Proposed Changes to Cash Dividend Adjustment Policies

DATE: JANUARY 9, 2006
SUBJECT: PROPOSED CHANGES TO CASH DIVIDEND ADJUSTMENT POLICIES – THE “10% RULE”

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 “10%
Rule”. 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 “Effective Date” 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 “ordinary” if the amount
does not exceed 10% of the value of the underlying stock on the declaration date (the socalled
“10% Rule”). 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 – 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 “Ordinary” 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
“special”. OCC would normally adjust for extraordinary or “special” dividends unless
the amount was less than $12.50 per contract. The determination of whether a given cash
dividend is “ordinary” 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 “special” 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 “10% Rule”. 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.

“Initial” 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 “special” and appropriate for option adjustment even though
it may not have been foreseeable. Likewise, increases to regular dividends will also not be
deemed “special”.

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 “ordinary” 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. “Ordinary” cash dividends would be redefined as those paid “pursuant to a policy or
practice of paying such dividends on a quarterly or other regular basis.” Such
dividends would not generally trigger option adjustment. Other cash dividends would
be “extraordinary” or “special” and qualify for adjustment.
2. A size threshold of $12.50 per option contract would be applied for “special”
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.

 

Thank you much. This was very helpful.

 

Don't like this........

What about all the traders who bought leaps based on the current rules?

IMO, if this rule change happens then it will create even more uncertainty - as it will be difficult to determine in many cases whether or not the dividend in question is "ordinary".

 

The OCC is owned and run by the exchanges (ISE, CBOE, etc.). I wonder what that means in regards to the hope we are being looked after.

 

Good comments. Is it really so that the exchanges/ OCC would be impartial (and not look at open interest and time value of the calls and puts) to determine whether or not the dividend will be deemed ordinary?

It would seem to me that if this will not be challenged by anyone (like Metooxx) it will be implemented. Any additional feedback anyone can provide would be appreciated in the hope of helping everyone understand its full implications.

 

This rule should be challenged as many will be hurt by it. The reality is that all they are really doing is giving more power to the OCC to make decisions on adjustments by lowering the threshold.

The current proposed rule change is very similar to the current SSF rules for adjustments. That is, if the dividend is deemed "special' then an adjustment takes place. One controversial ruling happened in the fall of 2003 when BBY announced an initial dividend of .30 with subsequent quarterly dividends of .10.

http://www.optionsclearing.com/market/ssf_memos/19252.pdf

The OCC ruled it special. I didn't agree - so I spoke to one of the people on the panel who made the decision and I was astonished to find out that he knew next to nothing about this dividend.

1) Initially he told me that it was ruled a special dividend thus adjusted because he saw it reported as a "special" dividend on Bloomberg. Can you believe that one? I told him that just because Bloomberg reports it this way doesn't mean the company considers it "special". He said he would get back to me. (He needed another story)

2) So he calls me back later and says that since it was BBY's first dividend - that there was no way to predict such a dividend thus an adjustment was made. Can you believe this one? I told him about how MSFT surprised the market by declaring a dividend in Jan 2003 that surprised the market (first one) and there was no adjustment to MSFT's SSF indicating an inconsistency. He said he would get back to me. (He needed another excuse)

3) He calls me back a few days later and says that BBY did not indicate any forward guidance on the dividend when announced thus it was deemed special (note: that the new proposed rules actually stipulate this for new dividends). Little does he know that in the press release it does provide guidance (see below). When I informed him of this - silence once again and this time he states that someone else will get back to me. BTW, MSFT did not provide any guidance after their initial dividend and in fact later paid an annual dividend as MSFT called it 8 months later (with no adjustment again).


MINNEAPOLIS--(BUSINESS WIRE)--Oct. 21, 2003-- The Board of Directors of Best Buy Co., Inc. (NYSE:BBY) today declared a cash dividend of 40 cents per common share, the first cash dividend ever declared by the Company. The dividend of 30 cents per common share is payable on Dec. 9, 2003, to shareholders of record as of the close of business on Nov. 18, 2003. A quarterly dividend of 10 cents per common share is payable on Jan. 28, 2004, to shareholders of record as of the close of business on Jan. 7, 2004. The two dividend payments allow Best Buy to commence its currently desired rhythm of paying $0.40 per share per fiscal year.




4) Lead counsel for the OCC contacts me days later and states that the "ONLY" difference between the MSFT ruling and the BBY ruling was that MSFT attributed their dividends to the previous quarters while BBY did not and that is why the BBY dividend was deemed "special". Little did she know that on the conference call dated October 21, 2003 the CEO states exactly that within the first few minutes - that the dividend was attributable to the previous three quarters. She was stunned by this and said she would get back to me.


I assumed another excuse was coming but this time I got the two page legal document that basically says that the OCC looks at each situation on a "case by case" basis and their rulings are final.


So, who in their right mind wants them ruling on more issues?

Lowering the threshold will dramatically increase the number of rulings and yes there is an inherent conflict of interest.

 

WOW!

 

Here is a quick lesson for those who think comment letters to the SEC are meaningless. There were only a few comment letters to the SEC re the OCC's dividend adjustment rule change but they were "good" ones and the OCC has been forced/persuaded to modify and to grandfather the rule (if approved by the SEC - FEB 2009)


http://www.optionsclearing.com/market/infomemos/2006/oct/22210.pdf


I still disagree with the premise of the rule as it will create more uncertainty in the marketplace than the 10% rule currently does thus the rule should be disapproved (to protect investors)- but the reality is that it will probably be a net benefit for traders like myself as I thrive on uncertain markets as long as those dopes at the OCC make consistent rulings........

 

I'm confused.... I've seen information about both. Which will cause and adjustment to an options contract?

The dividend greater than 10% of the stock price or a cash dividend over $12.50. Thanks.