No. 3 provides a clear, objective standard for determining the 
comprehensive surveillance requirements for trading options on Fund 
Shares where the underlying index or portfolio contains non-U.S. 
stocks. In addition, Amendment No. 3 strengthens the Exchange's 
proposal by including contained listing standards for options on Fund 
Shares.
    Finally, the Commission notes that no comments were received on the 
original CBOE proposal, which was subject to the full 21-day comment 
period. Accordingly, the Commission believes that there is good cause, 
consistent with Section 6(b)(5) of the Act, to approve Amendment Nos. 2 
and 3 to the proposed rule change on an accelerated basis.
    Amendment No. 4 merely corrects an erroneous cross-reference in 
Interpretation and Policy .08 to Rule 5.4.\26\
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    \26\ Because Amendment No. 4 is technical in nature, it is not 
subject to a notice and comment requirement.
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    Interested persons are invited to submit written data, views and 
arguments concerning Amendment Nos. 2 and 3 to the proposed rule 
change, including whether such Amendments are consistent with the Act. 
Persons making written submissions should file six copies thereof with 
the Secretary, Securities and Exchange Commission, 450 Fifth Street, 
NE., Washington, DC 20549. Copies of the submission, all subsequent 
amendments, all written statements with respect to the proposed rule 
change that are filed with the Commission, and all written 
communications relating to the proposed rule change between the 
Commission and any person, other than those that may be withheld from 
the public in accordance with the provisions of 5 U.S.C. 552, will be 
available for inspection and copying in the Commission's Public 
Reference Section, 450 Fifth Street, NW., Washington, DC. Copies of 
such filing will also be available for inspection and copying at the 
principal office of the CBOE. All submissions should refer to File No. 
SR-CBOE-97-03 and should be submitted by July 31, 1998.
    For the foregoing reasons, the Commission finds that the CBOE's 
proposal to list and trade options on Fund Shares is consistent with 
the requirements of the Act and the rules and regulations thereunder.
    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\27\ that the proposed rule change (File No. SR-CBOE-97-03), as 
amended, is approved.

    \27\ 15 U.S.C. 78s(b)(2).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\28\
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    \28\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 98-18413 Filed 7-9-98; 8:45 am]
BILLING CODE 8010-01-M