DATE: JANUARY 9, 2006 SUBJECT: PROPOSED CHANGES TO CASH DIVIDEND ADJUSTMENT POLICIES â THE â10% RULEâ The OCC Board of Directors recently approved changes in adjusting option contracts in response to cash dividends or distributions. The proposed changes represent a significant departure from long-standing practice, under what has come to be known as the â10% Ruleâ. The changes will be effective on a date to be announced following SEC approval and distribution of a supplement to the Options Disclosure Document (see âEffective Dateâ below). Background and Rationale Article VI, Section 11 of the OCC By-Laws provides that as a general rule, outstanding options will not be adjusted to compensate for ordinary cash dividends. Interpretation .01 to that Section provides that a cash dividend will generally be deemed to be âordinaryâ if the amount does not exceed 10% of the value of the underlying stock on the declaration date (the socalled â10% Ruleâ). OCC and the exchanges decide on a case-by-case basis whether to adjust for dividends exceeding that amount. As a result, OCC historically has not adjusted for special dividends unless the amount of the dividend was 10% or more of the stock price. Regular dividends are known and can thus be priced into option premiums. By definition, however, special dividends cannot be anticipated in advance and therefore cannot be integrated into option pricing models. If adjustments are not made in response to special dividends â by calling for the delivery of the dividend -- call holders can capture the dividends only by exercising their options. Often in these cases, especially with LEAPS options (or FLEX options which can exist for 5-10 years), early exercise would sacrifice substantial option time value. This economic disadvantage can be further magnified if the option position is large, as is often the case today. (Conversely, put holders often receive a windfall benefit, benefiting from the increase in the in-the-money value on the ex date.) To the extent that equity options can be priced accurately and consistently without dislocations due to unforeseen special dividends, these economic disadvantages can be avoided The 10% Rule predated a number of significant developments: the introduction of LEAPS options, the sizeable open interest seen today, large contract volume associated with trading and spreading strategies, and modern option pricing models that take dividends into account. When open interest and individual positions were smaller, not adjusting for dividends of less than 10% did not have the pronounced impact it does today. Additionally, changes to the tax code which now tax dividends more favorably have provided an incentive for companies to pay more dividends, including special dividends. OCC exchanges believe that special dividends will be more common in the future. It is therefore appropriate that the 10% Rule be reassessed in the light of these considerations. Changes to Cash Dividend Adjustment Policies The Definition of âOrdinaryâ Cash Dividends Under the change to the OCC By-Laws approved by the OCC Board, a cash dividend or distribution would be considered ordinary (regardless of size) if it was declared pursuant to a policy or practice of paying such dividends on a quarterly or other regular basis. Dividends paid outside such practice would be considered extra-ordinary or âspecialâ. OCC would normally adjust for extraordinary or âspecialâ dividends unless the amount was less than $12.50 per contract. The determination of whether a given cash dividend is âordinaryâ according to this definition would be the responsibility of the adjustment panels of the OCC Securities Committee. (These adjustment panels are convened for the purpose of determining the appropriate contract adjustment under the OCC By-Laws in response to corporate events. They are composed of two members of each exchange that trades the affected option and a representative of OCC. The OCC representative votes only in the event of a tie. The adjustment panels consider each corporate event on a case by case basis.) Minimum Size Threshold In the interest of providing some limit on option symbol proliferation arising from adjustments, cash dividends that are determined to be âspecialâ will also be subjected to a size test before contract adjustment is effected: the per contract value of the dividend must be at least $12.50. This size threshold will be applied at the option contract level. That is, a special dividend attributable to any component of an option deliverable must yield at least $12.50 in value for that given option. (It would thus be possible for a given special dividend to trigger a contract adjustment for one option on a given stock but not trigger an adjustment for a another option on the same stock with a smaller deliverable.) The advantage of a fixed dollar threshold is avoiding uncertainty: the per contract value of the dividend can be immediately determined, without the need to do a percentage calculation based on the closing price of the underlying shares on the declaration date, as is currently the case under the â10% Ruleâ. The simple calculation of the value of the dividend on a per contract basis can even be applied to proposed or contingent (not yet declared) dividends, thus eliminating a lot of uncertainty that exists under the current method. âInitialâ Dividends and Dividend Increases Under the new approach for handling special cash dividends, an initial dividend, afterwards to be paid according to a regular schedule, declared by a company that previously did not pay dividends, will not be considered âspecialâ and appropriate for option adjustment even though it may not have been foreseeable. Likewise, increases to regular dividends will also not be deemed âspecialâ. Threshold Consistency Across Relevant Interpretations: Fund Shares Interpretations .01 and .08 to Article VI, Section 11 of the OCC By-Laws apply to cash distributions. Interpretation .01, which is proposed to be amended to fix a $12.50 per contract adjustment threshold, applies in general to all cash distributions. Interpretation .08 carves out an exception to the policy of not adjusting for âordinaryâ cash distributions for fund share capital gains distributions. Under Interpretation .08, there is a zero threshold for fund share capital gains distributions. To provide consistency, the OCC Board has approved applying the same $12.50 per contract size threshold to all adjustments for cash distributions: in addition to other criteria, all cash distributions must also yield at least $12.50 per contract value in order to trigger adjustment. Effective Date These changes in adjustment methodology for cash dividends require changes in the OCC By- Laws which must be approved by the Securities and Exchange Commission. Also, a supplement to the Options Disclosure Document describing the changes will need to be distributed. The changes in adjustment policy will be effective on a date to be announced after these events have occurred. OCC estimates a minimum of 4-5 months will be needed. OCC understands the option exchanges will also be publishing notices and providing educational efforts to prepare for this change. Summary The proposed changes to adjustment policies for cash dividends are as follows: 1. âOrdinaryâ cash dividends would be redefined as those paid âpursuant to a policy or practice of paying such dividends on a quarterly or other regular basis.â Such dividends would not generally trigger option adjustment. Other cash dividends would be âextraordinaryâ or âspecialâ and qualify for adjustment. 2. A size threshold of $12.50 per option contract would be applied for âspecialâ dividends otherwise qualifying for option adjustment. Special dividends yielding per contract values smaller than this amount would not trigger adjustment. 3. The same $12.50 per contract threshold would apply to all cash distributions (including fund share capital gains distributions.) 4. Before these policy changes become effective, the SEC must approve the By-Law changes and an Options Disclosure Document supplement must be published. OCC will advise the date on which the proposed changes become effective.