32372 Federal Register / Vol. 72, No. 112 / Tuesday, June 12, 2007 / Notices

Amex has requested that the amendments, all written statements credit events in one or more debt Commission waive the 30-day operative with respect to the proposed rule securities of an issuer, referred to as delay. The Commission believes that change that are filed with the credit default options. On December 21, waiving the 30-day operative delay is Commission, and all written 2006, CBOE filed Amendment No. 1 to consistent with the protection of communications relating to the the proposed rule change; on January investors and the public interest.9 The proposed rule change between the 16, 2007, CBOE filed Amendment No. 2 Commission notes that the proposed Commission and any person, other than to the proposed rule change; on rule change is modeled on a recently those that may be withheld from the February 2, 2007, CBOE filed approved Philadelphia Stock Exchange public in accordance with the Amendment No. 3 to the proposed rule proposal.10 Amex’s proposal does not provisions of 5 U.S.C. 552, will be change; 3 and on February 7, 2007, appear to raise any novel regulatory available for inspection and copying in CBOE filed Amendment No. 4 to the issues and will allow Amex without the Commission’s Public Reference proposed rule change. The proposed undue delay to implement backup Room. Copies of such filing also will be rule change, as amended, was published trading arrangements for options— available for inspection and copying at for comment in the Federal Register on particularly exclusively listed options— the principal offices of the Exchange. February 14, 2007.4 The Commission in the event of a Disabling Event. All comments received will be posted received no comments on the proposal. At any time within 60 days of the without change; the Commission does On March 28, 2007, CBOE filed filing of the proposed rule change, the not edit personal identifying Amendment No. 5 to the proposed rule Commission may summarily abrogate information from submissions. You change (‘‘Amendment No. 5’’). This such rule change if it appears to the should submit only information that notice and order notices Amendment Commission that such action is you wish to make available publicly. All No. 5; solicits comments from interested necessary or appropriate in the public submissions should refer to File persons on Amendment No. 5; approves interest, for the protection of investors, Number SR–Amex–2007–51 and should the proposed rule change, as amended, or otherwise in the furtherance of the be submitted on or before July 3, 2007. on an accelerated basis; and designates purposes of the Act. For the Commission, by the Division of credit default options as ‘‘standardized Market Regulation, pursuant to delegated IV. Solicitation of Comments options’’ pursuant to Rule 9b–1 under authority.11 the Act.5 Interested persons are invited to Florence E. Harmon, II. Description of the CBOE Proposal submit written data, views, and Deputy Secretary. arguments concerning the foregoing, [FR Doc. E7–11265 Filed 6–11–07; 8:45 am] A. Generally including whether the proposed rule BILLING CODE 8010–01–P change is consistent with the Act. CBOE proposes to list and trade credit Comments may be submitted by any of default options, which are cash-settled, the following methods: SECURITIES AND EXCHANGE binary options 6 that are automatically COMMISSION exercised upon the occurrence of Electronic Comments specified credit events or expire • Use the Commission’s Internet [Release No. 34–55871; File No. SR–CBOE– worthless. A credit default comment form (http://www.sec.gov/ 2006–84] would be referenced to the debt rules/sro.shtml) or Self-Regulatory Organizations; securities issued by a specified public • Send an e-mail to rule- 7 Chicago Board Options Exchange, company (‘‘Reference Entity’’) and [email protected]. Please include File Incorporated; Notice of Filing of would either have a fixed payout or Number SR–Amex–2007–51 on the Amendment No. 5 to a Proposed Rule expire worthless, depending upon subject line. Change To List and Trade Credit whether or not a credit event (as Paper Comments Default Options; and Order Granting described below) occurs during the life of the option. Upon confirmation of a • Accelerated Approval of the Proposed Send paper comments in triplicate credit event prior to the last day of to Nancy M. Morris, Secretary, Rule Change, as Modified by Securities and Exchange Commission, Amendment Nos. 3, 4, and 5, and Designating Credit Default Options as 3 Amendment No. 3 replaced the original filing, 100 F Street, NE., Washington, DC as modified by Amendment Nos. 1 and 2, in its 20549–1090. Standardized Options Under Rule 9b– entirety. 1 of the Securities Exchange Act of 4 All submissions should refer to File See Securities Exchange Act Release No. 55251 1934 (February 7, 2007) (SR–CBOE–2006–84), 72 FR Number SR–Amex–2007–51. This file 7091 (‘‘CBOE Proposal’’). number should be included on the June 6, 2007. 5 See 17 CFR 240.9b–1. Pursuant to Rule 9b– subject line if e-mail is used. To help the 1(a)(4) under the Act, the Commission may, by Commission process and review your I. Introduction order, designate as ‘‘standardized options’’ comments more efficiently, please use On October 26, 2006, the Chicago securities that do not otherwise meet the definition for ‘‘standardized options.’’ Standardized options only one method. The Commission will Board Options Exchange, Incorporated are defined in Rule 9b–1(a)(4) as: ‘‘[O]ptions post all comments on the Commission’s (‘‘CBOE’’ or ‘‘Exchange’’) filed with the contracts trading on a national securities exchange, Internet Web site (http://www.sec.gov/ Securities and Exchange Commission an automated quotations system of a registered rules/sro.shtml). Copies of the (‘‘Commission’’) a proposed rule securities association, or a foreign securities exchange which relate to options classes the terms submission, all subsequent change, pursuant to Section 19(b)(1) of of which are limited to specific dates and the Securities Exchange Act of 1934 prices, or such other securities as the 9 For purposes only of waiving the operative (‘‘Act’’) 1 and Rule 19b–4 thereunder,2 to Commission may, by order, designate.’’ 17 CFR delay for this proposal, the Commission has permit CBOE to list and trade cash- 240.9b–1(a)(4). considered the proposed rule’s impact on settled, binary call options based on 6 A is a style of option having only efficiency, competition, and capital formation. See two possible payoff outcomes: Either a fixed 15 U.S.C. 78c(f). amount or nothing at all. 10 See Exchange Act Release No. 51926 (June 27, 11 17 CFR 200.30–3(a)(12). 7 Proposed CBOE Rule 29.1(f) also includes as a 2005), 70 FR 38232 (July 1, 2005) (SR–PHLX–2004– 1 15 U.S.C. 78s(b)(1). ‘‘Reference Entity’’ the guarantor of the debt 65). 2 17 CFR 240.19b–4. security underlying the .

