

[Federal Register: March 9, 2006 (Volume 71, Number 46)]
[Notices]               
[Page 12226-12228]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr09mr06-108]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-53400; File No. SR-OCC-2006-01]

 
Self-Regulatory Organizations; The Options Clearing Corporation; 
Notice of Filing of Proposed Rule Change To Revise Option Adjustment 
Methodology

March 2, 2006.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ notice is hereby given that on January 12, 2006, The 
Options Clearing Corporation (``OCC'') filed with the Securities and 
Exchange Commission (``Commission'') the proposed rule change as 
described in Items I, II, and III below, which items have been prepared 
by OCC. The Commission is publishing this notice to solicit comments on 
the proposed rule change from interested parties.
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    \1\ 15 U.S.C. 78s(b)(1).
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    OCC is seeking to amend Article VI (Clearance of Exchange 
Transactions), Section 11A of OCC's By-Laws to (1) eliminate the need 
to round strike prices and/or units of trading in the event of certain 
stock dividends, stock distributions, and stock splits and (2) provide 
for the adjustment of outstanding options for special dividends (i.e., 
cash distributions not declared pursuant to a policy or practice of 
paying such distributions on a quarterly or other regular basis). The 
proposed rule change would also add a $12.50 per contract threshold 
amount for cash dividends and distributions to trigger application of 
OCC's adjustment rules.

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, OCC 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. OCC has prepared summaries, set forth in sections (A), 
(B), and (C) below, of the most significant aspects of these 
statements.\2\
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    \2\ The Commission has modified the text of the summaries 
prepared by OCC.
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(A) Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

A. Changes Relating to Adjustments for Certain Stock Dividends, Stock 
Distributions, and Stock Splits
    OCC's By-Laws currently specify two alternative methods of 
adjusting for stock dividends, stock distributions, and stock splits. 
In cases where one or more whole shares are issued with respect to each 
outstanding share, the number of outstanding option contracts is 
correspondingly increased and strike prices are proportionally 
reduced.\3\ In all other cases, the number of shares to be delivered 
under the option contract is increased and the strike price is reduced 
proportionately.\4\
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    \3\ For example, in the event of a 2-for-1 split, an XYZ $60 
option calling for the delivery of 100 shares of XYZ stock would be 
subdivided into two XYZ $30 options, each calling for the delivery 
of 100 shares of XYZ stock.
    \4\ For example, in a 3-for-2 split, an XYZ $60 option calling 
for the delivery of 100 shares would be adjusted to call for the 
delivery of 150 shares and the strike price would be reduced to $40.
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    Although these two methods have been used since the inception of 
options trading, in certain circumstances either method can produce a 
windfall profit for one side and a corresponding loss for the other due 
to rounding of adjusted strike prices. These profits and losses, while 
small on a per-contract basis, can be significant for large positions. 
Because equity option strike prices are currently stated in eighths, 
OCC's By-Laws require adjusted strike prices to be rounded to the 
nearest eighth. For example, if an XYZ $50 option for 100 shares were 
to be adjusted for a 3-for-2 split, the deliverable would be increased 
to 150 shares and the strike price would be adjusted to $33.33, which 
would then be rounded up to $33\3/8\. Prior to the adjustment, a call 
holder would have had to pay $5,000 to exercise ($50 x 100 shares). 
After the adjustment, the caller has to pay $5,006.25 for the 
equivalent stock position ($33.375 x 150 shares). Conversely, an 
exercising put holder would receive $5,006.25 instead of $5,000. The 
$6.25 difference represents a loss for call holders and put writers and 
a windfall for put holders and call writers.
    A loss/windfall can also occur when the split results in a 
fractional deliverable (e.g., when a 4-for-3 split produces a 
deliverable of 133.3333 shares). In those cases, OCC's By-Laws 
currently require that the deliverable be rounded down to eliminate the 
fraction, and if appropriate, the strike price be further adjusted to 
the nearest eighth to compensate for the diminution in the value of the 
contract resulting from the elimination of the fractional share. 
However, even if these steps are taken, small rounding inequities may 
remain.
    The windfall profits and correspondent losses resulting from the 
rounding process have historically been accepted as immaterial. Due to 
recent substantial increases in trading volume and position size, 
however, they have become a source of concern to exchanges and market 
participants. In addition, OCC has been informed that some traders may 
be exploiting announcements of splits and similar events by quickly 
establishing positions designed to capture rounding windfalls at the 
expense of other market participants.
    The inequity that results from the need to round strike prices can 
be eliminated by using a different adjustment method: Namely, adjusting 
the deliverable but not the strike prices or the values used to 
calculate aggregate exercise prices and premiums. As an illustration of 
the proposed adjustment methodology, in the XYZ $50 option 3-for-2 
split example described above, the resulting adjustment would be a 
deliverable of 150 shares of XYZ stock while the strike price would 
remain at $50. In this case, the presplit multiplier of 100, used to 
extend aggregate strike price and premium amounts, is unchanged. For 
example, a premium of 1.50 would equal $150 ($1.5 x 100) both before 
and after the adjustment. An exercising call holder would continue to 
pay $50 times 100 (for a total of $5,000) but would receive 150 shares 
of XYZ stock instead of 100.\5\ This is the method currently used for 
property distributions such as spin-offs and special dividends large 
enough to require adjustments under OCC's By-Laws.
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    \5\ The same adjustment methodology would apply to reverse stock 
splits or combination of shares. For example, in a 3-for-4 reverse 
stock split on a XYZ $50 option calling for the delivery of 100 
shares, the resulting adjustment would be a deliverable of 75 shares 
of XYZ stock while the strike price would remain at $50.
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    The inequity that results from the need to eliminate fractional 
shares from

