

[Federal Register: June 13, 2006 (Volume 71, Number 113)]
[Notices]               
[Page 34174-34178]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr13jn06-108]                         

-----------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-53935; File No. SR-CBOE-2003-41]

 
Self-Regulatory Organizations; Chicago Board Options Exchange, 
Inc.; Notice of Filing of Proposed Rule Change and Amendment Nos. 1, 2, 
and 3 Thereto To List and Trade Options on Corporate Debt Securities

June 2, 2006.
    Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'') \1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on September 22, 2003, the Chicago Board Options Exchange, Inc. 
(``CBOE'' or ``Exchange'') filed with the Securities and Exchange 
Commission (``SEC'' or ``Commission'') the proposed rule change as 
described in Items I, II, and III below, which Items have been prepared 
by CBOE. On March 1, 2003, CBOE filed Amendment No. 1 to the proposed 
rule change.\3\ CBOE filed Amendment No. 2 to the proposed rule change 
on August 24, 2005.\4\ CBOE filed Amendment No. 3 to the proposed rule 
change on May 26, 2006.\5\ The Commission is publishing this notice to 
solicit comments on the proposed rule change, as amended, from 
interested persons.
---------------------------------------------------------------------------

    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ In Amendment No. 1, CBOE replaced and superseded the 
original Exhibit A, which contained its rule text, in its entirety. 
In addition, CBOE provided explanatory commentary in response to 
questions raised by Commission staff regarding the proposal 
including, but not limited to, listing and maintenance standards, 
strike price intervals, and margins.
    \4\ Amendment No. 2 replaced and superseded the Exchange's 
original Form 19b-4 in its entirety.
    \5\ Amendment No. 3 replaced and superseded the Exchange's 
original Form 19b-4 in its entirety.
---------------------------------------------------------------------------

I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    CBOE proposes to introduce for trading a new type of option, called 
``Corporate Debt Security Options'' (``CDSOs''), which would be options 
based on corporate bonds. The text of the proposed rule change is 
available on CBOE's Web site (http://www.cboe.com), at the principal 

office of CBOE, and at the Commission's Public Reference Room.

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

    In its filing with the Commission, CBOE included statements 
concerning the purpose of, and basis for, the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. CBOE has prepared summaries, set forth in Sections A, B, 
and C below, of the most significant aspects of such statements.

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

1. Purpose
    Over-the-counter (``OTC'') transactions in corporate debt 
securities (e.g., bonds and notes) recently have been become subject to 
enhanced transparency and now are reported publicly through the NASD's 
Trade Reporting and Compliance Engine (``TRACE'') system. This enhanced 
transparency and price reporting has given rise to an OTC market in 
options on corporate debt securities over the past few years. CBOE 
believes that an exchange-traded alternative may provide a useful risk 
management and trading vehicle for member firms and their customers.
    The Exchange understands that products similar to CDSOs that are 
proposed in this rule filing are currently traded in the OTC market by 
hedge funds, proprietary trading firms, and a few very large fixed 
income funds. These market participants have indicated that there could 
be room for significant growth in OTC trading of options on corporate 
debt securities as transparency further improves in the market for the 
underlying corporate debt securities and if a listed option product 
were introduced. CBOE expects that users of these OTC products would be 
among the primary users of exchange-traded CDSOs. CBOE states that its

[[Page 34175]]