VerDate Aug<31>2005 11:38 Jun 11, 2007 Jkt 211001 PO 00000 Frm 00097 Fmt 4703 Sfmt 4703 E:\FR\FM\12JNN1.SGM 12JNN1 cprice-sewell on PROD1PC67 with NOTICES Federal Register / Vol. 72, No. 112 / Tuesday, June 12, 2007 / Notices 32373

trading of a credit default option series,8 The requirement that the equity is a credit default option would be cash- the options positions existing as of that securities of an issuer of a debt security settled and the exercise-by-exception time would be automatically exercised underlying a credit default option meet provisions of OCC Rule 805 19 would and the holders of long options the criteria of Rule 5.4 is designed to not apply. Market-makers shall be positions would receive a fixed cash ensure that the issuer’s securities enjoy appointed to credit default options payment of $100,000 per contract.9 If no widespread investor interest. The pursuant to CBOE’s existing credit event is confirmed during the life requirement that the Reference Entity be requirements,20 as supplemented by of the option, the final settlement price an issuer of a registered NMS stock will proposed CBOE Rule 29.17. would be $0. help ensure that investors have access to Additionally, CBOE represents that Credit events that would trigger comprehensive public information there will be a maximum of one series automatic exercise include a failure to about the issuer, including the per quarterly expiration in a given credit make payment pursuant to the terms of registration statement filed under the default option class, and that it, and the the underlying debt security and any Securities Act of 1933 (‘‘Securities Act’’) Options Price Reporting Authority other event of default specified by CBOE and other periodic reports.14 (‘‘OPRA’’), have the necessary systems at the time the Exchange initially lists A credit default option could not be capacity to handle the additional quote a particular class of credit default exercised at the discretion of the volume anticipated to be associated options. The events of default that investor, but instead would have an with credit default options. CBOE may specify must be defined in automatic payout only upon the Once a particular credit default option accordance with the terms of the debt occurrence of a credit event. The class has been approved for listing and security underlying the credit default expiration date would be the fourth trading, the Exchange would, from time option (‘‘Reference Obligation’’) or any business day after the last day of trading to time, open for trading a series of that other debt security of the Reference of the series, which would be the third class. If a credit default option initially Entity (collectively with the Reference Friday of the expiration month.15 A approved for trading no longer meets Obligation, ‘‘Relevant Obligations’’).10 credit default option generally would the Exchange’s requirements for expire up to 123 months from the time continued approval, the Exchange B. Listing Standards it is listed, and the Exchange usually would not open for trading any A credit default option must conform would open one to four series for each additional series of options and, as to the initial and continued listing year up to 10.25 years from the current provided in CBOE Rule 5.4, could standards under proposed CBOE expiration.16 prohibit any opening purchase Chapter XXIX. CBOE may list and trade transactions in such series. The a credit default option that overlies a C. Trading proposed trading rules for credit default debt security of a Reference Entity, Credit default options will trade on options are designed to create an provided that such issuer or guarantor, CBOE’s Hybrid Trading System from environment that takes into account the or its parent if a wholly owned 8:30 a.m. to 3 p.m. (Central Time) 17 in small number of transactions likely to subsidiary, has at least one class of a manner similar to the trading of equity occur, while providing price securities that is registered under the options. With limited distinctions, as improvement and the transparency Act and is an ‘‘NMS stock’’ 11 as defined described more fully in the proposal, benefits of competitive Exchange floor in Rule 600 of Regulation NMS under CBOE’s equity option trading rules will bidding, as compared to the over-the- the Act.12 The registered equity apply to credit default options.18 Also, counter (‘‘OTC’’) market. securities issued by the Reference Entity credit default options will be eligible for Upon the confirmation of a credit also would have to satisfy the trading as Flexible Exchange Options event or the redemption of all Relevant requirements of CBOE Rule 5.4 for (‘‘FLEX Options’’). A FLEX Option that Obligations, the applicable credit continued options trading, which default option class would cease trading requires, among other things, that an will not be deemed to meet the Exchange’s and all outstanding contracts in that equity security underlying an option be requirements for continued approval when: (a) class would be subject to automatic There are fewer than 6,300,000 shares of the itself widely held and actively traded.13 exercise. In addition, the CBOE’s trading underlying security held by persons other than halt procedures applicable to equity those who are required to report their security 8 Proposed CBOE Rule 29.9 requires that CBOE holdings under Section 16(a) of the Act (15 U.S.C. options shall apply to credit default confirm the occurrence of a credit event through at 78p); (b) there are fewer than 1,600 holders of the options.21 When determining whether least two sources, which may include underlying security; (c) the trading volume (in all to institute a trading halt in credit announcements published via newswire services or markets in which the underlying security is traded) default options, CBOE floor officials information service companies, the names of which was less than 1,800,000 shares in the preceding would be announced to the membership via a CBOE twelve months; (d) the market price per share of the would consider whether current regulatory circular, or information contained in any underlying security closed below $3 on the quotations for the Relevant Obligation(s) order, decree, or notice of filing, however described, previous trading day as measured by the closing or other securities of the Reference of or filed with the courts, the Commission, an price reported in the primary market in which the Entity are unavailable or have become exchange, an association, the Options Clearing underlying security traded; or (e) the underlying Corporation (‘‘OCC’’), or another regulatory agency security ceases to be an NMS stock. unreliable. The Exchange’s board of or similar authority. 14 Section 13 of the Act, 15 U.S.C. 78m, requires directors shall also have the power to 9 The settlement amount would be $100,000 per that any issuer of a security registered pursuant to impose restrictions on transactions or contract unless adjusted pursuant to proposed Section 12 of the Act, 15 U.S.C. 78l, would file with exercises in one or more series of credit CBOE Rule 29.4, as discussed below. the Commission annual reports and information default options as the board, in its 10 See proposed CBOE Rule 29.1(c). and documents necessary to keep reasonably judgment, determines advisable in the 11 ‘‘NMS stock’’ means any security, or class of current the information in its Section 12 registration securities, other than an option for which statement. interests of maintaining a fair and transaction reports are collected, processed, and 15 If a credit event is confirmed, the expiration orderly market or otherwise deems made available pursuant to an effective transaction date would be the second business day after the reporting plan, or an effective national market confirmation of a credit event. See proposed CBOE 19 OCC Rule 805 sets forth the expiration date system plan for reporting transaction in listed Rule 29.1(d) and (e). exercise procedures for options cleared and settled options. See 17 CFR 242.600(b)(46) and (47). 16 See proposed CBOE Rule 29.2(b)(1) and (2). by the OCC. 12 See proposed CBOE Rule 5.3.11. 17 See proposed CBOE Rule 29.11. 20 See Chapter VIII of CBOE’s Rules. 13 CBOE Rule 5.4 provides that, absent 18 See proposed CBOE Rules 29.11–29.17 and 21 See CBOE Rules 6.3 and 6.3B; proposed CBOE exceptional circumstances, an underlying security 29.19. Rule 29.13.

