

[Federal Register: August 22, 2007 (Volume 72, Number 162)]
[Notices]               
[Page 47097-47102]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr22au07-161]                         

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

SECURITIES AND EXCHANGE COMMISSION

 [Release No. 34-56275; File No. SR-CBOE-2007-26]

 
Self-Regulatory Organizations; Chicago Board Options Exchange, 
Incorporated; Order Granting Approval of a Proposed Rule Change To List 
and Trade Credit Default Basket Options, as Modified by Amendment No. 
3, and Designating Credit Default Basket Options as Standardized 
Options Under Rule 9b-1 of the Securities Exchange Act of 1934

August 17, 2007.

I. Introduction

    On April 5, 2007, the Chicago Board Options Exchange, Incorporated 
(``CBOE'' or ``Exchange'') filed with the Securities and Exchange 
Commission (``Commission'') a proposed rule change, pursuant to section 
19(b)(1) of

[[Page 47098]]

the Securities Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 
thereunder,\2\ to permit CBOE to list and trade cash-settled, binary 
options \3\ based on the occurrence of credit events in the debt 
securities of one or more issuers, referred to as credit default basket 
options. On June 15, 2007, CBOE filed Amendment No. 1 to the proposed 
rule change; on June 19, 2007, CBOE withdrew Amendment No. 1 and filed 
Amendment No. 2 to the proposed rule change; and on June 21, 2007, CBOE 
withdrew Amendment No. 2 and filed Amendment No. 3 to the proposed rule 
change.\4\ The proposed rule change, as modified by Amendment No. 3, 
was published for comment in the Federal Register on June 28, 2007 for 
a 15-day comment period.\5\ The Commission received no comments on the 
proposal. This order approves the proposed rule change, as modified by 
Amendment No. 3, and designates credit default basket options as 
``standardized options'' pursuant to Rule 9b-1 under the Act.\6\
---------------------------------------------------------------------------

    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ A binary option is a style of option having only two 
possible payoff outcomes: either a fixed amount or nothing at all.
    \4\ Amendment No. 3 replaced the original filing in its 
entirety.
    \5\ See Securities Exchange Act Release No. 55938 (June 21, 
2007), 72 FR 35523 (``CBOE Proposal'').
    \6\ See 17 CFR 240.9b-1. Pursuant to Rule 9b-1(a)(4) under the 
Act, the Commission may, by order, designate as ``standardized 
options'' securities that do not otherwise meet the definition of 
``standardized options.'' Standardized options are defined in Rule 
9b-1(a)(4) as: ``[O]ptions contracts trading on a national 
securities exchange, an automated quotations system of a registered 
securities association, or a foreign securities exchange which 
relate to options classes the terms of which are limited to specific 
expiration dates and exercise prices, or such other securities as 
the Commission may, by order, designate.'' 17 CFR 240.9b-1(a)(4).
---------------------------------------------------------------------------

II. Description of the CBOE Proposal

A. Generally

    On June 6, 2007, the Commission approved a proposal by CBOE to list 
and trade credit default options, which are cash-settled binary options 
that are automatically exercised upon the occurrence of specified 
credit events or expire worthless. \7\ CBOE now proposes to list and 
trade credit default basket options, which are cash-settled binary 
options based on a basket of at least two Reference Entities (described 
below). This proposal would add new rules applicable to credit default 
basket options and amend certain existing rules applicable to credit 
default options to make them applicable to credit default basket 
options.
    Credit default options are referenced to debt securities issued by 
a specified public company (``Reference Entity'') \8\ and either have a 
fixed payout or expire worthless, depending upon whether a credit event 
occurs during the life of the option. Upon confirmation of a credit 
event prior to the last day of trading of a credit default option 
series,\9\ the options positions existing as of that time are 
automatically exercised and the holders of long options positions 
receive a fixed cash payment of $100,000 per contract.\10\ If no credit 
event is confirmed during the life of the option, the final settlement 
price is $0.
---------------------------------------------------------------------------

    \7\ See Securities Exchange Act Release No. 55871, 72 FR 32372 
(June 12, 2007) (SR-CBOE-2006-84) (approving CBOE's proposal to list 
and trade credit default options) (``Credit Default Option Approval 
Order''). See also Securities Exchange Act Release No. 55919 (June 
18, 2007), 72 FR 34498 (June 22, 2007) (SR-CBOE-2007-62) (making 
various technical changes to CBOE's credit default option rules).
    \8\ Proposed CBOE Rule 29.1(f) also includes as a ``Reference 
Entity'' the guarantor of the debt security underlying the credit 
default option. For purposes of credit default basket options, 
Reference Entities are referred to as ``Basket Components.'' See 
proposed CBOE Rule 29.1(h).
    \9\ CBOE Rule 29.9(c) (to be relettered CBOE Rule 29.9(d)) 
requires that CBOE confirm the occurrence of a credit event through 
at least two sources, which may include announcements published via 
newswire services or information service companies, the names of 
which would be announced to the membership via a CBOE regulatory 
circular, or information contained in any order, decree, or notice 
of filing, however described, of or filed with the courts, the 
Commission, an exchange, an association, the Options Clearing 
Corporation (``OCC''), or another regulatory agency or similar 
authority.
    \10\ However, the settlement amount could be adjusted pursuant 
to proposed CBOE Rule 29.4.
---------------------------------------------------------------------------

