CBOE-ISE Face-off in Court Over the Future of Options Exchange Trading in a Case With Huge Repercussions

The Chicago Board Options Exchange [CBOE], McGraw-Hill (parent company of S&P) and Dow Jones Indexes have jointly sued the International Securities Exchange (ISE) in an attempt to prevent the ISE from listing and trading options without a license on the Dow Jones Industrial Average and S&P 500 Index.

The CBOE currently has an exclusive licensing agreement to trade options on both indexes. Earlier this month, however, the ISE asked a judge to invalidate those agreements and open the field to everyone. The CBOE et al. filed the new suit ostensibly to prevent this from happening.

The stakes in the legal battle are large, both for the parties involved and for the broader index industry.

For the CBOE, the S&P 500 index option is one of its most profitable and popular contracts, with more than 400,000 contracts trading hands on any given day. Meanwhile, the ISE is eager to break into one of the last fields it hasn’t been able to access – and the largest area of the index options business.

The specific concerns, however, pale before the issues facing the broader industry. While the countervailing lawsuits focus on the S&P 500 and the Dow, any ruling would effectively apply to any and all index options. In short, if the judge goes along with the ISE’s request, the entire idea of licensing indexes for options could go poof.

Amazingly, that could just be the start. Already, earlier this summer, an appeals court confirmed that index developers have no right to license options on index-linked ETFs. Some legal scholars – such as Alison Rende and Jonathan Mazer (see the November issue of the Journal of Indexes) have argued that trends in case law point towards a direct challenge to the right of indexers to license options on financial products at all. If that happens, it’s Katy-bar-the-door in the index legal war room.

This current case would represent a major step in that direction if it breaks the ISE’s way.

Looking to build the best case, the savvy folks at the CBOE have filed their lawsuit in the great state of Illinois, home to one of the most important and powerful verdicts in the history of index developer property rights litigation. As CBOE Chairman and CEO William J. Brodsky said in the press release announcing the suit:

CBOE initiated this action in order to enforce our contractual rights with our partners, S&P and Dow Jones. Those rights were firmly established by legal precedent set years ago in Illinois.

The relevant case law is the 1983 Illinois Supreme Court decision in Board of Trade of the City of Chicago v. Dow Jones & Co. In that case, the CBOT wanted to trade futures contracts based on Dow Jones indexes. According to Mazer and Rende, the Court gave an “expansive reading” to the tort of misappropriation in its ruling, and sided with Dow Jones. That ruling helped cement the independent right of index developers to create indexes and license (or not license) them as they see fit. I encourage you to read the full Mazer/Rende article for an in-depth description of the relevant case law in this area.

While there are certainly ways that a judge could side with the ISE without directly challenging the aforementioned CBOT ruling, it is a strong weapon in the anti-ISE camp.

Where Does This Go?

Either way, the stakes and the arguments here are huge. The ISE believes that ending exclusive licenses would spur competition, increase volume and lower costs - all of which is probably true. Dow Jones and S&P would likely argue that restricting their licensing capabilities is a violation of their rights, and would crimp the development of new indexes in the future - which may be true as well. And the CBOE, for its part, believes that the ISE is trying to unfairly “free-ride” on the hard work it did developing index options in the first place; to the CBOE, allowing “free-riding” would hurt long-term innovation in the options business.

Officials at all three exchanges have declined to comment, but that doesn’t mean things are quiet in the index community. The CBOE sent out this information circular, which reads as a bromide against the ISE. Claiming that it “invented index options and … has been responsible for virtually every index option enhancement that followed,” the CBOE tries to paint the ISE as the bad cop:

It may be more cost effective to pursue new products through litigation than through research and development, but we don’t subscribe to the argument that these lawsuits are of benefit to investors. Product innovation benefits investors. Lawsuits add to the cost of product development and ultimately create disincentives to innovate.

Ouch.

This may be the most important story in the indexing space this year.