Appendix — Investment Co. Institute v. Securities & Exchange Commission
Supreme Court brief1990
Ask Donna
What actually matters in this document.
Text
89-1502" PILED.
MAR 22 1990
Nos. VOSEPH F. SAPNIOL, JR,
CLERK
IN THE a
Supreme Court of the Gnited States
OCTOBER TERM, 1989
AMERICAN STOCK EXCHANGE, INC., CHICAGO BOARD
OPTIONS EXCHANGE, INCORPORATED, AND THE
OPTIONS CLEARING CORPORATION,
Petitioners,
vV.
CHICAGO MERCANTILE EXCHANGE, et ai.,
Respondents.
PHILADELPHIA STOCK EXCHANGE, INC.,
Petitioner,
V
CHICAGO MERCANTILE EXCHANGE, et al.,
Respondents.
PETITIONS FOR A WRIT OF CERTIORARI
TO THE UNITED STATES COURT OF APPEALS
FOR THE SEVENTH CIRCUIT
(SEVENTH CIRCUIT NOS. 89-1763 and 89-1786)
JOINT APPENDIX OF PETITIONERS
BURTON R. RISSMAN EARL H. NEMSER
Counsel of Record Counsel of Record
ROGER PASCAL Cadwalader,
WILLIAM H. NAVIN Wickersham & Taft
Schiff Hardin & Waite 100 Maiden Lane
7200 Sears Tower New York, New York 10038
Chicago, Illinois 60606 (212) 504-6000
(312) 876-1000
Attorneys for The Options Attorneys for Philadelphia
Clearing Corporation Stock Exchange, Inc.
App. 1
INDEX TO APPENDIX
Appendices PAGE
Appendix A: Opinion of the Court of Appeals for
the Seventh Circuit, Nos. 89-1538, 89-1763, 89-
1786, and 89-2012 (August 18, 1989) .......... App.
Appendix B: Order of the Securities and Ex-
change Commission under review in No. 89-
PEE Bhs SE hr ca oe ewe ees App.
Appendix C: Order of the Securities and Ex-
change Commission under review in No. 89-
ye Bi. ee ee oe App.
Appendix D: Per Curiam Opinion of the Court of
Appeals for the Seventh Circuit denying peti-
tions for rehearing and suggestions of rehear-
ing en banc, Nos. 89-1538, 89-1763, 89-1786, and
SP-SU1Z Wictaber ZG, 1960)... «cas ccc cc ceess App.
Appendix E: Statutes and Regulations Involved. App.
Commodity Exchange Act, as amended, 7
U.S.C. 88 1-26 (1988):
Sec. 2(a)(1)(A), 7 U.S.C. § 2 (1988) .......... App.
Sec. 2(a)(1)(B), 7 U.S.C. § 2a (1988) ......... App.
Securities Exchange Act of 1934, as amended,
15 U.S.C. 88 78a-78// (1988):
Sec. 3(a){10), 15 U.S.C. § 78e(a)(10) (1988).... App.
Sec. 9(g), 15 U.S.C. § 78i(g) (1988) .......... App.
Sec. 25(a), 15 U.S.C. § 78y(a) (1988) ......... App.
Sec. 28(a), 15 U.S.C. § 78bb(a) (1988)........ App.
Rules and Regulations Under the Securities
and Exchange Act of 1934:
Rule 9b-1, 17 C.F.R. § 240.9b-1 (1989) ....... App.
26
84
108
112
112
116
119
120
121
122
123
App. 1
APPENDIX A
3n the
United States Court of Appeals
For the Seventh Circuit
Nos. 89-1538, 89-1763, 89-1786, and 89-2012
CHICAGO MERCANTILE EXCHANGE, BOARD OF TRADE OF THE
CiTy OF CHICAGO, and INVESTMENT COMPANY INSTITUTE,
Petitioners,
v.
SECURITIES AND EXCHANGE COMMISSION,
Respondent,
and
PHILADELPHIA STOCK EXCHANGE, INC., OPTIONS CLEARING
CORPORATION, AMERICAN STOCK EXCHANGE, INC., and
CHICAGO BOARD OPTIONS EXCHANGE, INC.,
Intervening Respondents.
Petitions for Review of Orders of
the Securities and Exchange Commission.
ARGUED JUNE 9, 1989—DeEcIDED AuGusT 18, 1989
Before BAUER, Chief Judge, EASTERBROOK, Circuit
Judge, and FAIRCHILD, Senior Circuit Judge.
EASTERBROOK, Circuit Judge. The Commodity Futures
Trading Commission has authority to regulate trading of
futures contracts (including futures on securities) and op-
tions on futures contracts. The Securities and Exchange
App. 2
2 Nos. 89-1538, 89-1763, 89-1786 & 89-2012
Commission has authority to regulate trading of securities
and options on securities. If an instrument is both a se-
curity and a futures contract, the CFTC is the sole regu-
lator because ‘‘the Commission shall have exclusive juris-
diction with respect to . . . transactions involving... .
contracts of sale (and options on such contracts) for future
delivery of a group or index of securities (or any interest
therein or based upon the value thereof)”, 7 U.S.C. §2afii).
See also 7 U.S.C. §2 (“the Commission shall have ex-
clusive jurisdiction, except to the extent otherwise pro-
vided in section 2a of this title’); Chicago Board of Trade
v. SEC, 677 F.2d 1137 (7th Cir.), vacated as moot, 459
U.S. 1026 (1982) (GNMA Options). If, however, the in-
strument is both a futures contract and an option on a
security, then the SEC is the sole regulator because ‘“‘the
[CFTC] shall have no. jurisdiction to designate a board
of trade as a contract market for any transaction whereby
any party to such transaction acquires any put, call, or
other option on one or more securities . . . including any
group or index of such securities, or any interest therein
or based on the value thereof.” 7 U.S.C. §2a(i).
The CFTC regulates futures and options on futures; the
SEC regulates securities and options on securities; juris-
diction never overlaps. Problem: The statute does not de-
fine either ‘‘contracts . . . for future delivery” or “‘op-
tion’’—although it says that “‘ ‘future delivery’. . . shall
not include any sale of any cash commodity for deferred
shipment or delivery’. See Lester G. Telser, Futures and
Actual Markets: How They Are Related, 59 J. Business
S5 (1986). Each of these terms has a paradigm, but new-
fangled instruments may have aspects of each of the pro-
totypes. Our case is about such an instrument, the index
participation (IP). We must decide whether tetrahedrons
belong in square or round holes.
I
Index participations are contracts of indefinite duration
based on the value of a basket (index) of securities. The
seller of an IP (called the “‘short’”’ because the writer need
App. 3
Nos. 89-1538, 89-1763, 89-1786 & 89-2012 3
not own the securities) promises to pay the buyer the
value of the index as measured on a “cash-out day’. Any
index, such as the Standard & Poor’s 500, can be used.
The buyer pays for the IP in cash on the date of sale
and may borrow part of the price (use margin) on the
same terms the Federal Reserve sets for stock—currently
50%. The exchange designates a conversion ratio between
the index and the IP, so that (say) each IP unit entitles
the holder on cash-out day to the value of the index times
100. Until cash-out the IP may trade on the exchange just
like any other instrument. At the end of each quarter the
short must pay the buyer (the “long’’) a sum approxi-
mating the value of dividends the stocks in the index have
paid during the quarter. From the perspective of the long,
then, an IP has properties similar to those of a closed-
end mutual fund holding a value-weighted portfolio of the
securities in the index: the IPs last indefinitely, pay
dividends, and may be traded freely; on cash-out day the
IP briefly becomes open-end, and the investor can
withdraw cash without making a trade in the market.
Things differ from the short’s perspective. Unlike the
proprietor of a mutuai fund, the short need not own the
securities in the index; it will own them (equivalently, a
long futures contract based on the same index) only to
reduce risk. The short receives the long’s cash but must
post margin equal to 150% of the value of the IP, similar
to the margin required for a short sale of stock. The short
sees the IP as a speculative or hedging instrument scarce-
ly distinguishable from a futures contract that terminates
on the cash-out day, plus an option held by the long to
roll over the contract to the next cash-out date. Cash-out
days for an IP generally are the third Friday of March,
June, September, and December, the expiration dates of
the principal stock-index futures contracts, making the link
even more apparent.
Longs and shorts do not deal directly with each other.
After the parties agree on the price, the Options Clear-
ing Corporation (OCC) issues the IP to the long, receiv-
ing the cash; at the same time the OCC pays the short
App. 4
4 Nos. 89-1538, 89-1763, 89-1786 & 89-2012
and “‘acquires” the short’s obligation to pay at cash-out
time. OCC guarantees the short’s obligations to the long,
to secure which it holds the short’s 150% margin. As the
quarter progresses the short must pony up cash to cover
dividend-equivalent obligations. When a long exercises the
cash-out privilege, the OCC chooses a short at random
to make the payment. Any link between the original
buyer and seller of an IP thus does not extend beyond
the formation of the instrument; after that instant, each
person’s rights and obligations run to the OCC exclusive-
ly. This arrangement also permits either party to close
its position by making an offsetting transaction. If the
seller of an IP buys an identical contract in the market,
the OCC cancels the two on its books.
The Philadelphia Stock Exchange asked the SEC in
February 1988 for permission to trade IPs. The American
Stock Exchange and the Chicago Board Options Exchange
later filed proposals of their own. Each exchange’s IP dif-
fers slightly from the others. Philadelphia’s IP, called a
“Cash Index Participation’’, allows the long to exercise
the cash-out privilege on any business day, at a discount
of 0.5% from the value of the index. (The long may cash
out on a quarterly date without penalty.) The AMEX’s
IP, called the ‘‘Equity Index Participation’’, permits the
long to cash out quarterly for money or shares of stock
in a ratio matching the index. Holders of 500 or more EIP
trading units based on the S&P 500 index (each the equiv-
alent of 100 multiples of that index) may exercise the right
to receive securities, and they must pay a “delivery charge”
to be established by the AMEX. Writers of EIPs may
volunteer to deliver stock; if not enough do, a “physical
delivery facilitator’ at the AMEX will buy stock in the
market, using money provided by the shorts whose posi-
tions have been liquidated. The CBOE’s product, the
“Value of Index Participation”, has a semi-annual rather
than quarterly cash-out date. CBOE’s wrinkle is that the
short as well as the long may cash out, by tendering the
value of the index on the cash-out date. If shorts seek-
ing to close their positions exceed the number of longs
App. 5
Nos. 89-1538, 89-1763, 89-1786 & 89-2012‘ 5
who want cash, the OCC will choose additional long posi-
tions at random to pay off.
The three stock exchanges and the OCC asked the SEC
to allow them to trade these varieties of IP. Each con-
tended that the SEC has exclusive jurisdiction because
IPs are securities and not futures contracts. The AMEX
added that in its view an IP is an option on securities,
activating the savings clause of §2a(i). The Chicago Board
of Trade and the Chicago Mercantile Exchange, supported
by the CFTC, asked the SEC to deny the requests. Each
futures market, and the CFTC, argued that IPs are fu-
tures and not securities, so that the CFTC’s jurisdiction
is exclusive under 7 U.S.C. §§ 2 and 2a(ii). Complicating
the picture, the Investment Company Institute argued
that if IPs are securities and not futures, the OCC is an
“investment company”’, offering a product combining fea-
tures of closed-end and open-end mutual! funds, and must
register under the Investment Company Act of 1940, 15
U.S.C. §§ 80a-1 to 80a-64.
On April 11, 1989, the SEC granted the exchanges’ re-
quests. Release No. 34-26709, 54 Fed. Reg. 15280 (1989).
At the same time, its Division of Market Regulation, act-
ing with delegated authority, allowed the OCC to change
its rules so that it could issue, settle, and clear IPs.
Release No. 34-26713, 54 Fed. Reg. 15575 (1989). The SEC
concluded that IPs are “‘stock’”’ within the meaning of
§3(aX10) of the Securities Exchange Act of 1934, 15 U.S.C.
§78c(aX10). IPs are negotiable, pay dividends, may ap-
preciate in value, and may be hypothecated; the only at-
tribute of stock missing from IPs is voting rights, which
the SEC thought unimportant. 54 Fed. Reg. at 15285-86.
If not stock, the SEC concluded, IPs are “certificates of
interest or participation in” stock, another of the in-
struments defined as “securities” in §3(aX10). See 54 Fed.
Reg. at 15286.1 Next the SEC found that IPs are not
1 Commissioner Cox, while otherwise joining the SEC’s opinion,
disavowed reliance on the contention that IPs are -“‘stock” but
agreed with his colleagues that they are “certificates of interest
or participation”. 54 Fed. Reg. at 15293.
App. 6
6 Nos. 89-1538, 89-1763, 89-1786 & 89-2012
“futures”, id. at 15286-89, because they lack two features
the SEC thought essential: ‘“futurity’’ and “bilateral
obligation”. ‘‘Futurity”” means that value is set in the
future, while as the SEC observed the buyer of an IP
pays a price fixed at the time of sale; “bilateral obliga-
tion’ means that the contract is executory on both sides
until expiration or settlement, while the long on an IP
performs at the time of purchase, leaving only the short
with executory obligations. The SEC went on to say, id.
at 15289-90, that the OCC need not register under the
Investment Company Act because there is no “‘issuer”’
within the meaning of §3(aX1) of that statute, 15 U.S.C.
§80a-3(aX1). Concluding that IPs may serve as substitutes
for “program trading’, provide “an additional layer of
liquidity to the market”, and afford “‘an alternative vehi-
cle for retail customers to invest in ‘the market’ ”’, 54 Fed.
Reg. at 15290, the SEC allowed the exchanges to pro-
ceed with their plans. We denied the futures markets’ re-
quest for a stay but accelerated the hearing of the case
on the merits. IPs have been trading on the three ex-
changes since May.
II
Three preliminary matters.
First, the futures markets are not plagued by regula-
tion of their own activities. They complain, instead, that
the SEC has passed up an opportunity to throttle three
competitors. The futures markets may obtain relief only
if there is a case or controversy within the meaning of
Article III, and then only if they fall within the zone of
interests protected by the Securities Exchange Act and
the exclusivity clauses of the Commodity Exchange Act.
The last time a dispute of this character was before us,
we held that the futures markets have standing, GNMA
Options, 677 F.2d at 1140-41 n.4, but did not mention the
‘“‘zone”’ question. Our opinion in Chicago Board of Trade
v. SEC, No. 89-1084 (7th Cir. Aug. 17, 1989) (Delta Op-
tions), requires decision in the futures markets’ favor.
Delta Options concludes that the futures markets may
App. 7
Nos. 89-1538, 89-1763, 89-1786 & 89-2012 7
challenge the registration of a clearing agency that facil-
itates transactions for their competitors, even though the
futures markets’ interests may be adverse to those of in-
vestors. Today’s case is easier, because the exclusivity
clauses of the Commodity Exchange Act are at least ar-
guably there for the benefit of the futures markets. Too,
if the SEC is right that IPs are not futures, then the
futures markets not only must suffer competition with
their existing contracts but also would be forbidden to
trade IPs themselves. The CME and the CBOT conse-
quently are proper parties to invoke judicial review.
Second, the futures markets lodged with the court a
lengthy report the CFTC submitted to the Senate Com-
mittee on Agriculture, Nutrition and Forestry explaining
its position that it (and not the SEC) has jurisdiction of
IPs. The stock exchanges ask us to strike this report
because it is not part of the SEC’s administrative record.
They also want us to strike from the appendix affidavits
of Todd E. Petzel that were prepared after the SEC’s
decision. We deny these motions. The CFTC’s report to
the Senate is a public document, which the court would
be free to consult whether or not anyone had supplied
it; lodging simply reduces the workload of the court’s
librarian. The Petzel affidavits, by contrast, are case-
specific documents that may be presented only if part of
the administrative record. Wisconsin Electric Power Co.
v. Costle, 715 F.2d 323, 326-27 (7th Cir. 1983); cf. Edison
Electric Institute v. OSHA, 849 F.2d 611, 623 n.16 (D.C.
Cir. 1988). They are. Although prepared after the SEC’s
decision, they were submitted to that agency in support
of the futures markets’ request for a stay. The stock ex-
changes asked the SEC to strike them; it took no action
on that request. So the affidavits entered the administra-
tive record and may be included in the record here, for
what they are worth. Edison Electric; see also Associa-
tion of Pacific Fisheries v. EPA, 615 F.2d 794, 811-12
(9th Cir. 1980) (Kennedy, J.).
Third, the SEC asks us to dismiss one of the petitions
for review, No. 89-1538. The futures markets filed a peti-
tion the instant the SEC voted at a public meeting on
App. 8
8 Nos. 89-1538, 89-1763, 89-1786 & 89-2012
March 14 to approve the trading of IPs. They filed addi-
tional petitions after the SEC issued its orders on April
11. Section 25(aX1) of the ’34 Act, 15 U.S.C. §78y(aX1),
which supplies this court’s jurisdiction, authorizes review
of ‘‘a final order of the Commission entered pursuant to
this chapter’’. The petition shall be filed “within sixty
days after the entry of the order’. The Commission’s
Rules of Practice define “entry” as the date the order
is adopted, reflected by its caption. Rule of Practice 22(k),
17 C.F.R. §201.22(k). Until the Commission has “entered”’
an “order’’, there is nothing to review. There is a big
difference between a vote and an order. Only the order
gives legal effect to the SEC’s vote.
The futures markets contend that the vote is reviewable
because the stock exchanges could have started to trade
IPs immediately thereafter, and they refer to TT World
Communications, Inc. v. FCC, 621 F.2d 1201 (2d Cir.
