in the supreme court of the united...
TRANSCRIPT
No. 12-940 ================================================================
In The
Supreme Court of the United States
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INTERNATIONAL SECURITIES EXCHANGE, LLC,
Petitioner,
v.
CHICAGO BOARD OPTIONS EXCHANGE, INC.; CME GROUP INDEX SERVICES, LLC;
THE MCGRAW-HILL COMPANIES, INC.,
Respondents.
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On Petition For A Writ Of Certiorari To The Illinois Appellate Court
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BRIEF FOR CITADEL INVESTMENT GROUP AS AMICUS CURIAE IN SUPPORT OF THE
PETITION FOR CERTIORARI
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ANDREW C. BAAK, Counsel of Record STEPHEN J. COWEN (Special Counsel) BARTLIT BECK HERMAN PALENCHAR & SCOTT LLP 54 W. Hubbard Street, Suite 300 Chicago, IL 60654 (312) 494-4400 [email protected]
Attorneys for Amicus Curiae
================================================================ COCKLE LAW BRIEF PRINTING CO. (800) 225-6964
OR CALL COLLECT (402) 342-2831
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TABLE OF CONTENTS
Page
INTEREST OF AMICUS ..................................... 1
SUMMARY OF ARGUMENT .............................. 2
ARGUMENT ........................................................ 3
I. Options on Indexes in Modern Finance ....... 3
A. Indexes, Index Funds, and Exchange Traded Funds (“ETFs”) ........................ 3
B. Using Options to Reduce Risk ............. 4
C. Options Exchanges and Trading ......... 8
D. Benefits of Multi-Exchange Competi-tion ....................................................... 11
E. National Policy Favors Multi-Listing and Interexchange Competition .......... 13
F. The Decision Below ............................. 16
II. Reasons for Granting the Petition for Certiorari ................................................... 19
A. The Decision Below Is Erroneous on an Important Federal Preemption Is-sue ........................................................ 19
1. Exclusive listing imposes enor-mous costs on investors .................. 20
2. Index creators have incentives to innovate even without exclusive listing .............................................. 21
3. Exclusive listing stifles incentives to innovate ...................................... 22
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TABLE OF CONTENTS – Continued
Page
B. The Decision Below Forecloses Fur-ther Percolation ................................... 24
C. The Decision Below Has Significant Implications Outside of Index Op-tions Trading ....................................... 26
CONCLUSION ..................................................... 28
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TABLE OF AUTHORITIES
Page
CASES
Board of Trade of City of Chicago v. Dow Jones & Co., Inc., 456 N.E.2d 84 (Ill. 1983) .... 17, 18, 20, 21
Chicago Bd. Options Exch., Inc. v. Int’l Sec. Exch., LLC, 677 F.3d 1361 (Fed. Cir. 2012) ..... 22, 23
Chicago Bd. Options Exch., Inc. v. Int’l Sec. Exch., LLC, 973 N.E.2d 390 (Ill. App. Ct. 2012) .................................................................. 16, 22
Dow Jones & Co. v. Int’l Sec. Exch., Inc., 451 F.3d 295 (2d Cir. 2006) .................................... passim
Int’l News Serv. v. Associated Press, 248 U.S. 215 (1918) ................................................................ 18
Loomis v. Exelon Corp., 658 F.3d 667 (7th Cir. 2011) .......................................................................... 4
McGraw-Hill Co. v. Int’l Sec. Exch., Inc., No. 05 Civ.1129, 2005 WL 2100518 (S.D.N.Y. Sept. 1, 2005) .................................................................... 14
Nasdaq Stock Mkt., Inc. v. Archipelago Hold-ings, LLC, 336 F. Supp.2d 294 (S.D.N.Y. 2004) ........................................................................ 24
U.S. Golf Ass’n v. St. Andrews Sys., 749 F.2d 1028 (3d Cir. 1984) .................................................. 18
STATUTES
15 U.S.C. § 78c-3(h)(1)(A) ........................................... 13
15 U.S.C. § 78f(b)(5) ................................................... 13
15 U.S.C. § 78k-1(a)(1)(C) .......................................... 13
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TABLE OF AUTHORITIES – Continued
Page
OTHER AUTHORITIES
2 William F. Patry, Patry on Copyright (2012) .......... 18
Andrew Dowell and Joann S. Lublin, Strings Attached to Options Grant for GE’s Immelt, Wall St. Journal, April 20, 2011 ............................. 27
Annette Nazareth, Remarks Before the STA Annual Conference, Oct. 5, 2005 <tinyurl.com/ byfb4ds> ............................................................ 14, 15
Black’s Law Dictionary (7th ed., abr. 2000) ......... 10, 12
CBOE 2011 Annual Report <tinyurl.com/ b7rhg76> ................................................................. 22
CBOE Fee Schedule Feb. 20, 2013 <tinyurl.com/ b32gfzz> ..................................................................... 9
CBOE Holdings’ CEO Discusses Q4 2012 Results – Earnings Call Transcript, Feb. 8, 2013 <tinyurl.com/b2zl3lf> ....................................... 9
CBOE Market Statistics 2011 <tinyurl.com/ aq5xjwn> ................................................................... 6
Eric N. Berg, Commodity Exchanges See Threat, N.Y. Times, Mar. 13, 1989 .......................... 23
Kenneth Griffin, We must overturn the status quo in derivatives, Financial Times, Oct. 26, 2009 ....................................................................... 5, 8
