Free For All

November 01, 2005

The recent decision in the lawsuits of Dow Jones and McGraw-Hill against the International Securities Exchange (ISE) allow investors to trade an interest in the S&P 500 and Dow Jones Industrial Average without paying a licensing fee. That much is not in dispute.

In a remarkable, precedent-setting decision, on September 1, 2005, Judge Harold Baer Jr. of the U.S. District Court Southern District of New York dismissed the lawsuit of McGraw-Hill out of hand and stated that he would likely do the same if the ISE filed a similar motion to dismiss in Dow Jones' lawsuit. [1]

The lawsuit represents the first time an index provider has ever lost an intellectual property dispute (unless you count the Nasdaq/Archipelago lawsuit. [2] )  The judge's order is a particularly stinging blow to index providers for a number of reasons: 1) Exchanges can now in effect list options on SPDRs and DIAMONDs ETFs to gain exposure to the S&P 500 and DJIA without having to pay a licensing fee to Dow Jones or McGraw-Hill; 2) Index option volume has been exploding with record volumes showing up on the derivatives exchanges daily; 3) Index providers have already been seeing margins squeezed in an increasingly competitive environment even as business booms and 4) The decision could open up the proverbial can of worms for index providers, in that future licensing deals of all kinds might be challenged by product creators and distributors.

So how did Judge Baer come up with this decision?

His reasoning is, in fact, very clear and easy to understand. In essence it is this: Trading options on an ETF is just like trading options on a company's stock. Once shares of ETFs are sold, the index providers have no ownership interest in the equities. And owners of equities are free to buy and sell them-or enter into contracts to buy and sell them as they wish.

A number of legal precedents are cited in the order, including all of the past intellectual triumphs of the index providers (like Comex vs. McGraw-Hill [3] and CBOT vs. Dow Jones). But clearly the most compelling precedent for Judge Baer was that of Golden Nugget vs. the American Stock Exchange. In that case, the Golden Nugget had sued the Amex for trading options on its equities without compensating the company. In that judgement, the court held that shares of common stock are not unlike used BMWs or Chevrolets. That is, the owner can buy and sell as he sees fit, and there's nothing wrong with non-deceptively using the product's brand name to identify it.

The most poignant argument raised by Dow Jones is that selling options on DIAMONDs is not really about the transfer of DIAMONDs shares, but is a means of speculating on the rise and fall of the DJIA, just like index options (which had been determined in CBOT vs. Dow Jones to be subject to Dow Jones' rights as owners of intellectual property).

The judge dismisses this by saying, "…the fact remains that there is a difference between an index option that literally disappears without the index, and an option on an ETF, which is comprised of a bundle of stocks that still retain value even if the index they track ceases to exist."

Wow.

Now first I should say that I'm not a lawyer (I only play one on T.V.), but I have a number of very clear views about this lawsuit and the dismissal. I'll share some of those with you first, and then some of my thoughts about the implications of the lawsuit.

Some broad observations:

  • Dow Jones, in particular, came up with some pretty silly arguments that appear to have been just thrown in for good measure.
  • Make no mistake about it, this is a groundbreaking judgement with significant financial implications that could alter the landscape of the index industry.
  • Had Judge Baer presided over the COMEX vs. McGraw-Hill lawsuit, it is likely that the COMEX would have won the suit with a similar dismissal order.

First, lets have a little fun picking on the judge.

Early in the Procedural History of the Opinion and Order, in referring to Dow Jones and McGraw-Hill he says, "Each sells what are called exchange-traded funds." This is not true. It's like saying that Microsoft sells computers. They license the right to use their indexes to fund managers, who then sell the ETFs. This is an important distinction, because it's all about the index, not the product. To me, drawing the parallel to Golden Nugget vs. Amex (saying that the options are akin to the sale of a used car) is not the proper logic. A better parallel might be operating software inside a computer. The computer is property that can be bought and sold as one wishes, but the software-what makes the computer go-is intellectual property.

Less material, but no more wrong, is Baer's statement on page three of the order, "An ETF is usually established as a unit investment trust." This is patently untrue. While both the SPDRs and DIAMONDs (among the first ETFs) are unit investment trusts, the overwhelming majority of ETFs are in fact now open-ended mutual funds subject to the 1940 Act, requiring boards, and able to manage their portfolios with more flexibility. On page 11, he says, "… the product is the ETF which has been created by the index provider." Index providers do not create ETFs.

At one point Judge Baer also says, "... the product is the ETF which has been created by the index provider." Index providers do not create ETFs.

To me, the distance between the index provider and the ETF is key but in the opposite way Judge Baer notes. He says because the options don't trade on the index itself, but on the ETF, that the index providers have no claim on a product that is not formally tied to the indexes. I would say that the fully transparent way these products trade ties them integrally to the index. While an ETF is traded "like" a security, the value of the underlying portfolio must equal the index it is based on, and when it does not, market forces, i.e. arbitrage, will quickly bring it back into line with the index. Therefore, Index=ETF=Index, and any option on the ETF must also equal a position in the Index.