VerDate Aug<31>2005 11:38 Jun 11, 2007 Jkt 211001 PO 00000 Frm 00098 Fmt 4703 Sfmt 4703 E:\FR\FM\12JNN1.SGM 12JNN1 cprice-sewell on PROD1PC67 with NOTICES 32374 Federal Register / Vol. 72, No. 112 / Tuesday, June 12, 2007 / Notices

advisable in the public interest or for F. Position Limits the requirement will be the 22 the protection of investors. Pursuant to proposed CBOE Rule lesser of the current market value plus 20% of the cash settlement amount or D. Clearance and Settlement 29.5, credit default options will be subject to a position limit equal to 5,000 the cash settlement amount. Because credit default options do not contracts on the same side of the These requirements may be satisfied by have an exercise price, they do not, by market. Credit default options shall not a deposit of cash or marginable their terms, meet the definition of be aggregated with option contracts on securities. These requirements may not ‘‘standardized options’’ for purposes of the same underlying security and will be satisfied by presentation to the Rule 9b–1 under the Act.23 However, as not be subject to the hedge exemption member organization carrying the discussed herein, the Commission today to CBOE’s standard position limits. customer’s account of a letter of credit is using its authority pursuant to Rule Instead, the following hedge exemption meeting the requirements of proposed 30 9b–1 to designate credit default options strategies and positions shall be exempt CBOE Rule 12.3(l)(1)(iii). as ‘‘standardized options’’ under Rule from CBOE’s position limits: (i) A credit A credit default option carried short in a customer’s account will be deemed 9b–1. Consequently, credit default default option position ‘‘hedged’’ or a covered position, and eligible for the option transactions would be eligible for ‘‘covered’’ by an appropriate amount of cash account, provided any one of the clearance and settlement by the OCC in cash to meet the cash settlement amount following is either held in the account accordance with procedures that are obligation (e.g., $100,000 for a credit at the time the option is written or is substantially similar to existing systems default option with an exercise settlement value of $100 multiplied by received into the account promptly and procedures for the clearance and thereafter: (i) Cash or cash equivalents settlement of exchange-traded options.24 a contract multiplier of 1,000); and (ii) a credit default option position equal to 100% of the cash settlement E. Adjustments ‘‘hedged’’ or ‘‘covered’’ by an amount of amount or (ii) an escrow agreement. The an underlying debt security(ies) that Exchange believes that these Credit default options will be subject requirements strike the appropriate 25 serves as a Relevant Obligation(s) or to adjustments in two circumstances. other securities, instruments, or balance and adequately address First, if the original Reference Entity is interests related to the Reference Entity concerns that a member or its customer succeeded by another entity in that is sufficient to meet the cash may try to maintain an inordinately accordance with the terms of the settlement amount obligation.26 Also, large unhedged position in credit underlying debt security, the related CBOE’s market-maker and firm default options. In addition, in credit default options would be replaced facilitation exemptions to position Amendment No. 5, the Exchange notes by one or more credit default options limits will apply.27 that, in accordance with CBOE Rule derived from the debt securities of the 12.3(a)(3), an escrow agreement must be successor entity or entities. To the G. Margin issued in a form acceptable to the extent necessary and appropriate for the The margin (both initial and Exchange, and that it has traditionally protection of investors and the public maintenance) required for writing short recognized as acceptable the escrow interest, all other terms and conditions and long positions in credit default agreement forms of the OCC and the of the successor options would be the options will be as follows: 28 New York Stock Exchange. same as the original credit default • For a qualified customer 29 carrying In Amendment No. 5, the Exchange options. a long position in credit default options, also represents the following: Second, if the specific debt security the margin requirement will be 20% of ‘‘As part of its regulatory oversight of (the Reference Obligation) is redeemed the current market value of the credit member organizations, the Exchange default option. generally reviews member organizations’ during the life of the credit default • For a non-qualified customer compliance with margin requirements option, another debt security of the carrying a long position in a credit applicable to customer accounts. In the Reference Entity would be specified as default option, the margin requirement future, the Exchange will include [c]redit the new Reference Obligation. In the [d]efault [o]ption margin requirements as part will be 100% of the current market of this review. Additionally, the Exchange event that all debt securities of the value of the credit default option. Reference Entity (i.e., all Relevant will review member organizations’ internal • For a non-qualified customer procedures for managing credit risk Obligations) are redeemed during the carrying a short position in a credit associated with extending margin to life of the credit default option, the default option, the margin requirement customers trading [c]redit [d]efault [o]ptions. option would cease trading and, will be the cash settlement amount, i.e., The Exchange also notes that, pursuant to assuming that CBOE has not confirmed $100,000 per contract. CBOE Rule 12.10, the Exchange may at any a credit event, the contract payout • For a qualified customer carrying a time impose higher margin requirements would be $0. when it deems such higher margin short position in a credit default option, requirements advisable.’’