Lawrence G. MacMillan, Options as a Strategic Investment (Mariann Hutlak ed., 2002) ........... 3, 6, 9
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TABLE OF AUTHORITIES – Continued
Page
Lucy F. Ackert & Yisong S. Tian, Evidence on the Efficiency of Index Options Markets, Q1 Fed. Reserve Bank of Atlanta Economic Re-view (2000) .......................................................... 7, 21
Michael Santoli, Fair Winds Ahead, Barrons, Oct. 8, 2012 <tinyurl.com/aqw366x> ...................... 27
Nina Mehta, CBOE Sets Fees for Electronic S&P 500 Options on C2 Exchange, Bloom-berg, Sept. 28, 2011 <tinyurl.com/3r73nrd> .......... 22
Notice of Filing, Exchange Act Release No. 34-50469, 83 SEC Docket 2608, 2004 WL 2723985 (Sept. 29, 2004) ......................................... 24
Notice of Filing, Exchange Act Release No. 34-68702, 78 Fed. Reg. 5548 (Jan. 25, 2013) ............... 15
Options Clearing Corporation Historical Vol-ume Query 2012 ........................................................ 6
Patrick de Fontnouvelle, Raymond P.H. Fishe, & Jeffrey H. Harris, The Behavior of Bid-Ask Spreads and Volume in Options Markets dur-ing the Competition for Listings in 1999, Journal of Finance Vol. LVIII(6) (2003) ................. 12
Richard A. Brealey & Stuart C. Myers, Princi-ples of Corporate Finance (7th ed. 2003) .............. 5, 6
Richard Posner, Misappropriation: A Dirge, 40 Hous. L. Rev. 621 (2003) ................................... 18, 21
S&P Indices, Annual Survey of S&P Indexed Assets (Dec. 31, 2010) <tinyurl.com/ azx3q6k> ................................................................... 3
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TABLE OF AUTHORITIES – Continued
Page
SEC, Concept Release: Competitive Develop-ments in the Options Markets (2004) <tinyurl. com/adwcdt6> .......................................................... 14
Serena Ng, Warren Buffett Says New Money Managers Will ‘Get Paid for Their Perfor-mance’, Wall St. Journal, Sept. 13, 2011 ................ 27
Stewart Mayhew, Competition, Market Struc-ture, and Bid-Ask Spreads in Stock Option Markets, 57 J. Finance 931 (2002) ................... 11, 12
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INTEREST OF AMICUS
Amicus curiae Citadel LLC (“Citadel”),1 through its Citadel Securities LLC (“Citadel Securities”) business, is the leading retail equity and listed equity options market maker in the United States. During 2012, Citadel Securities traded approximately 19% of U.S.-listed equity options volume, and approximately 14% of U.S. listed equity volume, based on publicly reported transaction volume.
Citadel affiliates also trade options as part of Citadel’s asset management business, which deploys capital on behalf of private funds’ capitalized inves-tors – including pension funds, ERISA plans, individ-uals, and other entities – across multiple investment strategies in the world’s financial markets.
As a key liquidity provider and asset manager, Citadel and its affiliates have an interest in the important national issue this case presents relating to the maintenance of uniform national exchange laws and policies that improve market competition, transparency, and performance for all investors.
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1 The parties have consented to the filing of this brief, written evidence of which accompanies the filing. The parties received notice, at least 10 days prior to the due date, of amicus curiae’s intention to file this brief. No counsel for a party authored this brief in whole or in part, and no person (other than amicus curiae or its counsel) made a monetary contribution intended to fund the preparation or submission of this brief.
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SUMMARY OF ARGUMENT
The Court should grant the petition for certiorari for three principal reasons.
First, the Illinois Appellate Court’s decision is patently erroneous on a federal preemption question of national importance. The decision below is harmful to the investing public because it allows the creators of published indexes to prevent competition in the listing of index options and to impose upon the invest-ing public a general tax on the use of those options.
Second, further percolation of this issue in the lower courts is unlikely because the injunction im-posed by the Illinois court below effectively prohibits exchanges across the country from listing the index options at issue.
Third, the decision below has significant implica-tions for markets and investors even outside of index options trading. The Illinois Appellate Court’s reason-ing extends to listing and trading other options and derivatives, as well as to private hedging transactions and, potentially, aspects of performance-based pay, all of which will impose costs well beyond the stakes directly at issue here.
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ARGUMENT
I. Options on Indexes in Modern Finance
A. Indexes, Index Funds, and Exchange Traded Funds (“ETFs”)
An index is a “compilation of the prices of several common entities into a single number.” Lawrence G. MacMillan, Options as a Strategic Investment 971 (Mariann Hutlak ed., 2002). A stock market index is a compilation constructed to track and measure the performance of the stock market. An index might track the performance of stocks across the market as a whole, or an index might track the performance of the stocks in a particular sector of the market. In either case, the stock index is a compilation – often but not always an average – comprising the prices of a selected set of stocks.