[[Page 12227]]

the deliverable and to compensate by further reducing the strike price 
to the nearest eighth can be eliminated by adjusting the deliverable to 
include cash in lieu of the fractional share. As an illustration, 
consider a 4-for-3 split of the stock underlying an XYZ $80 option with 
a 100 share deliverable. Employing the proposed adjustment method, the 
deliverable would be adjusted to 133.3333 shares, which would be 
rounded down to 133 shares, and the strike price would remain $80. 
However, instead of compensating for the elimination of the .3333 share 
by reducing the strike prices, the strike prices would be left 
unchanged, and the deliverable would be adjusted to 133 shares plus the 
cash value of the eliminated fractional share (.3333 x the post-split 
value of a share of XYZ stock as determined by OCC). The adjusted 
option would also continue to use 100 as the multiplier to calculate 
aggregate strike and premium amounts.
    The proposed revised adjustment methodology would not generally be 
used for 2-for-1 or 4-for-1 stock distributions or splits (since such 
distributions or splits normally result in strike prices that do not 
require rounding to the nearest eighth). In addition, the revised 
adjustment methodology would not generally be used for stock dividends, 
stock distributions, or stock splits with respect to any series of 
options having exercise prices stated in decimals.\6\ For those 
options, the existing adjustment rules would continue to apply. The 
reason for this is that once the market has converted to decimal 
strikes, the rounding errors created by rounding to the nearest cent 
would be immaterial even given the larger positions taken in today's 
markets and the other factors discussed above. Because conversion to 
decimal strikes might be phased in rather than applied to all series of 
equity options simultaneously, the rule has been drafted to cover both 
methods of expressing exercise prices, applying the appropriate rule to 
each.
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    \6\ Although there are currently no decimal strikes for equity 
options, OCC wants to avoid the need for further amendments to its 
By-Laws and the options disclosure document in the event that such 
strikes are introduced in the future.
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    The proposed changes in adjustment methodology would not be 
implemented until the exchanges have conducted appropriate educational 
efforts and definitive copies of an appropriate supplement to the 
options disclosure document, Characteristics and Risks of Standardized 
Options, were available for distribution.\7\
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    \7\ OCC will notify the Commission and issue an Important Notice 
when the proposed adjustment methodology is implemented.
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B. Changes to the Definition of ``Ordinary Dividends and 
Distributions''
    Article VI, Section 11A(c) of OCC's By-Laws currently provides that 
as a general rule, outstanding options will not be adjusted to 
compensate for ordinary cash dividends. Interpretation and Policy .01 
under Section 11A of Article VI provides that a cash dividend will 
generally be deemed to be ``ordinary'' if the amount does not exceed 
10% of the value of the underlying stock on the declaration date (``10% 
Rule''). The OCC Securities Committee is authorized to decide on a 
case-by-case basis whether to adjust for dividends exceeding that 
amount. As a result, OCC historically has not adjusted for special cash 
dividends unless the amount of the dividend was greater than 10% of the 
stock price at the close of trading on the declaration day.
    The 10% Rule predated a number of significant developments, 
including, the introduction of Long-term Equity AnticiPation Security 
(``LEAPS'') options, the sizeable open interest seen today, the large 
contract volume associated with trading and spreading strategies, and 
modern option pricing models that take dividends into account. When 
open interest and individual positions were smaller, not adjusting for 
dividends of less than 10% did not have the pronounced impact it does 
today. Additionally, changes to the tax code which now tax dividends 
more favorably have provided an incentive for companies to pay more 
dividends, including special dividends. In light of these 
considerations, it is appropriate that the 10% Rule now be revised.
    Under the revision proposed by OCC, a cash dividend or distribution 
would be considered ordinary (regardless of size) if the OCC Securities 
Committee determines that such dividend or distribution was declared 
pursuant to a policy or practice of paying such dividends or 
distributions on a quarterly or other regular basis. In addition, as a 
general rule, a cash dividend or distribution that is less than $12.50 
per contract would not trigger the adjustment provisions of Article VI, 
Section 11A.
1. No Adjustment for Regularly-Scheduled Dividends Needed
    Dividends declared by an issuer pursuant to a policy or practice of 
such issuer are known and can thus be priced into option premiums. By 
definition, however, special dividends cannot be anticipated in advance 
and therefore cannot be integrated into option pricing models. If 
adjustments are not made in response to special dividends (i.e., by 
calling for the delivery of the dividend) call holders can capture the 
dividends only by exercising their options. Often in these cases, 
especially with LEAPS options or FLEX options which can exist for 5 to 
10 years, early exercise would sacrifice substantial option time value. 
This economic disadvantage would be further magnified if the option 
position is large, as is often the case today. Conversely, put holders 
often receive a windfall benefit from the increase in the in-the-money 
value on the ex date. To the extent that equity options can be priced 
accurately and consistently without dislocations due to unforeseen 
special dividends, these economic disadvantages can be avoided. 
Moreover, because special dividends are one-off events, adjusting for 
them would not cause the proliferation of outstanding series that would 
result from adjusting for regular dividends as explained below.
2. De Minimis Threshold
    Adjusting for dividends can cause a proliferation of outstanding 
option symbols and series.\8\ In the interest of providing some limit 
on option symbol proliferation, the proposed rule change includes a de 
minimis threshold of $12.50 per contract. Special dividends smaller 
than these amounts would not trigger an adjustment.
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    \8\ Symbols proliferate when adjustments are made because often 
the dividend amount must be added to the deliverable yielding a non-
standard option. The exchanges then introduce standard options with 
the same strikes.
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    OCC believes that a threshold that is a set dollar amount is 
preferable to one that is a percentage of the stock price (like OCC's 
existing 10% Rule) because there are operational problems with applying 
a percentage threshold. Under the existing 10% Rule, in order to 
determine whether this threshold is met, the per share dividend amount 
is applied to the closing price of the underlying security on the 
dividend declaration date. The date the dividend is announced (by press 
release or by some other means) is not normally the ``declaration 
date'' when the dividend is officially declared by an issuer's board of 
directors. Until the actual declaration date, investors and traders may 
not know whether or not an announced dividend will trigger an 
adjustment based on the company's share price. In the interim, it is 
difficult for traders and investors to price their options because