member firms have also indicated to the Exchange that the listing and 
trading of CDSOs would allow their customers to better manage the risk 
associated with the volatility of underlying bond positions. 
Additionally, CBOE notes that persons writing CDSOs would have the 
corresponding ability to earn option premium income and carefully 
tailor their own risk exposure. Further, CBOE's members have indicated 
that these customers desire the enhanced liquidity that an exchange-
traded product would bring. CBOE believes that CDSOs listed on the 
Exchange would have three important advantages over the contracts that 
are traded in the OTC market. First, as a result of greater 
standardization of contract terms, exchange-listed contracts should 
develop more liquidity. Second, counter-party credit risk would be 
mitigated by the fact that the contracts are issued and guaranteed by 
The Options Clearing Corporation (``OCC''). Finally, the price 
discovery and dissemination provided by CBOE and its members would lead 
to more transparent markets. CBOE believes that the Exchange's ability 
to offer CDSOs would aid it in competing with the OTC market and at the 
same time expand the universe of listed products available to 
interested market participants.
    Accordingly, the Exchange proposes to list and trade CDSOs that are 
designed to offer investors exposure to actively traded OTC corporate 
bonds that have initial amounts outstanding over $250 million. The face 
value of a corporate debt security underlying a CDSO would be $100,000. 
Proposed CBOE Rule 28.7 would provide that there would be up to five 
expiration months, none further out than 15 months, but the Exchange 
could list additional expiration months further out than 15 months 
where a reasonable active secondary market exists.
    Series with strike prices in, at, and out-of-the-money initially 
would be listed (up to ten per month initially). The Exchange 
represents that it would delist CDSO series for which there is no open 
interest. In addition, the Exchange proposes to limit the strike price 
intervals that it could list for CDSO series, which, as proposed, would 
be fixed at a percentage of principal amounts (based on a par quote 
basis of $100) as follows:
     0.5% ($0.50) or greater, provided that the series to be 
listed is no more than 5% above or below the current market price of a 
corporate debt security either reported on TRACE during TRACE system 
hours or effected through on or through the facilities of a national 
securities exchange, as applicable, on the day prior to the day the 
series is first listed for trading;
     1.0% ($1.00) or greater, provided that the series to be 
listed is no more than 10% above or below the current market price of a 
corporate debt security either reported on TRACE during TRACE system 
hours or effected on or through the facilities of a national securities 
exchange, as applicable, on the day prior to the day the series is 
first listed for trading; and
     2.5% ($2.50) or greater, provided that the series to be 
listed is greater than 10% above or below the current market price of a 
corporate debt security either reported on TRACE during TRACE system 
hours or effected on or through facilities of a national securities 
exchange, as applicable, on the day prior to the day the series is 
first listed for trading.
    The increments proposed herein are designed to allow the Exchange 
flexibility to list strike increments at appropriate levels, while at 
the same time would establish reasonable limits on the number of 
strikes that may be listed in order to diminish any potential effect on 
the Exchange's quote capacity thresholds. The Exchange affirms that, as 
structured, it has sufficient systems capacity to support the listing 
of CDSOs in the strike price increments proposed herein.
    According to the Exchange, the option premium would be quoted in 
points where each point equals $1,000. The minimum tick would be 0.05 
($50.00). The expiration date would be the Saturday immediately 
following the third Friday of the expiration month. CDSOs would be 
European-style options and could be exercised only on the last day of 
expiration. Trading in CDSOs ordinarily would cease on the business day 
(usually a Friday) preceding the expiration date. Trading hours would 
be 8:30 a.m. to 3:02 p.m. Chicago time.
    Prices of CDSOs generally would be based on the prices of corporate 
debt securities that are reported through TRACE by members of NASD. The 
TRACE rules require NASD members dealing in corporate debt securities 
to report transactions in eligible debt securities to TRACE within 15 
minutes of execution. NASD currently notifies subscribers regarding 
general TRACE reporting system outages via the following electronic 
communications: (i) http://apps.nasd.com/Regulatory_Systems/ trace--sub.asp; and (ii) http://www.nasdaqtrader.com/dynamic/newsindex/ 
dynamic/newsindex/ 
vendoralerts--2005.stm.
    The settlement process for CDSOs would be the same as the 
settlement process for equity options under CBOE rules, except as 
necessary to take into account that the securities underlying CDSOs are 
debt securities.\6\ CDSOs would be physically settled and exercise 
notices that are properly tendered would result in delivery of the 
underlying corporate debt securities on the third business day 
following exercise. Payment of a CDSO's exercise price would be 
accompanied by payment of accrued interest on the underlying corporate 
debt security from, but not including, the last interest payment date 
to, and including, the exercise settlement date, as specified in OCC 
rules.
---------------------------------------------------------------------------

    \6\ If the outstanding debt issuance amount of an underlying 
corporate debt security is insufficient to satisfy the delivery 
requirements under CBOE Rule 11.3, OCC rules provide for special 
settlement exercise procedures.
---------------------------------------------------------------------------