Two stock market indexes are directly at issue in this case. Both indexes are widely published as measures of the health of the market as a whole. The Standard & Poor’s 500 Index (S&P 500) reflects an average – weighted by relative market value – of the share prices of 500 major companies in the United States. See, e.g., Dow Jones & Co. v. Int’l Sec. Exch., Inc., 451 F.3d 295, 298 (2d Cir. 2006) (“Dow Jones”). As of the end of 2010, over $5.5 trillion in assets were benchmarked to the S&P 500, with indexed assets making up over $1 trillion of that total. See S&P Indices, Annual Survey of S&P Indexed Assets (Dec. 31, 2010) <tinyurl.com/azx3q6k>.
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The Dow Jones Industrial Average (DJIA) is a separate index designed to reflect the market value of the shares of 30 leading industrial companies in the United States. Dow Jones, 451 F.3d at 298.
Because indexes are designed to track the per-formance of the market, an investor seeking to obtain returns reflecting overall performance of the market might choose to invest in a portfolio of stocks that reflect the S&P 500 or the DJIA. To meet the demand for such investment vehicles, passively managed “index funds” offer a portfolio of stocks designed to track a particular index. See, e.g., Loomis v. Exelon Corp., 658 F.3d 667, 670 (7th Cir. 2011).
Similarly, but distinctly, “exchange traded funds” (or “ETFs”) are designed to track index performance and issue publicly traded shares in the ETF itself. Each ETF share consists of a “basket” of the shares of the companies used to calculate the index, weighted in the same proportions as in the index. Dow Jones, 451 F.3d at 298. Buying shares in ETFs that track the performance of an index – for example, the DJIA or the S&P 500 – allows investors to “buy and sell shares that are backed by the securities which make up the DJIA and the S&P 500, and therefore rise and fall with those indexes.” Ibid.
B. Using Options to Reduce Risk
Market index portfolios are highly diversified, meaning their diverse assortment of securities reduc-es the variability of returns and the “unique risk”
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associated with any given security or industry. The unique risk of a particular security “stems from the fact that many of the perils that surround an individ-ual company are peculiar to that company and per-haps its immediate competitors.” Richard A. Brealey & Stewart C. Myers, Principles of Corporate Finance 168 (7th ed. 2003). Unique risk can be diversified away because individual stock prices do not move in concert – they are not perfectly correlated. Id. at 165-68. But no matter how diversified a portfolio might be, there remains “systemic risk” – also known as “market risk” – that “stems from the fact that there are economy-wide perils that threaten all business-es.” Id. at 168.
Derivatives provide an investor with a vehicle to reduce – or hedge against – this systemic risk. A derivative is an “[a]sset whose value derives from that of some other asset.” Brealey & Myers at 1042. Derivatives “serve a vital purpose in our global econ-omy” by “help[ing] institutions manage balance-sheet risk and cut the cost of capital, which in turn spurs investment.” Kenneth Griffin, We must overturn the status quo in derivatives, Financial Times, Oct. 26, 2009.
Options are derivative “contracts [that] give the purchaser of the option the right, but not the obliga-tion, to buy or sell a security at a specified price (the ‘strike price’),” on or before a specified date. Dow
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Jones, 451 F.3d at 298.2 In 2012, over 4 billion option contracts were traded in the United States – more than five times the volume traded in 2000 and nearly twenty times the volume traded in 1990. See Options Clearing Corporation Historical Volume Query 2012. In 2011, the primary option contract on the S&P 500 (denoted “SPX”) had a volume of 197,509,449 con-tracts traded. CBOE Market Statistics 2011 at 62 <tinyurl.com/aq5xjwn>. This makes the SPX the “most-actively traded index option in the U.S.” CBOE 2011 Annual Report at 1 <tinyurl.com/b7rhg76>.
A call option gives the purchaser the “right to buy a share for a specified [strike] price,” whereas a put option gives the purchaser the “right to sell the share.” Brealey & Myers at 566. In practice, certain option contracts are not “settled” or closed out – meaning performance of the contract is completed – by the sale or purchase of the underlying security. Instead, “settlement is generally effectuated by a cash payment representing the difference between the market price and the strike price.” Dow Jones, 451 F.3d at 298. In the case of index options – the options directly at issue here – they are always cash-settled or “cash-based” because there is no underlying security to exchange. MacMillan at 965.
2 An “American-style option” traded on U.S. exchanges may be exercised on or before its expiration date, whereas a “Europe-an-style option” traded on U.S. exchanges may be exercised only on its expiration date.
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Index options have played a critical role in finan-cial markets because they allow investors to antici-pate market movements “without having to buy or sell a large number of securities, and they permit portfolio managers to limit downside risk.” See, e.g., Lucy F. Ackert & Yisong S. Tian, Evidence on the Efficiency of Index Options Markets, Q1 Fed. Reserve Bank of Atlanta Economic Review 40 (2000). Because investors have over $5 trillion in assets tied in one way or another to the S&P 500 index, options trading on that index are particularly important to reduce the systemic risk in those positions.
