[Federal Register Volume 60, Number 61 (Thursday, March 30, 1995)]
[Notices]
[Pages 16518-16521]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-7841]



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SECURITIES AND EXCHANGE COMMISSION
[Release No 34-35532; File No. SR-CBOE-94-43]


Self-Regulatory Organizations; Chicago Board Options Exchange, 
Inc.; Order Approving a Proposed Rule Change and Notice of Filing and 
Order Granting Accelerated Approval of Amendment No. 2 to a Proposed 
Rule Change Relating to the Listing of Regular and Long-Term Index 
Options on the S&P SmallCap 600 Index

March 24, 1995.

I. Introduction

    On November 8, 1994, the Chicago Board Options Exchange, Inc. 
(``CBOE'' or ``Exchange'') filed with the Securities and Exchange 
Commision (``Commission'' or ``SEC''), pursuant to Section 19(b)(1) of 
the Securities Exchange Act of 1934 (``Act'')\1\ and Rule 19b-4 
thereunder,\2\ a proposal to list and trade on the Exchange cash-
settled, European-style index options on the Standard & Poor's SmallCap 
600 Index (``S&P SmallCap 600'' or ``Index''), a broad-based 
capitalization weighted index designed to measure the performance of 
small capitalization stocks. The CBOE filed Amendment No. 1 to its 
proposal on January 9, 1995, and Amendment No. 2 to its proposal on 
March 14, 1995.\3\ The proposed rule change was published for comment 
and appeared in the Federal Register on February 1, 1995.\4\ No 
comments were received regarding the CBOE's proposal.

    \1\15 U.S.C. 78s(b)(1) (1988).
    \2\17 CFR 240.19b-4 (1994).
    \3\Amendment No. 1 Provides the following information regarding 
the Index: (1) Industry groups represented; (2) price and volume 
information regarding the component stocks; and (3) component stock 
seleciton criteria. See letter from Eileen Smith, Director, Product 
Development, Research Department, CBOE, to Steve Youhn, Attorney, 
Division of Market Regulation (``Division''), Commission, dated 
January 5, 1995 (``Amendment No. 1'').
    Amendment No. 2 provides that the CBOE will monitor the Index 
semi-annually, and will notify staff of the Commission in the event 
that certain index component capitalization and volume levels fall 
below designated thresholds. See letter from Joseph Levin, Vice-
President, Research & Product Development, CBOE, to Michael 
Walinskas, Branch Chief, Division, Commission, dated March 14, 1995 
(``Amendment No. 2'').
    \4\See Securities Exchange Act Release No. 35280 (January 25, 
1995), 60 FR 6325.
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II. Description of the Proposal

A. General

    The CBOE proposes to list and trade cash-settled, European-style 
stock index options on the S&P SmallCap, a capitalization-weighted 
index of 600 domestic stocks chosen for market size, liquidity, and 
industry group representation.

B. Composition of the Index

    The S&P SmallCap 600 Index has been designed to measure the 
performance of small capitalization stocks. The Index is a 
capailization-weighted index of U.S. stocks with each stock affecting 
the Index in proportion to its market capitalization.
    As of October 19, 1994, the 600 component stocks ranged in 
capitalization from $933 million to $46 million, and the market 
capitalization of the Index totalled $181 billion. The largest stock 
accounted for 0.51% of the total weighting of the Index, while the 
smallest accounted for 0.03%. The median capitalization of the 
components in the Index was $267 million. A breakdown of the component 
stocks by trading markets shows that Nasdaq is the primary market for 
53% of the weight of the Index (318 issues), the New York Stock 
Exchange (``NYSE'') represents 43% (257 issues), and the American Stock 
Exchange (``Amex'') represents 4% (25 issues). The Nasdaq stocks in the 
Index are authorized as Nasdaq National Market Securites, the top tier 
of Nasdaq stocks.
    A total of 98 industry groups are represented in the Index. The top 
five groups and their weights are: (1) Computer Software and Services--
9.01%; (2) Insurance--5.13%; (3) Savings and Loans--4.88%; (4) Health 
Care Services--4.31%; and (5) Banks--Regional--4.26%. During the period 
April through September 1994, the average monthly trading volume for 
the Index component stocks ranged from 93,000 to 25.3 million shares. 
The average monthly volume was 1.9 million shares. The top 100 stocks 
account for 33.42% of the Index, while the bottom 100 stocks account 
for 5.69% of the Index. The prices for each of the components ranged 
from $1.385 to $64.50. The average price was $19.37. The shares 
outstanding for each of the Index component stocks ranged from 4.0 
million to 189.0 million with an average of 17.8 million.\5\