    CBOE states that issuers generally calculate the accrued interest 
in one of two methods, each of which is detailed in Appendix A to the 
contract specifications set forth in Exhibit B. The Exchange would 
notify OCC of the accrued interest calculation methodology that applies 
to each corporate debt security prior to the listing thereof. CBOE has 
proposed to establish tiered position limits based upon a policy to cap 
position limits at 10% of the total float of the underlying bond. The 
``total float'' of the underlying corporate debt security would exclude 
amounts held by 10% holders of the corporate debt security. In other 
words, if a person holds more than 10% of a particular corporate debt 
security, the amount held by such person would not be included in the 
``total float'' for purposes of determining the applicable position and 
exercise limits. For example, if a person holds 14% of the total 
outstanding issuance of a corporate debt security, the applicable 
position and exercise limits would only be based on the remaining 86% 
of the issuance that is not held by such person. The Exchange believes 
that the 10% threshold amount is a reasonable measure of those market 
participants, such as pension funds, that have purchased a corporate 
debt security for long-term investment versus those that have purchased 
a corporate debt security with a willingness to sell such security in 
the short-term period and thus increase the amount of liquidity in the 
particular issue. CBOE also believes this 10% level is sufficient to 
inhibit market manipulation or to mitigate other possible disruptions 
in the market. CBOE's proposed lowest position limit for equity options 
is 13,500 contracts, which, if exercised, would represent approximately 
19.28% of the minimum

[[Page 34176]]

float of an equity security eligible to underlie a CBOE equity option 
(seven million shares).\7\ Moreover, CBOE's proposed 13,500 equity 
option contract limit applies to those options having an underlying 
security that does not meet the requirements for a higher option 
contract limit. CBOE believes the proposed 10% position limit for 
CDSOs, which is significantly less than that for equity options, is 
sufficiently high to account for the differences in liquidity between 
the equity and debt markets. Therefore, CBOE proposes the following 
tiers:
---------------------------------------------------------------------------

    \7\ See CBOE Rule 4.11 (Position Limits).

------------------------------------------------------------------------
              Issue float                         Position limit
------------------------------------------------------------------------
$200,000,000-$499,999,000..............  200 contracts.
500,000,000-749,999,000................  500 contracts.
750,000,000-999,999,000................  750 contracts.
1,000,000,000-2,499,999,000............  1,000 contracts.
2,500,000,000 and greater..............  2,500 contracts.
------------------------------------------------------------------------

    The Exchange is proposing comprehensive initial listing and ongoing 
maintenance requirements for CDSOs, which are set forth in proposed 
CBOE Rules 5.3.10 and 5.4.14. In addition to standards such as the 
required amount of underlying security holders and outstanding float 
amounts, the Exchange is also proposing as a criterion for listing a 
particular corporate debt security for options trading that the issuer 
of the corporate debt security or the issuer's parent, if the issuer is 
a wholly-owned subsidiary, has at least one class of common or 
preferred equity securities registered under section 12(b) of the 
Act.\8\ This criterion is designed to ensure that there is adequate 
information publicly available regarding the issuer of a corporate debt 
security underlying an option traded on the Exchange. The corporate 
debt security market is largely an OTC market and many corporate debt 
securities, including those among the most actively traded, are not 
themselves registered under section 12 of the Act. The issuers of many 
unregistered corporate debt securities, however, have equity securities 
registered under section 12 of the Act. These issuers are required to 
provide periodic reports to the public due to the equity registration, 
and the Exchange believes that the fact that their corporate debt 
securities are unregistered does not diminish in practical terms the 
information provided by their periodic reports. Thus, CBOE believes 
that the proposed requirement would enable a wide array of actively 
traded corporate debt securities to be eligible for options trading 
while ensuring sufficient public disclosure of information about any 
corporate debt securities underlying exchange-traded options.\9\
---------------------------------------------------------------------------

    \8\ 15 U.S.C. 78l(b).
    \9\ Proposed CBOE Rule 5.3.10 was amended to also include the 
requirement that the issuer of a corporate debt security has 
registered the offer and sale of the security under the Securities 
Act of 1933.
---------------------------------------------------------------------------

    The Exchange is proposing as another listing criterion that the 
stock of an issuer of a corporate debt security be eligible for options 
trading under CBOE Rule 5.4. The provisions of CBOE Rule 5.4 would 
require that an equity security underlying an option be itself widely 
held and actively traded. The Exchange believes that a requirement that 
the stock of an issuer of a corporate debt security meet the criterion 
of CBOE Rule 5.4 would provide additional indicia that such issuer's 
securities are subject to widespread investor interest. Moreover, the 
Exchange believes that this requirement would ensure that a corporate 
debt securities option is not used as a proxy for equity options 
trading of an issuer whose stock does not meet the criterion of CBOE 
Rule 5.4.
    With respect to credit ratings of corporate debt securities, the 
initial listing standards would provide that corporate debt securities 
on which options transactions are listed must have credit ratings 
issued by Moody's Investors Service (``Moody's'') that are Caa \10\ or 
higher and credit ratings issued by Standard & Poor's that are CC \11\ 
or higher. The proposed maintenance standards require that the 
corporate debt securities maintain the ratings set forth in the initial 
listing standards. CBOE believes that these initial and maintenance 
standards are appropriate because they provide a measure of certainty 
with respect to the satisfaction of regularly scheduled interest 
payments on the corporate debt security, which triggers the 
corresponding requirement to pay the accrued interest under proposed 
CBOE Rule 28.15. The Exchange also believes that market participants 
investing in corporate debt securities should have the opportunity to 
use CDSOs to mitigate risk when the underlying corporate debt security 
is subject to credit downgrades and potentially price declines.
---------------------------------------------------------------------------