Consider a concrete example of how options can be used to hedge against market risk. Suppose inves-tor ABC manages a fund in which several large pension funds are invested. ABC holds a portfolio of securities that are uniquely selected and well diversi-fied but also highly correlated to the S&P 500, which at the time has a value of 1000. In order to secure a return that is tied to the performance of the selected portfolio of securities and not macro-economic factors, ABC might want to isolate the company-specific risks of securities in the portfolio and minimize broader market risk. For example, ABC might want to limit potential losses to the portfolio should the market perform poorly and lose 10% of its value by June 2013, such that the S&P 500 would fall to 900 on or before then.
Assuming such options are listed and available, ABC could buy a put option with a strike price of 1000 that can be exercised on or before the expiration
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date. This put option gives ABC the right to receive the difference between the value of the index on or before the expiration date in June 2013 – $900 – and the strike price stated in the option contract – $1000. That difference of $100 would help offset losses to the portfolio due to the broader market downturn, allow-ing the overall return to ABC’s investors to be based more directly on the performance of the securities that ABC selected for the portfolio.
C. Options Exchanges and Trading
The Respondent index creators have granted Respondent CBOE an exclusive license to create, list, trade, market, and promote options on the DJIA and S&P 500. See, e.g., Dow Jones, 451 F.3d at 299-300.
Both CBOE and Petitioner ISE operate national securities exchanges. Exchanges provide centralized locations – either physical or internet-based – for trading securities and other financial instruments. Trades also occur in “over-the-counter” (OTC) mar-kets where parties enter into bilateral contracts with one another subject to fewer regulations. Because they are less transparent than exchanges and subject to fewer rules, OTC markets can, unfortunately, mask trillions of dollars in systemic risk. See, e.g., Griffin, We must overturn the status quo in derivatives (detail-ing the importance of reform of OTC derivatives markets).
Both the CBOE and ISE exchanges offer options on a wide variety of underlying securities. Among the
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essential market participants at option exchanges are “market makers,” members of the exchanges who “quote” prices at which they will agree to buy or sell options for their own account. MacMillan at 979. Citadel Securities, an affiliate of amicus Citadel, is the largest options market maker in the United States.
Exchanges like the CBOE charge users “ex-change fees” that vary across different investment products. As with any exclusive offering, exchange fees are higher where particular options are listed on only one exchange. Consistent with this, the CBOE’s rates on S&P 500 options carry CBOE’s “highest options rate per contract.” CBOE Holdings’ CEO Discusses Q4 2012 Results – Earnings Call Tran-script, Feb. 8, 2013 <tinyurl.com/b2zl3lf>. Those higher rates for S&P 500 products are in sharp con-trast to rates on options listed on multiple exchanges, where CBOE’s own CEO acknowledges that competi-tion is “fierce.” Ibid.
And in addition to higher exchange fees, the CBOE also tacks on a per-contract license surcharge fee to both sides of an S&P 500 or DJIA option trans-action. CBOE Fee Schedule Feb. 20, 2013 at 2 <tinyurl.com/b32gfzz>.
As with other securities traded at an exchange, any given option traded at any given time will typi-cally have both a best “bid” price and a best “ask” price listed on the exchange. The best “bid” price is the “highest price that a prospective buyer is willing
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to pay for a security at a given time.” Black’s Law Dictionary 967 (7th ed., abr. 2000). The best “ask” price is the “lowest price at which a seller is willing to sell a security at a given time.” Ibid.
When a particular investor directs his broker to buy a particular option, the broker will identify which exchanges are trading that option in order to find the best “ask” price. After finding the lowest ask price across whichever exchanges are offering the particu-lar option that the customer seeks – known as the National Best Bid and Offer (NBBO) – the broker will route the customer’s order to one or more exchanges. In the case of the options on the S&P 500 and DJIA, the decision below in effect mandates that the broker look only to the ask prices on the CBOE.
What does this use of the exchange mean for the customer buying the option? The most widely used measure of trading cost is the difference – the “spread” – between the bid price and the ask price. Because it reflects the difference between the prices at which a given investor could buy an option and then instantaneously sell it, the bid-ask spread measures the effective cost to the customer of using the exchange. The lower the bid-ask spread, the lower the transaction cost to the investor for using the exchange.
Investors naturally seek lower bid-ask spreads to save money. Even small decreases in bid-ask spreads can reap significant savings for investors. For exam-ple, in a typical transaction, Citadel Securities might
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make a market for a pension fund seeking to reduce the risk in its assets tied to the S&P 500. The pension fund wants to buy 10,000 option contracts on the S&P 500 index (the option denoted “SPX”). Each contract references 100 underlying “shares” (when the option references a stock or other security) or “units” (when the option references an index rather than a stock or other security). Prices are quoted – and so too are bid-ask spreads – on a per share (or per unit) basis.
So for a 10,000 option contract transaction, if the bid-ask spread falls by 5 cents, then all else equal, the cost to the pension fund for the contract transaction would decrease by $50,000: ($.5 savings per unit) x (100 units per contract) x (10,000 contracts) = $50,000.