22 See proposed CBOE Rule 29.8. 26 See proposed CBOE Rule 29.5. Lastly, in Amendment No. 5, the 23 See 17 CFR 240.9b–1. 27 Proposed CBOE Rule 29.5 requires that for Exchange makes non-substantive 24 On February 13, 2007, the OCC filed with the purposes of its market-maker hedge exemption changes to the text of CBOE Rule 12.5, Commission pursuant to Section 19(b)(1) of the Act, (CBOE Rule 4.11.05) the position must be within to clarify that a credit default option 15 U.S.C. 78s(b)(1), and Rule 19b–4 thereunder, 17 20% of the applicable limit before an exemption that is carried for the account of a CFR 240.19b–4, a proposed rule change to enable would be granted. With respect to CBOE’s firm it to clear and settle credit default options proposed facilitation exemption (CBOE Rule 4.11.06), qualified investor may be deemed to to be listed by CBOE. The proposed rule change was proposed CBOE Rule 29.5 provides that the published for comment in the Federal Register on aggregate exemption position could not exceed 30 In Amendment No. 5, CBOE deletes from February 27, 2007. Securities Exchange Act Release three times the standard limit of 5,000 contracts. proposed rule 12.3(l)(1)(iii) the option of using a No. 55362, 72 FR 9826 (March 5, 2007). On March 28 See proposed CBOE Rule 12.3(l); Amendment letter of credit to satisfy margin requirements 7, 2007, the OCC filed Amendment No. 1 to the No. 5. applicable to credit default options and makes non- proposed rule change. See SR–OCC–2007–01 (as 29 Proposed CBOE Rule 12.3(l)(1)(i) defines substantive corrections to the formatting of amended, the ‘‘OCC Proposal’’). The Commission ‘‘qualified customer’’ as a person or entity that proposed CBOE Rule 12.3(l)(1)(iii) and the has not yet taken action on the OCC proposal. owns and invests on a discretionary basis no less ‘‘Interpretations and Policies’’ heading that 25 See CBOE Proposed Rule 29.4. than $5,000,000 in investments. accompanies CBOE Rule 12.3.

VerDate Aug<31>2005 11:38 Jun 11, 2007 Jkt 211001 PO 00000 Frm 00099 Fmt 4703 Sfmt 4703 E:\FR\FM\12JNN1.SGM 12JNN1 cprice-sewell on PROD1PC67 with NOTICES Federal Register / Vol. 72, No. 112 / Tuesday, June 12, 2007 / Notices 32375

have market value for the purposes of 84 and should be submitted on or before Act; 35 in addition, the Commission CBOE Rule 12.3(c). July 3, 2007. finds that credit default options are options on an interest in, or based on H. Surveillance IV. Discussion the value of an interest in, a security or The Exchange has represented that it The Commission finds that the securities and, therefore, are securities will have in place adequate surveillance proposed rule change is consistent with under Section 3(a)(10) of the Act.36 procedures to monitor trading in credit the requirements of the Act and the The Commission interprets ‘‘based on default options prior to listing and rules and regulations thereunder the value [of a security or securities]’’ in trading such options. applicable to a national securities Section 3(a)(10) of the Act 37 to include III. Solicitation of Comments exchange.31 In particular, the options whose pricing in the secondary Commission finds that the proposal is market moves in relation to the value of Interested persons are invited to consistent with Section 6(b)(5) of the the underlying security or securities of submit written data, views, and Act,32 which requires, among other the option in question. Thus the fact arguments concerning Amendment No. things, that the rules of an exchange be that the payout of a cash-settled option 5, including whether Amendment No. 5 designed to prevent fraudulent and will not increase or decrease based on is consistent with the Act. Comments manipulative acts and practices; to the price movement of the underlying may be submitted by any of the promote just and equitable principles of security of that option is not following methods: 38 trade; to foster cooperation and dispositive. Electronic Comments coordination with persons engaged in Because credit default options are not currently traded, there is no empirical • regulating, clearing, processing Use the Commission’s Internet data regarding their pricing in the comment form (http://www.sec.gov/ information with respect to, and facilitating transactions in securities; to secondary market. However, credit rules/sro.shtml); or default options are essentially exchange- • Send an e-mail to rule- remove impediments to and perfect the mechanism of a free and open market traded equivalents of single-name, OTC [email protected]. Please include File credit default swaps.39 A single-name Number SR–CBOE–2006–84 on the and a national market system; and, in