1980), which accepted jurisdiction of a petition filed prior
to the written order. The FCC’s decision in JTT went
into force before entry of a written document; bound by
the decision, ITT, as the party being regulated, needed
to file a petition to obtain a stay. The SEC’s vote did
not produce an immediately effective order. It did not re-
quire the futures markets to take any action. The vote
(without the order) had no effect on the futures markets
different in kind from a refusal (for the time being) to
take action against their competitors. To see this, sup-
pose that the stock exchanges had started trading IPs
forthwith, and the SEC had done nothing. Inaction would
be neither final nor reviewable, for the reasons given in
Delta Options. The vote of March 14 was at most a clue
that if the stock exchanges were to move aggressively,
the SEC would not act. Petition No. 89-1538 is dismissed
for want of a reviewable order.
Ill
A
A futures contract, roughly speaking, is a fungible prom-
ise to buy or sell a particular commodity at a fixed date
App. 9
Nos. 89-1538, 89-1763, 89-1786 & 89-2012 9
in the future. Futures contracts are fungible because they
have standard terms and each side’s obligations are guar-
anteed by a clearing house. Contracts are entered into
without prepayment, although the markets and clearing
house will set margin to protect their own interests. Trad-
ing occurs in “the contract’’, not in the commodity. Most
futures contracts may be performed by delivery of the
commodity (wheat, silver, oil, etc.). Some (those based on
financial instruments such as T-bills or on the value of
an index of stocks) do not allow delivery. Unless the par-
ties cancel their obligations by buying or selling offset-
ting positions, the long must pay the price stated in the
contract (e.g., $1.00 per gallon for 1,000 gallons of orange
juice) and the short must deliver; usually, however, they
settle in cash, with the payment based on changes in the
market. If the market price, say, rose to $1.50 per gallon,
the short would pay $500 (50¢ per gallon); if the price fell,
the long would pay. The extent to which the settlement
price of a commodity futures contract tracks changes in
the price of the cash commodity depends on the size and
balance of the open positions in “the contract’’ near the
settlement date. When the contract involves financial
instruments, though, the price is fixed by mechanical
computation from the instruments on which the con-
tracts are based. See Leist v. Simplot, 638 F.2d 282,
286-87 (2d Cir. 1980) (Friendly, J.), affirmed on other
grounds under the name Merrill Lynch, Pierce, Fenner
& Smith, Inc. v. Curran, 456 U.S. 353 (1982); Philip
McBride Johnson & Thomas Lee Hazen, 1 Commodities
Regulation §§ 1.03—.04, 1.10 (2d ed. 1989); Bryan Byrne,
Jr., The Stock Index Futures Market (1987).
A security, roughly speaking, is an undivided interest
in a common venture the value of which is subject to
uncertainty. Usuaily this means a claim to the assets and
profits of an “issuer”. Shares of stock entitle their holders
to receive dividends and payments on liquidation (or a
change in corporate form), see Landreth Timber Co. v.
Landreth, 471 U.S. 681 (1985); bonds and other debt in-
struments promise interest plus a balloon payment of prin-
cipal at the end. Unusual interests such as rights in orange
App. 10
10 Nos. 89-1538, 89-1763, 89-1786 & 89-2012
groves still may be “securities” if they represent a pro
rata share of a variable pool of earnings. SEC v. W.J.
Howey Co., 328 U.S. 293 (1946). See generally Louis Loss
& Joel Seligman, 2 Securities Regulation 926-89 (3d ed.
1988).
Securities usually arise out of capital formation and ag-
gregation (entrusting funds to an entrepreneur), while
futures are means of hedging, speculation, and price reve-
lation without transfer of capital. So one could think of
the distinction between the jurisdiction of the SEC and
that of the CFTC as the difference between regulating
capital formation and regulating hedging. Congress con-
ceived the role of the CFTC in that way when it created
the agency in 1974 to assume functions that had been per-
formed by the Department of Agriculture but which were
no longer thought appropriate for that Department as
futures markets expanded beyond commodities into finan-
cial instruments. See GNMA Options for a recap of the
history. Unfortunately, the distinction between capital for-
mation and hedging falls apart when it comes time to
allocate the regulation of options.
A call option is a promise by the writer to deliver the
underlying instrument at a price fixed in advance (the
‘strike price’) if the option is exercised within a set time.
The buyer pays a price (the “‘premium’’) in advance for
the opportunity; the writer may or may not own the in-
strument he promises to deliver. Call options are writ-
ten “out of the money’’—that is, the exercise price ex-
ceeds the market price at the outset. The writer will
make money if by the time the option expires the market
price is less than the strike price plus the premium (plus
the interest earned on the premium in the interim); the
buyer of the option hopes that the market price will rise
above the strike price by enough to cover the premium,
the time value of money, and the transactions costs of
executing the option. Options play valuable roles in price-
discovery, and they also allow the parties to adjust the
net riskiness of their portfolios. Writers of call options
reduce the risk they bear if the market falls while limiting
App. 11
Nos. 89-1538, 89-1763, 89-1786 & 89-2012 11
gains if the market rises; buyers hope for large propor-
tional gains if the market rises while accepting the like-
lihood that the options will turn out to be worthless. Op-
tions are side deals among investors, which do not aug-
ment an entrepreneur’s coffers (except to the extent
greater liquidity and opportunities to adjust risk increase
social marginal propensity to invest). Dwight M. Jaffee,
The Impact of Financial Futures and Options on Capital
Formation, 4 J. Futures Markets 417 (1984). Unlike finan-
cial and index futures, options call for delivery of the
underlying instrument—be it a share of stock or a futures
contract.
The SEC consistently has taken the position that op-
tions on securities should be regulated as securities. For
some years the CFTC maintained that options on secu-
rities should be regulated as futures because options are
extrinsic to capital formation and because it is almost
always possible to devise an option with the same eco-
nomic attributes as a futures contract (and the reverse).
Matters came to a head in 1980, when both agencies as-
serted jurisdiction over options on securities based on
pools of notes. The Government National Mortgage Asso-
ciation (GNMA) sold pass-through certificates represen-
ting proceeds of mortgage notes, and persons started
writing options on them to allow hedging against move-
ments in interest rates. The SEC observed that options
written on securities are securities under §3(aX10) of the
’34 Act; indeed the SEC contended that because options
are securities it should regulate all options. The CFTC
countered that options on financial instruments are futures
under §4c(b) of the CEA, 7 U.S.C. §6c(b), and added that
because its jurisdiction is exclusive, it is the sole lawful
regulator. When the SEC allowed stock exchanges to start
trading GNMA options, the futures markets sought review
in this court and the CFTC howled bloody murder.
While the case was pending, the agencies reached a
pact, which the SEC calls the Shad-Johnson Agreement
and the CFTC calls the Johnson-Shad Agreement. (John
Shad was the SEC’s Chairman at the time, and Phillip
App. 12
12 Nos. 89-1538, 89-1763, 89-1786 & 89-2012
Johnson the CFTC’s.) This Accord (as we shall call it to
avoid offending either agency) provided that jurisdiction
over options follows jurisdiction over the things on which
the options are written. So the SEC received jurisdiction
of options on securities, while the CFTC got jurisdiction
of options on futures contracts. Things were not quite
done, though, because we held in GNMA Options that the
agencies could not alter their jurisdiction by mutual agree-
ment. 677 F.2d at 1142 n.8. Starting from the proposi-
tion that options on GNMAs are both securities and fu-
tures, we held that the CFTC’s jurisdiction is exclusive
in light of 7 U.S.C. §§ 2 and 2a.
Congress then enacted the Accord almost verbatim, pro-
ducing the explicit reference to options in §3(aX10) of the
’34 Act, the SEC savings clause in §2a(i) of the CEA, and
a small change in 7 U.S.C. §6n to implement an un-
derstanding about pools. The legislature thought that this
Accord would resolve things and restore a regime in
which the SEC supervises capital formation and the
CFTC hedging. See S. Rep. No. 97-384, 97th Cong., 2d
Sess. 21-24 (1982); H.R. Rep. No. 97-565, 97th Cong., 2d
Sess., Part I at 38-40 (1982); H.R. Rep. No. 97-626, 97th
Cong., 2d Sess., Part II at 3 (1982); 128 Cong. Rec. 24910
(1982) (Rep. De La Garza); Loss & Seligman, 2 Securities
Regulation at 1064-80; Jerry W. Markham & David J. Gil-
berg, Stock and Commodity Options—Two Regulatory Ap-
proaches and Their Conflicts, 47 Albany L. Rev. 741
(1983).
The legislation implementing the Accord left in place
the premise on which GNMA Options was founded: if an
instrument is both a security and a futures contract, then
the CFTC’s jurisdiction is exclusive. Section 2a(ii) has no
other possible meaning. Like many an agreement resolv-
ing a spat, the Accord addressed a symptom rather than
the problem. Options are only one among many instru-
ments that can have attributes of futures contracts as well
as securities. Financial markets work best when they of-
fer every possible combination of risk and return—a con-
dition financial economists call “spanning’’—so that in-
App. 13
Nos. 89-1538, 89-1763, 89-1786 & 89-2012 13
vestors can construct a portfolio to each need and taste.
Exchanges and professional investors therefore continually
devise financial products to fill unoccupied niches. See
Dennis W. Carlton, Futures Markets:. Their Purpose,
Their History, Their Growth, Their Successes and Fail-
ures, 4 J. Futures Markets 237 (1984); William L. Silber,
Innovation, Competition and New Contract Design in
Futures Markets, 1 J. Futures Markets 123 (1981). These
products are valuable to the extent that they do not
match the attributes of instruments already available.
New products, offering a new risk-return mixture, are
designed to depart from today’s models.
Which means that the dispute of 1980-82 about options
will be played out—is being played out—about each new
instrument. Today’s case repeats the conflict. Other novel
instruments are being handled by regulation. For exam-
ple, on July 17, 1989, the CFTC adopted rules exempt-
ing from its regulation certain hybrid instruments com-
bining equity or debt with payments based on the price
of commodities. 17 C.F.R. Part 34, 54 Fed. Reg. 30684
(1989). Only merger of the agencies or functional separa-
tion in the statute can avoid continual conflict. Functional
separation is hard to achieve (new instruments will ap-
pear at any border). The SEC favors merger; it has asked
Congress repeatedly for jurisdiction over all products (in-
cluding stock-index and financial futures) based on secu-
rities, which would relegate the CFTC to its original role
as superintendent of commodities futures. The CFTC has
so far defended its position, in part with the argument
that multiple regulatory bodies allow greater competition
and experimentation—a new product can reach market if
either agency approves the variant within its domain. See
Daniel R. Fischel, Regulatory Conflict and Entry Regula-
tion of New Futures Contracts, 59 J. Business S85 (1986);
Ronald W. Anderson, The Regulation of Futures Con-
tracts Innovations in the United States, 4 J. Futures
Markets 297 (1984).
Unless Congress changes the allocation of jurisdiction
between the agencies, the question a court must resolve
ennenieemeineeaeebeeieenaill
App. 14
14 Nos. 89-1538, 89-1763, 89-1786 & 89-2012
is the same as in GNMA Options: is the instrument a
futures contract? If yes, then the CFTC’s jurisdiction is
exclusive, unless it is also an option on a security, in
which case the SEC’s jurisdiction is exclv-ive. So long
as an instrument is a futures contract (and not an option),
whether it is also a “‘security”’ is neither here nor there.
Still, if IPs really are ‘“‘stock’’ they almost certainly are
not “futures contracts”, so the inquiries aren’t so distinct
as the statutes imply.
B
From the perspective of the long, IPs look like an in-
terest in a portfolio of stock. IPs last indefinitely (except
for the chance that a long may be cashed out involun-
tarily on the CBOE), may be sold like stock or used to
secure margin and other loans, change in value with the
market, and pay dividends. IPs lack other common at-
tributes of stock: they do not confer voting rights and
are not ‘certificated’; owners of IPs receive dividend-
equivalent payments quarterly, not when the firms pay
dividends. We need not debate whether these differences
come to anything, for they pale beside the larger dif-
ficulties in calling IPs “stock”. The greatest is that IPs
are not stock in anything. There isn’t an issuer—which
the SEC emphasized when concluding that the Investment
Company Act is inapplicable, 54 Fed. Reg. at 15289-90.
Stock is an equity interest in an issuer, the residual claim
to the profits of a venture. United Housing Foundation,
Inc. v. Forman, 421 U.S. 837 (1975). Landreth rejected
the “‘sale-of-business doctrine’”’ because the owner of 100%
of the equity interest in a firm still owns “‘stock’’.? Pur-
2 Attributes such as transferrability, appreciation, and votes are
useful to distinguish “real stock” from pieces of paper labeled
“stock”’ that do not convey the ordinary interests of equity.
Landreth, 471 U.S. at 686. Such documents had been issued in
Forman as part of a residential co-op development. Transferrabil-
ity and the like are not talismans, however, but only ways to iden-
(Footnote continued on following page)
App. 15
Nos. 89-1538, 89-1763, 89-1786 & 89-2012 15
chasers of IPs don’t own equity, directly or indirectly;
they don’t have a claim to the proceeds and liquidating
distribution of a business; there isn’t an underlying pool
of assets; there is only a ‘‘short’”’ on the other side. The
absence of an issuer—IPs don’t carry votes because they
don’t have anything to do with equity—tells all. There is
no common venture, not even the commonality repre-
sented by a mutual fund (which reinvests in real stock
and creates the risk that the stakeholder will join Robert
Vesco with the kitty).
IPs do not fit comfortably into any of the other pigeon-
holes of §3(aX10). A “certificate of interest or participa-
tion in... any of the foregoing”’ securities is a security
too, but IPs do not represent an “interest or participa-
tion” in the stocks in the index; they are based on the
value of stock without creating a legal interest in stock.
Perhaps the closest match is the language, part of the
Accord in 1982, covering a “privilege on any security...
or group or index of securities (including any interest
therein or based on the value thereof)’. Then there’s the
catch-all: “‘in general, any instrument commonly known
as a ‘security’ ”’. IPs convey privileges based on the value
of an index, and what is ‘‘commonly known as a security”
changes as new instruments come into use. So there is
a basis for drawing IPs within §3(aX10), even though they
do not duplicate a recognized category. See also, e.g., SEC
v. United Benefit Life Insurance Co., 387 U.S. 202 (1967).
Although the SEC found IPs to be securities by look-
ing at the promises made to the longs, the CFTC found
them to be futures by virtue of the promises made by
the shorts, a perspective implied by the CEA’s references
to “contracts . . . for future delivery’’—emphasizing the
2 continued
tify equity claims. Much real “stock” does not trade or appreciate
in value, because it is covered bY buy-sell eements. (Closely
held firms often provide that stock may be sold only to the firm,
and then at a formula price.) It is nonetheless stock, as Landreth
holds, because it is a real equity claim to a business.
App. 16
16 Nos. 83-1538, 89-1763, 89-1786 & 89-2012
shorts’ obligation. Shorts on IPs make the same pledge
as shorts on stock-index futures contracts: to pay the
value of an index on a prescribed day (the expiration date
for the futures contract, the cash-out date for the IP). The
short owes this obligation to the clearing house rather
than to the long. IPs may be settled by buying or sell-
ing an offsetting obligation, after which the clearing house
cancels the two on the books, just as with futures con-
tracts. Shorts on IPs must put up more margin than
shorts on futures contracts and must make dividend-equiv-
alent payments, but the CFTC did not find these differ-
ences any more dispositive than the SEC found the IPs’
lack of voting rights. Shorts also face an obligation of in-
definite duration on the Philadelphia and AMEX IPs, but
the CFTC and the futures markets treat this as no more
than a prepaid rollover privilege.
Despite the congruence of futures and iPs on the short
side, the SEC and the stock exchanges say that both
“futurity” and “‘bilateralism” are missing. According to
the SEC, IPs lack “‘futurity”’ because an IP is the “‘pres-
ent obligation to pay current value’. And IPs are not
bilateral because the long performs in full by paying up
front, although in a futures contract both sides must per-
form on settlement or expiration.
With respect to bilateralism, the SEC’s point is ines-
capable. With respect to futurity, the SEC is wrong. IPs
are no more a “present obligation to pay current value’’
than are futures contracts. The holder of either an IP or
a stock-index futures contract may go to market and trade
it; the price necessarily tracks current value. Neither the
long on an IP nor the long on a futures contract can com-
pel the short to pay current value, however.*® Both the
3 The daily cash-out-at-a-penalty feature of the Philadelphia’s IP
may oblige the short to pay “current” value less 0.5%, but none
of the parties to the case suggests that the Philadelphia’s product
should be treated differently on this account. We therefore do not
pursue it. Similarly, we bypass the delivery option in the AMEX
IP and the short’s opportunity to get out of the CBOE IP, both
of which make IPs look more like futures.
App. 17
Nos. 89-1538, 89-1763, 89-1786 & 89-2012 17
futures contract and the IP are settled quarterly (the
same dates for both kinds of instrument, except for the
CBOE’s omission of two of the four dates). The short’s
obligation is to pay the value of the index on that date—
which lies in the future to the same extent as the settle-
ment date of any futures contract. Even from the long’s
point of view, IP and futures contract ultimately look the
same. The long pays up front for the IP, but the long
on a futures contract promises up front to make a defined
payment on the settlement date; the difference in the tim-
ing of the payment does not affect the fact that valua-
tion comes at the defined future date.
So the IP has futurity but not bilateralism. It looks like
a futures contract to the short—except that it is of in-
definite duration, carries a dividend-equivalent obligation,
and requires higher margin. It looks like a mutual fund
to the long—except that it has no voting rights, does not
represent any interest in an underlying pool of stock, and
may be settled by executing an offsetting transaction.