Now consider that in 2011 alone the SPX’s trad-ing volume on the CBOE was 197,509,449 contracts. Small decreases in bid-ask spreads over this number of contracts could save investors billions of dollars.
D. Benefits of Multi-Exchange Competi-
tion
When multiple exchanges compete with each other on price to offer customers the same options, the bid-ask spreads – and, by extension, costs to investors – decrease. One study compared bid-ask spreads between options listed only on the CBOE (“single-listed” options) with options listed on the CBOE and at least one other exchange (“multi-listed options”). See Stewart Mayhew, Competition, Market
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Structure, and Bid-Ask Spreads in Stock Option Markets, 57 J. Finance 931 (2002). The study found that “multi[ ]-listed options tend to have narrower quoted and effective bid-ask spreads than single-listed options,” even after “accounting for other factors influencing spreads.” Id. at 956.
Other studies have found that multi-listed op-tions and interexchange competition “significantly” reduced transaction costs – including bid-ask spreads – and that these decreases persist over time. See Patrick de Fontnouvelle, Raymond P.H. Fishe, & Jeffrey H. Harris, The Behavior of Bid-Ask Spreads and Volume in Options Markets during the Competi-tion for Listings in 1999, 58 J. Finance 2437 (2003). These empirical studies are consistent with Citadel’s real-world experience as a key liquidity provider, market maker, and asset manager.
Liquidity also tends to increase (and therefore improve) when securities are listed across multiple exchanges. See, e.g., id. at 2448 (“Average [option] series volume increases from the pre- to post-multiple-listing period.”). Large investors need suffi-cient liquidity to hedge, meaning there needs to be a large enough number of units available for trading so that “large transactions can occur without substantial price variations.” Black’s Law Dictionary at 754. To investors and market makers like Citadel Securities, this is particularly important because without suffi-cient liquidity, the investors cannot make invest-ments they need – and market makers cannot make the markets these investors need – because the
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transaction itself will affect the price of the security and erode the value of the investment.
E. National Policy Favors Multi-Listing
and Interexchange Competition
Acknowledging these benefits to investors, the Congress has made it clear that interexchange com-petition is “in the public interest” and protects inves-tors. See, e.g., 15 U.S.C. § 78k-1(a)(1)(C) (it is “in the public interest and appropriate for the protection of investors . . . to assure [ ] economically efficient execution of securities transactions . . . [and] fair competition among . . . exchange markets”) (emphasis added); see also 15 U.S.C. § 78f(b)(5) (federal policy is to “remove impediments to and perfect the mecha-nism of a free and open market and a national mar-ket system”).
The recent overhaul of the various components of OTC derivatives trading markets under the legisla-tion commonly known as “Dodd-Frank” further emphasized the national interest in maintaining efficient, competitive exchange-based trading in order to protect investors. See, e.g., 15 U.S.C. § 78c-3(h)(1)(A) (requiring security-based swaps subject to clearing requirements to be traded on an exchange unless they meet certain statutory exemptions).
Echoing the views of Congress, the SEC has consistently favored interexchange competition and multi-exchange listing because of their benefits to investors. In one study, the SEC found that “[o]ne of
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the most palpable results of enhanced competition in the options markets is the narrowing of spreads. Lower spreads can provide better prices for inves-tors.” SEC, Concept Release: Competitive Develop-ments in the Options Markets (2004) <tinyurl.com/ adwcdt6>. After the Southern District of New York rejected CBOE’s and the index creators’ efforts to maintain a monopoly on options on ETFs tracking the S&P 500 and the DJIA, see McGraw-Hill Co. v. Int’l Sec. Exch., Inc., No. 05 Civ.1129, 2005 WL 2100518 (S.D.N.Y. Sept. 1, 2005), SEC Commissioner Annette Nazareth explained that the court’s decision was “consistent with the strong public policy of promoting multiple listing and trading of products in our na-tional market system.” Annette Nazareth, Remarks Before the STA Annual Conference, Oct. 5, 2005 <tinyurl.com/byfb4ds>. The Second Circuit’s Dow Jones decision later upheld the SDNY’s ruling. 451 F.3d 295.
Commissioner Nazareth went on to note that the day after the SDNY’s decision, Petitioner ISE began listing and trading options on DIAMONDS – ETFs that track the DJIA – and that “as a result, the CBOE aggressively reduced the transaction fees it charges customers to trade DIAMOND option contracts (from 45 cents to 15 cents for options over $1).” Nazareth, Remarks. The “CBOE also eliminated the license fee surcharge applicable to market maker transactions in options on DIAMONDs.” Ibid. Commissioner Naza-reth concluded, “What better evidence of the salutary
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benefits of competition on the markets could there be?” Ibid.
For S&P 500 and DJIA options, however, there is no competition, as CBOE itself has acknowledged. For example, on January 25, 2013 – the very day the petition for certiorari was filed with this Court – the CBOE hiked transaction fees on the SPX and ex-plained to the SEC that this would not “cause any unnecessary burden on intermarket competition because SPX is a proprietary product that is traded solely on CBOE.” Notice of Filing, Exchange Act Release No. 34-68702, 78 Fed. Reg. 5548 (Jan. 25, 2013). In other words, there is no burden on competi-tion because there’s no competition to burden.