    Credit default basket options are like credit default options, but 
instead of being based on the debt securities of one Reference Entity, 
they are based on the debt securities of two or more Reference 
Entities, or Basket Components. There would be two types of credit 
default basket options: (i) Multiple payout credit default basket 
options that automatically pay holders a cash settlement amount each 
time a credit event is confirmed in a Basket Component during the life 
of the option, after which the applicable Basket Component would be 
removed from the basket, or expire worthless if no credit events are 
confirmed during the life of the option; and (ii) single payout credit 
default basket options that automatically pay holders a single cash 
settlement amount when the first credit event is confirmed in any 
Basket Component, or expire worthless if no credit event for any Basket 
Component is confirmed during the life of the option.\11\ Unlike a 
multiple payout credit default basket option, a single payout credit 
default basket option ceases trading after confirmation of the first 
credit event.
---------------------------------------------------------------------------

    \11\ Credit events that trigger an automatic pay out include a 
failure to make payment pursuant to the terms of an underlying debt 
security and any other event of default specified by CBOE at the 
time it initially lists a particular class of credit default basket 
options. For each Basket Component, the events of default that CBOE 
may specify must be defined in accordance with the terms of the 
specific debt security underlying the Basket Component (each a 
``Reference Obligation'') or any other debt securities of the Basket 
Component other than non-recourse indebtedness (collectively with 
the Reference Obligation, ``Relevant Obligations''). See proposed 
CBOE Rules 29.1(c) and 29.2A.
---------------------------------------------------------------------------

    The cash payout for credit default basket options is calculated 
differently than for credit default options. For both types of credit 
default basket options, each time a credit event is confirmed during 
the life of the option, the holder of the option would receive a cash 
payment per contract that is equal to one minus the Basket Component 
recovery rate specified by the Exchange at listing, multiplied by the 
notional face value of the applicable Basket Component.\12\ For 
example, if there is a credit event in a Basket Component with notional 
face value of $10,000 and a recovery rate of 40%, the cash payment per 
contract would be $6,000.\13\ As with credit default options, if no 
credit event is confirmed during the life of the option, the final 
settlement price would be $0.
---------------------------------------------------------------------------

    \12\ At the time of listing, the Exchange will designate the 
notional face value and recovery rate of each Basket Component. See 
proposed CBOE Rule 29.2A (setting forth the requirements for the 
designation and terms of credit default basket options); and 
proposed CBOE Rules 29.1(a)(ii) and (j) (setting forth the 
definitions for ``cash settlement amount'' for credit default basket 
options and ``Notional Face Value of Basket Component,'' 
respectively).
    \13\ $10,000 x (1 - 0.40) = $6,000.
---------------------------------------------------------------------------

B. Listing Standards

    Like credit default options, credit default basket options must 
conform to the initial and continued listing standards under proposed 
CBOE Chapter XXIX.\14\ CBOE is proposing to list and trade only credit 
default basket options overlying debt securities of multiple Reference 
Entities each having at least one class of securities that is 
registered under the Act and is an ``NMS stock'' \15\ as defined in 
Rule 600 of Regulation NMS under the Act.\16\ Any registered equity 
security issued by the Reference Entity also would have to satisfy the 
requirements of CBOE Rule

[[Page 47099]]

5.4, which requires, among other things, that an equity security 
underlying an option be itself widely held and actively traded.\17\ 
This requirement is designed to ensure that the issuer's securities 
enjoy widespread investor interest. The requirement that each Reference 
Entity be an issuer or guarantor of registered NMS stock will help 
ensure that investors have access to comprehensive public information 
about the Reference Entity, including the registration statement filed 
under the Securities Act of 1933 (``Securities Act'') and other 
periodic reports.\18\
---------------------------------------------------------------------------