subject line. general to protect investors and the 35 public interest. The CBOE’s proposal, by 15 U.S.C. 78c(a)(10). Paper Comments 36 15 U.S.C. 78c(a)(10). In determining whether a enabling CBOE to offer a security that is a security, the Commission and the • Send paper comments in triplicate will be listed and traded on the courts have looked to the economic reality of the to Nancy M. Morris, Secretary, Exchange, as opposed to the OTC product. See Caiola v. Citibank, N.A., New York, 295 F.3d 312, 325 (2d Cir. 2002), quoting United Securities and Exchange Commission, market, would extend to investors the Housing Foundation v. Foreman, 421 U.S. 837, 848 Station Place, 100 F Street, NE., benefits of a listed exchange market, (1975) (‘‘In searching for the meaning and scope of Washington, DC 20549–1090. which include: A centralized market the word ‘security’ * * * the emphasis should be center; an auction market with posted, on economic reality’’). Construing the definition of All submissions should refer to a security in this manner permits the Commission Amendment No. 5 to File Number SR– transparent market quotations and and the courts ‘‘sufficient flexibility to ensure that CBOE–2006–84. This file number transaction reporting; standardized those who market investments are not able to should be included on the subject line contract specifications; and the escape the coverage of the Securities Acts by guarantee of the OCC. creating new instruments that would not be covered if e-mail is used. To help the by a more determinate definition.’’ Reves v. Ernst Commission process and review your As a threshold matter, the & Young, 494 U.S. 56, 63 n.2 (1990). comments more efficiently, please use Commission finds that the credit default 37 Id. only one method. The Commission will options proposed by CBOE are 38 In addressing whether a ‘‘digital option’’ or a post all comments on the Commission’s securities. Section 3(a)(10) of the Act 33 ‘‘binary option’’ with a fixed payout is an option based on the value of a security or securities, the Internet Web site (http://www.sec.gov/ defines security to include, in part, ‘‘any court in Stechler v. Sidley, Austin Brown & Wood, rules/sro.shtml). Copies of the put, call, , option or privilege on L.L.P., 382 F.Supp.2d 580, 596–97 (S.D.N.Y. 2005), submission, all subsequent any security, certificate of deposit, or held that the issue ultimately turned on questions amendments, all written statements group or index of securities (including of fact and declined to decide the issue on a motion to dismiss. However, the court’s analysis made clear with respect to the proposed rule any interest therein or based on the that the existence of a fixed payout that is not tied change that are filed with the value thereof).’’ After careful analysis, in a proportionate manner to the price of an Commission, and all written the Commission finds that credit default underlying security is not a determining factor in 34 deciding whether an instrument is an option on a communications relating to the options are options based on the value security. Rather, the court accepted that, in proposed rule change between the of a security or securities and, therefore, evaluating the economic reality of an instrument, it Commission and any person, other than securities under Section 3(a)(10) of the is appropriate to consider whether the resale value those that may be withheld from the of the instrument moves in relation to the movement of an underlying reference. public in accordance with the 31 In approving this proposed rule change, the 39 Despite the similarities between credit default provisions of 5 U.S.C. 552, will be Commission notes that it has considered the options and OTC credit default swaps, the available for inspection and copying in proposed rule’s impact on efficiency, competition, Commission wishes to make two things clear. First, and capital formation. See 15 U.S.C. 78c(f). the Commission’s Public Reference because credit default options will be exchange- 32 15 U.S.C. 78f(b)(5). traded and not individually negotiated (and not Room. Copies of such filing also will be 33 15 U.S.C. 78c(a)(10). necessarily between eligible contract participants), available for inspection and copying at 34 Although credit default options do not share they are not qualifying agreements under the principal office of the Exchange. All every feature of a classic option, the Commission Section 206A of the Gramm-Leach-Bliley Act comments received will be posted nonetheless finds that credit default options are (‘‘GLBA’’), 15 U.S.C. 78c note, and, therefore, not option contracts. In particular, the Commission excluded from the definition of security by Section without change; the Commission does notes that the buyer of a credit default option pays 3A of the Act, 15 U.S.C. 78c–1. Second, certain OTC not edit personal identifying to the seller a nonrefundable premium, has rights credit default swaps are not securities. The finding information from submissions. You but no further obligations under the contract, and that credit default options are securities because should submit only information that has no further risk exposure because the seller bears they are options based on the value of a security all the risk of the credit event occurring. See United might suggest that OTC credit default swaps are you wish to make available publicly. All States v. Bein, 728 F.2d 107, 112 (2d Cir. 1984) also options based on the value of a security or submissions should refer to Amendment (highlighting characteristics that distinguish securities and, therefore, excluded from the No. 5 of File Number SR–CBOE–2006– options from futures contracts). Continued

VerDate Aug<31>2005 11:38 Jun 11, 2007 Jkt 211001 PO 00000 Frm 00100 Fmt 4703 Sfmt 4703 E:\FR\FM\12JNN1.SGM 12JNN1 cprice-sewell on PROD1PC67 with NOTICES 32376 Federal Register / Vol. 72, No. 112 / Tuesday, June 12, 2007 / Notices