In Citadel Securities’ own market experience, multi-listing and interexchange competition have pushed transaction costs downward, inuring to the benefit of investors. For example, a decade ago, most listed options in the United States were single-listed. Since then, the options markets have become highly competitive and most equity options are now listed on numerous exchanges. As a result, average spreads and transaction costs are a fraction of what they were before, and the options markets have grown substan-tially.
The disparate treatment of S&P 500 and DJIA options results in higher transaction costs, wider bid-ask spreads, and lower liquidity – all of which multi-listing and interexchange competition would ameliorate.
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F. The Decision Below
The Illinois Appellate Court held that Section 301 of the Copyright Act did not preempt Respon-dents’ state law claims for “misappropriation” against Petitioner ISE for its listing of options based on the published value of the S&P 500 or DJIA without a license from the indexes’ creators. Chicago Bd. Op-tions Exch., Inc. v. Int’l Sec. Exch., LLC, 973 N.E.2d 390, 400 (Ill. App. Ct. 2012). The court acknowledged that Respondents have no right to prevent republica-tion of the published index values themselves but nevertheless concluded that Respondents could enjoin ISE’s listing of the index options based on ISE’s alleged misappropriation of the effort Respondents expended to create the index values.
Relying upon what it called a “plain reading” of a House of Representatives Report on the 1976 amendments to the Copyright Act, the Illinois Appel-late Court concluded that the House Report left unpreempted state causes of action that protect “unauthorized appropriation” of both “hot news” and “newer form of data updates from scientific, business, or financial databases” – which the court took to include the indexes. 973 N.E.2d at 399. But putting aside the question whether a House Report can create broad exemptions to statutory preemption that do not appear in the statute’s text, widely published indexes are not “business [and/or] financial databases.” It is far more plausible that – in referring to “financial databases” – the House Report meant to invoke the types of lists and other privately maintained data
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that can be protected as trade secrets under state law, rather than indexes and index values that are broad-ly and necessarily published.
In holding that the Copyright Act does not preempt state-law claims related to index values, the decision below undermined the uniformity of the federal copyright scheme. Investors and market participants rely upon uniformity in areas of law affecting the national securities markets, and this case acutely highlights the need for such uniformity because the state law claims at issue are particularly costly and disruptive to competition.
The decision below and Respondents’ claims rest in part upon the Illinois Supreme Court’s decision in Board of Trade of City of Chicago v. Dow Jones & Co., 456 N.E.2d 84 (Ill. 1983) (“Board of Trade”). The Illinois Supreme Court decided Board of Trade at the dawn of the index options era, when only 150 million options contracts of any kind traded nationally – a small fraction of the 4 billion option contracts that traded last year. Board of Trade held that the Chicago Board of Trade’s unlicensed creation of a futures contract based on the value of the DJIA “misappro-priated” the Dow Jones’s creation of the DJIA. The Illinois Supreme Court reasoned that its decision would protect the incentive to innovate in the field of indexes. That incentive, the court believed, “out-weighed any detriment to the public” the decision caused. 456 N.E.2d at 90.
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Commentators and courts have consistently criticized the Illinois Supreme Court’s reasoning. See, e.g., 2 William F. Patry, Patry on Copyright § 4:10 (2012) (“Subsequent decisions have taken an appro-priately dim view of [the] claims [in Board of Trade]”); U.S. Golf Ass’n v. St. Andrews Sys., 749 F.2d 1028, 1038 n.17 (3d Cir. 1984) (Board of Trade’s analysis was “significantly” out of step with “incen-tive analysis” “employed in traditional INS-type misappropriation cases”); Richard Posner, Misappro-priation: A Dirge, 40 Hous. L. Rev. 621, 640 (2003) (Board of Trade “strayed” outside the “lines laid down” by this Court’s decision in Int’l News Serv. v. Associated Press, 248 U.S. 215 (1918), with “results [that] have not always been happy”).
In practice, the Illinois Appellate Court’s refusal to find preemption of the state misappropriation claims at issue effectively imposes a single state’s (misguided) law upon investors across the nation and bars multi-listing and interexchange competition for trading index derivatives without the permission of index providers. In doing so, Illinois imposes billions of dollars of increased trading costs upon investors across the nation and redirects those billions of dollars as profits to the CBOE as a result of its grip on the options index market.
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II. Reasons for Granting the Petition for Certiorari
For at least three reasons, amicus Citadel re-spectfully submits that this petition is grant-worthy.
First, the decision below is erroneous on an important copyright preemption issue, imposes enormous costs on investors, and underestimates the effects it will have on incentives to innovate.
Second, further percolation is unlikely to provide the Court with additional useful analysis on the preemption question because the injunction imposed by the Illinois court below effectively prohibits ex-changes across the country from listing the options at issue.
And third, if left to stand, the analysis in the decision below will impose costs on investors well beyond those directly at issue here and will chill experimentation in performance-based pay and other transactions that use indexes as points of reference.
