883 F.2d 537 (7th Cir. 1989), 89-1538, Chicago Mercantile Exchange v. S.E.C.

Docket Nº:89-1538, 89-1763, 89-1786 and 89-2012.
Citation:883 F.2d 537
Party Name: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.
Case Date:August 18, 1989
Court:United States Courts of Appeals, Court of Appeals for the Seventh Circuit
 
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Page 537

883 F.2d 537 (7th Cir. 1989)

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.

Nos. 89-1538, 89-1763, 89-1786 and 89-2012.

United States Court of Appeals, Seventh Circuit

August 18, 1989

Argued June 9, 1989.

Opinion on Denial of Rehearing and Rehearing En Banc Oct. 23, 1989.

Page 538

Jerrold E. Salzman, James T. Malysiak, Phillip L. Stern, Freeman, Freeman & Salzman, Chicago, Ill., for Chicago Mercantile Exchange.

Robert Steigerwald, Kirkland & Ellis, Washington, D.C., Garrett B. Johnson, Kirkland & Ellis, Chicago, Ill., Mark D. Young, Kirkland & Ellis, Washington, D.C., for Board of Trade of City of Chicago.

Paul Gonson, Solicitor (with him on the brief, Daniel L. Goelzer, Gen. Counsel, Anne E. Chafer, Asst. Gen. Counsel, Joan A. McCarthy, Special Counsel, and Keith E. Carpenter and Joseph O. Click, Attys. Phillip D. Parker, Associate Gen. Counsel), S.E.C., Washington, D.C., for S.E.C., respondent.

David C. Bohan, Jenner & Block, Chicago, Ill., Earl H. Nemser, H. Peter Haveles, Jr., Ralph Berman, Miriam Judlowe, Cadwalader, Wickersham & Taft, New York City, for Philadelphia Stock Exchange, Inc.

Burton R. Rissman, Paul E. Dengel, Schiff, Hardin & Waite, Chicago, Ill, for Options Clearing Corp.

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Mahlon M. Frankhauser, Edmund R. Schroeder, John Sullivan, Audrey R. Hirschfeld, David S. Frye, Lord, Day & Lord, Barrett Smith, Washington, D.C., for American Stock Exchange, Inc.

Joanne Moffic-Silver, Nancy R. Crossman, Andrew D. Spiwak, Chicago, Ill., for Chicago Bd. Options Exchange, Inc.

Joanne T. Medero, Ellyn S. Roth, Gracemary Rizzo, Commodity Futures Trading Com'n, Washington, D.C., for amicus curiae Commodity Futures Trading Com'n.

Roger Pascal, Burton R. Rissman, Paul E. Dengel, Schiff, Hardin & Waite, Chicago, Ill., for Options Clearing Corp.

Jay L. Witkin, Joanne T. Medero, Ellyn S. Roth, Gracemary Rizzo, Commodity Futures Trading Com'n, Washington, D.C., for Commodity Futures Trading Com'n, amicus curiae.

Matthew P. Fink, Washington, D.C., David M. Miles, Scott A. Williams, Russell G. Galer, Fried, Frank, Harris, Shriver & Jacobson, Washington, D.C., for petitioners.

William J. Taylor, Jr., Taylor & Taylor, Philadelphia, Pa., for Investment Co. Institute.

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 options on futures contracts. The Securities and Exchange Commission has authority to regulate trading of securities and options on securities. If an instrument is both a security and a futures contract, the CFTC is the sole regulator because "the Commission shall have exclusive jurisdiction 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. Sec. 2a(ii). See also 7 U.S.C. Sec. 2 ("the Commission shall have exclusive jurisdiction, except to the extent otherwise provided 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, 103 S.Ct. 434, 74 L.Ed.2d 594 (1982) (GNMA Options ). If, however, the instrument 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. Sec. 2a(i).

The CFTC regulates futures and options on futures; the SEC regulates securities and options on securities; jurisdiction never overlaps. Problem: The statute does not define either "contracts ... for future delivery" or "option"--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 newfangled instruments may have aspects of each of the prototypes. 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 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.

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At the end of each quarter the short must pay the buyer (the "long") a sum approximating 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 mutual 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 scarcely 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 Clearing Corporation (OCC) issues the IP to the long, receiving the cash; at the same time the OCC pays the short 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 exclusively. 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 differs 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 equivalent 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 positions 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 seeking to close their positions exceed the number of longs who want cash, the OCC will choose additional long positions 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 contended 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 Sec. 2a(i). The Chicago Board of Trade and the Chicago Mercantile Exchange...

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