    \14\ CBOE is amending Chapter XXIX to make it applicable to all 
``Credit Options,'' which would include credit default options and 
credit default basket options.
    \15\ ``NMS stock'' means any security, or class of securities, 
other than an option for which transaction reports are collected, 
processed, and made available pursuant to an effective transaction 
reporting plan. See 17 CFR 242.600(b)(46) and (47).
    \16\ See proposed CBOE Rule 5.3.11.
    \17\ CBOE Rule 5.4 provides that, absent exceptional 
circumstances, an underlying security will not be deemed to meet the 
Exchange's requirements for continued approval when: (i) There are 
fewer than 6,300,000 shares of the underlying security held by 
persons other than those who are required to report their security 
holdings under Section 16(a) of the Act (15 U.S.C. 78p); (ii) there 
are fewer than 1,600 holders of the underlying security; (iii) the 
trading volume (in all markets in which the underlying security is 
traded) was less than 1,800,000 shares in the preceding 12 months; 
(iv) the market price per share of the underlying security closed 
below $3 on the previous trading day, as measured by the closing 
price reported in the primary market in which the underlying 
security traded; or (v) the underlying security ceases to be an NMS 
stock.
    \18\ Section 13 of the Act, 15 U.S.C. 78m, provides that any 
issuer of a security registered pursuant to Section 12 of the Act, 
15 U.S.C. 78l, must file with the Commission annual reports and 
information and documents necessary to keep reasonably current the 
information in its Section 12 registration statement.
---------------------------------------------------------------------------

    Also, as with credit default options, a credit default basket 
option could not be exercised at the discretion of the investor, but 
instead would have an automatic payout only upon the occurrence of a 
credit event. The expiration date would be the fourth business day 
after the last day of trading of the series, which would be the third 
Friday of the expiration month.\19\ The Exchange usually would open one 
to four series for each year up to 10.25 years from the current 
expiration.\20\
---------------------------------------------------------------------------

    \19\ For a single payout credit default basket option, if a 
credit event is confirmed, the expiration date would be the second 
business day after the confirmation of the first credit event. For a 
multiple payout credit default basket option, if a credit event is 
confirmed in every Basket Component, the expiration date would be 
the second business day after the confirmation of the last credit 
event. For either type of credit default basket options, if a 
Redemption Event is confirmed in all Basket Components, the 
expiration date would be the second business day after the last 
confirmation date. See proposed CBOE Rules 29.1(d)(ii) and (e)(ii). 
See also proposed CBOE Rule 29.4.
    \20\ See proposed CBOE Rule 29.2A(b)(1) and (2).
---------------------------------------------------------------------------

C. Trading

    The trading rules for credit default basket options would be 
consistent with those applicable to credit default options. 
Specifically, credit default basket options would trade on CBOE's 
Hybrid Trading System from 8:30 a.m. to 3 p.m. (Central Time) \21\ in a 
manner similar to the trading of equity options. With limited 
distinctions, as described more fully in the proposal, CBOE's equity 
option trading rules would apply to credit default options.\22\ Also, 
credit default basket options would be eligible for trading as Flexible 
Exchange Options (``FLEX Options''). A FLEX Option that is a credit 
default basket option would be cash-settled and the exercise-by-
exception provisions of OCC Rule 805 \23\ would not apply. Market-
makers would be appointed to credit default options pursuant to CBOE's 
existing requirements,\24\ as supplemented by proposed CBOE Rule 29.17. 
Additionally, CBOE represents that it, and the Options Price Reporting 
Authority (``OPRA''), have the necessary systems capacity to handle the 
additional quote volume anticipated to be associated with credit 
default basket options.
---------------------------------------------------------------------------

    \21\ See proposed CBOE Rule 29.11.
    \22\ See proposed CBOE Rules 29.11-29.15, 29.16, and 29.19.
    \23\ OCC Rule 805 sets forth the expiration date exercise 
procedures for options cleared and settled by the OCC.
    \24\ See Chapter VIII of CBOE's rules.
---------------------------------------------------------------------------

    Once a particular credit default basket option class has been 
approved for listing and trading, the Exchange would, from time to 
time, open for trading a series of that class. If a credit default 
option class initially approved for trading no longer meets the 
Exchange's requirements for continued approval, the Exchange would not 
open for trading any additional series of options and, as provided in 
CBOE Rule 5.4, could prohibit any opening purchase transactions in such 
class. The proposed trading rules for credit default basket options are 
designed to create an environment that takes into account the small 
number of transactions likely to occur, while providing price 
improvement and the transparency benefits of competitive floor bidding, 
as compared to the over-the-counter (``OTC'') market.
    Upon the confirmation of the first credit event (in the case of a 
single payout credit default basket option), a credit event in every 
Basket Component (in the case of a multiple payout credit default 
basket option), or the redemption of all Relevant Obligations (in the 
case of either type of credit default basket option), the applicable 
credit default basket option class would cease trading. In addition, 
CBOE's trading halt procedures applicable to equity options would apply 
to credit default basket options.\25\ When determining whether to 
institute a trading halt in credit default basket options, CBOE floor 
officials would consider whether current quotations for a Relevant 
Obligation or other securities of a Reference Entity are unavailable or 
have become unreliable.\26\ The Exchange's board of directors would 
also have the power to impose restrictions on transactions or exercises 
in one or more series of credit default basket options as the board, in 
its judgment, determines advisable in the interests of maintaining a 
fair and orderly market or otherwise deems advisable in the public 
interest or for the protection of investors.\27\
---------------------------------------------------------------------------