Fact is, it is no less a future than it is a security, and
no more. It just doesn’t fit. Which is the whole point. It
isn’t supposed to be just like something else; the IP was
designed as a novel instrument so that it could offer at-
tributes previously missing in the market.
The only thing of which we are sure is that an IP is
not an option on a security. The AMEX contends that
it is a prepaid option, with a premium equal to the full
value and an exercise price of zero. The SEC did not ac-
cept this contention, writing:
(WJhile IPs contain some characteristics of stock in-
dex options (e.g., the issuance and clearance and set-
tlement features of IPs are analogous to those of
stock index options), the Commission believes that
IPs predominantly have the attributes of a portfolio
of common stock.
54 Fed. Reg. at 15286 n.57. The only “characteristics of
stock index options” that either the AMEX or the SEC
identified are those introduced by the presence of a clear-
App. 18
18 Nos. 89-1538, 89-1763, 89-1786 & 89-2012
ing house—characteristics that the IP shares with stock-
index futures to the last detail. Unless we were to say
that all futures are also options (they aren’t), these
features do not make IPs options. The very features that
the SEC emphasizes to show that IPs are securities—
indefinite duration, payment up front in cash, dividend
equivalency, and so »n—show that IPs cannot be options.
Options are writter, out of the money, limited in time,
and establish a careful balance among premium, strike
price, and duration; the writer retains dividends. IPs
possess none of these distinguishing features. As the
AMEX defines an “‘option’’, someone who buys an auto-
mobile for cash and drives it away really has obtained
an option with a high premium, zero strike price, per-
petual duration, and 100% probability of exercise. Words
are useful only to the extent they distinguish some things
from others; symbols that comprise everything mean noth-
ing. IPs are not options.
C
Having concluded that neither the ’34 Act nor the CEA
addresses the status of IPs in a straightforward way, the
logical thing to do is to defer to the agency’s resolution
of the problem. Chevron U.S.A. Inc. v. Natural Resources
Defense Council, Inc., 467 U.S. 837 (1984). But which
agency? Each claims to be exercising its discretion; each
7 entitlement to deference on a subject within its
omain.
Although cases frequently say that courts should defer
to the judgment of the responsible agency whenever the
statute is ambiguous as applied to a subject, e.g., NLRB
v. Hearst Publications, Inc., 322 U.S. 111 (1944), this is
something of an oversimplification. Ambiguity does not
necessarily dictate whether the court or the agency has
the dispositive word. Many’s the statute that drops a half-
resolved dispute in the lap of the courts even though one
or more agencies exercise jurisdiction. Think of the anti-
trust laws, which courts freely construe even though both
App. 19
Nos. 89-1538, 89-1763, 89-1786 & 89-2012 19
the Antitrust Division of the Department of Justice and
the Federal Trade Commission may lay claim to greater
expertise. When a statute has gaps and uncertainties—
the status of all rules—the anterior question is: who is
charged with filling the gaps? Often statutes delegate com-
prehensive powers to agencies, and the meaning of the
law is that agencies shall solve novel problems as they
arise. Solutions may involve complex and unanticipated
adjustments. Courts can be more confident that power has
been delegated than that any particular exercise is “right’’.
Deference to the agency’s conclusion follows naturally
from such a determination, for what Congress wanted to
obtain is the judgment of the agency—Congress delegates
precisely because it cannot foresee and resolve all prob-
lems. See Chevron, 467 U.S. at 843-45; Young v. Com-
munity Nutrition Institute, 476 U.S. 974, 981-84 (1986);
Homemakers North Shore, Inc. v. Bowen, 832 F.2d 408,
411-12 (7th Cir. 1987); Henry P. Monaghan, Marbury and
the Administrative State, 83 Colum. L. Rev. 1 (1983).
When the agency is the addressee of the statutory com-
mand, it takes the leading part in giving structure to the
statute; when the court is the addressee, it has the prin-
cipal role.
When two agencies claim to be the addressees, though,
this allocation breaks down. Perhaps a court could say
that because the agencies disagree, neither is entitled to
deference. Yet disagreement doesn’t make the court the
recipient of interpretive powers. One or the other agen-
cy is still in charge. Courts readily could accept both the
SEC’s application of the 34 Act to IPs and the CFTC’s
application of the CEA. Our difficulty is not any logical
conundrum in deferring to both agencies when they dis-
agree. It is instead that a dispute about the agencies’
jurisdiction is a zero-sum game because of the exclusivity
clauses in the CEA.
Any distinction between action under delegated powers
and fixing the scope of delegation will break down at the
edges, and some recent cases suggest that a court should
not try to draw such a line in the first place—one of them
App. 20
20 Nos. 89-1538, 89-1763, 89-1786 & 89-2012
concerning the scope of the CFTC’s powers. CFTC v.
Schor, 478 U.S. 833, 844-46 (1986); see also Mississippi
Power & Light Co. v. Mississippi ex rel. Moore, 108 S.
Ct. 2428, 2444 (1988) (Scalia, J., concurring); CSX Trans-
portation v. United States, 867 F.2d 1439, 1445 (D.C. Cir.
1989) (Edwards, J., dissenting) (suggesting that Chevron
disallows inquiry into the extent of delegation, although
that should be the right question). But even if unambig-
uous delegation is not a necessary condition of deference,
it is an important ingredient in the formula, else it be-
comes impossible to distinguish statutes such as the Sher-
man Act from those such as the Clean Air Act, or to con-
ceive where the boundary between court and commission
falls. Delegation to agencies is not without its costs to
the separation of powers; holding agencies within their
delegated scope is an important task in maintaining con-
stitutional structure.‘
Difficulties in establishing the competence of the agen-
cies and the judicial branch do not influence the outcome
of this case, however. We may assume without deciding
that even in this jurisdictional dispute, each agency is en-
titled to leeway in applying its own statute to IPs.
D
If each agency’s interpretation of its own statute is en-
titled to some deference, then the IP is both a security
and a futures contract. It has some attributes of both,
and all attributes of neither, as we have laid out in ex-
cessive detail. Neither characterization can be called
wrong.
4 See also Cynthia R. Farina, Statutory Interpretation and the
Balance of Power in the Administrative State, 89 Colum. L. Rev.
452, 502-26 (1989); Richard J. Pierce, Jr., Two Problems in Ad-
ministrative Law, 1988 Duke L.J. 300; Stephen Breyer, Judicial
Review of Questions of Law and Policy, 38 Admin. L. Rev. 363
(1986); Clark Byse, Judicial Review of Administrative Interpreta-
tion of Statutes, 2 Admin. L.J. 255 (1988).
App. 21
Nos. 89-1538, 89-1763, 89-1786 & 89-2012 21
The only element of financial futures contracts that is
missing is “‘bilateralism’’. Yet bilateralism is not essen-
tial to a futures contract. CFTC v. Co Petro Marketing
Group, Inc., 680 F.2d 573 (9th Cir. 1982), held that a con-
tract that imposes performance obligations only on the
short may be a futures contract. Co Petro sold interests
in gasoline that were designed to look like forward con-
tracts, which under the CEA are not futures contracts.
Buyers put down deposits to obtain Co Petro’s promise
to deliver gasoline on future dates. These contracts could
not be traded on any market, but Co Petro promised to
pay the investor in cash if the market price should rise
(that is, the investor could sell the contract back to Co
Petro). The investor risked no more than 95% of his de-
posit; if the price of gasoline fell, the investor’s position
would be closed. Thus buyers of Co Petro’s contracts per-
formed fully on the date they posted the depusit; there-
after only Co Petro had obligations. Despite that, and
despite the fact that the contracts were illiquid, the court
of appeals concluded that they were futures contracts be-
cause their value depended entirely on the price of the
commodity at their expiration date, and they were not
formed in contemplation of physical delivery.
The SEC brushes off Co Petro and similar cases in dis-
trict courts as based on the principle that once it smells
sulfur (Co Petro may have been a bucket shop), either
agency may protect the investor. No such principle may
be found in the ’34 Act or the CEA, however. An instru-
ment either is or is not a futures contract. If it is, the
CFTC has jurisdiction; if it is not, the CFTC lacks juris-
diction; if the CFTC has jurisdiction, its power is ex-
clusive. The SEC’s position entails the proposition that
if Co Petro Marketing Group, Inc., had approached the
CFTC after losing in the Ninth Circuit and applied for
permission to trade its gasoline contracts as futures, the
CFTC would have had to say no, on the ground that the
contracts are not ‘“‘contracts . . . for future delivery” un-
der the CEA. That can’t be right.
App. 22
22 Nos. 89-1538, 89-1763, 89-1786 & 89-2012
Perhaps this point will be clearer if we ask what would
have happened if the CBOT and CME had fupreacaee
the CFTC in 1987 (before the Philadelphia Stock Ex-
change filed its proposal with the SEC) seeking permis-
sion to trade IPs. When we asked the SEC’s Solicitor dur-
ing oral argument whether the CFTC could have granted
such an application, he said yes—largely on the ground
that granting the application would have introduced a new
product with benefits for investors. When we persisted
with the question whether the CFTC could grant the iden-
tical application, filed by the CBOT and CME in 1989
(after the SEC’s decision), the Solicitor said no, on the
ground that by 1989 the SEC had asserted jurisdiction.
Yet this principle of first-come-first-served finds no sup-
port in the ’34 Act or the CEA. Either IPs are futures
contracts or they aren’t. If they are futures contracts,
then the CFTC could have approved their trading in 1987
(as the Solicitor agreed); if IPs were futures in 1987, they
are futures today, and the CFTC still may approve their
trading. But if the CFTC may approve their trading be-
cause they are futures contracts, then the CFTC’s juris-
diction is exclusive.
Doubtless such a decision gives the futures markets the
opportunity to block competition from an innovative finan-
cial product. The SEC’s order, and its brief in this court,
casts much of the argument in the form: ‘‘The IP is a
desirable product; the futures markets have not proposed
to trade IPs; if IPs are futures then the CFTC’s jurisdic-
tion is exclusive and IPs won’t exist, which would be
regrettable; therefore IPs are not futures.” Everything
works until the “therefore’’. Whether IPs are futures
can’t depend on who first proposed to trade them, or on
whether anyone does. We doubt the premise of the SEC’s
argument as well as its conclusion, for if IPs are useful
to investors, then someone will offer them—if not the
CBOT and CME, then a market in New York, or Kansas
City, or Tokyo. The CBOT and CME will be compelled
to follow or they will lose business. There are too many
futures exchanges to suppose that a conspiracy could sup-
App. 23
Nos. 89-1538, 89-1763, 89-1786 & 89-2012 23
press a beneficial financial instrument, cf. Matsushita
Electric Industrial Co. v. Zenith Radio Corp., 475 U.S.
574, 590 (1986). But whether or not a futures market will
seek to trade a financial product does not change the
nature of that product, and both the ’34 Act and the CEA
define coverage by the attributes of the instrument rather
than by the identity of those who own or trade it. This
is the central message of Landreth, which at the SEC’s
urging rejected the ‘‘sale of business doctrine”’ precisely
because that doctrine disregarded the characteristics of
the financial instrument in order to go straight to the
question whether certain persons needed the protection
of the law—that is to say, whether coverage was a good
idea.
From time to time, the Supreme Court has looked to
the purposes of the ’34 Act to define ‘‘securities’’, usual-
ly with a view to enlarging the definition. (The exception
is Marine Bank v. Weaver, 455 U.S. 551 (1982).) With the
SEC urging it on, the Court has drawn in orange groves
covered by joint harvesting contracts, W.J. Howey, lease-
holds in land near oil wells, SEC v. C.M. Joiner Leasing
Corp., 320 U.S. 344 (1943), and other unusual instruments
that have some (but far from all) attributes of conven-
tional securities. Obviously the SEC does not ask us to
abandon this approach—for itself. It demands, however,
that we apply strictissimi juris to the CEA, to hold that
only an instrument with every attribute of a conventional
futures contract may be one. Why? If the interpretive ap-
proach is proper for the securities acts, it is no less prop-
er for the futures acts. It has been employed under both
statutes—not only in Co Petro but also in redefining
futures contracts to omit the delivery otiigation. Recall
the statutory scope of the CEA: contracts ‘‘for future de-
livery”. Commodity futures contracts may be settled by
delivery; financial futures contracts are settled exclusively
in cash. One might have thought the prospect of “future
delivery” the sine qua non of a “futures” contract. Yet
no one, not even the SEC, doubts that a contract may
be a futures contract even though it provides for cash
App. 24
24 Nos. 89-1538, 89-1763, 89-1786 & 89-2012
settlement. If delivery is not essential, then the “‘tradi-
tional’”’ elements of futures contracts are not invariable
ingredients of the CFTC’s jurisdiction.
Perhaps the SEC wants us to put a thumb on the
scales, enlarging the category “‘securities’’ while shrink-
ing the category “futures” because of the exclusivity
clauses in the CEA: if both categories expand, then the
SEC’s jurisdiction shrinks. We do not conceive it our func-
tion, however, to invent counterweights to statutes; judges
should be interpreters rather than sappers and miners.
As we said in GNMA Options, 677 F.2d at 1161, ‘‘{oJur
task should not reflect a value judgment as to which of
the competing agencies is best equipped to regulate these
[products].”’
To the extent instrumental arguments influence the cov-
erage of the laws, they do not necessarily cut for the
SEC. The futures markets’ reply brief invites us to im-
agine a ‘‘Wheat Index Participation’”’ (WIP) having the
same characteristics as the IP except that it is based on
an index of wheat prices rather than of stock prices. The
buyer would pay cash for the WIP and be able to trade
it freely; on a date identical to the expiry of the wheat
futures contracts, the writer could be required to pay cash
measured by the value of the wheat index. According to
the SEC, such an instrument would not be a futures con-
tract because it would lack both futurity and bilateralism
(and we would agree on the latter point). So the CFTC
could not allow it to be traded, no matter how valuable
participants in the market might find it. On the other
hand, the WIP certainly would not be “stock” and prob-
ably would not meet the criteria for being a “security”
of any kind. So the SEC could not allow it to be traded
on stock exchanges (anyway, the WIP would be a duck
out of water on the AMEX!). We could escape from such
silliness by reaching the logical conclusion that a WIP
would be a futures contract. Yet if the WIP is a futures
contract, it is hard to avoid the conclusion that the IP
is one, too.
App. 25
Nos. 89-1538, 89-1763, 89-1786 & 89-2012 25
The petition for review in No. 89-1538 is dismissed for
want of jurisdiction. The Investment Company Institute’s
petition, No. 89-2012, presents questions that we need not
reach in light of our disposition of the futures markets’
claims. On petition Nos. 89-1763 and 89-1786, the SEC’s
orders approving the applications of the stock exchanges
and the OCC are set aside.
A true Copy:
Teste:
Clerk of the United States Court of
Appeals for the Seventh Circuit
USCA 79004—Midwest Law Printing Co., Inc., Chicago—8-18-89—500
App. 26
APPENDIX B
SECURITIES AND EXCHANGE COMMISSION
(Release No. 34-26709; File Nos. SR-Phlx-88-07;
SR-Amex-88-10; SR-CBOE-88-09)
Self-Regulatory Organizations; Philadelphia Stock
Exchange, Inc.; American Stock Exchange, Inc.;
Chicago Board Options Exchange, Inc.;
Order Approving Proposed Rule Changes Relating to the
Listing and Trading of Index Participations
I. Introduction
On February 29, April 18, and May 26, 1988, the Philadel-
phia Stock Exchange, Inc. (“Phlx’’), the American Stock Ex-
change, Inc. (“Amex’’), and the Chicago Board Options Ex-
change, Inc. (“CBOE”) (collectively “exchanges’’), respec-
tively, submitted to the Securities and Exchange Commis-
sion (“SEC” or “Commission’’), pursuant to Section 19(b)(1)
of the Securities Exchange Act of 1934 (“Act’’),! and Rule
19b-4 thereunder,’ proposed rule changes to list for trading
market basket products designated as index participations
(“IPs’’).
The proposed rule changes were noticed in Securities Ex-
change Act Release Nos. 25495 (March 238, 1988), 53 FR
10311; 25664 (May 5, 1988), 53 FR 16805; and 25799 (June 13,
1988), 58 FR 22754. The exchanges subsequently submitted
amendments to their proposed rule changes.? The Commis-
sion received 25 comment letters relating to the proposed
rule changes.
! 15 U.S.C. 878s(b)(1) (1982).
2 17 C.F.R. 8240.19b-4 (1988).
3 These Amendments have been noticed for public comment in
the Federal Register. See notes 6, 7, 9, 10, 14, and 17 infra.
+ See notes 22-28 and 30-31, infra and accompanying text.
App. 27
II. Background and Description of the Products
A. Terms of the Contracts
An IP is a present interest in the current value of a port-
folio of stocks. IPs are of indefinite duration, and entitle
holders to cash payments equivalent to a proportionate
share of any regular cash dividends paid on the component
stocks of the underlying equity portfolio. Investors buying
and selling IPs can realize profits or limit losses on their
investment by entering into an offsetting sale or purchase of
an IP in a closing transaction and thereby receive or make
payment of the difference between the cost of the opening
and closing transactions. Alternatively, investors purchas-
ing IPs may elect instead to realize profits or limit losses on
their investment through exercising a cash-out privilege®
which is available, depending on the IP, on a daily, quarterly,
or a semi-annual basis.