    \5\See Amendment No. 1, supra note 3.
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    S&P relies on several criteria to select Index component stocks. 
Among other things, stocks must trade on the NYSE or Amex, or be Nasdaq 
National Market securities; stocks must trade above $1.00 at the time 
of selection; companies with 50% or more of their shares outstanding 
held by another corporation are not included; companies with 60% or 
more of their shares held by insiders are not included; stocks must 
have at least a six month trading history; stocks that do not trade on 
any three days during a 12-month period are not included; and share 
turnover (annual trading volume as a percent of shares outstanding) has 
to exceed 20% on an annualized basis. Index component stocks are then 
chosen from the field of stocks that meets these criteria so that they 
balance the economic sector weighings, described above.\6\

    \6\Id. The CBOE has represented that should the character of the 
Index change from the basic description contained herein, it shall 
so notify the Commission staff, and such change could require a 
filing pursuant to Section 19(b)(1) of the Exchange Act and Rule 
19b-4 thereunder. Telephone conversation between Eileen Smith, 
Director, Product Development, Research Department, CBOE, and 
Francois Mazur, Attorney, Division, Commission, on March 1, 1995.
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C. Calculation of the Index

    The methodology used to calculate the value of the Index is similar 
to that used to calculate the value of the S&P 500 Index. The value of 
the Index is determined by adding the price of each stock multiplied by 
the number of shares outstanding. This sum is then divided by an index 
divisor (``Index Divisor'') which gives the Index a value of 100 on its 
base date of December 31, 1993. The Index Divisor is adjusted for 
pertinent changes as described below in the section titled 
``Maintenance.'' The Index had a closing value of 96.82 on September 
30, 1994.

D. Maintenance

    The S&P SmallCap 600 will be maintained by S&P, and the CBOE has 
represented that it will not influence any S&P decisions concerning 
maintenance of the Index.\7\ To maintain [[Page 16519]] continuity of 
the Index, the Index Divisor will be adjust to reflect certain events 
relating to the component stocks. These events include, but are not 
limited to, adjustments for company additions and deletions, share 
changes, stock splits, stock dividends, and stock price adjustments due 
to company restructurings or spinoffs. Some corporate actions, such as 
stock splits and stock dividends, require simple changes in the common 
shares outstanding and the stock prices of the companies in the Index. 
Other corporate actions, such as share issuances, change the market 
value of the Index and require an Index Divisor adjustment as well.

    \7\See March 1, 1995 telephone conversation, supra note 6.
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    Although the CBOE is not involved in the maintenance of the Index, 
it has represented that it will monitor the Index on a semi-annual 
basis and will notify staff of the Commission when: (1) 10% of the 
capitalization of the Index comprises securities with a market 
capitalization of less than $100 million; or (2) when 10% of the 
capitalization of the Index is made up of components with an average 
daily trading volume of less than 10,000 shares over the previous six 
months.\8\

    \8\See Amendment No. 2, supra note 3.
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E. Index Option Trading

    In addition to regular Index options, the Exchange may provide for 
the listing of long-term (up to three years expiration) index options 
series (``LEAPS'') and reduced-value LEAPS on the Index. For reduced-
value LEAPS, the underlying value would be computed at one-tenth of the 
Index level. The current and closing index value of any such reduced-
value LEAP will, after such initial computation, be rounded to the 
nearest one-hundredth.
    The Exchange seeks to have the discretion to list series in 2\1/2\ 
point intervals when the Index level is below 200. The minimum tick 
size for series trading below $3 will be \1/16\th and for series 
trading above $3 the minimum tick will be \1/8\th. The trading hours 
for options on the Index will be from 8:30 a.m. to 3:15 p.m. Chicago 
time.

F. Settlement of Index Options

    The proposed options on the Index will expire on the Saturday 
following the third Friday of the expiration month. Trading in the 
expiring contract month will normally cease at 3:15 p.m. (Chicago time) 
on the immediately preceding Thursday. The exercise settlement value of 
the Index at option expiration will be calculations by S&P based on the 
opening prices of the component securities on the business day prior to 
expiration, which will normally be a Friday (``A.M. Settlement'').\9\ 
If a stock fails to open for trading, the last available price on the 
stock will be used in the calculation of the Index, as is done for 
currently listed indexes.