    \25\ See CBOE Rules 6.3 and 6.3B; proposed CBOE Rule 29.13.
    \26\ See id.
    \27\ See proposed CBOE Rule 29.8.
---------------------------------------------------------------------------

D. Clearance and Settlement

    Like credit default options, credit default basket options do not 
have an exercise price, and thus by their terms, do not meet the 
definition of ``standardized options'' for purposes of Rule 9b-1 under 
the Act.\28\ However, as discussed herein, the Commission today is 
using its authority pursuant to Rule 9b-1 to designate credit default 
basket options as ``standardized options'' under Rule 9b-1. 
Consequently, credit default basket option transactions will be 
eligible for clearance and settlement by the OCC in accordance with 
procedures that are substantially similar to existing systems and 
procedures for the clearance and settlement of exchange-traded 
options.\29\
---------------------------------------------------------------------------

    \28\ 17 CFR 240.9b-1.
    \29\ On April 20, 2007, the OCC filed with the Commission, a 
proposed rule change to enable it to clear and settle credit default 
basket options proposed to be listed by CBOE. On June 14, 2007, the 
OCC filed Amendment No. 1 to the proposal. The proposed rule change, 
as amended, was published for comment in the Federal Register on 
June 27, 2007. Securities Exchange Act Release No. 55939 (June 21, 
2007), 72 FR 35291 (SR-OCC-2007-06) (the ``OCC Proposal''). The 
Commission has not yet taken action on the OCC proposal. The 
Commission also notes that the Options Disclosure Document (``ODD'') 
was recently amended to incorporate disclosure related to both 
credit default options and credit default basket options. See 
Securities Exchange Act Release No. 55921 (June 18, 2007), 72 FR 
34495 (June 22, 2007) (SR-ODD-2007-03).
---------------------------------------------------------------------------

E. Adjustments

    Like credit default options, both types of credit default basket 
options would be subject to adjustments in two circumstances.\30\ 
First, if a Basket Component is succeeded by another entity in 
accordance with the terms of the underlying debt securities, the 
Exchange will specify a new recovery

[[Page 47100]]

rate and basket weight for each successor Basket Component. The newly 
specified weights would equal the weight of the original Basket 
Component. To the extent necessary and appropriate for the protection 
of investors and the public interest, all other terms and conditions of 
the options would be the same as the original credit default basket 
options.
---------------------------------------------------------------------------

    \30\ See CBOE proposed Rule 29.4.
---------------------------------------------------------------------------

    Second, if the Reference Obligation of a Basket Component is 
redeemed or matures during the life of the credit default basket 
option, the Exchange would specify another debt security of the 
Reference Entity as the new Reference Obligation for that Basket 
Component. If all debt securities of a Basket Component (i.e., all 
Relevant Obligations) are redeemed during the life of the credit 
default basket option, that Basket Component would be removed from the 
basket.

F. Position Limits

    Pursuant to proposed CBOE Rule 29.5, credit default basket options 
would be subject to a position limit equal to 50,000 contracts on the 
same side of the market. Credit default basket options would not be 
aggregated with option contracts on the same underlying security and 
would not be subject to the hedge exemption to CBOE's standard position 
limits. Instead, the following hedge strategies and positions would be 
exempt from CBOE's position limits: (i) A credit default basket option 
position ``hedged'' or ``covered'' by an appropriate amount of cash to 
meet the cash settlement amount obligation; and (ii) a credit default 
basket option position ``hedged'' or ``covered'' by an amount of any of 
the Basket Component's debt securities, instruments, or interests 
sufficient to meet: (A) In the case of a single payout credit default 
option, the cash settlement amount obligation that would be the 
greatest if any of the Basket Components of that option were to 
experience a credit event; or (B) in the case of a multiple payout 
credit default option, the sum of the sum of each Basket Component's 
cash settlement amount.\31\ Also, CBOE's market-maker and firm 
facilitation exemptions to position limits would apply.\32 \
---------------------------------------------------------------------------