The dates on which IPs purchasers may obtain the full
index value upon exercise of the cash-out privilege are des-
ignated as cash-out times. Excluding the Phlx’s daily cash-
out alternative, the cash-out time for each quarter or semi-
annual period, depending on the IP, will be determined and
made public by each Exchange before the beginning of such
period.
The Phlx IP, called the Cash Index Participation (“CIP’’),
permits holders to exercise the cash-out feature on a daily
basis in addition to the designated quarterly cash-out time.®
> See discussion on p. 6 infra.
6 The CIP, when first proposed by the Phlx, provided for a quar-
terly cash-out only. Subsequently, on September 26 and October
11, 1988, the Phlx submitted Amendments Nos. 2 and 3, respec-
tively to its proposed rule change. In general, these amendments
would permit CIP holders to exercise the cash-out feature on a
(Footnote continued on following page)
ate neinntinititieaeaaill
App. 28
A CIP holder that exercises the cash-out feature on any day
other than the designated quarterly cash-out time will re-
ceive 99.5% of the underlying portfolio’s value. The Phlx
notes that the .5% differential subtracted from the index
value received by such CIP holders is a fee that reflects the
substantial benefit to CIP holders of daily cash-out, and that
CIP holders may avoid the discount by closing out their po-
sitions for cash in the market or by cashing out at a regular
quarterly cash-out date.
The Amex product is termed the Equity Index Participa-
tion (“EIP’’). EIPs, as originally proposed by the Amex, en-
abled purchasers to exercise a cash-out privilege on a quar-
terly basis. On October 27, 1988, the Amex submitted an
amendment to permit EIP holders to receive either cash or
physical delivery of shares of the component stocks of the
S&P 500 Index and the Major Market Index under specified
circumstances.’ More specifically, the holder of one or more
delivery units’ that has not chosen to exercise the cash-out
privilege has the right to obtain on each delivery time, which
6 continued
daily as well as quarterly basis. To exercise the daily cash-out
feature an IP holder must submit notice of this exercise by 4:15
p.m. The IP holder would receive a cash payment equal to 99.5%
of the index value as of the close of business the following day.
The Phlix has tentatively determined to establish the quarterly
cash-out time to coincide with the expiration of the leading stock
index futures contracts [7.e. the opening of trading on the third
Friday of March, June, September, and December (‘‘Expiration
Friday’’)]. See Securities Exchange Act Release No. 26174 (Octo-
ber 13, 1988), 53 FR 40814.
’ See Securities Exchange Act Release No. 26243 (November 2,
1988), 538 FR 45407.
* A delivery unit is defined as the minimum number, as specified
by the Amex, of EIPs of a particular class that must be held in an
individual account by a holder at the time of exercise of the deliv-
ery privilege, or that must be maintained as a short position in an
(Footnote continued on following page)
SL
App. 29
coincides with the quarterly cash-out time, the physical de-
livery of the proportionate number of shares of each stock
comprising the underlying index, subject to certain condi-
tions. A delivery fee established by the Amex will be
charged to EIP holders taking physical delivery of the com-
ponent stocks.
Under the Amex proposal, exercise notices requesting
physical delivery of one or more delivery units will be as-
signed first, on a random basis, to those short EIP positions
that have notified the Options Clearing Corporation (‘““(OCC’’)
of a desire to make physical delivery. If the number of deliv-
ery units for which holders have requested physical delivery
exceeds the number of units made available for delivery by
persons with short EIP positions, then an Amex-designated
physical delivery facilitator will assume responsibility for
delivering the physical shares with respect to such excess
number of units.%
The CBOE product, called the Value of Index Participa-
tion (“VIP’’), differs from both the Phlx CIP and the Amex
8 continued
equivalent account by a person who notifies OCC of a desire to
make physical delivery of securities tu a holder if assigned an
exercise. The Amex has tentatively established the delivery unit
as 50,000 EIPs per unit for the S&P 500 Index and 25,000 EIPs per
unit for the XMI. The Amex believes that permitting physical de-
livery of units below these levels would be impractical because of
the minute number of shares of individual stocks that would be
deliverable. If the Amex intends to modify the minimum number
of EIPs that constitute a delivery unit, then the exchange must
submit a separate proposed rule change for Commission approval.
% The Amex’s Amendment No. 2 to its EIP filing noted that the
physical delivery facilitator could deliver shares out of inventory,
buy shares at the opening on the cash-out date, or borrow shares.
However, in order to ameliorate any concerns regarding the
facilitator’s advance knowledge of physical delivery unit imbal-
(Footnote continued on following page)
App. 30
EIP in that it allows VIP sellers, as well as purchasers, to
exercise 4 cash-out privilege on a semi-annual basis. A per-
son with a short VIP position desiring to exercise the cash-
out privilege originally was required to pay a premium of 1%
of the index’s value. The CBOE eliminated this charge, how-
ever, in an amendment filed on November 1, 1988.!° The Ex-
change believes that the existence of a cash-out privilege for
holders of both long and short positions will cause the price
of VIPs to trade more closely to the value of the underlying
portfolio because it will allow a hedged short VIP holder an
alternative to reversing his position by purchasing the VIP
at the current market price and selling the underlying equi-
ties.
Notice of exercise of the IP cash-out privilege must be
provided by an IP purchaser on or before a time specified
and made public by the Exchange on which the IP is traded.
The exchanges have determined to establish and make pub-
lic the cut-off time for the submission of notices of exercise
of an IP cash-out privilege before the beginning of each
quarterly or semi-annual cash-out time. At the present time,
the exchanges have established an exercise cut-off time of
the close of trading on the day before the quarterly or semi-
annual cash-out time (7.e. 4:15 p.m. on the Thursday before
9 continued
ances, the Amex submitted an additional amendment under which
the facilitator may satisfy such imbalances only by delivering com-
ponent shares purchased at the opening on the cash-out date. This
facilitator will be compensated out of proceeds received from
shorts who have been assigned exercise notices. Initially, the
Amex contemplates designating only one facilitator per EIP class
and notes the facilitator may be the specialist unit for that class
of EIPs. See Securities Exchange Act Release No. 26355 (Decem-
ber 13, 1988), 53 FR 51181.
10 See Securities Exchange Act Release No. 26257 (November 7,
1988), 53 FR 45833. This amendment also changed the cash-out
feature from a quarterly to a semi-annual cycle.
App. 31
the quarterly or semi-annual cash-out time).!! An exercise
notice may be tendered to the OCC only by the OCC clearing
member in whose account the IP is carried. Upon exercise
of the quarterly or semi-annual cash-out privilege an IP pur-
chaser may obtain at the cash-out time the IP index value
based on the opening trades of the portfolio’s component
stocks on the next day.!2
Pursuant to the exchanges’ proposed rules, each member
organization will establish fixed procedures for the alloca-
tion of IP exercise notices assigned to a short (or long also
in the case of CBOE VIPs) position in IPs in such member
organization’s customers’ accounts. Such allocation shall be
made on either a “first-in, first-out’”’ basis, automated ran-
dom selection basis that has been approved by the ex-
changes, or on a manual random selection basis. Each mem-
ber organization will inform its customers in writing of the
method it uses to allocate exercise notices to its customers’
accounts, explaining its manner of operation and the conse-
quences of that system.
Pursuant to the exchanges’ proposed rules, al! bids and
offers made on the trading floor for IPs will be deemed to be
for one unit of trading unless a specified greater number of
IPs is expressed. A bid or offer for more than a unit of
trading of IPs will be deemed to be for the amount thereof
11 If the exchanges intend to modify the exercise cut-off time they
must submit separate proposed rule changes for Commission ap-
proval pursuant to Section 19(b)(2).
12 A CIP holder exercising the daily cash-out privilege on a day
other than the quarterly cash-out time receives the value of the
portfolio at the close of the next trading day, less the .5 percent
exercise fee described above.
App. 32
or a smaller number of units of trading of IPs. The unit of
trading in IPs shall be 100 IPs unless otherwise designated
by the Exchange.!8
The exchanges have reserved the right, in the event of
extreme IP trading inactivity or under exceptional circum-
stances, to require that purchasers and sellers settle their IP
contracts at the closing index value determined by a desig-
nated cash-out time, upon one year’s prior notice to the pub-
lic.
B. Portfolios Underlying the Proposed Index Participa-
tions
1. Composition, Calculation and Adjustment
The exchanges contemplate trading IPs on a variety of
underlying portfolios, most of which are relied upon as well-
established and widely-disseminated market indicators or
market segment indicators, and some of which are new. The
Phix has designated two underlying portfolios for CIP trad-
ing: a broad-based portfolio designed by the Exchange
(“Blue Chip” Index) and the Standard & Poors 500 (“S&P”’
500) portfolio. '4
The Blue Chip CIP is an IP based on a price-weighted
portfolio composed of 25 highly capitalized listed common
stock issues representing primarily industrial corporations,
13 If the exchanges intend to modify the unit of trading from 100
IPs they must submit separate proposed rule changes for Commis-
sion approval.
14 Originally, the Phlx proposed trading a Stock Market CIP that
was based on a 100 stock portfolio developed by the Exchange and
was designed to track closely with the S&P 500. On August 23,
1988, the Phlx submitted Amendment No. 1 to the filing in which
it withdrew its proposed Stock Market CIP and indicated that it
would trade a S&P 500 CIP in its place. See Securities Exchange
Act Release No. 26058 (September 2, 1988), 53 FR 35247.
—————
App. 33
and which is designed to replicate the performance of the
Dow Jones Industrial Average (‘““DJIA’’). Each Blue Chip
CIP will represent 1/100 (the multiplier) times the value of
the portfolio, and each S&P 500 CIP will represent 1/10
(the multiplier) times the value of the portfolio. The standard
unit of trading in such CIPs will be 100 CIPs, and bids and
offers will be expressed in decimals. The Exchange expects
to establish a starting Blue Chip CIP portfolio value of ap-
proximately 2000, so that each Blue Chip CIP would be
priced at approximately $20.00, and each Blue Chip CIP trad-
ing unit would be priced at approximately $2,000. The value
of the portfolio will be adjusted to account for stock splits,
stock dividends, and extraordinary cash dividends. The value
of the portfolio will not be adjusted for regular cash divi-
dends paid out to CIT holders. If the character of any stock
in the portfolio materially and substantially changes on the
account of delisting, merger, acquisition, or otherwise, the
Exchange will replace such stock with another stock which
possesses similar characteristics so as to retain the integrity
and representativeness of the portfolio.
The Amex EIPs will be based on the Major Market Index
(““XMI’’)!6 and the S&P 500.17 The XMI is a broad-based
15 See Securities Exchange Act Release No. 19907 (June 24, 1983),
48 FR 30814 for a detailed description of the S&P 500 Stock Index.
As of December 6, 1988, the closing index value for the S&P 500
was 277.58. Thus, each S&P 500 CIP would be priced at $27.75, and
each S&P 500 trading unit would be priced at $2,775.
16 See Securities Exchange Release Nos. 19610 (March 17, 1983),
48 FR 12486; 19709 (April 27, 1983), 48 FR 20179 for a detailed
description of the XMI.
‘7 The Exchange originally proposed to trade EIPs on the XMI
and the Institutional Index (‘XII’). On July 21, 1988, however, the
Exchange submitted to the Commission Amendment No. 1 to File
No. SR-Amex-88-10 to trade EIPs on the S&P 500 rather than on
the XII. See Securities Exchange Act Release No. 25942 (July 25,
1988), 53 FR 28929.
App. 34
price-weighted portfolio developed by the Amex, and is com-
prised of 20 highly capitalized issuers. Each XMI EIP will
represent 1/10 (the multiplier) times the portfolio’s value,'*
and the standard unit of trading in such EIPs will be 100
EIPs. Bids and offers for EIPs will be quoted in decimals.
The CBOE VIPs are based on the capitalization-weighted
CBOE 50 and CBOE 250 portfolios!® developed and main-
tained by the Exchange, and the S&P 500 Index, calculated
and maintained by Standard and Poor’s Corporation. Each
CBOE VIP will represent 1/10 (the Index multiplier) times
the Index value,”° and the standard unit of trading will be
100 VIPs. Bids and offers for VIPs will be quoted in frac-
tions of 1/8 of a point.
2. Publication
Publication of the values underlying the IPs will occur at
two levels.?! First, the exchanges will make public the com-
ponent portfolios they use for calculating the value of their
participations. This is necessary to provide market profes-
18 As of December 6, 1988 the closing index value for the XMI
was approximately 423. Thus, each XMI EIP would be priced at
$42.30, and each XMI EIP trading unit would be priced at $4,230.
9 See Letter from Jonathan G. Katz, Secretary, SEC to Dr.
Paula Tosini, Director, Division of Economic Analysis, CFTC,
dated April 22, 1988 for a detailed description of both the under-
lying CBOE 50 and CBOE 250 portfolios.
20 As of December 6, 1988 the closing value for the CBOE 250
was approximately 248. Thus, each CBOE 250 VIP would be priced
at $24.80, and each CBOE VIP trading unit would be priced at
$2,480.
“1 Publication and dissemination of the values of the portfolios
underlying IPs will help to ensure the maintenance of a fair and
orderly market in the product consistent with the goals of Section
11A(a)(1) of the Act and to reduce the possibility of fraudulent or
manipulative trading involving the IPs. See 15 U.S.C. § 78f(b)(5)
(1982).
a
App. 35
sionals, institutions, and other public investors a basis for
relating the value of these participations to their own stock
positions, and for maximizing the utility of the participa-
tions. The Phlx, Amex, and CBOE currently publicize the
means by which they compute values of the portfolios un-
derlying their participations (7.e. summation of share prices
divided by a specific divisor, times the multiplier).
Second, in addition to the real-time computation of under-
lying portfolio values that will be the subject of index par-
ticipation trading, those values will be widely disseminated.
Because products related to the portfolios underlying the
Amex EIP, the CBOE VIP, and the Phix S&P 500 CIP previ-
ously have been approved for trading, those values are al-
ready widely disseminated. Additionally, the Phix has re-
tained Bridge Data, Inc. to compute and perform all neces-
sary maintenance of the Blue Chip CIP. Pursuant to Phix
Rule 1003B, updated underlying portfolio values will be dis-
seminated and displayed by means of primary market prints
reported over the Consolidated Last Sale Reporting System
and the facilities of the Options Price Reporting Authority.
The value of the underlying portfolios will also be available
on broker-dealer interrogation devices to subscribers of the
CIPs information.
III. Comments Received
The Commission received 25 comment letters in response
to its requests for comments on the Phlx, Amex, and CBOE
proposed rule changes. Fifteen of the twenty-five comment
letters were submitted on behalf of the Commodity Futures
Trading Commission (‘“‘CFTC’’), the Chicago Board of Trade
(“CBT”), or the Chicago Mercantile Exchange (“CME”’).
These letters expressed the belief that the IPs are futures,
and therefore that the Commission lacks jurisdiction to ap-
App. 36
prove the proposed rule changes.” In response to these
futures industry comment letters the Commission received
letters from the Phix and CBOE, and a comment letter from
the Amex, which included opinions of their respective legal
counsels, stating that IPs are securities and therefore sub-
ject to SEC jurisdiction. Two letters came from the Phlx
and Amex that addressed issues related to timing of Com-
mission action on IPs.24 The Commission also received a let-
ter from the Phlx commenting on Amex Amendment No. 2
to its EIP filing providing for physical delivery,” a letter
from the Amex responding to this Phlx comment letter,
and letters from three investors, two expressing support for
immediate approval of CIPs”’ and one suggesting that EIPs
22 See Letters-to Jonathan G. Katz, Secretary, SEC, from Jean
A. Webb, Secretary, CFTC (April 29 (‘Ist CFTC Letter’), June 1,
and July 8, 1988); Thomas R. Donovan, President and Chief Exec-
utive Officer, CBT (April 20 (‘ist CBT Letter’), June 1, July 8, and
November 30, 1988); William Brodsky, President and Chief Execu-
tive Officer, CME (April 20 (‘lst CME Letter’), May 18, and No-
vember 29, 1988); Phillip Stern and Jerrold Salzman, Attorneys,
Freeman, Freeman & Salzman on behalf of the CME (August 2,
November 7 (“5th CME Letter’’), and December 1, 1988 and March
2, 1989). See also Letter from Jean A. Webb, Secretary, CFTC, to
Shirley E. Hollis, Assistant Secretary, SEC, dated December 13,
1988.
“3 See note 34 infra.
“4 See Letters to Jonathan G. Katz, Secretary, SEC, from
Nicholas A. Giordano, President, Phlx (June 29, 1988) (‘‘Phlx let-
ter’); Kenneth R. Liebler, President and Chief Operating Officer,
Amex (July 27, 1988) (‘Amex letter’).
25 See Letter from Nicholas A. Giordano, President, Phx to Jon-
athan G. Katz, Secretary, SEC, dated November 23, 1988.
*6 See Letter from Gordon L. Nash, Senior Executive Vice Presi-
dent, Legal and Regulatory Affairs, Amex to Jonathan G. Katz,
Secretary, SEC, dated February 10, 1989.
27 See Letter from Dennis Weidenbenner to Richard G. Ketchum,
Director, Division of Market Regulation, SEC, dated September
29, 1988; Letter from William A. Dodd, Jr. to David Ruder, Chair-
man, SEC, dated February 24, 1989.
_ App. 37
are an unnecessary investment tool.2 In addition, the Com-
mission received a letter from the Investment Company In-
stitute (“ICI’’) arguing that IPs are investment company
shares and thus must receive relief from the Investment
Company Act of 194029 before they may be traded on a na-
tional securities exchange.*® Subsequent to the Commis-
sion’s consideration of the proposed IPs during an open
meeting on March 14, 1989, the Commission received a letter
on behalf of the ICI arguing that the issuance and trading
of IPs create investment companies. In particular, the ICI
claimed that the individuals holding long IP positions and
short IP positions each constitute an “issuer” under the stat-
utory definition of that term because they are an “organized
group of persons.’’*!
