[Federal Register Volume 60, Number 193 (Thursday, October 5, 1995)]
[Notices]
[Pages 52234-52241]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-24794]
-----------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-36296; File No. SR-NASD-95-37]
Self-Regulatory Organizations; Notice of Filing and Order
Granting Accelerated Approval of Proposed Rule Change and Amendments
No. 1, 2 and 3 to the Proposed Rule Change by the National Association
of Securities Dealers, Inc. Relating to Listing and Trading of Broad-
Based Index Warrants on The Nasdaq Stock Market
September 28, 1995.
Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Act''), 15 U.S.C. 78s(b)(1), notice is hereby given that on August
28, 1995, the National Association of Securities Dealers, Inc.
(``NASD'' or ``Association'') filed with the Securities and Exchange
Commission (``Commission'' or ``SEC'') the proposed rule change as
described in Items I, II, and III below, which Items have been prepared
by the NASD. The NASD filed Amendment No. 1 (``Amendment No. 1'') to
the proposed rule change on September 22, 1995.\1\ on September 27,
1995, the NASD filed Amendment No. 2 (``Amendment No. 2'') to the
proposal.\2\ On September 28, 1995, the NASD filed Amendment No. 3
(``Amendment No. 3'') to the proposal.\3\ This Order approves the
proposed rule change, as amended, on an accelerated basis and also
solicits comments on the proposed rule change, as amended, from
interested persons.
\1\ Letter from Joan C. Conley, Corporate Secretary, NASD, to
Michael Walinskas, SEC, dated September 22, 1995. Amendment No. 1,
which is superseded, in part, by Amendment No. 2, raises position
limits on the Russell 2000 Index and S&P MidCap 400 Index (``MidCap
Index''). It also establishes that Section 13, Liquidation of
Positions, will apply to short sales in warrants.
\2\ Letter from T. Grant Callery, Vice President and General
Counsel, NASD, to Michael Walinskas, SEC, dated September 27, 1995.
Amendment No. 2 reduces the position limits on the MidCap Index to
7.5 million warrants.
\3\ Letter from Joan C. Conley, Corporate Secretary, NASD, to
Michael Walinskas, SEC, dated September 28, 1995. Amendment No. 3
clarifies the settlement methodology to be utilized for index
warrants.
---------------------------------------------------------------------------
I. Self-Regulatory Organization's Statement of the Terms of Substance
of the Proposed Rule Change
The NASD is proposing several changes to its rules to accommodate
the trading of the index warrants based on broad-based indexes on The
Nasdaq Stock Market (``Nasdaq''). The proposed changes augment and
enhance the Association's regulatory requirements applicable to index
warrants which were previously approved by the Commission in June
1992.\4\ In addition, unlike the current regulatory structure for index
warrants whereby the Commission separately approves each type of index
warrant for trading (i.e., Hong Kong Index warrants or Nikkei Index
warrants), the proposed changes streamline the approval process for
index warrants by providing that an index is eligible to underlie an
index warrant traded through the facilities of the Nasdaq system once
the Commission has approved such index to underlie an index warrant or
option.
\4\ See Securities Exchange Act Release No. 30773 (June 3,
1992), 57 FR 24835 (June 11, 1992) (``Index Warrant Approval
Order'').
---------------------------------------------------------------------------
Specifically, the NASD proposes the following rule amendments.
First, Section 2(c)(2) of Part III of Schedule D
[[Page 52235]]
to the NASD's By-Laws is revised to add new listing standards
applicable to the issuers of index warrants. Previously, issuers of
index warrants were required to have assets in excess of $100 million.
Under the revised standards:
(1) issuers would be required to have a minimum tangible net worth
in excess of $250 million or, in the alternative, have a minimum
tangible net worth in excess of $150 million, provided the issuer has
not issued warrants such that the aggregate original issue price of all
of the issuer's stock index, currency index, and currency warrant
offerings (combined with offerings by its affiliates) listed on Nasdaq
or a national securities exchange exceeds 25% of the issuer's net
worth;
(2) the term of the index warrants must provide that unexercised
in-the-money warrants will be automatically exercised on either the
delisting date (if the issue is not listed on a national securities
exchange) or upon expiration;
(3) for warrant offerings where U.S. stocks constitute 25 percent
or more of the index value, issuers must use the opening prices (``a.m.
settlement'') of the U.S. stocks to determine the index warrant
settlement value for expiring warrants on the final determination of
settlement value date (``valuation date'') as well as during the two
business days immediately preceding valuation date \5\;
\5\ See Amendment No. 3.