is an agreement (sometimes called ‘‘’’). The there is a failure to pay or other default between a protection buyer and a yield (or credit) spread is the difference event under the terms of the underlying protection seller whereby the buyer between the yield on the debt debt security. pays a periodic fee in return for a instrument and the yield on a debt For these reasons, credit default contingent payment by the seller upon security of similar maturity whose yield options are options ‘‘based on the value the occurrence of a credit event with represents pure interest rate risk, such [of a security or securities]’’ and, respect to one or more reference as U.S. Treasuries,40 and represents the therefore, securities. obligations of a reference entity. Credit additional yield required by an investor In addition, the Commission has events typically include one or more of to compensate it for the credit risk determined that credit default options the following: (1) Bankruptcy, (2) associated with the potential default on are options on an ‘‘interest in,’’ or based obligation acceleration, (3) obligation the particular debt instrument of an on the value of an interest in, a security default, (4) a failure to pay, (5) issuer.41 As a consequence of this or securities within the meaning of repudiation or moratorium, or (6) relationship between debt securities and Section 3(a)(10) of the Act.44 A security restructuring. Similarly, as explained credit default swaps, the credit default is a collection of rights (and obligations) above, each credit default option shall swap market enables more widespread running between the issuer and the specify (a) the Reference Entity, (b) the trading in an issuer’s creditworthiness holder of the security. The concept of an specific debt security or securities that than was previously possible. ‘‘interest in’’ a security plainly includes serve as its Reference Obligation or There is a close empirical correlation rights generating a pecuniary interest in other Relevant Obligations, and (c) the between the price of a credit default a security, such as the right to a applicable events of default that trigger swap (as expressed in the CDS spread) dividend payment or bond (coupon) payout (as determined in accordance and the yield (or credit) spread of the payment. One relevant ‘‘interest in’’ a with the terms of the Reference specific reference obligation or debt security underlying a credit default Obligation or other Relevant obligations of that credit default swap.42 option is the right to receive (coupon) Obligations), which could include such This correlation is to be expected payments under the terms of that debt events as a failure to pay, obligation because the valuation of credit default security. When a (coupon) payment is acceleration or default, and swaps and debt securities are each not made, impairing the value of that restructuring. Hence, credit default based on credit risk, and because of the interest, the protection seller must make options have essentially the same potential for arbitrage between the a payment to the protection buyer. structure as credit default swaps. secondary bond market and the credit Similarly, a specified default event may In the case of a credit default swap, default swap market.43 Similarly, trigger other rights of a holder of the the amount the buyer pays for because credit default options are debt security. The default events that protection is based on a quoted spread exchange-traded equivalents of credit trigger exercise and payment under the expressed in basis points on a notional default swaps, the Commission expects credit default option are meaningful amount specified in the swap that there will be a close empirical only because they are material terms of agreement. This quoted spread is often correlation between the pricing of a a security, essential to the debt holder’s referred to as a ‘‘CDS spread’’ and is specific credit default option during the rights and interests in that security.45 principally based on the probability that life of the contract and the yield spread The credit default option payout is the Reference Entity will default (i.e., its of the Reference Obligation or other contingent on these security-dependent creditworthiness). More specifically, the Relevant Obligations of that credit events. For these reasons, credit default CDS spread represents the price default option. options are options on an interest in, or required by a swap counterparty to We further note, more generally, that based on the value of an interest in, a credit default options expressly compensate it for the credit risk security or securities.46 associated with the potential default on reference in their payout conditions a Moreover, the economic reality of a particular reference obligation or term of an underlying security that is credit default options supports the obligations of an issuer. Similarly, the material to the value of that security. A conclusion that credit default options value of a debt security is a function of credit default option will pay out if are securities. Taking a short position the issuer’s creditworthiness, which is (i.e., taking on the role of a protection 40 Some academics have hypothesized that there expressed in terms of a ‘‘yield spread’’ may be some deviation between the yield on U.S. seller) via credit default options would Treasuries and pure interest rate risk because bond be akin to purchasing the corporate definition of swap agreement because Section interest is subject to state tax but U.S. Treasuries are bond that is the Reference Obligation or 206A(b)(1) of the GLBA, 15 U.S.C. 78c note, not. See, e.g., Haibin Zhu, An Empirical other Relevant Obligations of that credit excludes from the definition of swap agreement Comparison of Credit Spreads between the Bond ‘‘any put, call, straddle, option, or privilege on any Market and the Credit Default Swap Market, BIS security, certificate of deposit, or group or index of Working Papers No. 160 (August 2004) (also noting 44 15 U.S.C. 78c(a)(10). securities, including any interest therein or based that transparency and the widespread use of U.S. 45 Although certain default events trigger the on the value thereof.’’ However, Congress Treasuries as collateral could explain apparent exercise and payment of a credit default option, it specifically enumerated ‘‘credit default swaps’’ deviations). would not be accurate to describe these options as (without defining the term) as one example of a 41 While the terms of both corporate securities options on ‘‘an event’’. There is no event delivered qualifying swap agreement. See Section 206A(a)(3) and credit default swaps are established when upon exercise of the option, rather a payment is of the GLBA, 15 U.S.C. 78c note. The Commission parties enter into the respective contracts, the fair delivered. The crucial question is what causes the views the specific enumeration of ‘‘credit default market value of these contracts can vary over the option to be in-the-money and pay out. In the case swaps’’ as reflecting the intention of Congress to life of the contracts in response to changing of credit default options, it is an event that is exclude certain OTC credit default swaps from the perceptions of the creditworthiness of an issuer. created by a security. definition of security pursuant to Sections 206B & 42 See, e.g., Roberto Blanco, Simon Brennan, and 46 It is important to note that merely because the C of the GLBA, 15 U.S.C. 78c note. Credit default Ian W. Marsh, An Empirical Analysis of the option does not transfer ownership of the interest swaps that involve terms similar to credit default Dynamic Relation between Investment-Grade Bonds or right in a security—but instead becomes in-the- options, but that are otherwise excluded from the and Credit Default Swaps, The Journal of money and provides a cash payment if certain definition of security because they are qualifying Economics, Volume LX, No. 5 (Oct. 2005) (finding security rights are triggered—does not mean the swap agreements, remain subject to the credit default swap spreads to be quite close to option is not on an interest in a security. Cf. Caiola, Commission’s antifraud jurisdiction (including bond yield spreads). 295 F.3d 312 (2d Cir. 2002) (including within the authority over insider trading) as ‘‘security-based 43 See Zhu, An Empirical Comparison of Credit definition of ‘‘security’’ an option that did not swap agreements’’ under Section 206B of the GLBA, Spreads between the Bond Market and the Credit deliver an actual security or interest in a security, 15 U.S.C. 78c note. Default Swap Market, supra note 40. but merely a cash payment).

VerDate Aug<31>2005 11:38 Jun 11, 2007 Jkt 211001 PO 00000 Frm 00101 Fmt 4703 Sfmt 4703 E:\FR\FM\12JNN1.SGM 12JNN1 cprice-sewell on PROD1PC67 with NOTICES Federal Register / Vol. 72, No. 112 / Tuesday, June 12, 2007 / Notices 32377