A. Futures Industry Letters
In general, the CFTC, the CBT, and the CME (‘futures
commentators”) argue that the Commission lacks jurisdic-
tion to authorize IP trading through approval of the Ex-
changes’ proposed rule changes because an IP does not con-
stitute a “security” as defined in Section 3(a)(10) of the Act.*2
In particular, the futures commentators argue that the eco-
28 See Letter from K. Thomas Shipley, Executive Vice President,
Charter Investment Group, Inc., to David S. Ruder, Chairman,
SEC, dated March 29, 1989.
2 15 U.S.C. §8§ 80a-1 through 80a-52 (1982).
30 See Letter from Matthew P. Fink, ICI, to Richard G. Ketchum,
Director, Division of Market Regulation, SEC, dated December 19,
1988.
31 See Letter from David M. Miles, Attorney, Fried, Frank, Har-
ris, Shriver & Jacobson on behalf of the ICI, to David S. Ruder et
al., Chairman, SEC, dated March 31, 1989. The.Commission, in its
discretion, determined to consider this comment. 17 C.F.R.
202.6(b).
82°15 U.S.C. § 78(e)(1)Q) (1982).
App. 38
nomic function and purpose of IPs are characteristic of stock
index futures rather than stock or index options, and that
IPs are therefore subject to the exclusive jurisdiction of the
CFTC pursuant to Section 2(a)(1)(B) of the Commodity Ex-
change Act (“CEA”).
The futures commentators suggest several reasons to cat-
egorize IPs as stock index futures. First, they argue that
both the purchaser and seller of an IP contract have entered
into a transaction that may be cashed out at a future date at
a price based upon the difference between the price estab-
lished at the initiation of the contract and some undeter-
mined future price. Second, with the exception of the Amex
EIP, the IP contract provides for cash settlement only.
Third, while an IP long is entitled to hold his position indefi-
nitely, they argue that essentially the contract has a quar-
terly expiration—identical to the cycle now applicable for
similar futures contracts—due to the quarterly cash-out fea-
ture. The futures commentators suggest that this feature is
synonymous with an “undated futures market contract.”
They suggest further that the outcome of effective competi-
tion will be that an IP long actually will pay a commission to
“roll over’ his position, at the time he enters into an IP
contract, in the form of higher IP prices. Fourth, there is no
apparent option premium paid by an IP long.
The CME, specifically, suggests that, although IPs include
two features that may not be immediately recognized as
standard features of futures contracts, those features serve
the economic equivalent of futures characteristics.* First,
the short will be required to pay to the long cash payments
equivalent to a proportionate share of any regular cash divi-
dends paid on the component stocks of the underlying index.
The CME suggests that the concept of a cash payment from
33 See lst CME Letter at 2-3.
Ee Te
App. 39
the short to the long, related to measured or theoretical
shrinkages in the value of the underlying product, is a fea-
ture also found in futures contracts. Second, IPs afford
longs the right to select the time at which shorts will be
compelled to make cash delivery. The CME notes that this is
a standard feature of most physical commodity based
futures contracts, and that a futures contract holder gener-
ally has a far wider range of options (e.g., the ability to
control the exact date, time, and place of the delivery of the
commodity to the long).
The Phlx, CBOE, and Amex (the “exchanges”’) argue that
IPs should be viewed as securities as defined in Section
3(a)(10) of the Act.*4 In general, the Phlx and CBOE base
their argument on SEC v. C.M. Joiner Leasing Corp.*° in
which the Supreme Court emphasized the economic function
of instruments in determining whether they constituted se-
curities.*® Specifically, the Phlx argues that although IPs do
not possess all of the familiar characteristics of common
stock as described in Landreth Timber Co. v. Landreth* an
4 See generaily Letter from William W. Uchimoto, Acting Gen-
eral Counsel, Phix, to Richard G. Ketchum, Director, Market Reg-
ulation, SEC, dated May 24, 1988, enclosing opinion of Cadwalader,
Wickersham and Taft, Phlx legal counsel, regarding SEC jurisdic-
tion over IPs (“Cadwalader Letter’’); Letter from Nancy R. Cross-
man, First Vice President, Legal Services, CBOE to Howard
Kramer, Assistant Director, Division of Market Regulation, SEC,
dated September 9, 1988, enclosing opinion of Gardner, Carton and
Douglas, CBOE legal counsel, regarding SEC jurisdiction over
IPs; Letter from Edmund R. Schroeder, Attorney, Lord Day &
Lord, Barrett Smith, Amex legal counsel, to Jonathan G. Katz,
Secretary, SEC, dated January 13, 1989.
35 320 U.S. 344 (1943).
x6 Joiner Leasing Cerp., 320 U.S. at 350-51 (1943). The Amex
argues that an IP is a security because it is: (1) a call or option on
any security or group or index of securities; (2) a certificate of
interest or participation in stock; and (3) a right to purchase stock.
*7 471 U.S. 681, 686-87 (1985). See discussion on pp. 28-29 infra.
App. 40
IP does possess most of the characteristics of stock, and
purchases and sales of an IP are intended to replicate the
economic substance of purchases and sales of an equivalent
amount of the underlying stocks.*
First, the exchanges argue that IPs entitle holders to re-
ceive on a quarterly basis cash payments equivalent to the
regular cash dividends declared on the component stocks of
the underlying index. Second, the Phlx argues that an IP
purchaser will have the ability to pledge or hypothecate his -
interest in the IP. For example, as a typical provision of
customer agreements with a brokerage firm, an investor
normally will pledge or hypothecate his interest in the IP,
including profits and dividends, as security to the broker for
any indebtedness arising in connection with his account or
any other indebtedness to the broker. Third, the Phlx argues
that IPs will be freely transferable in exchange transac-
tions; thus, IPs will be negotiable in the same sense as ex-
change-traded equities and equity and non-equity securities
options. Fourth, the exchanges argue that IPs will have the
capacity to appreciate in value as the securities comprising
the underlying portfolio increase in value.
In addition, the Phlx and CBOE assert that, although the
purchase and sale of an IP does not constitute the purchase
and sale of the underlying shares of stock, the economic
substance of transactions in the IP leads to the conclusion
that the IP should be viewed as stock for purposes of the
definition of security. An IP purchaser or seller will have
similar risks and obligations as a person long or short stock.
The Phlx notes further that, to the extent these risks and
obligations differ from those associated with stock, they re-
semble a stock index option because of the availability of a
cash-out privilege, and because IPs would be issued by the
38 See Cadwalader letter, supra note 34, at 5.
App. 41
OCC rather than a corporation. Moreover, the Phlx argues
that the cash settlement feature of IPs should not lead to the
conclusion that IPs are more akin to stock index futures
than to securities as defined under Sections 3(a)(10) of the
Act. The Phlx suggests that in amending the definition of
the term “security” to include “‘any put, call, straddle, op-
tion, or privilege on any security . . . or group or index of
securities (including any interest therein or based on the
value thereof) . . . ” Congress explicitly recognized that
products which function economically as securities are them-
selves securities, although they are cash-settled based on
the value of underlying securities or indexes.
The Phix and CBOE argue that IPs are securities because,
in addition to possessing the characteristics of stock, IPs
may be classified as ‘an instrument commonly known as a
security.” In making this determination the Phlx and CBOE
rely on the majority view in Landreth that the reasonable
expectation of investors that they are purchasing securities
subject to the securities laws is of particular significance in
determining whether an instrument bearing only some of
the traditional characteristics of a type of security enumer-
ated in Section 3(a)(10) is a security.*9
The exchanges suggest that, even if an IP may be consid-
ered a commodity under the CEA definition, it is not a “con-
tract of sale for future delivery” for purposes of that Act.
In this regard, the exchanges argue that although IPs may
possess certain elements characteristic of futures contracts
[e.g., standardized terms and the ability of investors to real-
ize profits or limit losses through entry into offsetting sales
or purchases and payment of the difference between the pur-
chase (sale) price and the price at which the closing transac-
tion is effected] they lack the most significant element for
CEA purposes—the element of futurity.
99 Infra note 46.
App. 42
The exchanges assert that, unlike stock index futures con-
tracts, a purchase or sale of an IP does not entail a commit-
ment by an investor to buy or sell the value of the under-
lying index at some time in the future. The exchanges argue
that a purchase or sale of the IP involves an actual purchase
or sale of the current value of the underlying index, similar
to an actual transfer of ownership of the underlying
stocks.”
In addition, the exchanges note that IPs have other char-
acteristics that differ from futures contracts. First, unlike
futures contracts that are listed for trading in different con-
tract months, IPs have a perpetual existence with no fixed
expiration date. Second, the IP gives the purchaser a cash-
out privilege and the right to receive on a quarterly basis
cash payments equivalent to a proportionate share of any
regular cash dividends paid on the component stocks of the
underlying portfolio. Futures, on the other hand, require
settlement upon expiration of the contract and do not grant
the right to receive payment of dividends. Third, IPs are less
highly leveraged than stock index futures because their pro-
posed margin requirement is 50% of the IP value. In addi-
tion, the exchanges note that the IP margin represents a
down payment on the purchase price, rather than earnest
money or a performance bond, which is the function served
by the much lower levels of margin applicable to stock index
futures contracts.
B. Proprietary and Other Concerns
In two comment letters regarding Amex’s proposed trad-
ing of EIPs, the Phix alleges that the Amex appropriated the
CIP design to create the EIP. The Amex filed its EIP pro-
40 The exchanges note that when an IP is purchased 100% of the
instrument’s value must be paid. In this regard, even if an IP were
margined, an IP purchaser would have to contribute 50% of the
transaction’s value and cenvince a lender to loan the remaining
50%.
App. 43
posal with the Commission shortly after the Phlx, and its
original EIP design was virtually identical to the CIP design.
The Phix notes that it has expended a great deal of time,
effort, and expense in designing and submitting this new
product to the Commission for approval. For example, sig-
nificant staff time and outside legal counsel fees have been
spent in preparing the CIP to be traded. The Phlx believes
that allowing the Amex to begin trading an identical product
at the initiation of CIP trading would undercut the Phlx’s
efforts to develop new and innovative products such as CIPs.
Further, the Phlx suggests that its CIP product constitutes
protectable intellectual or creative work of pecuniary value
and is therefore protected under common law principles and
statutory law.‘! The Phlx argues both that a vested property
right arises with respect to its CIP and that the Amex has
infringed its CIP copyright by appropriating entire provi-
sions constituting the vast preponderance of the Phlx’s CIP
contract specifications and trading rules and presenting
them as Amex rules.
For these reasons, the Phlx argues that approval of the
Amex’s EIP proposal would be inconsistent with Section
6(b)(5), Section 6(b)(8), and Section 11A(a)(1)(C)(ii) of the Act.
The Phlix believes that, at the least, it should be provided a
12 to 18 month head start in the introduction of its IP prod-
uct. In addition to the proprietary product comments, the
Phlx argues that the Amex proposal is deficient in discuss-
ing the side-by-side trading concerns that could arise from
EIP trading.4* The Phlx suggests that, because Amex pro-
41 See, e.g., International News Service v. Associated Press, 248
U.S. 215 (1918); Standard & Poor’s Corp. v. Commodity Exchange,
Inc., 683 F.2d 704 (2d Cir. 1982); Board of Trade of the City of
Chicago v. Dow Jones & Co., 98 JIl.2d 109, 456 N.E.2d 84 (1983).
42 The Phlix notes that the Amex proposes to trade an EIP on the
XMI in addition to the XMI index option currently traded on the
(Footnote continued on following page)
App. 44
poses to trade EIPs on the Amex’s MMI, a portfolio upon
which Amex currently lists and trades options, there exists
the potential for significant time and place advantages and
concomitant inside market information, as well as possible
conflict of interest and manipulation concerns.
In response to Phlx’s comments regarding Amex’s EIPs
proposal the Amex submitted a comment letter outlining
four major rebuttals to the Phlx letter. First, the Amex
suggests that the Commission lacks the authority to adjudi-
cate Phlx’s property claims. In this regard, the Amex notes
that there is no evidence that Congress intended to provide
the Commission with the authority to adjudicate property
interests among competing parties because Congress has
enacted an elaborate statutory framework for the establish-
42 continued
Amex floor. The Phlx alleges that the trading of an XMI EIP and
XMI option should be prohibited because of informational advan-
tages and potential manipulative schemes that could occur as a
result of trading these two products on the same floor, side-by-
side. The Commission previously has noted that the side-by-side
trading of stocks and options on those stocks’while raising regu-
latory concerns, may be permitted provided adequate audit trail,
surveillance information and regulatory safeguards are in place.
The Commission has determined that any side-by-side trading con-
cerns (e.g., informational advantages and potential manipulative
schemes) are not present with regard to Amex’s EIPs for several
reasons. First, the Amex will not be trading an individual stock
and an option on that individual stock side-by-side. Instead, the
Amex will be trading an index option and the equivalent of a port-
folio of stocks on its floor. Second, the 20 stocks that comprise the
XMI, and therefore directly determine the index’s value, have a
primary market on the New York Stock Exchange (“NYSE”)
rather than the Amex. Consequently, any informational advan-
tages associated with trading an XM! EIP on the Amex are mini-
mal. Finally, the Commission is satisfied that existing audit trail
data, surveillance information and regulatory safeguards are suf-
ficient to allay any side-by-side trading concerns.
43 Supra note 24.
a ee
App. 45
ment, preservation, and protection of intellectual or creative
works and established specific federal agencies (e.g., the U.S.
Patent and Trademark Office and U.S. Copyright Office) to
administer and enforce these laws. The Amex further notes
that the Act provides, neither expressly nor implicitly, that
competing property claims among self-regulatory organiza-
tions (“SROs”) is a proper area of Commission consideration
in determining whether to approve specific rule proposals.
Second, the Amex suggests that a Section 19(b) proceed-
ing is inappropriate for adjudicating property rights because
such a proceeding would involve the Commission in an ex-
haustive factual investigation including, but not limited to,
a determination of which exchange actually developed the
product. The Amex notes that it is prepared to document the
fact that it has been actively working for several years on
the development of a market basket security and has ex-
pendec extensive time and resources in so doing.
Third, the Amex suggests that the Phlx CIP is legally
protected by neither statutory nor common law principles.
The Amex asserts that such a trading instrument is a con-
cept, and thus an idea that can-not (sic) be protected under
federal statutory law. The Amex suggests that because it
does not seek to utilize any underlying portfolio designed,
calculated and disseminated by Phlx as a basis for EIPs
trading, and because none of the cases cited in the Phlix
letter suggested that duplication or imitation of the idea or
the concept on which a commercial enterprise is based would
constitute a misappropriation, the Amex has not misappro-
priated the Phlx product.
Fourth, the Amex suggests that the ‘fair competition’”’
mandate of Section 11A(a)(C)(ii) of the Act does not autho-
rize the Commission to grant exclusive franchises. The
App. 46
Amex notes that the cases cited by Phlx in support of its
proprietary rights theory recognized that the freedom to
imitate and duplicate is of vital importance in a free market
economy. In addition, the Amex, citing the experiences of
the options markets, argues that Phlx’s contention that
innovation and commitment to the development of new prod-
ucts will be stifled unless SROs are provided some protected
property interest in ideas filed with the Commission is simply
erroneous.
IV. Discussion
After careful consideration of the comments received, ap-
plicable statutory provisions, and relevant judicial and ad-
ministrative decisions, the Commission concludes that IPs
are securities within the definition of that term in the Act
and are not contracts of sale for future delivery, and that
therefore such products are subject to the jurisdiction of the
Commission. In addition, the Commission concludes that
Phix should not be provided either exclusive trading privi-
leges over IPs or the opportunity to commence IPs trading
in advance of other exchanges.
For these reasons and for additional reasons set forth be-
low, the Commission finds that the proposed rule changes
relating to the listing and trading of IPs are consistent with
the requirements of the Act and the rules and regulations
thereunder applicable to a national securities exchange, in
4 The Amex, referring to several Commission releases, notes
that the development of new options products has consistently
been determined by the Commission not to provide any claim to
exclusive trading rights, regardless of which SRO was responsible
for initiating the design thereof, for expending funds, time and
resources to promote the product, or being the first to file with the
Commission.
App. 47
general, and the requirements of Section 6 and the rules and
regulations thereunder, in particular.
A. Jurisdiction
IPs confer the present right to receive the current value
of a portfolio of stocks, are of indefinite duration, and entitle
holders to payments equivalent to regular cash dividends
paid on the underlying stocks. For the reasons set forth
below, the Commission concludes that IPs are securities as
defined in the Act. Further, the Commission concludes that
IPs are not futures contracts subject to regulation under the
CEA, and that regulation of IPs as securities is consistent
with the purposes underlying both the Act and the CEA.
1. IPs are Securities
The Commission concludes that each of the proposed IP
products is a security within the definition of that term un-
der Section 3(a)(10) of the Act. Congress intended that the
term ‘‘security” be interpreted broadly, and the Supreme
Court has, on several occasions, observed that the definition
of the term security “is quite broad ... and includes both
instruments whose names alone carry well-settled meaning,
as well as instruments of ‘more variable character’... ’’* It
is, thus, well settled that the term “security” is to be inter-
preted flexibly to encompass new instruments that are simi-
lar to, or have the characteristics of, instruments already
recognized as securities. In particular, if “economic reality”
suggests that such an instrument has the characteristics of
instruments that clearly are securities, then it should be de-
fined as a security, even if the instrument does not fit explic-
itly within the Act’s enumeration of specific instruments
‘ Landreth, 471 U.S. at 686 (1985) [quoting Marine Bank, 455
U.S. at 556 (1982); SEC v. C.M. Joiner Leasing Corp., 320 U.S. 344,
351 (1943)].