---------------------------------------------------------------------------
(4) in instances where the stock index underlying a warrant is
comprised in whole or in part with securities traded outside the United
States, the foreign country securities or American Depositary Receipts
(``ADRs'') thereon that (i) are not subject to a comprehensive
surveillance agreement, and (ii) have less than 50% of their global
trading volume in dollar value within the U.S., shall not, in the
aggregate, represent-more than 20% of the weight of the index, unless
such index is otherwise approved for warrant or option trading; and
(5) to assist in the surveillance of index warrant trading, as a
condition of listing on Nasdaq, issuers would be required to notify the
NASD of any early warrant exercises by 4:30 p.m., Eastern Standard
Time, on the day the settlement value for the warrants is determined.
Second, the proposal adds a new Schedule J to the NASD's By-Laws.
This schedule consolidates all of the regulatory requirements
applicable to the conduct of accounts, the execution of transactions,
and the handling of orders in index warrants listed on Nasdaq and
exchange-listed stock index warrants, currency index warrants, and
currency warrants by members who are not members of the exchange on
which the warrant is listed or traded. In particular, Schedule J
provides that: (1) All customer accounts trading index warrants,
currency index warrants, and currency warrants must be approved to
trade options; \6\ (2) the options suitability rule applies to all
recommendations to customers involving the purchase or sale of index
warrants, currency index warrants, and currency warrants; and (3) the
options rules contained in Article III, Section 33(b) of the NASD's
Rules of Fair Practice regarding discretionary accounts, the
supervision of accounts, customer complaints are applicable to index
warrants, currency index warrants, and currency warrants. In addition,
Schedule J provides that the NASD's rules governing options
communications with the public shall apply to communications with the
public concerning index, currency, and currency index warrants. To
assist NASD members in complying with the regulatory requirements
applicable to index warrants, currency index warrants, and currency
warrants, the NASD proposes to distribute a Notice-to-Members providing
guidance regarding member firm compliance responsibilities when
handling transactions in warrants.
\6\ In this connection, the NASD will permit NASD members to
accept the representation of an investment adviser registered under
the Investment Advisers Act of 1940 concerning the eligibility
status of certain customers to engage in warrant trading even if the
underlying documentation relating to the managed account is not
provided to the member. The NASD's position would apply to the
managed accounts of an institutional customer or where the
investment adviser account represents the collective investment of a
number of persons (e.g., an investment club account). Permitting
member firms to accept the representation of an investment adviser
in these instances will conform the handling of warrant accounts to
the current practice for options accounts.
---------------------------------------------------------------------------
In addition, Schedule J provides for position limits, exercise
limits, and reporting requirements applicable to index warrants. The
position limits are consolidated position limits, meaning that index
warrants on the same index on the same side of the market must be
aggregated for position limit purposes. Specifically, for index
warrants other than index warrants based on the MidCap Index, the
position limit is 15 million warrants, provided the initial offering
price of the warrants was at or below $10. For index warrants based on
the MidCap Index, the position limit is 7.5 million warrants, provided
the initial offering price of the warrants was at or below $10.\7\ The
proposal also contains a provision that equalizes positions in index
warrants that initially were priced above $10 with those that were
priced at or below $10. In particular, positions will be equalized by
dividing the original issue price of the index warrants priced above
$10 by ten and multiplying this number by the size of the index warrant
position. For example, if an investor held 100,000 Nasdaq 100 Index
warrants priced initially at $20, the size of this position for
position limit purposes would be 200,000, or 100,000 times 20 divided
by 10.
\7\ See Amendment No. 2.
---------------------------------------------------------------------------
The exercise limits provide that no investor or group of investors
acting in concert may, within five consecutive business days, exercise
more index warrants on the same index on the same side of the market
than the applicable index warrant position limit. The reporting
requirements provide that positions of 100,000 or more index warrants
on the same index on the same side of the market must be reported to
the Association. Schedule J also contains provisions setting forth the
NASD's authority to mandate the liquidation of index warrant positions
in excess of applicable position limits.\8\ In addition, proposed
Schedule J provides that the NASD may halt or suspend trading in an
index warrant if it concludes that such action is appropriate in the
interests of a fair and orderly market and the protection of
investors.\9\
\8\ See Amendment No. 1.