Judge Baer also makes the case that options on ETFs are no different than options on publicly traded corporate stock. But there is a difference. Publicly traded stock is valued on an earnings stream of the underlying company. There is no intellectual input by the company into valuing its stock price. It is determined by market behavior. On the other hand, as demonstrated above, an ETF is based on an index value, which in turn is based on a precisely determined portfolio of securities, with quantitative methodology or the actual equities chosen by a specific group of individuals at an index provider. The argument by Baer claims that the index provider ceasing to produce the index does not mean that the ETF ceases (and hence, the ETF options continue) even if accepted is beside the point.  The point is that investors in the options are seeking exposure to the index.  And the index is indisputably intellectual property.

What this really comes down to is that Judge Baer is acting in what he believes to be the interest of open and competitive markets. A real touchstone for the Dow Jones suit was the fact that Dow Jones granted an exclusive license to the CBOE to trade DIAMONDS options. In so doing, Dow Jones locked out competition in the options markets, something that is no longer possible with ordinary equities markets in which, while a stock may trade on one market, other exchanges have unlisted trading privileges that allow them to trade any stock they wish.

Conversely, in the ETF industry, many widely used indexes have been locked into exclusive licensing agreements, particularly by Barclays Global Investors (iShares). My thinking is that the judge, were he able to find some legal reasoning to match his inclinations, would prohibit such agreements which, while they may optimize index provider licensing fees and cut down on market dispersion, may also subject investors to higher overall expense ratios than they may have been able to get in more competitive markets.

And while I personally am nothing if not vigilantly aware of investor interest, I also think that intellectual property is like anything else that can be sold. If you make pants, you can feel free to try to sell them for $250 a pair. And if people want them, they'll buy them. If not, they'll buy some other brand. In short, my thinking is that open options trading is an end-around to access an index. And agree or not with the exclusive deal, pricing etc., those products are trading on exposure to the index provider's intellectual property in any event, and indisputably so in the case of cash-settled options.

Implications

The truth of the matter is that investors are already using options on ETFs to get around licensing agreements and be able to trade exposure to indexes. If you believe in the reasoning behind Golden Nugget, then the ISE is getting off on a technicality in this case. In fairness to Judge Baer, it appears that he does not believe in the logic of Golden Nugget, and would tend toward the idea that publicly available indexes are in the public domain.

Consider this Round One in a possible three-round heavyweight fight. The good news for the index providers is that Judge Baer's decision has a number of flaws in terms of accuracy and in terms of reasoning. There are simply too many facts that have been missed, and he has made simple factual errors in rendering the decision. According to some industry experts close to the lawsuit, Judge Baer was not considered one of the most financially astute of judges in the District Court system and likely was below average in understanding securities markets behavior. The reason that this is good for the index providers is that it leaves a Grand Canyon of an opening for an appeal to the federal appeals court, where the "bar" may be higher for technical clarity of the argument. Clearly, this is a case that involves technical precision in understanding the construction of the financial instruments, their pricing and their usage by investors.  Thus, Round Two could well be the important turning point in this heavyweight bout, even though the index providers in Round One were dealt a body blow that left them breathless for the moment.

What does all of this mean in terms of the bottom line for the index industry? Well, I don't think Dow Jones or McGraw-Hill are going to go out of business any time soon, but the implications could well be enormous from a revenue standpoint. With the possibility now a reality that any exchange could trade options on any ETF (without actually buying and selling the ETF itself), we could be moving toward a brand name index free-for-all.

Endnotes

Following are bios of the contributors:

Jim Wiandt is editor of the Journal of Indexes and publisher of Exchange-Traded Funds Report and IndexUniverse.com . Wiandt was formerly publisher of indexfunds.com and is author of Exchange Traded Funds , published by John Wiley & Sons. Before entering the index publishing business, Mr. Wiandt worked as an editor and writer for Compton's Encyclopedia. Previously, he served as an aide in the British Parliament, a contract writer in West Africa and a Peace Corps volunteer in Niger. Albert Neubert is Senior Vice President of Business Development, Information Management Network.  He is responsible for the creation and implementation of new conference programs. Mr. Neubert is also one of the world's leading consultants in the index business field where he develops new indexes, index-linked products and marketing strategies for clients. Neubert worked with Standard & Poor's for 25 years and was a member of the S&P Index Committee.

[1] A copy of the ruling can be viewed at www.indexuniverse.com.

[2] Judge Denise Cote of the Southern District of New York dismissed a lawsuit by the Nasdaq Stock Market against Archipelago which had attempted to block Archipelago from trading the Nasdaq 100 Trust ETF (QQQ) on it's electronic platform.  Archipelago had launched an aggressive marketing campaign to promote the trading.

[3] Albert S. Neubert was an assistant manager in S&P's Index Services Group in 1981, where he was a part of a management team that supported the legal action against the COMEX, in McGraw-Hill vs. COMEX, involving COMEX's missappropiation of the S&P marks and intellectual property rights in the S&P 500.  McGraw-Hill prevailed in the suit, and this watershed decision paved the way for index providers to license their indexes as the basis for financial products around the world.

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