A. The Decision Below Is Erroneous on
an Important Federal Preemption Is-sue
Amicus Citadel agrees with the petition for certiorari’s arguments setting forth why the Copy-right Act preempts Respondents’ state-law claims. Indeed, this case illustrates why preemption is needed to ensure national uniformity, because Respondents’
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state-law misappropriation claims are themselves so harmful to investors across the country.
Board of Trade, which provides the basis for Respondents’ state-law claims, purported to weigh the competing interests of maintaining incentives to innovate against the public interest in uninhibited use of information in the public domain. 456 N.E.2d at 90. But the weighing analysis was wrong in at least three critical ways.
First and most important, the Illinois Supreme Court underestimated the enormous costs its decision would impose on investors. Second, a contrary ap-proach – or a finding of preemption by the court below – would not stifle innovation in the creation of new indexes. And third, the Illinois Supreme Court failed to anticipate how its ruling would actually stifle innovation by allowing index creators and their licensee exchanges to obtain an unfair competitive advantage based on widespread publication and exclusive access without regard to whether they offer superior services or technology.
1. Exclusive listing imposes enormous
costs on investors
The court below, in relying on Board of Trade, failed to acknowledge that single listing imposes enormous costs on investors – via higher bid-ask spreads, increased exchange fees, and insufficient liquidity – which ultimately decrease the overall efficiency of the index options market. See, e.g.,
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Ackert & Tian at 51. These costs are enormous – billions of dollars or more – given the volume of the options at issue and the trillions of dollars tied to them. These costs in turn reduce the benefits that index options bring to global markets and the econo-my. Id. at 40, 51.
2. Index creators have incentives to
innovate even without exclusive listing
The Illinois Appellate Court, relying on Board of Trade, incorrectly concluded that multi-listing and interexchange competition would destroy the incen-tive to innovate new indexes. Index creators already receive massive revenues for publishing and distrib-uting their index averages, as even Board of Trade recognized. 456 N.E.2d at 89. And they retain “sub-stantial” competitive advantages as first-movers. Posner, 40 Hous. L. Rev. at 639. There is no reason to conclude that, in the absence of single-listing, these benefits would be insufficient to motivate future innovation in index creation.
To the contrary, the experience with options on ETFs – which have seen significant innovation and growth in volume and number of classes traded since they were multi-listed in 2005 – confirms that multi-listing and interexchange competition do not harm innovation.
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3. Exclusive listing stifles incentives to innovate
The Illinois Appellate Court itself noted that at least 90% of all index options by volume in the United States trade on the CBOE. 973 N.E.2d at 407. The CBOE continues to tout “record” annual revenues from its “flagship SPX option,” see CBOE 2011 Annu-al Report at 1, a cash cow that is the result of CBOE’s exclusive SPX listing rights rather than any competi-tive advantages or innovations.
One significant consequence of this exclusivity is that single-listing and exclusive trading allow CBOE to ignore cost-saving innovations – electronic trading is the best example – that other exchanges offer investors. Although the CBOE has begun using electronic trading or a hybrid version of it – particu-larly for options that competing exchanges list and trade electronically – the CBOE still uses in part a “pit”-based or “open outcry” trading floor for its “flagship” SPX option. See, e.g., Nina Mehta, CBOE Sets Fees for Electronic S&P 500 Options on C2 Exchange, Bloomberg, Sept. 28, 2011 <tinyurl.com/ 3r73nrd>.
“In an open-outcry system, trading takes place through oral communications between market profes-sionals at a central location in open view of other market professionals.” Chicago Bd. Options Exch., Inc. v. Int’l Sec. Exch., LLC, 677 F.3d 1361, 1364 (Fed. Cir. 2012). “For example, an order is typically relayed out to a trader standing in a ‘pit.’ ” Ibid. “The trader
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shouts out that he has received an order and waits until another trader or traders shouts back a two-sided market (the prices at which they are willing to buy and sell a particular option contract), then a trade results.” Ibid.
The CBOE’s exclusive grip on options like the SPX means it faces no competitive pressure to inno-vate how such options are traded. As a result, the SPX is one of the last “pit” or “open outcry” traded exchange products in the market.
The potential drawbacks of open outcry trading are well known in the industry, ranging from mere friction in the trading process to notorious allegations of self-dealing and noncompetitive, prearranged trades. See, e.g., Eric N. Berg, Commodity Exchanges See Threat, N.Y. Times, Mar. 13, 1989 (providing anecdotal examples of self-dealing and favoritism in Chicago Board of Trade’s soybeans futures pit). In contrast, electronic trading uses computers and networks that can instantaneously – and without bias or favoritism – match buyers and sellers based upon price alone. Electronic trading provides increased speed, efficiency, and transparency. But as long as the CBOE or any given exchange can maintain exclusive listings of important derivatives like index options, competitive pressure will not be strong enough to motivate those exchanges to adopt pro-investor technologies.
The CBOE itself has previously acknowledged the market benefits of competition. In 2004, the
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Southern District of New York held that the Nasdaq could not stop another exchange from listing options on index ETFs the Nasdaq had created. See Nasdaq Stock Mkt., Inc. v. Archipelago Holdings, LLC, 336 F. Supp.2d 294, 303-04 (S.D.N.Y. 2004).