App. 48
that constitute securities.** indeed, in a world of rapid devel-
opment of new financial instruments, it cannot be expected
that Congress would have identified the exact form of all
instruments that constitute securities.‘
% Landreth (sic) 471 U.S. at 694 (1985); Tcherepnin v. Knight, 389
U.S. 332, 336 (1967). Section 3(a)(10), 15 U.S.C. § 78(a)(10) (1982),
defines the term “security” as including:
any note, stock, treasury stock, bond, debenture, *ertificate of
interest or participation in any profii-sharing agreement or in
any oil, gas, or other mineral royalty or lease, any collateral-
trust certificate, preorganization certificate or subscription,
transferable share, investment contract, voting-trust certifi-
cate, certificate of deposit, for a security, any put, call, strad-
dle, 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), or any put, call, straddle, op-
tion, or privilege entered into on a national securities ex-
change relating to foreign currency, or in general, any instru-
ment commonly known as a “security”; or any certificate of
interest or participation in, temporary or interim certificate
for, receipt for, or warrant or right to subscribe to or pur-
chase, any of the foregoing; but shall not include currency or
any note, draft, bill of exchange, or banker’s acceptance which
has a maturity at the time of issuance of not exceeding nine
months, exclusive of days of grace, or any renewal thereof the
maturity of which is likewise limited.
The Commission notes that the definitions of the term “security”’
in Section 3(a)(10) of the Act and Section 2(1) of the Securities Act
of 1933 (“Securities Act’) are virtually identical and have been
treated as such by the Supreme Court in decisions dealing with the
scope of the term. See, e.g., Marine Bank, 455 U.S. at 555 n.3
(1982); United Housing Foundation, Inc. v. Foreman, 421 U.S. 837,
847 n.12 (1975).
* While the Commission, in its analysis of IPs, has focused pri-
marily on the portions of the definition discussed in the text, there
may be additional bases for concluding that IPs are securities. For
example, an IP can be analogized to a receipt for tue interests in
the securities upon which it is based or to a certificate of deposit
for a security. In addition, an analysis of IPs as investment con-
tracts also supports the conclusion that they are securities.
App. 49
IPs possesg the key characteristics of stock. In Landreth
Timber Co. v: Landreth, the Supreme Court’s most recent
decision addressing the definition of the term “security,” the
Court described five characteristic features of stock as: (1)
the right to receive dividends; (2) negotiability; (3) the ability
to be pledged or hypothecated; (4) the capacity to appreciate
in value; and (5) the conferring of voting rights in proportion
to che number of shares owned.*? IPs have all of these char-
acteristics, except voting rights, and have other characteris-
ties of stock as well.
With regard to the Landreth characteristics: (1) IP pur-
~ chasers will be entitled to receive on a quarterly basis cash
payments equivalent to a proportionate share ot any regular
cash dividends paid on the component stocks of the under-
lying portfolio; (2) because IPs will be freely transferable in
exchange transactions, such instruments will be negotiable
in the same sense as exchange-traded stock; (3) IP purchas-
ers also will have the ability to pledge or hypothecate their
IP interests;® and (4) IPs will have the capacity to appreciate
in value as the underlying components appreciate in value.®!
The only characteristic cited in Landreth that IPs do not
provide are voting rights in the stocks comprising the index.
*® 471 U.S. 681 (1985).
‘Jd. at 686-87.
» A customer's agreement with his brokerage firm typically pro-
vides that an investor normally will pledge his interest in a securi-
ty, including profits and dividends, as collateral to the broker for
any indebtedness arising in connection with his account or any
other indebtedness to the broker. In contrast, futures are execu-
tory cqntracts which may not be pledged, except regarding rights
to fe cash payments required by the futures contract.
In addition, insofar as the Amex EIP is concerned, the pur-
chaser or holder of the EIP has the right to receive physical deliv-
ery of shares of the component stocks of the Index if he exercises
the delivery privilege regarding a sufficient number of EIPs.
App. 50
This difference is not, by itself, determinative inasmuch as
there are many types of securities, including some types of
stock, that do not possess voting rights. For example, pre-
ferred stock generally possesses either limited or no voting
power.” Accordingly, the absence of voting rights does not
preclude the characterization of IPs as a security.
IPs have two other important characteristics normally as-
sociated with stock. First, IPs do not expire. An investor can
hold them for an indeterminate time, just as an investor may
retain a portfolio of stock indefinitely. Second, purchase re-
quirements and margin treatment for IPs are analogous to
stock purchase and margin requirements. As with stock, an
IP purchaser pays the full purchase price for his investment
at the time of purchase. The IP purchase may be financed
by borrowing up to 50% of the IP purchase price just as a
stock purchaser may borrow up to 50% of the stock purchase
price. Thus, a margin transaction in IPs includes an actual
borrowing with the full purchase price then passed through
to the IP seller. Accordingly, since IPs so closely resemble a
portfolio of stock they should be included within the defini-
tion of stock in Section 3(a)(10).
IPs also fall within the term “certificate of interest or
participation in” stock. IPs allow investors to replicate a pur-
chase of a portfolio of securities because the value and ben-
efits of IP ownership track the value and benefits of the
stocks underlying the portfolio. In addition, IPs are ex-
pressly termed “participations.”
2 As the Court noted in Landreth, “various types of preferred
stocks may have different characteristics and still be covered by
the Acts.” Landreth , 471 U.S. at 687, n.2 (19835).
3 While the name of an instrument is not by itself dispositive in
determining whether the instrument is included within the statu-
tory definition of the term “security,” the name is one factor taken
into consideration. Landreth, 471 U.S. at 686 (1985); United Hous-
ing Foundation v. Foreman, 421 U.S. 837, 850 (1975).
App. 51
Although IP transactions will be reflected by book entries
rather than by the transfer of paper certificates, the absence
of such certificates does not remove them from the term
“certificate.” The system for IP transfer is similar to the
immobilized depository system used in connection with mod-
ern day securities transfers, which likewise do not require a
formal certificate.*
In addition to the fact that IPs fit within several of the
more specific terms enumerated in Section 3(a)(10), it also is
clear that the “economic substance” of an IP* is essentially
4 L. Loss & J. Seligman, II Securities Regulation 597, 997-98
n.286 (3d ed. 1989).
55 The absence of a certificated instrument does not alter the
characterization of an instrument as a security. In this regard, it
is noteworthy that, under relevant state commercial laws, the def-
inition of the term “investment security” does not turn on whether
investors can obtain certificated instruments to evidence their
ownership interests. See, e.g., Del. Code Ann. tit. 6 § 8-102(1)(c)
(1988) [Uniform Commercial Code § 8-102(1)(c)]. Under state com-
mercial laws in effect in at least 35 jurisdictions, the term “invest-
ment securities,” specifically includes “‘uncertificated securities,”
transfers of which are registered upon books maintained for that
purpose by or on behalf of the issuer. See, e.g., Del. Code Ann. tit.
6 § 8-102(1)(b) (1988); Ill. Ann. Stat. tit. 26 § 8-102(1)(b) (1988); Con-
solidated Laws of N.Y. Ann. Book 62 1/2 § 8-102(1)(b) (1989). OCC
will issue all CIPs, EIPs, and VIPs, and will maintain books for
registering transfers of the same.
In addition, other investments routinely are issued or held in
book-entry form. Several types of securities commonly trade with-
out any physical, negotiable certificates evidencing ownership in-
terests. For exampie, U.S. Treasury Bills, Bonds, and Notes are
issued exclusively in book-entry form through Federal Reserve
Banks. Moreover, numerous states have issued debt securities
that restrict significantly an investor’s ability to obtain negotiable
certificates. See Securities and Exchange Commission, 53rd An-
nual Report 35 (1987); 51st Annual Report 25, 120 (1985); Securities
Exchange Act Release No. 22168 (June 25, 1985), 50 FR 27078.
56 The Court has on several occasions held that “in searching
for the meaning and the scope of the word ’security’ in the Act{s],
(Footnote continued on following page)
eee |
App. 52
indistinguishable from the economic substance of the more
specific instruments that are defined as securities by the
statute. An investor who owns an IP will own an instrument
having the same economic substance as a portfolio of stocks.
The financial returns on the IP will be substantially identical
to the returns from holding the underlying portfolio: capital
gains or losses will be directly related to the gains or losses
from the portfolio’s stocks; cash payments made quarterly
to the IP holder will consist of an amount equivalent to the
regular cash dividends paid by the issuers whose securities
comprise the portfolio; and margining treatment for the IP
purchasers and sellers is identical to stock margin require-
ments. Thus, because the “economic substance” of the pur-
chase of an IP is equivalent to the purchase of a portfolio of
stock, and the attributes of IPs are those commonly associ-
ated with securities, an IP constitutes “an instrument com-
monly known as a security.”
To the extent certain IP characteristics differ somewhat
from the characteristics of stock, they resemble characteris-
tics commonly found in rights to purchase or puts or calls
on a security or index of securities—interests specifical-
ly denominated as securities by the Act.5” In this regard,
the cash-out and physical delivery features of IPs are the
equivalent of a put or call right that accompanies the port-
folio of stock represented by the IP, much like “buy-sell”
% continued
form should be disregarded for substance and the emphasis should
be on economic reality.” See, e.g. , Tcherepnin, 389 U.S. at 336
(1967).
57 The futures commentators suggest that IPs are dissimilar to
index options because there is no apparent premium paid by an IP
long. In this regard, while IPs contain some characteristics of
stock index options (e.g., the issuance and clearance and settle-
ment features of IPs are analogous to those of stock index op-
tions), the Commission believes that IPs predominantly have the
attributes of a portfolio of common stock.
App. 53
agreements for stocks.® In particular, the periodic cash-out
feature merely creates a right similar to that commonly
found in stock transactions where, at specified times, one
party to a transaction has a right to purchase or sell a secu-
rity according to a formula price that might be determined
on the basis of book value, an appraisal, or a formula related
to market value (whereas the IP right is related to the price
of a specified index of securities).
These additional attributes, like the other features of IPs,
cause the IP to fall within the instruments included within
the definition of the term “security” in Section 3(a)(10) of the
Act.© Accordingly, for all of the above reasons, an IP is a
security as defined in the Act.
2. IPs are not Futures
Futures commentators argue that the Commission lacks
jurisdiction to authorize the trading of IPs on securities ex-
changes because IPs constitute stock index futures subject
to the exclusive jurisdiction of the CFTC.® The Commission
disagrees with the futures commentators’ suggestion that
IPs constitute futures contracts.
The term “futures contract” is not defined in the CEA or
the CFTC’s regulations. While characterization of the term
8 See, e.g., D. Gladstone, Venture Capital Handbook 129-30, 237
(1983); Arley Merchandise Corp. [1984-1988 Transfer Binder] Fed.
Sec. L. Rep. (CCH) {| 77,878.
59 Moreover, the addition of a periodic ‘“‘buy-sell” or “‘put-call’’
right does not transform a security subject to such a right into a
future; nor does it transform a portfolio of stock subject to such a
right into a future; and it does not transform an IP into a future.
60 See 15 U.S.C. 88 77b(1) and 78e(a)(10) (1982).
61 See Section 2(a)(1)(B) of the CEA.
App. 54
“future” requires an examination of all the surrounding cir-
cumstances, futures contracts generally are: (1) standard-
ized contracts imposing a bilateral obligation for the pur-
chase or sale of commodities at a specific price that provide
for future, as opposed to immediate, delivery on a specific
date; (2) directly or indirectly offered to the general public;
(3) secured by earnest money or “margin;”’ (4) entered into
primarily for the purpose of assuming or shifting risk as
opposed to transferring ownership of commodities; and (5)
generally extinguished by executing off-setting contracts
prior to the date on which delivery is called for by acceptance
of a cash payment representing the difference in price be-
tween the initial and off-setting transactions.
Not all of these characteristics are equally significant in
determining whether an instrument is a future. In particu-
lar, the phrase that most commonly appears in the CEA is
“contracts of sale of a commodity for future delivery.’”’® The
CEA’s emphasis on the futurity of the contracts subject to
its regulation, the common meaning inherent in the term
“futures” contract, and the fact that case law that has
sought to define the term “futures contract” has relied ex-
62 Gilberg, Regulation of New Financial Instruments Under the
Federal Securities and Commodities Laws, 30 Vand. L. Rev. 1599,
1606-08 (1986). See Merrill Lynch, Pierce, Fenner & Smith, Ine. v.
Curran, 456 U.S. 353 (1982); CFTC v. Co Petro Marketing Group,
Inc., 680 F.2d 573 (9th Cir. 1982); CFTC v. National Coal Exch., Inc.,
[1980-1982 Transfer Binder] Comm. Fut. L. Rep. (CCH) 121,424
(W.D. Tenn. 1982); Jn re First Nat’l. Monetary Corp. [1982-1984
Transfer Binder] Comm. Fut. L. Rep. (CCH) 121,707 (CFTC 1983);
In re Stovall [1977-1980 Transfer Binder] Comm. Fut. L. Rep.
(CCH) {20,941 (CFTC 1979); Advance Notice of Proposed
Rulemaking (Regulation of Hybrid and Related Instruments), 52
FR 47022 (December 11, 1987) at 47023.
63 (emphasis supplied). I P.M. Johnson and T. L. Hazen, Com-
modities Regulation, 81.03 at 9 (8d ed. 1989).
App. 55
tensively on the presence of future pricing (or delivery),® all
suggest strongly that if a contract lacks the element of fu-
turity it lacks the central distinguishing characteristic of a
futures contract.
Since futurity is essential to a futures contract, and no
element of futurity exists in an IP contract, an IP is not a
futures contract. A stock index futures contract contains an
element of futurity because the contract is the obligation to
pay for or receive the value of the index at a predetermined
date in the future. In stark contrast, however, an IP contract
represents the present obligation to pay or right to receive
the current value of an underlying portfolio of securities. In
this respect, an IP is substantially the same as a transfer of
a portfolio of securities that also gives rise to the present
obligation to pay or right to receive the current value of the
underlying portfolio of securities. Whereas the price of the
IP is determined at the date of purchase, a futures contract
is contractually defined by reference to a price that must be
paid or received on a specific date in the future.
In addition to lacking the element of futurity, IPs do not
share with futures the element of bilateral obligation to
receive or to pay the value of the index at a specified date in
the future. Once the purchaser of the IP has made full pay-
ment for the contract the purchaser has no continuing obli-
gations, only rights. The purchaser has the right to sell out
‘4 See note 62, supra.
65 The periodic cash-out feature of an IP does not cause the value
of the IP ever to be defined on the basis of any price other than a
current price, whereas the value of a future is always defined with
reference to the expectation of the future price at the delivery
date.
66 If the IP purchaser has bought on margin, the purchaser may
have a continuing margin obligation, but that obligation is to the
lender, not to the IP seller. See note 40, supra.
er |
App. 56
the contract at any time, the right to hypothecate the con-
tract, and the tight to “cash out” the contract at pre-set
periodic dates.’ The obligation of an IP contract to make
regular cash dividend equivalent payments falls unilaterally
on the seller. The other obligation of an IP contract—to pay
the present market price of the IP when the other side
cashes out—is also unilateral. More importantly, the IP
cash-out obligation is fundamentally different from the obli-
gation inherent in a futures contract because the IP obliga-
tion is contingent upon exercise of the cash-out privilege.
Indeed, unless the privilege is exercised, the obligation is
perpetual until the holder of the obligation extinguishes its
IP position. No futures contract has this characteristic.
As noted previously, in addition to the primary elements
of futurity and bilateral obligation, several other character-
istics have been used to determine the existence of futures
contracts.*9 In particular, the characteristics of standardiza-
tion and offset provide little meaningful assistance in deter-
mining whether an instrument is a futures contract rather
than a security. Other markets, such as stock options mar-
kets, regularly offer standardized contracts to the general
public without having those contracts considered ‘futures
6? The Commission believes that the cash settlement feature of
an IP does not support the futures commentators’ argument that
in substance an IP is a stock index future. In the 1982 amendments
to the definition of the term “security” contained in both the Secu-
rities Act and the Act, Congress explicitly recognized that prod-
ucts designed to have the economic substance of securities are
themselves securities, even though settled in cash on the basis of
the value of an underiying index.
68 The unilateral obligation falls only on the seller of a CIP or
EIP, and on both parties with a VIP. The VIP obligations for the
seller and purchaser are not bilateral in that each is discretionary
because it is dependent on the exercise of the right imposing that
obligation.
69 Supra note 62 and accompanying text.
App. 57
contracts.’ The fact that IPs are standardized and offered
to the public neither adds to nor detracts from the Commis-
sion’s conclusion that IPs are not futures. Similarly, the off-
set characteristics of IPs and stock options are identical.
Specifically, as in the case of options, the sale of an IP with
the same terms as the one purchased, or the purchase of an
IP with the same terms as the one sold, will extinguish the
previously established IP position. The availability of a sec-
ondary market to offset an IP position thus fails to distin-
guish IPs from other securities that are not futures and
provides no support for the categorization of IPs as futures.