default option with the interest rate risk market for trading in credit default prospectus. A broker-dealer must fully hedged. Both give the investor the options. provide a copy of the ODD to each same risk exposure to creditworthiness • The Exchange and the OPRA will customer at or before approving of the of an issuer. Indeed, credit default have the necessary systems capacity to customer’s account for trading any options may even more closely reflect accommodate the additional volume standardized option.50 Any amendment the financial condition of an SEC- associated with credit default options as to the ODD must be distributed to each registered issuer because, unlike proposed. customer whose account is approved for corporate bonds, which reflect both an This approval order is conditioned on trading the options class for which the issuer’s creditworthiness and general CBOE’s adherence to these ODD relates.51 interest rate risk, credit default options representations. Under Rule 9b–1, use of the ODD is would only reflect an issuer’s For the foregoing reasons, the limited to ‘‘standardized options’’ for creditworthiness. That ability to isolate Commission finds that the proposed which there is an effective registration and transfer credit risk, backed by the rule is consistent with the Act. statement on Form S–20 under the Securities Act or that are exempt from guarantee of a central counterparty and V. Accelerated Approval the transparency of an exchange, should registration.52 The Commission provide investors with additional The Commission finds good cause for specifically reserved in Rule 9b–1 the opportunities to gain exposure to the approving the proposed rule change, as ability to designate as standardized public debt market. modified by Amendment No. 5, prior to options other securities ‘‘that the For these reasons, the Commission the thirtieth day after publishing notice Commission believes should be finds that credit default options are of Amendment No. 5 in the Federal included within the options disclosure options based on the value of, and Register pursuant to Section 19(b)(2) of framework.’’ 53 options on interests in or based on the the Act.48 In Amendment No. 5, CBOE: The Commission hereby designates value of interests in, a security or (1) Modified the text of the proposed credit default options, as defined in the securities of the Reference Entity and, margin requirements applicable to OCC Proposal,54 as standardized therefore, securities under Section credit default options contained in options for purposes of Rule 9b–1 under 3(a)(10) of the Act.47 proposed Rules 12.3 and 12.5; (2) made the Act. Credit default options do not Further, the Commission believes that corresponding changes to the discussion meet the definition of ‘‘standardized the listing rules proposed by CBOE for sections of the Form 19b–4 and the options,’’ because they do not have an credit default options are reasonable Exhibit 1 thereto; and (3) inserted exercise price. However, they resemble and consistent with the Act. The information in the discussion sections Commission notes in particular that a of the Form 19b–4 and the Exhibit 1 50 See 17 CFR 240.9b–1(d)(1). 51 credit default option must be based on thereto regarding the form of escrow See 17 CFR 240.9b–1(d)(2). agreements and the Exchange’s 52 See 17 CFR 240.9b–1(b)(1) and (c)(8). See also a Reference Obligation issued by an 17 CFR 230.238. Rule 238 under the Securities Act entity that issues registered equity supervision of member organizations provides an exemption from the Securities Act for securities that are NMS stocks and that that extend margin to customers trading any standardized option, as defined by Rule 9b– meet the Exchange’s standards for Credit Default Options.49 The 1(a)(4) under the Act, with limited exceptions. Rule Commission believes that Amendment 238 does not exempt standardized options from the listing an equity option. These antifraud provisions of Section 17 of the Securities requirements are reasonably designed to No. 5 raises no significant regulatory Act, 15 U.S.C. 77q. Also, offers and sales of facilitate investors’ access to issues. The Commission therefore finds standardized options by or on behalf of the issuer information about the Reference Entity good cause exists to accelerate approval of the underlying security or securities, an affiliate of the proposed change, as modified by of the issuer, or an underwriter, will constitute an that may be necessary to price a credit offer or sale of the underlying security or securities default option appropriately. Amendment No. 5, pursuant to Section as defined in Section 2(a)(3) of the Securities Act, The Commission believes that the 19(b)(2) of the Act. 15 U.S.C. 77b(a)(3). See also Securities Act Release proposed position limits and margin No. 8171 (December 23, 2002), 68 FR 188 (January VI. Designation of Credit Default 2, 2003) (Exemption for Standardized Options From rules for credit default options are Options Pursuant to Rule 9b–1 Provisions of the Securities Act of 1933 and From reasonable and consistent with the Act. Registration Requirements of the Exchange Act of Rule 9b–1 establishes a disclosure The proposed position limit of 5,000 1934). framework for standardized options that 53 contracts in any credit default option See Securities Exchange Act Release No. 19055 are traded on a national securities and Securities Act Release No. 6426 (September 16, class appears to reasonably balance the exchange and cleared through a 1982), 47 FR 41950, 41954 (September 23, 1982). promotion of a free and open market for 54 registered clearing agency. Under this For purposes of its proposal, OCC would define these securities with minimization of the term ‘‘credit default option’’ as an option that framework, the exchange on which a incentives for and is automatically exercised upon receipt by the OCC standardized option is listed and traded insider trading. The proposed margin of a credit event confirmation with respect to the must prepare an Options Disclosure reference obligation(s) of a reference entity. Credit rules appear reasonably designed to Document (‘‘ODD’’) that, among other default options have only two possible payoff deter a member or its customer from outcomes: Either a fixed automatic exercise things, identifies the issuer and assuming an imprudent position in settlement amount or nothing at all. See proposed describes the uses, mechanics, and risks credit default options. Section 1.C.(2) of Article XIV of the OCC By-Laws. of options trading, in language that can • I11‘‘Credit event’’ would be as defined in the In support of this proposal, the be easily understood by the general rules of the exchange on which the credit default Exchange made the following investing public. The ODD is treated as options are listed, with respect to a reference representations: obligation for such option. See proposed Section a substitute for the traditional • The Exchange will have in place 1.C.(3) of Article XIV of the OCC By-Laws. • I11‘‘Reference entity’’ would mean the issuer or adequate surveillance procedures to 48 15 U.S.C. 78s(b)(2). Pursuant to Section 19(b)(2) guarantor of the reference obligation(s). See monitor trading in credit default options of the Act, the Commission may not approve any proposed Section 1.R.(1) of Article XIV of the OCC prior to listing and trading such options, proposed rule change, or amendment thereto, prior By-Laws. thereby helping to ensure the to the thirtieth day after the date of publication of • I11‘‘Reference obligations’’ would mean one or maintenance of a fair and orderly the notice thereof, unless the Commission finds more debt securities the terms of which define a good cause for so doing. credit event for a class of credit default options, as 49 The changes pursuant to Amendment No. 5 are provided in the rules of the listing exchange. See 47 15 U.S.C. 78c(a)(10). discussed more fully in Section II.G, supra. id.