[[Page 12228]]

they do not know if an adjustment will be made.
    The advantage of a fixed dollar threshold is avoiding uncertainty. 
The per contract value of the dividend can be immediately determined 
without the need to wait until the declaration date and without the 
need to do a calculation based on the closing price of the underlying 
shares.
3. Consistency Across Relevant Interpretations
    Interpretations and Policies .01 and .08 under Article VI, Section 
11A apply to cash distributions. Interpretation and Policy .01 (as 
proposed to be amended) would apply in general to all cash 
distributions. Interpretation and Policy .08 currently carves out 
exceptions for fund share cash distributions and does not include a 
threshold minimum. In the interest of clarity and consistency with 
Interpretation and Policy .01, Interpretation .08 would be revised to 
provide for the same $12.50 per contract threshold. Clause (ii) of 
Interpretation and Policy .08 would be deleted because it is an 
exception to the 10% Rule and would no longer be needed when the 10% 
Rule is abolished.
    OCC believes that the proposed rule change is consistent with the 
requirements of Section 17A of the Act \9\ and the rules and 
regulations thereunder applicable to OCC because (1) it is intended to 
eliminate inequities that result from certain rounding practices 
currently required by OCC's By-Laws and thus protect investors and (2) 
it is intended to make more predictable when cash distributions by an 
issuer will result in an adjustment to an option contract and thus make 
the process for adjustments more equitable for all investors.
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    \9\ 15 U.S.C. 78q-1.
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(B) Self-Regulatory Organization's Statement on Burden on Competition

    OCC does not believe that the proposed rule change would impose any 
burden on competition.

(C) Self-Regulatory Organization's Statement on Comments on the 
Proposed Rule Change Received From Members, Participants or Others

    Written comments were not and are not intended to be solicited with 
respect to the proposed rule change, and none have been received.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within thirty-five 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 ninety 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 self-regulatory organization consents, 
the Commission will:
    (A) By order approve such proposed rule change; 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, as amended, 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 rule-comments@sec.gov. Please include 

File Number SR-OCC-2006-01 on the subject line.

Paper Comments

     Send paper comments in triplicate to Nancy M. Morris, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-1090.

All submissions should refer to File Number SR-OCC-2006-01. 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 
provisions of 5 U.S.C. 552, will be available for inspection and 
copying in the Commission's Public Reference Section, 100 F Street, NE, 
Washington, DC 20549. Copies of such filing also will be available for 
inspection and copying at the principal office of OCC and on OCC's Web 
site at http://www.theocc.com. 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-OCC-2006-01 and should be submitted on or before March 
24, 2006.
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    \10\ 17 CFR 200.30-3(a)(12).

    For the Commission by the Division of Market Regulation, 
pursuant to delegated authority.\10\
Nancy M. Morris,
Secretary.
[FR Doc. E6-3326 Filed 3-8-06; 8:45 am]

BILLING CODE 8010-01-P