    \9\When the last trading day is moved because of Exchange 
holidays (such as when CBOE is closed on the Friday before 
expiration), the last trading day for expiring options will be 
Wednesday and the exercise settlement value of Index options at 
expiration will be determined at the opening of regular Thursday 
trading.
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G. Surveillance

    The Exchange will use the same surveillance procedures currently 
used for each of the Exchange's other index options to monitor trading 
in Index options and Index LEAPS on the S&P SmallCap 600. These 
procedures include complete access to trading activity in the 
underlying securities. In addition, the Intermarket Surveillance Group 
Agreement (``ISG Agreement''), dated July 14, 1983, as amended January 
29, 1990, will be applicable to the trading of options on the 
Index.\10\

    \10\The CBOE is a member of the 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.; the NYSE; the Pacific Stock Exchange, Inc.; and the 
Philadelphia Stock Exchange, Inc. Because of the potential 
opportunities for trading abuses involving stock index futures, 
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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H. Position Limits

    The Exchange proposes to establish position limits for options on 
the S&P SmallCap 600 at 100,000 contracts on either side of the market, 
and no more than 60,000 of such contracts may be in the series in the 
nearest expiration month. Exercise limits will be set at the same level 
as position limits.\11\ The Exchange represents that these limits are 
roughly equivalent, in dollar terms, to the limits applicable to 
comparable small-capitalization indexes, including the Wilshire Small 
Cap Index and the Russell 2000 Index.

    \11\See CBOE Rule 24.5.
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III. Discussion

    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\ The 
Commission finds that the trading of options on the Index will permit 
investors to participate in the price movements of the 600 securities 
on which the Index is based. The Commission also believes that the 
trading of options on the Index will allow investors holding positions 
in some or all of the securities underlying the Index to hedge the 
risks associated with their portfolios. Accordingly, the Commission 
believes S&P SmallCap 600 options will provide investors with an 
important trading and hedging mechanism that should reflect accurately 
the overall movement of stocks in the small-capitalization range of 
U.S. equity securities. By broadening the hedging and investment 
opportunities of investors, the Commission believes that the trading of 
S&P SmallCap 600 options will serve to protect investors, promote the 
public interest, and contribute to the maintenance of fair and orderly 
markets.\13\

    \12\15 U.S.C. 78f(b)(5) (1988).
    \13\Pursuant to Section 6(b)(5) of the Act, the Commission must 
predicate approval of any new option or warrant proposal upon a 
finding that the introduction of such new derivative instrument is 
in the public interest. Such a finding would be difficult for a 
derivative instrument 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. In this regard, the 
trading of listed options or warrants on the S&P SmallCap 600 Index 
will provide investors with a hedging vehicle that should reflect 
the overall movement of the small-capitalization stock universe. The 
Commission also believes that these options and warrants will 
provide investors with a means by which to make investment decisions 
in the small-capitalization equity market, allowing them to 
establish positions or increase existing positions in small-
capitalized stocks in a cost effective manner.
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    The trading of S&P SmallCap 600 options, however, raises several 
issues, including issues related to index design, customer protection, 
surveillance, and market impact. For the reasons discussed below, the 
Commission believes that the CBOE has adequately addressed these 
issues.

A. Index Design and Structure

    The Commission finds that it is appropriate and consistent with the 
Act to classify the Index as broad-based, and therefore to permit 
Exchange rules applicable to the trading of broad-based index options 
to apply to the Index options. Specifically, the Commission believes 
the Index is broad-based [[Page 16520]] because it reflects a 
substantial segment of the U.S. equities market, in general, and small-
capitalization securities in particular. First, the Index consists of 
600 relatively actively traded,\14\ small-capitalization domestic 
securities. Second, the total capitalization of the Index, as of 
October 19, 1994, was $181 billion, with the market capitalizations of 
the individual stocks in the Index ranging from a high of $933 million 
to a low of $46 million, with a median value of $267 million. Third, 
the Index includes stocks of companies from a broad range of 
industries, and no industry segment comprises more than 9.01% of the 
Index's total value.\15\ Fourth, as of October 19, 1994, no single 
stock comprises more than 0.51% of the Index's total value, and the 
percentage weighting of the 100 largest issues in the Index accounted 
for only 33.42% of the Index. Fifth, the Index selection and 
maintenance criteria will serve to ensure that the Index maintains its 
broad representative sample of stocks in the small-capitalization range 
of U.S. equity securities. Accordingly, the Commission believes it is 
appropriate to classify the Index as broad-based.