    \31\ See proposed CBOE Rule 29.5.
    \32\ Proposed CBOE Rule 29.5 would require that for purposes of 
its market-maker hedge exemption (CBOE Rule 4.11.05) the position 
must be within 20% of the applicable limit before an exemption would 
be granted. With respect to CBOE's firm facilitation exemption (CBOE 
Rule 4.11.06), proposed CBOE Rule 29.5 would provide that the 
aggregate exemption position could not exceed three times the 
standard limit of 50,000 contracts.
---------------------------------------------------------------------------

G. Margin

    The margin (both initial and maintenance) required for writing 
short and long positions in credit default basket options would be as 
follows:
     For a qualified customer carrying a long position in a 
credit default basket option, the margin requirement would be 15% of 
the current market value of the credit default basket option.
     For a non-qualified customer carrying a long position in a 
credit default basket option, the margin requirement would be 100% of 
the current market value of the credit default basket option.
     For a qualified customer carrying a short position in a 
multiple payout credit default basket option, the margin requirement 
would be the lesser of the current market value of the credit default 
basket option plus 15% of the sum of each Basket Component's cash 
settlement amount, or the sum of each Basket Component's cash 
settlement amount.
     For a non-qualified customer carrying a short position in 
a multiple payout credit default basket option, the margin requirement 
would be the sum of each Basket Component's cash settlement amount.
     For a qualified customer carrying a short position in a 
single payout credit default basket option, the margin requirement 
would be the lesser of the current market value of the credit default 
basket option plus 15% of the cash settlement amount of the Basket 
Component that would be the greatest if any of the Basket Components 
were to experience a credit event, or the cash settlement amount of the 
Basket Component that would be the greatest if any of the Basket 
Components were to experience a credit event.
     For a non-qualified customer carrying a short position in 
a single payout credit default basket option, the margin requirement 
would be the cash settlement amount of the Basket Component that would 
be the greatest if any of the Basket Components were to experience a 
credit event.
    These requirements may be satisfied by a deposit of cash or 
marginable securities.
    A credit default option carried short in a customer's account would 
be deemed a covered position, and eligible for the cash account, 
provided any one of the following is held in the account at the time 
the option is written or is received into the account promptly 
thereafter: (i) For multiple payout credit default basket options, cash 
or cash equivalents equal to 100% of the sum of each Basket Component's 
cash settlement amount; (ii) for single payout credit default basket 
options, cash or cash equivalents equal to 100% of the cash settlement 
amount of the Basket Component that would be the greatest if any of the 
Basket Components were to experience a credit event; or (iii) an escrow 
agreement. The Exchange believes that these requirements strike the 
appropriate balance and adequately address concerns that a member or 
its customer may try to maintain an inordinately large unhedged 
position in credit default options. The Exchange represents that, in 
accordance with proposed CBOE Rule 12.3(a)(4), an escrow agreement must 
be issued in a form acceptable to the Exchange, and that it has 
traditionally recognized as acceptable the escrow agreement forms of 
the OCC and the New York Stock Exchange.
    Lastly, pursuant to proposed CBOE Rule 12.5, a credit default 
basket option that is carried for the account of a qualified customer 
may be deemed to have market value for the purposes of CBOE Rule 
12.3(c).

H. Surveillance

    The Exchange has represented that it will have in place adequate 
surveillance procedures to monitor trading in credit default basket 
options prior to listing and trading such options.

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.\33\ In 
particular, the Commission finds that the proposal is consistent with 
section 6(b)(5) of the Act,\34\ which requires, among other things, 
that the rules of an exchange be designed to prevent fraudulent and 
manipulative acts and practices; to promote just and equitable 
principles of trade; to foster cooperation and coordination with 
persons engaged in regulating, clearing, processing information with 
respect to, and facilitating transactions in securities; to remove 
impediments to and perfect the mechanism of a free and open market and 
a national market system; and, in general to protect investors and the 
public interest. CBOE's proposal, by enabling it to list and trade 
securities heretofore existing only in the OTC market, would extend to 
investors the benefits of a listed exchange market,

[[Page 47101]]

which include: a centralized market center; an auction market with 
posted, transparent market quotations and transaction reporting; 
standardized contract specifications; and the guarantee of the OCC.
---------------------------------------------------------------------------

    \33\ In approving this proposed rule change, the Commission 
notes that it has considered the proposed rule's impact on 
efficiency, competition, and capital formation. See 15 U.S.C. 
78c(f).
    \34\ 15 U.S.C. 78f(b)(5).
---------------------------------------------------------------------------