The requirement that futures contracts generally be se-
cured by earnest money margin further differentiates IPs
from futures contracts. Margining practices for IPs and
futures are dramatically different. As noted above, as with
stock, an IP purchaser pays the full purchase price for the
IP investment at the time of purchase. Margin treatment for
IPs will be analogous to stock margin requirements. The
investor is required to pay the full purchase price of the IP
at the time of purchase, but may borrow up to 50% to pay
for the purchase. Thus, IP margins regulate credit. This is
entirely unlike a futures transaction in which margin acts as
a “good faith’ deposit to ensure that the parties will meet
their contractual obligations in the future.”! Accordingly, the
70 As another example, insurance contracts also are standard-
ized, offered to the public, and can rely on the occurrence of future
events, but are not considered ‘‘futures contracts.”
11 See generally Figlewski, Margins and Market Integrity: Mar-
gin Setting for Stock Index Futures and Options, 4 J. Futures
Markets 385 (1984). As recently explained in a Congressional re-
port:
Futures margins do not regulate credit, since no credit is
granted on futures contracts. Futures margins constitute a
(partial) guarantee that both parties will honor their financial
(Footnote continued on following page)
App. 58
“margin” element of the definition of futures suggests that
IPs are securities, not futures contracts.
The CME argues that, while an IP long position is entitled
to be held indefinitely, the quarterly cash-out feature creates
a quarterly expiration identical to the cycle now applicable
for similar futures contracts. The CME asserts that this fea-
ture is synonymous with an “undated futures market con-
tract.’’’2 The CME asserts further that the outcome of effec-
tive competition will be that at the time of purchase an IP
long actually will pay a higher IP price reflecting payment
of a commission to “roll over” the position, at the quarterly
expiration date. The analogy to undated futures markets
fails, however, for independent economic and legal reasons,
and the contention that IP pricing will reflect payment of a
“commission’’ to “roll over” this position is both speculative
and irrelevant.
71 continued
obligations and thus function as a kind of performance bond.
Moreover, futures margins, unlike securities margins, must
be posted daily (sometimes intra-daily) to cover ali daily losses
on futures contracts. Report on the Regulation of Futures
Margins, Comm. Print 100-6 (Aug. 1988) at 1, 8.
The futures commentators have argued that securities-style
margining is fundamentally different from futures-style margin-
ing, and, for the reasons set forth by those commentators, the
Commission agrees that IPs margins do not have the “earnest
money” characteristic of futures contracts. See, e.g., Testimony of
William F. Brodsky, President, CME Before the House Subcom-
mittee on Domestic Monetary Policy of the Committee on Banking,
Finance and Urban Affairs (May 25, 1988) at 2-4; Statement of
Karsten Mahlmann, Chairman, CBT Before the House Domestic
Monetary Policy Subcommittee of the Committee on Banking, Fi-
nance and Urban Affairs (May 25, 1988) at 34; Notice of Petition
for Rulemaking (Domestic Exchange-Traded Commodity Options;
Margins), 54 FR 11233 (March 17, 1989).
72 See , e.g., lst CME Letter at 2 [citing Gehr, Undated Futures
Markets, 8 J. Futures Markets, 89 (1988)].
App. 59
First, undated “futures” markets” require the joint deter-
mination of two prices: a spot commodities price and an as-
sociated intra-day interest charge” that is normally equal to
the interest that could be earned by investing an amount
equal to the value of the commodity plus the cost of one
day’s storage, 2.e., one day’s carrying cost.7> An investor
cannot participate in the undated futures market without
also paying or receiving the associated interest charge. Be-
cause of the need to incur this associated interest charge,
the “futures contract” never gives rise to a present interest
in the current value of a commodity. In contrast, IP con-
tracts have no associated interest charge and constitute a
present interest in a current value of an underlying portfo-
lio. Thus, the presence of the associated interest charge cre-
ates in an “undated” futures market an element of futurity
wholly absent from IPs.
Second, in regard to the suggestion that an IP long will
pay a commission, in the form of higher prices, to “roll over”
the position, the Commission believes that IP prices will be
based largely on the value of the underlying portfolio and
anticipated dividends on the components of the underlying
index. The Commission does not believe that a “roll over’
73 Gehr describes the market studied in his article as a
“curiosum.” Gehr, supra note 72, at 89. No such curiosa exist in
U.S. financial markets. Moreover, the fact that these markets
might be called “futures” in Hong Kong or elsewhere does not
mean that they would be defined as futures under the CEA. Finai-
ly, even if such markets were defined as futures markets under
the CEA, the presence of a daily interest charge still would distin-
guish them from IPs.
74 The daily “interest” payments, made for the privilege of defer-
ring, making or taking delivery of the commodity, may be “posi-
tive,” paid by sellers to buyers, or “negative,” paid by buyers to
sellers. Gehr, zd., at 90-91.
75 See Gehr, id., at 91.
App. 60
expense necessarily will be incorporated into an IP premium.
Moreover, even if such a de facto charge were to develop,
the Commission does not believe that such a charge would
transmute the IP into a “contract for future delivery” of the
underlying index because of the IPs’ other distinguishing
characteristics.
The CME also suggests that the IP dividend payment is
analogous to a cash payment from the short to the long,
related to measured or theoretical shrinkages in the value of
the underlying product, as occurs in the frozen skinned ham
futures market.76 The Commission observes, however, that
dividends are discretionary corporate payments, the size of
which is determined on a voluntary basis by the corpora-
tion’s board of directors. Corporations can raise or lower
dividends, and the right to receive dividends is a significant
attribute of stock. Thus, the payment of a cash dividend
equivalent to IP holders ensures that the IP contains the
investment features of stock. In contrast, the shrinkage fac-
tor in a frozen skinned ham futures contract is determined |
according to a pre-set formula calculated in order to assure
that purchasers of frozen skinned hams do not pay for a
weight that will not exist at that point in the future when
the contract expires and the ham has shrunk. The shrinkage
factor is thus inexorably linked to the futurity of the ham
contract (7.e., but for futurity, no price adjustment for
shrinkage would be necessary). The IP contract has no futu-
rity, is not subject to shrinkage, and receives and pays divi-
dends based on discretionary corporate decisions. The Com-
mission thus rejects the argument that IPs should be con-
sidered futures because the shrinkage of frozen skinned
hams is similar to the payment of corporate dividends.
76 See 1st CME Letter at 2-3.
nF
App. 61
Finally, the CME suggests that the Phlx daily CIP cash-
out does not alter its characterization as a futures contract.
In this regard, the CME claims that:
the differences between the S&P Futures and CIP are
insignificant, relating solely to a probable slight differ-
ence in pricing related to the theoretical daily conver-
gence of the cash and futures contract in the case of the
PHLX CIP and the quarterly convergence in the case of
the CME’s S&P 500 futures. That difference is defined
by well established arbitrage relationships reflecting
the differences in maturity dates.”
It is not at all clear that the pricing differences between
the S&P 500 future and the CIP will be “insignificant.” Pric-
ing of IPs and index futures should diverge because of the
substantial differences in margining practices, divergences
between an IP’s perpetual nature and the quarterly expira-
tion feature of a stock index future, and the payment of
regular cash dividend equivalents on IPs. In addition, IPs
will trade on markets with different marketmaking charac-
teristics and may be bought or sold by retail investors who
may not participate in the futures markets.7* Many IP in-
vestors also may be effectively prohibited from participating
in futures markets as a result of regulatory constraints or
contractual prohibitions. Therefore, because of differences
in the structure of the instruments, trading practices, and
investor populations, it is unsubstantiated speculation to
contend that the difference in pricing between IPs and index
futures will be “insignificant.”
In addition, the pricing differences between the S&P 500
future and all IPs (including those with quarterly cash-outs)
will not replicate the formula commonly used to determine
7 See 5th CME Letter at 1.
78 See note 96, infra and accompanying text.
App. 62
the theoretical value of a stock index futures contract. Such
a formula would add the interest on the price of the portfolio
to the index price, subtract the annualized dividend yield,
and factor in the days remaining until expiration.”
The futures commentators suggest that by manipulating
the terms of this and similar equations they are able to dem-
onstrate algebraic¢reiationships between the pricing of IPs
and the pricing of futures contracts, and thus that IPs
should be regulated as futures because they are priced
“like” futures. These equations, however, also can be used
to demonstrate, by a different manipulation of the equation’s
terms, that existing futures contracts are equivalent to a
straightforward stock portfolio position. It simply does not
follow that futures should be regulated as stocks because
they are priced “like” stocks, or vice versa. Similarly, IPs
should not be regulated as futures merely because an alge-
braic manipulation of a pricing formula might demonstrate
that they are priced like futures. Thus, the CME emphasis
on pricing similarities is not determinative.
Other somewhat more complex arbitrage and equivalence
relationships also do not serve to demonstrate that IPs are
futures. For example, it is possible to create a synthetic fu-
ture on a stock index by purchasing European style calls and
79 See generally B. Byrne Jr., The Stock Index Futures Market
170 (1987). The pricing formula contains the following elements:
Futures price = (Stock Portfolio Price) + [(Risk Free Inter-
est Rate — Annualized Dividend Yield on Stock Index) x
Days Until Expiration / 365].
Unlike futures, the interest on the difference between full pay-
ment for a portfolio of stocks and the earnest money margin pay-
ment for a future would not be relevant to IP pricing because IPs
are fully paid for at the time of the purchase. In addition, the value
of expected dividends on the portfolio would not be subtracted
because the IP purchaser would have the right to receive the
equivalent of those regular cash dividends.
App. 63
writing European style puts that have appropriate exercise
prices and times to maturity.*® “Hence when options on an
asset or commodity are traded, but there is no futures mar-
ket, it is always possible to construct a synthetic futures
contract.’’®! It does not follow, however, that, because
futures positions can be replicated by options positions,
futures are really options. Likewise, it does not follow that,
because options positions can be replicated by futures, op-
tions are really futures. Similarly, futures can be used to
replicate a variety of other securities. For example, futures
can be used to create a portfolio that has the cash flow char-
acteristics of a broad based equity portfolio. Again, it does
not follow that an equity portfolio should be regulated as a
future or that an index future should be regulated as a se-
curity because it is possible to define an arbitrage or equiva-
lence relationship between them. Thus, while the modern
theory of finance and its virtually limitless repertoire of
equivalence relations may be very valuable for arbitrage,
pricing and other analytic purposes, it is of little value when
it comes to addressing the technical, legal issues of jurisdic-
tion posed by the introduction of IPs and other financial
products. Indeed, the limitless use of such models would be
plainly inconsistent with the structure of the CEA and the
securities laws, which are designed to separate regulation
futures and securities.*
80 T. Copeland & J. Weston, Financial Theory and Corporate
Policy 322 (3d ed., 1988).
81 Id. at 323.
82 When Congress in the CEA expanded the definition of the term
“commodity” to include “all services, rights and interests in which
contracts for future delivery are presently or in the future dealt
in,” it carefully preserved this Commission’s jurisdiction, including
its authority to regulate novel instruments as securities. Specifi-
cally, Congress included a proviso that, with the exception of the
grant of exclusive jurisdiction regarding contracts for future de-
(Footnote continued on following page)
App. 64
Moreover, the determination that [Ps are securities and
not futures contracts is in no way inconsistent with the pur-
poses of the CEA and subsequent amendments thereto.
Futures regulation at the federal level is a direct outgrowth
of serious problems in the marketplace that Congress per-
ceived as detrimental to interstate commerce and the na-
tional public interest.*8 In 1936, when the CEA was en-
2 continued
livery, “nothing contained in this section shall (i) supersede or limit
the jurisdiction at any time conferred on the Securities and Ex-
change Commission . . . or (ii) restrict the Securities and Ex-
change Commission . . . from carrying out [its] duties and respon-
sibilities . . . .” This is further emphasized in Section 2(a)(1)(A) of
the CEA which provides that ‘“‘nothing in this Act shall be deemed
to govern or in any way be applicable to transactions in .
security rights . . . unless such transactions involve the sale
thereof for future delivery conducted on a board of trade.
7 U.S.C. § 2(a)(1)(A) (1982) (emphasis supplied).
The intent of Congress not to limit this Commission’s traditional
jurisdiction over the wide variety of financial instruments which
fall within the broad definition of the term “security” under the
federal securities laws was expressed repeatedly in the Act’s leg-
islative history. For example:
Although the expanded definition of ‘commodity’ . . . in-
cludes rights and interests which are securities as defined in
the federal securities laws . . . except as to transactions
[involving delivery on a contract market], the expanded defi-
nition of commodity is not intended to derrogate [sic] from
the jurisdiction of the Secuiities and Exchange Commis-
Ee
See Report of the House Comm. on Agriculture to Accompany
H.R. 13113, H.R. Rep. No. 98-975, 938d Cong., 2d Sess. 28 (1974)
(emphasis supplied).
Attempts to rely on arbitrage relationships to limit the scope of
the Commission’s jurisdiction over contracts that are not for fu-
ture delivery are thus directly at odds with the language and in-
tent of the CEA.
8 7 U.S.C. § 5 (1982).
App. 65
acted (extensively amending the Grain Futures Act of 1922),
Congress recognized that pervasive manipulation, excessive
speculation, trading abuses (e.g., wash sales, fictitious
trades, and accommodation trades), and the rampant growth
of boiler-rooms threatened to destroy the utility of the
futures markets. In 1974, Congress determined that addi-
tional tools were necessary to ensure adequate regulation of
all futures trading and futures professionals and to allow
for the extension of the economic benefits of futures trading
to those areas of commerce where the functions of futures
markets might be useful.
Approval of IPs for trading on securities exchanges, in a
fully regulated environment, would not give rise to the
abuses that Congress sought to prevent by adopting the
CEA. As exchange-listed securities, IPs will be subject to a
comprehensive regulatory structure under the federal secu-
rities laws and to Commission oversight similar to the regu-
latory regime applicable to futures under the CEA. Indeed,
84 Bromberg, Commodities Law and Securities—Overlaps and
Preemptions, 1 J. Corp. L. 217, 269 (1976). For example, both the
Commission and the CFTC have the power to: (1) determine which
contract markets and securities exchanges may operate under
their respective jurisdictions; (2) establish the rules of membership
and operation for the markets and exchanges under their respec-
tive jurisdiction; (3) oversee the exercise of self-regulatory author-
ity by such markets and exchanges; (4) approve specific instru-
ments for trading on those markets and exchanges; and (5) estab-
lish rules governing the registration and activities of brokers on
those markets and exchanges. Indeed, it is important to note that
both the securities and futures acts place a substantial emphasis
on competition. Compare 15 U.S.C. 88 78f, 780, and 780-3 (1982)
with 7 U.S.C. § 19 (1982). In this regard, there is no basis upon
which to conclude that Congress sought to adopt an expansive
definition of the term “futures contracts” for the purpose of pre-
venting competition by organized securities markets with the com-
modity markets.
App. 66
the CFTC’s regulatory authority over contract markets was
modeled in part on the Commission’s authority over securi-
ties exchanges.®5
3. IPs Are Not Subject to the Investment Company
Act
The Commission believes that an IP does not involve the
creation of an investment company, because there is no “‘is-
suer,” within the meaning of Section 3(a) of the Investment
Company Act of 1940, 15 U.S.C. § 80a-3, that is either “‘en-
gaged . . . primarily in the business of investing, reinvest-
ing, or trading in securities” or “engaged . . . in the busi-
ness of investing, reinvesting, owning, holding, or trading in
securities, and owns . . . investment securities having a
value exceeding 40 per centum of the value of such issuer’s
total assets . . . .” Moreover, OCC, the issuer of IPs, is a
clearing agency registered as such under the Act. A clearing
agency cannot be registered as such under the Act until the
Commission makes certain findings required by Section
17A(b)(3), including that the clearing agency has the capac-
ity to facilitate the prompt and accurate clearance and set-
tlement of securities transactions and to safeguard securi-
ties and funds in its custody. These qualifications support
the conclusion that the OCC would be an issuer primarily
engaged “in a business or businesses other than that of in-
vesting, reinvesting, owning, holding, or trading in securi-
ties.’’"°6 Moreover, given the existing securities law regu-
lation of the OCC under Section 17A of the Act and the
exchanges under Section 6 of the Act, the Commission sees
*° Courts also have observed that the “{s]tructure and power of
the CFTC are duplicative of the SEC.” Mullis v. Merrill Lynch,
Pierce, Fenner, & Smith, Inc., 492 F. Supp. 1345, 1350 (D. Nev.
1980).
*6 See Section 3(b)(1) of the Investment Company Act of 1940. 15
U.S.C. 8 80a-3(b)(1) (1982).
App. 67
no purpose that would be served by subjecting this arrange-
ment to investment company regulation.
Nor does there exist an investment company within the
OCC (or OCC combined with the exchanges), the IP purchas-
ers viewed collectively, or the IP shorts viewed collectively.
Unlike Prudential Ins. Co. v. SEC,’ where the Third Circuit
affirmed a finding of the Commission that the “Investment
Fund” resulting from the sale of annuity contracts to a
group of purchasers® constituted a separate investment
company, the Commission has found no separate investment
company herein. In the case of IPs, nothing exists compara-
ble to the Investment Fund in Prudential, which the court
found to be a “completely segregated account, devoted to
investing in securities.’’®
B. Benefits of Market Baskets
The Division of Market Regulation’s Report on The Octo-
ber 1987 Market Break (‘Staff Report’), An Overview of
Program Trading and Its Impact on Current Market
Practices (‘“Katzenbach Report’),?! Commission recom-
87 326 F.2d 383 (3d Cir. 1964), cert. denied, 377 U.S. 953 (1964).
88 As discussed earlier, the term “investment company” requires
a finding that there exists an “issuer;’”’ the term “‘issuer’’ is, in
turn, defined to include “every person;” the term “person”’ is de-
fined to include a “company;” and “company” is defined to include
“any organized group of persons, whether incorporated or not.”