    \14\A significant majority of the stocks are relatively actively 
traded, as indicated by an Index component median average daily 
trading volume of 53,179 shares. Telephone conversation between 
Eileen Smith, Director, Product Development, Research Department, 
CBOE, and Francois Mazur, Attorney, Division, Commission, on 
February 23, 1995.
    The Commission notes that an index purportedly representing high 
capitalization stocks might not be deemed to have actively traded 
stocks if the components stocks' median average daily volume was 
only 53,179 shares. With regard to a small capitalization index, 
where almost by their nature the most active stocks will likely not 
be included, a median average daily trading volume less than that 
for existing broad based indexes could be acceptable, depending upon 
the index's other features. For the S&P SmallCap 600, the median 
average daily trading volume is acceptable given the large number of 
component stocks and the inclusion of criteria designed to exclude 
inactively traded stocks from being selected.
    \15\See Section II.B, supra.
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    The Commission believes that the general broad diversification, 
capitalizations, and relatively liquid markets of the Index's component 
stocks significantly minimize the potential for manipulation of the 
Index. First, as discussed above, the Index represents a broad cross-
section of domestic small capitalization stocks, with no single 
industry group or stock dominating the Index. Second, the majority of 
the stocks that comprise the Index are relatively actively traded.\16\ 
Third, the Commission believes that the Index selection and maintenance 
criteria will serve to ensure that the Index will not be dominated by 
low-priced stocks with small capitalizations, floats, and trading 
volumes.\17\ Fourth, the CBOE has represented that it will monitor the 
Index semi-annually and will notify the staff of the Commission when: 
(1) ten percent of the capitalization of the Index is comprised of 
securities with a market capitalization of less than $100 million; or 
(2) ten percent of the capitalization of the Index is made up of 
components with an average daily trading volume of less than 10,000 
shares over the previous six months.\18\ Fifth, the Exchange has 
proposed reasonable position and exercise limits for the Index options 
that will serve to minimize potential manipulation and other market 
impact concerns. Although a position and exercise limit of 100,000 
contracts is high by traditional standards, in dollar value it 
represents $968,200,000 (based on the September 30, 1994 Index closing 
value of 96.82), an amount equivalent to that allowed for other small-
capitalization index options currently trading.\19\ Accordingly, the 
Commission believes it is unlikely that attempted manipulations of the 
prices of the Index components would affect significantly the Index's 
value.

    \16\See supra note 14.
    \17\Currently, 65% of the Index is accounted for by stocks 
meetings the CBOE's options listing standards. Telephone 
conversation between Eileen Smith, Director, Product Development, 
Research Department, CBOE, and Francois Mazur, Attorney, Division, 
Commission, on February 28, 1995. These standards, which are uniform 
among the options exchanges, provide that a security underlying an 
option must, among other things, meet the following requirements: 
(1) the public float must be at least 7,000,000; (2) there must be a 
minimum of 2,000 stockholders; (3) trading volume must have been at 
least 2.4 million over the preceding twelve months; and (4) the 
market price must have been at least $7.50 for a majority of the 
business days during the preceding three calendar months. See CBOE 
Rule 5.3, Interpretation .01.
    As a general matter, for broad-based index options, the 
Commission prefers that at least 50% of an index's components 
continue to be options-eligible. Given the broad diversity of the 
SmallCap 600 Index and the selection and maintenance criteria, 
together with the fact that 65% of the Index's components are 
options eligible, the Commission believes that the Index will not be 
readily susceptible to manipulation. See supra Section II.B.
    \18\See Amendment No. 2, Supra note 3.
    \19\The Commission would not be inclined to approve such a high 
position limit if the position limit dollar equivalent amount were 
substantially higher than as currently proposed.
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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 Index options, 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; (2) 
only investors capable of evaluating and bearing the risk of options 
trading are engaged in such trading; and (3) special compliance 
procedures are applicable to options accounts. Accordingly, because the 
Index options will be subject to the same regulatory regime as the 
other standardized options traded on the CBOE, the Commission believes 
that adequate safeguards are in place to ensure the protection of 
investors in Index options.