    \10\ Under Moody's rating definitions, ``obligations rated Caa 
are judged to be of poor standing and are subject to very high 
credit risk.'' Moody's has two ratings lower than Caa: Ca and C. 
Moody's defines Ca-rated obligations as ``highly speculative and are 
likely in, or very near, default, with some prospect of recovery of 
principal and interest.'' Moody's defines C-rated obligations as 
``the lowest rated class of bonds and are typically in default, with 
little prospect for recovery of principal or interest.''
    \11\ Under Standard & Poor's rating definitions, ``an obligation 
rated CC is currently highly vulnerable to nonpayment.'' Standard & 
Poor's has two ratings lower than CC: C and D. Under Standard & 
Poor's definitions, C-rated obligations ``may be used to cover a 
situation where a bankruptcy petition has been filed or similar 
action has been taken, but payments on this obligation are being 
continued.'' Under Standard & Poor's definitions, ``an obligation 
rated `D' is in payment default. The `D' rating category is used 
when payments on an obligation are not made on the date due even if 
the applicable grace period has not expired, unless Standard & 
Poor's believes that such payments will be made during such grace 
period. The `D' rating also will be used upon the filing of a 
bankruptcy petition or the taking of a similar action if payments on 
an obligation are jeopardized.''
---------------------------------------------------------------------------

    The proposed margin (both initial and maintenance) for writing 
uncovered puts or calls would be as follows. An \12\ option writer 
would be required to deposit and maintain 100% of the current market 
value of the option plus 10% of the aggregate contract value minus the 
amount by which the option is out-of-the-money, if any, subject to a 
minimum for calls equal to 100% of the current market value of the 
option plus 5% of the aggregate contract value for any corporate debt 
security that is rated investment-grade.\13\ For non-investment-grade 
\14\ corporate debt securities, the margin requirement would be 100% of 
the current market value of the option plus 15% of the aggregate 
contract value minus the amount by which the option is out-of-the-
money, if any, subject to a minimum for calls equal to 100% of the 
current market value of the option plus 10% of the aggregate contract 
value. Writers of options on convertible corporate debt securities 
would be required to deposit and maintain 100% of the current market 
value of the option plus 20% of the aggregate contract value minus the

[[Page 34177]]

amount by which the option is out-of-the-money, if any, subject to a 
minimum for calls equal to 100% of the current market value of the 
option plus 10% of the aggregate contract value. In the case of puts 
for each of investment-grade, non-investment-grade, and convertible 
corporate debt securities, the minimum margin required would be 100% of 
the current market value of the option plus 5%, 10%, and 10%, 
respectively of the put exercise price. This methodology incorporates 
the same formula in CBOE Chapter 12 that the Exchange applies to all 
other option classes, but with percentages that consider the specific 
market factors pertaining to debt rating and type of the corporate debt 
security. For example, the Exchange requires a deposit of 100% of the 
current market value of the option plus a 20% Initial/Maintenance 
Margin and a 10% Minimum Margin. This same level would apply to 
convertible corporate debt securities that are the underlying for 
options listed under the proposed CBOE Chapter 28 rules. For 
investment-grade corporate debt securities that underlie options listed 
under the proposed CBOE Chapter 28 rules, the Exchange is proposing a 
10% Initial/Maintenance Margin and a 5% Minimum Margin because 
investment grade corporate debt securities generally experience lower 
price movements and lower volatility levels than stocks. CBOE states 
that, since non-investment-grade corporate debt securities exhibit 
price movements that are higher than investment-grade corporate debt 
securities, it is proposing a 15% Initial/Maintenance Margin and a 5% 
Minimum Margin for those securities. The Exchange believes that these 
proposed margin levels also are consistent with the Commission's Net 
Capital Rule for the underlying corporate debt securities.\15\
---------------------------------------------------------------------------