Within two weeks of this decision, the CBOE asked the SEC to let it reduce fees on options on ETFs in order to “help the [CBOE] compete more effectively for order flow in these products.” Notice of Filing, Exchange Act Release No. 34-50469, 83 SEC Docket 2608, 2004 WL 2723985, at *1 (Sept. 29, 2004). Where such competition is not precluded by rules like the one announced in the decision below, the CBOE understands that multi-listing results in competition based on price and innovation rather than exclusivity.
B. The Decision Below Forecloses Fur-
ther Percolation
The decision below is fundamentally out of step with well-established federal preemption principles and entrenches a virtual monopoly. But because of the nature of Respondents’ claims, the decision be-low’s harmful effects will remain in place absent this Court’s review.
Most exchanges will follow the Illinois Appellate Court’s decision even though they are not parties to the judgment. And should any exchange dare to create interexchange competition for the options at issue, Respondents will certainly sue in Illinois and
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achieve the result already before this Court. In prac-tical terms, by failing to find the claims at issue preempted, the decision below imposes misguided Illinois law on investors and exchanges across the nation.
The decision below also creates confusion and the risk of forum shopping. For example, in theory op-tions on index ETFs should be nearly identical substi-tutes for index options because the “actions of arbitrageurs, seeking to profit from any separation that develops between the prices of the ETF shares and the underlying portfolios, will constantly push the two into virtual parity.” Dow Jones, 451 F.3d at 298 n.3. In practice, however, investors cannot simply substitute options on index ETFs for index options.3 Adding to this complexity, the decision below – at odds with the Second Circuit’s treatment of options on index ETFs – means investors are left with incon-sistent rules as to whether similar instruments can be created and traded without a license.
3 There are a variety of reasons for this including: (1) index options like the SPX trade “European style,” whereas options on index ETFs trade “American style”; (2) index options are always cash settled; (3) there are dividend components to ETF shares; (4) the two kinds of options trade in different contract sizes (index options have a far greater number of units); (5) differ-ences in trading volume; and (6) index options receive more favorable tax treatment.
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C. The Decision Below Has Significant Implications Outside of Index Op-tions Trading
The Illinois Appellate Court’s reasoning and reliance on the use of legislative history to create an exception to copyright preemption for indexes has potentially unlimited applications – and consequenc-es – in the financial markets.
First, the Illinois court’s reasoning would extend to the listing and trading of other options and deriva-tives, as well as those on indexes beyond the S&P 500 and the DJIA. For example, the reasoning of the decision below would apply with equal force to fu-tures contracts – derivatives similar to options but which impose an obligation (rather than a right) to buy or sell at a future date. And the Illinois court’s reasoning would also seem to apply to indexes that track other segments of the market or similar measures of market performance. Eliminating compe-tition for futures and other derivatives on other indexes will magnify the decision below’s costs to investors.
Second, for years some shareholders and inves-tors have advocated tying compensation of CEOs or fund managers to their performance relative to that of stock market indexes. Adopting this innovation, in 2011 General Electric CEO Jeffrey Immelt’s compen-sation included options that would vest only if GE’s stock appreciation equaled or outperformed the S&P 500 from the beginning of 2011 through the end of
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2014. See, e.g., Andrew Dowell and Joann S. Lublin, Strings Attached to Options Grant for GE’s Immelt, Wall St. Journal, April 20, 2011. Months later, War-ren Buffet followed with a similar scheme for two of his fund managers. See, e.g., Serena Ng, Warren Buffett Says New Money Managers Will ‘Get Paid for Their Performance’, Wall St. Journal, Sept. 13, 2011.
Under the reasoning of the decision below and Respondents’ arguments, Respondents could sue GE and Mr. Immelt, or Warren Buffet and his fund managers, for misappropriation in Illinois for the “use” of the S&P 500 creators’ efforts and goodwill in creating the index. This cannot be the law, and if it is, the ruling below will chill experimentation and existing practices in the field of performance-based pay.
Or consider merger transactions that link financ-ing required to complete the deal to the performance of the S&P 500. See, e.g., Michael Santoli, Fair Winds Ahead, Barrons, Oct. 8, 2012 <tinyurl.com/aqw366x> (sale of Neuberger Berman to two private equity firms was contingent on the level of the S&P 500 and when the index fell, the deal collapsed).
Under the decision below, this sort of contingent planning is misappropriation of the S&P 500. The decision deprives dealmakers of uniform reference points for what market conditions must be in place to close a deal. The court’s holding will result in greater costs to markets as a whole if transactions cannot be structured so that they dissolve when changed
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market conditions make the transaction economically inefficient.
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CONCLUSION
The Court should grant the petition for a writ of certiorari.
Respectfully submitted,
Dated: February 2013
ANDREW C. BAAK, Counsel of Record STEPHEN J. COWEN (Special Counsel) BARTLIT BECK HERMAN PALENCHAR & SCOTT LLP 54 W. Hubbard Street, Suite 300 Chicago, IL 60654 Telephone: (312) 494-4400 Facsimile: (312) 494-4440 [email protected]
Attorneys for Amicus Curiae