    In connection with its earlier approval of credit default options, 
the Commission found that the credit default options proposed by CBOE 
are securities because they are options based on the value of a 
security or securities and because they are options on an interest in, 
or based on the value of an interest in, a security or securities.\35\ 
Under an analysis similar to that applied to credit default options, 
and after careful consideration of the terms of the two types of credit 
default basket options, the Commission finds that the credit default 
basket options proposed by CBOE are securities. Specifically, the 
Commission finds that credit default basket options are options based 
on the value of securities or a group or index of securities and are 
options on an interest in or based on the value of an interest in, 
securities or a group or index of securities and, therefore, are 
securities under section 3(a)(10) of the Act.\36\
---------------------------------------------------------------------------

    \35\ See Credit Default Option Approval Order, supra note 7.
    \36\ 15 U.S.C. 78c(a)(10).
---------------------------------------------------------------------------

    As a threshold matter, the Commission finds that credit default 
basket options are options, not futures contracts. Generally speaking 
an option grants the holder the right, but not the obligation, to buy 
or sell a specific quantity, at a specific price, on or before a 
specified future date.\37\ Courts have highlighted three 
characteristics in particular that distinguish options from futures 
contracts: (i) An options-buyer pays to the seller a nonrefundable 
premium; (ii) an options-buyer has rights but no further obligations 
under the contract; and (iii) an options-seller bears all the risk 
exposure.\38\ Examining credit default basket options in light of these 
characteristics, it is clear that credit default basket options are 
options. First, the buyer of a credit default basket option pays to the 
seller a nonrefundable premium. Second, the buyer of a credit default 
basket option has rights but no further obligations under the contract. 
Third, the buyer of a credit default basket option has no further risk 
exposure under the contract and the seller bears all the risk of the 
credit event occurring.
---------------------------------------------------------------------------

    \37\ See British American Commodity Options v. Bagley, 552 F.2d 
482, 484-85 (2d Cir. 1977).
    \38\ See CFTC v. U.S. Metals Depository Co., 468 F.Supp. 1149, 
1154 (S.D.N.Y. 1979); and United States v. Bein, 728 F.2d 107, 112 
(2d Cir. 1984).
---------------------------------------------------------------------------

    Although credit default basket options differ from classic options 
in certain respects, these differences do not affect the economic 
substance of the contract. First, credit default basket options are 
cash-settled and do not allow for physical delivery. It is well 
established, however, that cash-settled options based on prices of 
securities are options ``on'' such securities.\39\ Second, credit 
default basket options are automatically exercised, unlike a classic 
option that generally gives the option-holder the right but not the 
obligation to exercise if the option is in the money. In the case of 
cash-settled options, such as credit default basket options, however, 
giving the option-holder the right to decline to accept the cash upon 
the occurrence of an event of default would be economically 
meaningless.\40\ For this reason, under OCC rules, index option 
contracts are automatically exercised if they are in-the-money at 
expiration, and equity options contracts are automatically exercised if 
they are in-the-money by specified amounts. Third, the payout for a 
credit default basket option is fixed in advance and binary in nature, 
while in a classic option the payout can increase or decrease 
continuously in direct correlation with the price movement of the 
underlying instrument. The same is true, of course, of the payout of a 
futures contract. Thus, the fixed payout of credit default basket 
options does not weigh in favor of classifying them as either futures 
or options.
---------------------------------------------------------------------------

    \39\ See Caiola v. Citibank, N.A., New York, 295 F.3d 312, 326 
(2d Cir. 2002).
    \40\ See Stechler v. Sidley, Austin Brown & Wood, L.L.P., 382 
F.Supp.2d 580, 595-97 (S.D.N.Y. 2005).
---------------------------------------------------------------------------

    In short, even though the potential payout of a credit default 
basket option is cash-settled, automatically exercised, and fixed in 
advance, the buyer of a credit default basket option still pays a fixed 
premium for the possibility of receiving a greater amount--which is the 
essence of optionality.\41\
---------------------------------------------------------------------------

    \41\ See Brief of Amicus Curiae The Securities and Exchange 
Commission, at 24, Caiola v. Citibank, N.A., New York, 295 F.3d 312 
(2d Cir. 2002) (01-7545) (``Simply put, Caiola paid a little for the 
chance to get a lot'').
---------------------------------------------------------------------------

    Furthermore, the Commission finds that credit default basket 
options are securities under section 3(a)(10) of the Act.\42\ 
Specifically, credit default basket options are options based on the 
value of securities or a group or index of securities and are options 
on an interest in, or based on the value of an interest in, securities 
or a group or index of securities. In coming to these conclusions, the 
Commission carefully considered the terms of the credit default basket 
options, using an analytical approach similar to that which the 
Commission applied to credit default options.
---------------------------------------------------------------------------