C. Surveillance

    The Commission generally believes that a surveillance sharing 
agreement between an exchange proposing to list a stock index 
derivative product and the exchange(s) trading the stocks underlying 
the derivative product is an important measure for surveillance of the 
derivative and underlying securities markets. Such agreements ensure 
the availability of information necessary to detect and deter potential 
manipulations and other trading abuses, thereby making the stock index 
product less readily susceptible to manipulation.\20\ In this regard, 
the NYSE, Amex, and the NASD are all members of ISG.\21\ In addition, 
the CBOE will apply the same surveillance procedures as those used for 
existing broad based index options trading on the CBOE.

    \20\See Securities Exchange Act Release No. 31243 (October 5, 
1992), 57 FR 45849.
    \21\See supra note 10.
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D. Market Impact

    The Commission believes that the listing and trading of S&P 
SmallCap 600 Index Options on the CBOE will not adversely affect the 
underlying securities markets.\22\ First, as described above, the Index 
is broad-based and comprised of 600 stocks with no one stock or 
industry group dominating the Index. Second, as noted above, the stocks 
contained in the Index have relatively large capitalizations and are 
relatively actively traded. Third, existing CBOE stock index options 
rules and surveillance procedures will apply to S&P SmallCap 600 
options. Fourth, [[Page 16521]] the position limits of 100,000 
contracts on either side of the market, with no more than 60,000 of 
such contracts in a series in the nearest month expiration month, will 
serve to minimize potential manipulation and market impact concerns. 
Fifth, the risk to investors of contra-party non-performance will be 
minimized because the Index options will be issued and guaranteed by 
the Options Clearing Corportation just like any other standardized 
option traded in the United States.

    \22\The CBOE has stated that it has the necessary systems 
capacity to support new series that would result from the 
introduction of the S&P SmallCap 600 options. In addition, the 
Options Price Reporting Authority (``OPRA'') has represented that 
additional traffic generated by options and LEAPs on the S&P 
SmallCap 600 Index is within OPRA's capacity. See letter from Joseph 
P. Corrigan, Executive Director, OPRA, to Eileen Smith, Director, 
Product Development, Research Department, CBOE, dated October 26, 
1994.
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    Lastly, the Commission believes that settling expiring S&P SmallCap 
600 options (including full-value and reduced-value Index LEAPS) based 
on the opening prices of component securities is reasonable and 
consistent with the Act. As noted in other contexts, valuing expiring 
index options for exercise settlement purposes based on opening prices 
rather than closing prices may help reduce adverse effects on the 
securities underlying options on the Index.\23\

    \23\Securities Exchange Act Release No. 30944 (July 28, 1992), 
57 FR 33376.
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    The Commission finds good cause for approving Amendment No. 2 prior 
to the thirtieth day after the date of publication of notice of filing 
thereof in the Federal Register. Specifically, Amendment No. 2 provides 
that the CBOE will monitor, semi-annually, the Index and will notify 
staff of the Commission in the event that certain index component 
capitalization and volume levels fall below designated thresholds. The 
Commission believes that this monitoring provision is not a material 
change that raises regulatory concerns not already addressed by the 
proposal. Accordingly, the Commission believes it is consistent with 
Sections 6(b)(5) and 19(b)(2) of the Act to approve Amendment No. 2 to 
the proposal on an accelerated basis.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment No. 2. Persons, making written 
submissions should file six copies thereof with the Secretary, 
Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, 
D.C. 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 the 
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. Sec. 552, will be available for inspection and 
copying in the Commission's Public Reference Section, 450 Fifth Street, 
N.W., Washington, D.C. 20549. 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-94-43 and should 
be submitted by April 20, 1995.

V. Conclusion

    For the reasons discussed above, the Commission finds that the 
proposal is consistent with the Act, and, in particular, Section 6 of 
the Act.
    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\24\ that the proposed rule change (File No SR-CBOE-94-43), as 
amended, is approved.

    \24\15 U.S.C. 78s(b)(2) (1988).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\25\

    \25\17 CFR 200.30-3(a)(12) (1994).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 95-7841 Filed 3-29-95; 8:45 am]
BILLING CODE 8010-01-M