15 U.S.C. §§ 80a-3(a)(1), 2(a)(22), 2(a)(28), 2(a)(8) (1982).
89 Prudential, 326 F.2d at 387 (1964).
® Division of Market Regulation, The October 1987 Market
Break (February 1988) (“Staff Report’).
%1 N. Katzenbach, An Overview of Program Trading and Its
Impact on Current Market Practices (December 21, 1987) (“Kat-
zenbach Report’).
teas
App. 68
mendations,” and testimony by the Commission” suggest-
ed, among other things, that the listing and trading of a |
basket of stocks on an exchange could help ameliorate the
volatility and steep stock price declines experienced during |
and since October 1987. As noted in the Staff Report, the
creation of one or more posts where actual baskets or port-
folios of stock could be traded could alter the dynamics of
program trading, because the availability of such basket
trading could, in effect, restore program trades to more tra- |
ditional block trading techniques.% The Staff Report noted |
further that, while arbitrage ultimately would flow to indi- |
vidual component stocks, many institutional investors and
member firms effecting index arbitrage transactions could
focus their equity transactions at the basket posts where the
specialist and trading crowd could provide efficiencies asso-
ciated with effecting transactions in a portfolio of securities
as opposed to individual stocks. This could add an additional
layer of liquidity to the market to help absorb the velocity
and concentration of trading associated with index-related
trading strategies. Moreover, because market baskets
would be traded at a single location on the exchange floor,
% Securities and Exchange Commission Recommendations Re-
garding the October 1987 Market Break (February 38, 1988).
% Testimony of David S. Ruder, Chairman, SEC, Before the Sen-
ate Committee on Banking, Housing, and Urban Affairs, on Feb-
ruary 3, 1988.
% Staff Report at 3-18.
% Jd. Similar ideas have been discussed in J. Grundfest, “Would
More Regulation Prevent Another Black Monday?,” Address be-
fore the CATO Institute Policy Forum on July 20, 1988, at 13-14
(available at the Commission); H. Stoll and R. Whaley, Program
Trading and the Monday Massacre (November 4, 1987) (available
at the Owen Graduate School of Management, Vanderbilt Univer- |
sity); and H. Stoll, Portfolio Trading, Working Paper No. 87-14
(Sept. 1987) (available at the Owen Graduate School of Manage- |
ment, Vanderbilt University).
App. 69
at which program trading order flow could be concentra ed
and imbalances in such trading determined, they would not
result in the same market information limitations that result
from executing program trades in the individual stocks. Fi-
nally, as separate consolidated products, market baskets
would be easy and inexpensive to clear and settle and could
provide an alternative vehicle for retail customers to invest
in “the market.”
For the reasons discussed below, the Commission believes
that IPs will provide retail investors with a cost efficient
means to make investment decisions based on the direction
of the market as a whole% and may provide stock market
participants several advantages over existing methods of
effecting program trades of stocks.”
Because IPs would be traded as market baskets at a sin-
gle specialist post on the exchanges’ floors, program trading
% Because of the small retail size of index participations and the
attendant costs of executing sufficient IP transactions in an at-
tempt to replicate large portfolios, the Commission believes that
such instruments are designed to handle retail investor interest to
invest in the ‘‘market’”. The Phlx, Amex, and CBOE believe that
IPs could be used by retail investors to make investment decisions
based on the direction of the market as a whole, thereby providing
them with a cost efficient means by which to take advantage of
anticipated market swings. In addition, an IP investment could
provide an individual investor with an additional source of securi-
ties income. The product could also be useful to institutional in-
vestors for their investment strategies.
% In this regard, the Commission believes that the listing and
trading of IPs on national securities exchanges may reduce mar-
ket volatility associated with program trades of stock because,
excluding the Amex EIP, IPs generally will be cash-settled, and
existing exchanges’ stock index options surveillance procedures
will be applicable to IPs. The Amex notes that the share delivery
alternative provides a feature discussed in the Staff Report and
will enhance the utility of EIPs for institutions. Staff Report at
3-19 to 3-20.
a
App. 70
order flow involving IPs can be concentrated at that post and
imbalances in such trading determined. Thus, IPs trading
would not result in the same market information limitations
that result from executing program trades in individual
stocks. Moreover, the availability of IPs may provide a more
efficient alternative to direct program trades of individual
stocks for some institutional investors. Finally, as a separate
product, IPs would be easy and inexpensive to trade, clear
and settle.
C. EIP Physical Delivery Proposal
The Commission also believes that the Amex proposal to
permit physical delivery of its EIPs is consistent with the
Act. Indeed, the availability of physical delivery permits in-
stitutions to employ EIPs to adjust their stock portfolios. As
a result, EIPs may have a greater potential for providing the
liquidity benefits envisioned for market baskets in the Staff
Report. Although providing certain benefits, the Amex’s pro-
posed EIP physical delivery does raise some concerns. The
Amex’s proposed rule change provides for a physical deliv-
ery facilitator (““PDF’’) to make physical delivery of the com-
ponent stocks of the underlying portfolio to EIP holders who
exercise the delivery privilege, if and only if, the number of |
delivery units for which holders have requested physical de- |
livery exceeds the number of delivery units offered for phys-
ical delivery by persons holding short positions. The Amex |
proposes to inform the PDF, several hours before the open- |
ing of trading, of the imbalance between delivery units of- |
fered and delivery units demanded in order that the PDF
may make arrangements that would enable it to obtain as
agent at the opening the additional shares of the stocks that
constitute the underlying portfolio to satisfy its obligations.
The Commission believes that PDF pre-opening knowl-
edge of the imbalance between delivery units offered and
App. 71
delivery units demanded can provide the PDF with an infor-
mational advantage concerning pre-opening order flow. Be-
cause this imbalance would always be on the buy side, and
because its existence and magnitude would be known only
to the PDF, the AMEX proposal raises the possibility that
the PDF might take advantage of the information by estab-
lishing or liquidating stock, options, and/or futures posi-
tions. In this regard, however, the Amex will place restric-
tions on the PDF’s function. In particular, the PDF must
announce to the trading crowd, and the Exchange shall
cause to be publicly reported, the physical delivery unit im-
balance at or prior to 9:00 A.M. on Exercise Friday. Thus, the
PDF’s opportunity to trade on “inside” market information
should be substantially reduced. Moreover, because the PDF
must satisfy the physical delivery unit imbalance only by
purchasing such imbalance at the opening rather than utiliz-
ing its existing inventory, the PDF’s role is limited to that
of an agent. Accordingly, the Commission believes the Amex
has sufficiently addressed any concerns about the physical
delivery mechanism.
D. Phix Blue Chip Index
Certain of the proposed underlying portfolios, such as the
Amex MMI and the S&P 500, have been published for sev-
eral years and have been used as a basis for stock index
options trading. In approving these portfolios as bases for
options trading (and commenting on them for future trad-
ing), the Commission has determined that the use of these
underlying portfolios does not raise manipulation concerns.%*
The Commission believes that the introduction of IPs based
on these portfolios should not raise additional manipulation
% See Section 6(b)(5) of the Act, 15 U.S.C. § 78f(b)(5) (1982), which
requires that the rules of a national securities exchange be de-
signed to prevent fraudulent and manipulative practices.
iia
App. 72
concerns.” The Phix, however, has developed, specifically
for IPs trading, a new Blue Chip CIP.
For several reasons, the Commission does not believe that
the Blue Chip CIP raises significant manipulation concerns.
Although the Blue Chip CIP is comprised of only 25 securi-
ties, it represents approximately 13 industry groups and is
designed specifically to replicate the performance of the
DJIA. The broad diversification, large capitalization, and
deep and liquid markets of the portfolio’s component stocks
significantly minimize the potential for manipulation.! The
ten most highly price-weighted stocks in the Blue Chip CIP
account for less than 58% of the portfolio’s cumulative mar-
ket value.!! Although IBM accounts for 8.73% of the Blue
Chip CIP’s price-weighting, the Commission believes manip-
ulation of the CIP through trading in IBM is made more
difficult because the stock is widely held and actively trad-
9 The Commission believes that IPs will not raise the same prob-
lems as other portfolio-related products regarding to intermarket
trading strategies that at times may have increased the concentra-
tion and velocity of market movements. While the Commission
notes that IPs will create arbitrage opportunities with either the
cash market or other derivative products, and may spawn new
intermarket trading strategies, because of the proposed 50% mar-
gin requirement for IPs (analogous to stock margin requirements)
the leverage concerns that exist with other equity derivative prod-
ucts are absent. See Report of the Presidential Task Force on
Market Mechanisms (January 1988), at III-7; Division of Market
Regulation, The October 1987 Market Break, (February 2, 1988)
at 11-1. Moreover, by providing market participants with a means
to trade “the market” without buying and selling dozens or hun-
dreds of individual stocks, IPs could lessen the impact of portfolio
trading strategies.
100 The Blue Chip CIP is price-weighted. Accordingly, an issue’s
weight in the total portfolio value is based on its price per share
rather than its total market capitalization (7.e., price per share
times the number of shares outstanding).
101 By comparison the 10 most highly price-weighted stocks in the
MMI account for approximately 70% of that portfolio’s cumulative
market value.
App. 73
ed.!% In addition, the proposed trading of IPs by the ex-
changes, which already have well-established stock and op-
tions surveillance procedures, does not appear to give rise to
major surveillance concerns because existing surveillance
procedures will be applicable to IPs trading. In addition, the
Phix has the necessary surveillance sharing arrangement
with the exchanges whose securities comprise the Blue Chip
CIP. Specifically, the Phlx and the NYSE are members of the
Intermarket Surveillance Group (“ISG’’).!° As members,
these markets are required to share surveillance informa-
tion with one another.
E. Proprietary Concerns
In general, the Phix argues that simultaneous Commis-
sion approval of the Amex’s proposed rule change to trade
IPs would neither be in the public interest nor promote fair
competition among exchange markets. In support of this
view the Phix suggests that Commission approval of Amex’s
“copy cat’ filing would deprive the Phlx (which claims to be
the IP developer) of the opportunity to take advantage of the
primary market phenomenon. In addition, the Phlx suggests
that such Commission approval would stifle product innova-
tion, design, and creativity. The Commission is of the view
that approval of the Amex and Phlx proposals simultane-
ously is consistent with the Act.
To the extent that Phlx’s ‘copy cat” argument implicates
a claim of misappropriation or infringement of a protected
102 For the period February 1988 through January 1989, IBM’s
Average Daily Volume (“ADV”) was approximately 1,357,900
shares.
103 The on-going task of the ISG is to create and maintain a coor-
dinated intermarket surveillance system to ensure that
intermarket surveillance concerns are appropriately addressed.
App. 74
property right, the Commission believes it is inappropriate
for it to attempt to resolve these issues in a proceeding in-
volving the approval of securities to be traded in a particular
market place. Congress has enacted an elaborate statutory
framework for the establishment, preservation, and protec-
tion of intellectual property rights and established specific
federal agencies (e.g., the U.S. Patent and Trademark Office
and the U.S. Copyright Office), to administer these laws. Sep-
arate state causes of action also may be available to Phix.
Neither the plain language of these statutes nor any provi-
sion of the Act suggests that Congress intended that the
Commission attempt, in the context of an approval proceed-
ing, to resolve intellectual property right claims that can be
pursued elsewhere.
Moreover, while the Commission recognizes that, under
the appropriate circumstances, incentives for innovation can
promote long term competition and provide substantial ben-
efits to the marketplace, cn the basis of the record in this
proceeding the Commission believes that simultaneous ap-
proval of the Phix, Amex, and CBOE proposals is consistent
with the Act. The Commission has been presented with nu-
merous proposals to list and trade new securities products
in recent years. In particular, the Commission, on November
22, 1982, approved a number of exchange proposals to trade
narrow and/or broad based index options, often on similar
or identical indexes, although such indexes were submitted
to the Commission on different dates.!"
The Commission recognizes Phlx’s argument that IPs are
a novel product involving substantially more innovation than
past new options products. Nevertheless, the Commission
believes that the opportunity for competition among mar-
104 See Securities Exchange Act Release No. 19264 (November 22,
1982), 47 FR 53981.
aati
App. 75
kets trading IPs simultaneously furthers the purposes of
the federal securities laws.!% Past experience has indicated
that an exchange which initially commences trading an op-
tions contract has an extremely large advantage over any
subsequent competitor. Accordingly, the Commission is con-
cerned that a temporary granc of exclusivity to the Phlx
could have the effect of substantially reducing potential fu-
ture competition in IPs, which effect outweighs the benefits
of incentives to innovation that might, in this case, result
from a temporary grant of exclusivity. Thus, the Commis-
sion has concluded that simultaneous approval of the pro-
posals is consistent with the Act.
F. Regulation of Member Organizations Doing
Business with Public Customers
1. Disclosure
In order to promote investor protection and to ensure ade-
quate disclosure in connection with IPs, the Phlx, Amex, and
CBOE propose that their rules pertaining to standardized
options and the requirements of Commission Rule 9b-1 also
apply to IPs trading.!% In this regard, the OCC requests
105 See Securities Exchange Act Release Nos. 18297 (December 2,
1981), 46 FR 60376 (‘Unrestricted inter-exchange competition in
the non-equity options markets most likely would result in the
development of options contracts best suited to the economic
needs of market participants rather than discourage innovation,
research, and development of new products”’), 22026 (May 8, 1985)
50 FR 20310 (“The goals of the Act are inconsistent with affirma-
tively delaying the start-up of trading in options on over-the-
counter stocks in a manner that benefits one particular market
place because there is no regulatory purpose which would require
such a delay’’).
106 ~The applicability of Rule 9b-1 relieves an issuer from the re-
quirement of delivering a prospectus to each IP customer. Never-
theless, an issuer must deliver its prospectus to each market upon
which the IPs are traded, for the purpose of redelivery to IPs
customers upon their request.
aii
App. 76
that the Commission issue an order pursuant to Rule
9b-1(a)(4) of the Act, treating IPs for disclosure purposes as
another type of security that should be treated in a manner
similar to “standardized options” Under Rule 9b-1.!°%7 OCC
suggests that each of the reasons cited by the Report of the
Special Study of the Options Market (“Options Study”’)! for
establishing a separate disclosure system for standardized
options applies equally to IPs.
As with other securities issued by OCC, the clearing cor-
poration interposes itself between IP buyers and sellers, and
is technically the “issuer” of each contract. Moreover, just
as with other OCC issued securities, the Commission be-
lieves providing investors with detailed descriptive informa-
tion regarding the issuer would not be useful. Instead, a
disclosure document that provides a discussion of the terms
and risks of IPs would appear to be substantially more use-
ful to investors.
107 See Letter from William H. Navin, Schiff Hardin & Waite,
OCC legal counsel, to Richard G. Ketchum, Director, Division of
Market Regulation, and Linda C. Quinn, Director, Division of Cor-
poration Finance, SEC, dated July 6, 1988 (“Schiff Letter’). The
Schiff letter requests also that IPs be treated in a manner similar
to standardized options for purposes of Rules 134a and 153b and
Form S-20 under the Securities Act of 1933 (“Securities Act’’). In
addition, the Schiff letter requests that the Commission staff con-
firm that IPs will be treated in a manner similar to standardized
options for the purpose of calculating Securities Act registration
fees and that Form 8-A will be available for IP registration under
the Act notwithstanding that OCC is exempt from the periodic
reporting requirements of the Act. See Schiff letter at 5 and 6 for
a more detailed explanation. Moreover, although the exchanges
have not requested exemption of IP underlying securities from the
applicability of Rule 12a-6 of the Act, the Commission notes that
pursuant to that Rule IP underlying securities are exempt from
the operation of Section 12(a) of the Act.
108 Report of the Special Study of the Options Markets to the
Securities and Exchange Commission, 96th Cong., lst Sess.
(Comm. Print 1978) (‘Options Study’”’).
ee
App. 77
The Commission believes that the reasons cited by the
1978 Options Study for establishing a separate disclosure
system for other OCC issued securities are equally applica-
ble to IPs. First, regular disclosure under the Securities Act
of 1933 (‘Securities Act’) focuses on disclosures regarding
the issuer of the security. As with other OCC issued securi-
ties providing this type of disclosure to investors is not use-
fui for IPs. While OCC’s solvency is obviously relevant, an
investor primarily is purchasing the equivalent of a portfolio
of stock. Accordingly, a disclosure document that provides a
discussion of the terms and risks of IPs would appear sub-
stantially more useful to investors. Second, delivery of a
Securities Act prospectus to all IP investors and redelivery
of any updated prospectus would be an inefficient and unnec-
essarily costly way of educating the public regarding IPs. In
this regard, OCC has prepared a special IPs disclosure docu-
ment (“IDD’’) explaining in detail the economic and risk
characteristics of IPs, the mechanism of buying, selling and
exercising IPs, and the market in which IPs will trade.'”
In addition, the Amex, Phlx, and CBOE propose to require
that every exchange member and member organization de-
liver to each customer a current IDD at or prior to the time
such customer’s account is approved for IPs trading.!!°
09 In reviewing any disclosure materials submitted, the Com-
mission intends to assure that the materials specifically describe
IPs, explain their uses, detail the special risks associated with IPs
trading, and emphasize that IP contracts, unlike options, obligate
a writer to pay to the holder an amount equivalent to a proportion-
ate share of dividends declared on the underlying index compo-
nents.
110 See e.g., Amex Rule 926(a). The Commission believes that
prio
This text is long and has been trimmed here. Open the source document for the complete record.
This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.