    \42\ The Commission wishes to make clear that because credit 
default basket options will be exchange-traded and not individually 
negotiated (and not necessarily between eligible contract 
participants), they are not qualifying swap agreements under Section 
206A of the Gramm-Leach-Bliley Act (``GLBA''), 15 U.S.C. 78c note, 
and, therefore, not excluded from the definition of security by 
Section 3A of the Act, 15 U.S.C. 78c-1. Also, certain OTC credit 
default swaps (whether single-name or basket) are not securities. 
The finding that credit default basket options are securities 
because they are options based on the value of securities or a group 
or index of securities might suggest that single-name or basket OTC 
credit default swaps are also options based on the value of a 
security or group or index of securities and, therefore, excluded 
from the definition of swap agreement because Section 206A(b)(1) of 
the GLBA, 15 U.S.C. 78c note, excludes from the definition of swap 
agreement ``any put, call, straddle, option, or privilege on any 
security, certificate of deposit, or group or index of securities, 
including any interest therein or based on the value thereof.'' 
However, Congress specifically enumerated ``credit default swaps'' 
(without defining the term) as one example of a qualifying swap 
agreement. See Section 206A(a)(3) of the GLBA, 15 U.S.C. 78c note. 
The Commission views the specific enumeration of ``credit default 
swaps'' as reflecting the intention of Congress to exclude certain 
OTC credit default swaps from the definition of security pursuant to 
Sections 206B & C of the GLBA, 15 U.S.C. 78c note. Of course, OTC 
credit default swaps that involve terms similar to credit default 
basket options, but that are otherwise excluded from the definition 
of security because they are qualifying swap agreements, remain 
subject to the Commission's antifraud jurisdiction (including 
authority over insider trading) as ``security-based swap 
agreements'' under Section 206B of the GLBA, 15 U.S.C. 78c note.
---------------------------------------------------------------------------

    The Commission also believes that the listing and trading rules 
proposed by CBOE for credit default basket options are substantially 
similar to the listing and trading rules for credit default options, 
and are likewise reasonable and consistent with the Act. As with a 
credit default option, a credit default basket option must be based on 
Reference Obligations issued by entities that issue or guarantee 
registered equity securities that are NMS stocks and that meet the 
Exchange's standards for listing an equity option. These requirements 
are reasonably designed to facilitate investors' access to information 
about the Reference Entities that may be necessary to price a credit 
default basket option appropriately.
    The Commission believes that the proposed position limits and 
margin rules for credit default basket options are reasonable and 
consistent with the Act. The proposed position limit of 50,000 
contracts in any credit default basket option class appears to 
reasonably balance the promotion of a free and open market for these 
securities with minimization of incentives for market manipulation and 
insider trading. The proposed margin rules

[[Page 47102]]

appear reasonably designed to deter a member or its customer from 
assuming an imprudent position in credit default options.
    In support of this proposal, the Exchange made the following 
representations:
     The Exchange will have in place adequate surveillance 
procedures to monitor trading in credit default basket options prior to 
listing and trading such options, thereby helping to ensure the 
maintenance of a fair and orderly market for trading in credit default 
options.
     The Exchange and the OPRA will have the necessary systems 
capacity to accommodate the additional volume associated with credit 
default basket options as proposed.
    This approval order is based on CBOE's representations.
    For the foregoing reasons, the Commission finds that the proposed 
rule is consistent with the Act.

IV. Designation of Credit Default Basket Options Pursuant to Rule 9b-1

    Rule 9b-1 establishes a disclosure framework for standardized 
options that are traded on a national securities exchange and cleared 
through a registered clearing agency. Under this framework, the 
exchange on which a standardized option is listed and traded must 
prepare an ODD that, among other things, identifies the issuer and 
describes the uses, mechanics, and risks of options trading, in 
language that can be easily understood by the general investing public. 
The ODD is treated as a substitute for the traditional prospectus. A 
broker-dealer must provide a copy of the ODD to each customer at or 
before approving of the customer's account for trading any standardized 
option.\43\ Any amendment to the ODD must be distributed to each 
customer whose account is approved for trading the options class for 
which the ODD relates.\44\
---------------------------------------------------------------------------

    \43\ See 17 CFR 240.9b-1(d)(1).
    \44\ See 17 CFR 240.9b-1(d)(2).
---------------------------------------------------------------------------

    Under Rule 9b-1, use of the ODD is limited to ``standardized 
options'' for which there is an effective registration statement on 
Form S-20 under the Securities Act or that are exempt from 
registration.\45\ The Commission specifically reserved in Rule 9b-1 the 
ability to designate as standardized options other securities ``that 
the Commission believes should be included within the options 
disclosure framework.'' \46\
---------------------------------------------------------------------------