VerDate Aug<31>2005 11:38 Jun 11, 2007 Jkt 211001 PO 00000 Frm 00102 Fmt 4703 Sfmt 4703 E:\FR\FM\12JNN1.SGM 12JNN1 cprice-sewell on PROD1PC67 with NOTICES 32378 Federal Register / Vol. 72, No. 112 / Tuesday, June 12, 2007 / Notices

standardized options in other significant (‘‘Act’’),1 and Rule 19b–4 thereunder,2 system (‘‘Preferenced Orders’’). If the respects. Credit default options have an notice is hereby given that on May 9, Preferred Market Maker is not quoting at underlying security and an expiration 2007, the International Securities the NBBO at the time the Preferenced date. Like other standardized options, Exchange, LLC (‘‘ISE’’ or ‘‘Exchange’’) Order is received, the Exchange’s credit default options have standardized filed with the Securities and Exchange existing allocation and execution terms relating to exercise procedures, Commission (‘‘Commission’’) the procedures will be applied to the contract adjustments, time of issuance, proposed rule change as described in execution.3 The proposed rule is subject effect of closing transactions, Items I and II below, which Items have to a pilot program that is currently set restrictions, and other matters been prepared by the Exchange. The to expire on June 10, 2007.4 pertaining to the rights and obligations Commission is publishing this notice to of holders and writers. Further, credit solicit comments on the proposed rule Under the proposal, if a Preferred default options are designed to provide change from interested persons and is Market Maker is quoting at the NBBO at market participants with the ability to approving the proposal on an the time a Preferenced Order is hedge their exposure to an underlying accelerated basis. received, the allocation procedure is modified so that the Preferred Market security. The fact that credit default I. Self-Regulatory Organization’s options lack a specified exercise price Maker will receive an enhanced Statement of the Terms of Substance of allocation instead of the Primary Market does not detract from this option-like the Proposed Rule Change benefit. The Commission believes that Maker 5 equal to the greater of: (i) The the fact that the OCC, the clearing The ISE is proposing to make proportion of the total size at the best agency for all standardized options, is permanent its pilot program for price represented by the size of its willing to serve as issuer of credit Preferenced Orders. The text of the quote; or (ii) sixty percent of the default options supports the view that proposed rule change is available on contracts to be allocated if there is only adding credit default options to the ISE’s Web site at http://www.ise.com, at one other Non-Customer Order or standardized option disclosure the Exchange’s principal office, and at market maker quotation at the best price framework is reasonable. the Commission’s Public Reference and forty percent if there are two or Therefore, the Commission hereby Room. more other Non-Customer Orders and/or designates credit default options, such II. Self-Regulatory Organization’s market maker quotes at the best price.6 as those proposed by CBOE, as Statement of the Purpose of, and Unexecuted contracts remaining after standardized options for purposes of Statutory Basis for, the Proposed Rule the Preferred Market Maker’s allocation Rule 9b–1 under the Act. Change would be allocated pro-rata based on VII. Conclusion In its filing with the Commission, the size as described above. Exchange included statements Pursuant to this proposed rule change It is therefore ordered, pursuant to 55 concerning the purpose of and basis for seeking permanent approval of the pilot Section 19(b)(2) of the Act, that the the proposed rule change and discussed proposed rule change (SR–CBOE–2006– program, the Exchange also proposes to any comments it received on the delete from the Notes section in its 84) as modified by Amendment Nos. 3, proposed rule change. The text of these 4, and 5, be, and hereby is approved on Schedule of Fees a reference to the statements may be examined at the Preferenced Orders pilot program that an accelerated basis. places specified in Item III below. The It is further ordered, pursuant to Rule was adopted when the Exchange Exchange has prepared summaries, set initiated a payment for order flow 9b–1(a)(4) under the Act, the credit forth in Sections A, B, and C below, of default options, as defined in proposed program for Competitive Market the most significant aspects of such Makers.7 rule change (SR–OCC–2007–01) are statements. designated as standardized options. The Exchange believes the proposed A. Self-Regulatory Organization’s By the Commission. rule change is a necessary competitive Statement of the Purpose of, and response to the preferencing rules Florence E. Harmon, Statutory Basis for, the Proposed Rule Deputy Secretary. adopted by other options exchanges and Change will help the ISE attract and retain order [FR Doc. E7–11273 Filed 6–11–07; 8:45 am] 1. Purpose flow. This order flow will add depth BILLING CODE 8010–01–P and liquidity to the Exchange’s markets The purpose of the proposed rule change is to make permanent the and enable the Exchange to continue to SECURITIES AND EXCHANGE Exchange’s pilot program for compete effectively with other options COMMISSION preferenced orders as provided in exchanges. [Release No. 34–55864; File No. SR–ISE– paragraph .03 of the Supplementary Material to Rule 713. The proposal 3 Marketable customer orders are not 2007–35] automatically executed at prices inferior to the amends ISE’s procedure for allocating NBBO. If the ISE best bid or offer is inferior to the Self-Regulatory Organizations; trades among market makers and non- NBBO, it is handled by the Primary Market Maker International Securities Exchange, customer orders under Rule 713 to according to Rule 803(c). LLC; Notice of Filing and Order provide an enhanced allocation to a 4 See Securities Exchange Act Release No. 53921 ‘‘Preferred Market Maker’’ when it is (June 1, 2006), 71 FR 33019 (June 7, 2006). Granting Accelerated Approval of a 5 quoting at the national best bid or offer A Primary Market Maker may be the Preferenced Proposed Rule Change to Permanently Market Maker, in which case such market maker Extend the Pilot Program for (‘‘NBBO’’). Specifically, an Electronic would receive the enhanced allocation for Preferenced Orders Access Member may designate any Preferenced Market Makers. market maker appointed to an options 6 All allocations are automatically performed by June 5, 2007. class to be a Preferred Market Maker on the Exchange’s system. Pursuant to Section 19(b)(1) of the orders it enters into the Exchange’s 7 See Securities Exchange Act Release No. 53127 (January 13, 2006), 71 FR 3582 (January 23, 2006) Securities Exchange Act of 1934 (Notice of Filing and Immediate Effectiveness of 1 15 U.S.C. 78s(b)(1). Proposed Rule Change Relating to Payment for 55 15 U.S.C. 78s(b)(2). 2 17 CFR 240.19b–4. Order Flow Fee Changes).

VerDate Aug<31>2005 11:38 Jun 11, 2007 Jkt 211001 PO 00000 Frm 00103 Fmt 4703 Sfmt 4703 E:\FR\FM\12JNN1.SGM 12JNN1 cprice-sewell on PROD1PC67 with NOTICES