    \12\ Pursuant to a telephone conversation between Angelo 
Evangelou, Assistant General Counsel, and Dennis O'Callahan, 
Director Research and Product Development, CBOE, and Bonnie Gauch, 
Special Counsel, Marc McKayle, Special Counsel, and Ronesha Butler, 
Special Counsel, Division of Market Regulation, Commission, on June 
1, 2006, the description contained in this paragraph was conformed 
to reflect the provisions contained in proposed CBOE Rule 12.3.
    \13\ The definition of an investment-grade corporate debt 
security is set forth in proposed CBOE Rule 12.3(a)(15). The 
proposed definition mirrors the definition set forth in NASD rules 
pertaining to TRACE. For purposes of CBOE Rule 12.3, the Exchange 
would interpret the lowest of the four highest generic rated 
categories referenced in the proposed definition for ``Investment 
Grade'' to be, for example, Baa in the case of Moody's Investors 
Services and BBB in the case of Standard and Poor's.
    \14\ The proposed definition of a non-investment-grade corporate 
debt security is set forth in proposed CBOE Rule 12.3(a)(16). The 
proposed definition mirrors the definition set forth in the NASD 
rules pertaining to TRACE. The Exchange would interpret the lowest 
of the four highest generic rated categories referenced in the 
proposed definition for ``Non-Investment Grade'' to be, for example, 
Baa in the case of Moody's Investors Services and BBB in the case of 
Standard and Poor's.
    \15\ 17 CFR 240.15c3-1.
---------------------------------------------------------------------------

    CBOE believes that the operational capacity used to accommodate the 
trading of CDSOs on the Exchange would have a negligible effect on the 
total capacity used by the Exchange to trade its products on a daily 
basis.
    To the extent that features of CDSOs differ from other security 
options, CBOE would issue a circular to its members before the 
initiation of trading in CDSOs that would specify the special 
characteristics of CDSOs. This circular would highlight the exercise 
methodology of the series, explain the cash adjustment procedures, 
identify the new symbols for the CDSO series, and identify the initial 
expiration months and strike prices available for trading. The Exchange 
notes that these procedures are similar to the procedures used when the 
Exchange listed both A.M.- and P.M.-settled SPX Index options in 1992.
    The Exchange would monitor the media for rating downgrades and 
other corporate actions to ensure the Exchange's maintenance standards 
are fulfilled, and monitor for any corporate actions that may influence 
the pricing of corporate debt securities and CDSOs. In addition, the 
Exchange would work with OCC to revise the Options Disclosure Document 
to incorporate CDSOs in a manner that is satisfactory to both the 
Exchange and the Commission.
    The Exchange believes that the introduction of CDSOs would increase 
the variety of listed options to investors and expand the risk 
management choices for debt securities participants.
2. Statutory Basis
    The Exchange believes that its proposal, as amended, is consistent 
with the requirements of section 6(b) of the Act,\16\ in general, and 
section 6(b)(5) of the Act \17\ in particular, in that it is designed 
to promote just and equitable principles of trade as well as to protect 
investors and the public interest. The Exchange states that the 
introduction of CDSOs would increase the variety of listed options to 
investors and expand the risk management choices for debt securities 
participants.
---------------------------------------------------------------------------

    \16\ 15 U.S.C. 78f(b).
    \17\ 15 U.S.C. 78f(b)(5).
---------------------------------------------------------------------------

B. Self-Regulatory Organization's Statement on Burden on Competition

    CBOE does not believe that the proposed rule change, as amended, 
would impose any burden on competition that is not necessary or 
appropriate in furtherance of the purposes of the Act.

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

    No written comments were either solicited or received.

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

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which CBOE consents, the Commission will:
    (A) By order approve such proposed rule change, as amended, or
    (B) Institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change, 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-CBOE-2003-41 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-CBOE-2003-41. 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 Room. Copies of the filing 
also will be available for inspection and copying at the principal 
office of CBOE. All comments received will be posted without change; 
the Commission does not edit personal identifying information from 
submissions. You should submit only information that you wish to make 
available publicly. All submissions should refer to File Number SR-
CBOE-2003-41 and should be submitted on or before July 5, 2006.


[[Page 34178]]


    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\18\
Jill M. Peterson,
Assistant Secretary.
---------------------------------------------------------------------------

    \18\ 17 CFR 200.30-3(a)(12).
---------------------------------------------------------------------------

[FR Doc. E6-9154 Filed 6-12-06; 8:45 am]

BILLING CODE 8010-01-P