    \45\ See 17 CFR 240.9b-1(b)(1) and (c)(8). See also 17 CFR 
230.238. Rule 238 under the Securities Act provides an exemption 
from the Securities Act for any standardized option, as defined by 
Rule 9b-1(a)(4) under the Act, with limited exceptions. Rule 238 
does not exempt standardized options from the antifraud provisions 
of Section 17 of the Securities Act, 15 U.S.C. 77q. Also, offers and 
sales of standardized options by or on behalf of the issuer of the 
underlying security or securities, an affiliate of the issuer, or an 
underwriter, will constitute an offer or sale of the underlying 
security or securities as defined in Section 2(a)(3) of the 
Securities Act, 15 U.S.C. 77b(a)(3). See also Securities Act Release 
No. 8171 (December 23, 2002), 68 FR 188 (January 2, 2003) (Exemption 
for Standardized Options From Provisions of the Securities Act of 
1933 and From Registration Requirements of the Exchange Act of 
1934).
    \46\ See Securities Exchange Act Release No. 19055 and 
Securities Act Release No. 6426 (September 16, 1982), 47 FR 41950, 
41954 (September 23, 1982).
---------------------------------------------------------------------------

    The Commission hereby designates credit default basket options, as 
defined in the OCC Proposal,\47\ as standardized options for purposes 
of Rule 9b-1 under the Act. Like credit default options, credit default 
basket options do not meet the definition of ``standardized options,'' 
because they do not have an exercise price.\48\ However, they resemble 
standardized options in other significant respects. Credit default 
basket options have underlying securities and an expiration date. Like 
other standardized options, credit default basket options have 
standardized terms relating to exercise procedures, contract 
adjustments, time of issuance, effect of closing transactions, 
restrictions, and other matters pertaining to the rights and 
obligations of holders and writers. Further, credit default basket 
options are designed to provide market participants with the ability to 
hedge their exposure to underlying securities. The fact that credit 
default basket options lack a specified exercise price does not detract 
from this option-like benefit. The Commission believes that the fact 
that the OCC, the clearing agency for all standardized options, is 
willing to serve as issuer of credit default basket options supports 
the view that adding credit default basket options to the standardized 
option disclosure framework is reasonable.
---------------------------------------------------------------------------

    \47\ For purposes of its proposal, OCC would define the term 
``credit default basket option'' as an option that is based on a 
basket comprised of at least two reference entities and that is 
either a ``multiple payout credit default basket option'' or a 
``single payout credit default basket option.'' A ``multiple payout 
credit default basket option'' would mean a credit default basket 
option that automatically pays an exercise settlement amount each 
time a credit event is confirmed with respect to any one of the 
reference entities prior to expiration of the option. A ``single 
payout credit default basket option'' would be automatically 
exercised and pay a single exercise settlement amount only when the 
first credit event is confirmed with respect to a reference entity 
prior to expiration of the option. See proposed Section 1.C.(2) of 
Article XIV of the OCC By-Laws.
    ``Credit event'' would be as defined in the rules of the 
exchange on which the credit default basket options are listed, with 
respect to a reference obligation for such option. See proposed 
Section 1.C.(3) of Article XIV of the OCC By-Laws.
    ``Reference entity'' would mean any one of the issuers or 
guarantors of the reference obligation(s) that underlie a credit 
default basket option. See proposed Section 1.R.(1) of Article XIV 
of the OCC By-Laws.
    ``Reference obligation'' would mean any debt security the terms 
of which are used to define the occurrence of a credit event with 
respect to the reference entity that is its issuer or guarantor for 
a class of credit default basket options, as provided in the rules 
of the listing exchange. See id.
    \48\ See Credit Default Options Approval Order at Section VI 
(designating credit default options as standardized options for 
purposes of Rule 9b-1 under the Act).
---------------------------------------------------------------------------

    Therefore, the Commission hereby designates credit default basket 
options, such as those proposed by CBOE, as standardized options for 
purposes of Rule 9b-1 under the Act.

V. Conclusion

    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\49\ that the proposed rule change (SR-CBOE-2007-26), as modified 
by Amendment No. 3, be and hereby is approved.
---------------------------------------------------------------------------

    \49\ 15 U.S.C. 78s(b)(2).
---------------------------------------------------------------------------

    It is further ordered, pursuant to Rule 9b-1(a)(4) under the Act, 
that credit default basket options, as defined in proposed rule change 
SR-OCC-2007-06, are designated as standardized options.

    By the Commission.
Florence E. Harmon,
Deputy Secretary.
[FR Doc. E7-16587 Filed 8-21-07; 8:45 am]

BILLING CODE 8010-01-P