\9\ Among the factors that may be considered by the NASD are the
following: (1) Trading has been halted or suspended in underlying
stocks whose weighted value represents 20% or more of the index
value; (2) the current calculation of the index derived from the
current market prices of the stocks is not available; and (3) other
unusual conditions or circumstances detrimental to the maintenance
of a fair and orderly market are present.
---------------------------------------------------------------------------
Third, the NASD proposes to add a new Section 3(f)(10) to Article
III, Section 30 of the NASD Rules of Fair Practice governing the margin
treatment for index warrants, currency index warrants, and currency
warrants. Specifically, these new requirements, provide that the
initial and maintenance requirements for long positions in index
warrants shall be 100% of the full purchase price of the warrants. For
short positions in index warrants, the margin requirement is 100% of
the current market value of the warrant plus 15% of the current value
of the underlying index. The margin requirements for short positions
can be decreased to the extent that they are out-of-the-money, however,
the minimum requirement for each such warrant shall not be less than
the current value of the warrant plus 10% of the current index value.
[[Page 52236]]
Short sales of currency warrants will follow the margin
requirements currently applicable to standardized currency options.
Specifically, the NASD proposes that short sales of warrants on the
German Mark, French Franc, Swiss Franc, Japanese Yen, British Pound,
Australian Dollar and European Currency Unit shall each be subject to a
margin level of 100 percent of the current market value of each such
warrant plus a four percent ``add-on.'' \10\ The required margin can be
decreased to the extent that the warrant is out-of-the-money, however,
the minimum requirement for each such warrant must not be less than the
current value of the warrant plus .75% (.0075) of the value of the
underlying currency (or such other percentage as specified by the
national securities exchange listing the warrant and approved by the
Commission). The margin required on currency index warrants would be an
amount as determined by the national securities exchange listing the
warrant and approved by the Commission.
\10\ Warrants on the Canadian Dollar would be subject to a one
percent ``add-on.'' The ``add-on'' required on any other foreign
currency would be such other percentage as specified by the national
securities exchange listing the warrant and approved by the
Commission on a case-by-case basis.
---------------------------------------------------------------------------
The NASD also proposes that its index warrant, currency index
warrant, and currency warrant margin requirements be permitted offset
treatment for spread and straddle positions. In this regard, the NASD
proposes that index, currency, and currency index warrants may be
offset with either warrants or OCC-issued options on the same index,
currency, or currency index, respectively, in the same manner that
standardized index and currency options may be offset with other
standardized index and currency options. The proposed rules governing
the margin treatment for spreads and straddles involving index,
currency, and currency index warrants are proposed to be implemented on
a one-year pilot basis. The NASD also proposes to allow market
participants to use escrow receipts to cover a short call position in
broad-based stock index warrants. Specifically, no margin is required
for a short position in an index call warrant where the customer
promptly delivers an escrow receipt, issued by a bank or trust company,
certifying that the issuer holds for the account of the customer (1)
cash, (2) cash equivalents, (3) one or more qualified equity
securities, or (4) a combination thereof.
Fourth, the proposal makes two minor amendments to the NASD's rules
that serve to clarify the Association's rules regarding index warrants.
First, Section 19 of Part I of Schedule D to the NASD's By-Laws is
amended to clarify that the term Nasdaq National Market System security
includes all index warrants traded through Nasdaq. Second, the proposal
replaces language currently contained in a policy of the NASD's Board
of Governors issued under Article III, Section 2 of the Rule of Fair
Practice with a cross-reference to new Schedule J. This change is made
to eliminate duplicative and potentially confusing language in the
NASD's rules. The text of the proposed rule change is available at the
Office of the Secretary of the NASD and at the Commission.
II. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change
In its filing with the Commission, the NASD included statements
concerning the purpose of and basis for the purposed rule change and
discussed any comments it received on the proposed rule change. The
text of these statements may be examined at the places specified in
Item IV below. The NASD has prepared summaries, set forth in Sections
(A), (B), and (C) below, of the most significant aspects of such
statements.
A. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change
The NASD is submitting this proposed rule change to enhance the
NASD's regulatory scheme governing index warrants to ensure that, among
other things, investors in index warrants traded on Nasdaq are
adequately protected and that the trading of index warrants on Nasdaq
does not have any adverse market impacts.\11\ To this end, the NASD has
developed a new Schedule J to its By-Laws that consolidates all of the
relevant rules, regulations, practices and procedures applicable to
index warrants trading on Nasdaq and exchange-listed stock index
warrants, currency index warrants, and currency warrants traded by
members who are not members of the exchange on which the warrant is
listed or traded. The NASD also proposes to impose more stringent
standards on the issuers of index warrants, as well as certain
requirements as to the terms of the index warrants themselves. Under
the proposal, all exchange-traded index warrants and foreign currency
warrants presently outstanding will be grandfathered from these
provisions. Even though there currently are no index warrants listed on
Nasdaq, NASD rules provide that issuers of Nasdaq-listed index warrants
are required to have assets in excess of $100 million and members are
obligated to comply with the NASD's options rules governing
suitability, account opening, discretionary accounts, and account
supervision when handling customer orders in index warrants. The NASD's
current proposal expands these requirements in the following ways.
\11\ Due to the current definition of ``security'' in Section
3(a)(10) of the Act, 15 U.S.C. 78c(a)(10), the NASD, unlike the
national securities exchanges, does not have authority to list
issuances of currency and currency index warrants on Nasdaq. The
NASD is proposing rules, however, that will apply to transactions in
currency and currency index warrants entered into by NASD members
(or customers thereof) who are not members of the exchange on which
the currency or currency index warrant is listed or traded.
---------------------------------------------------------------------------
First, because index warrants are derivative in nature and closely
resemble index options, the NASD believes it is appropriate to apply to
index warrants, currency index warrants, and currency warrants the same
or similar safeguards for customer protection that are applicable to
exchange-traded standardized options. Accordingly, Schedule J is
patterned after the NASD's options rules contained in Article III,
Section 33 of the NASD's Rules of Fair Practice. In particular,
proposed Sections 3 through 9 of Schedule J impose on index warrants,
currency index warrants, and currency warrants the options rules
governing account opening, suitability, discretionary accounts,
supervision of accounts, customer complaints and communications with
the public and customers. These provisions will ensure that members are
adequately monitoring their customer accounts trading index, currency,
and currency index warrants and that only customers with an
understanding of these warrants and the financial capacity to bear the
risks attendant thereto will be permitted to trade these instruments
based on their broker's recommendation. In addition, as discussed
above, the proposed margin rules for index, currency, and currency
index warrants are comparable to those applicable to standardized index
and currency options. Accordingly, the NASD believes that the special
concerns attendant to the secondary trading of index warrants on Nasdaq
have been adequately addressed by the NASD.
Second, the NASD proposes to increase the listing standards
applicable to issuers of index warrants to ensure that only substantial
companies capable of meeting their warrant obligations are able to list
index warrants on Nasdaq. In particular, by switching from a $100
[[Page 52237]]
million gross assets standard to a standard where issuers will be
required to have a minimum tangible net worth in excess of $250 million
or, in the alternative, have a minimum tangible net worth in excess of
$150 million, provided the issuer has not issued warrants such that the
aggregate original issue price of all of the issuer's stock index,
currency index, and currency warrant offerings (combined with offerings
by its affiliates) listed on Nasdaq or a national securities exchange
exceeds 25% of the issuer's net worth, the NASD believes that issuers
will be better able to satisfy their warrant obligations.
Third, the NASD proposes to implement several safeguards designed
to ameliorate any potential adverse market impacts resulting from the
trading of index warrants. Specifically, the listing standards provide
that only broad-based indexes can underlie index warrants traded
through the facilities of the Nasdaq system. Sections 10 and 11 of
Schedule J provide for consolidated position and exercise limits for
index warrants on the same index on the same side of the market and
Section 12 imposes a reporting requirement for positions of 100,000
warrants on the same index on the same side of the market. In addition,
the listing standards provide that the settlement values for stock
index warrants overlying indexes with U.S. components greater than 25
percent of the value of the index must be determined with reference to
the opening prices of the U.S. securities in such indexes on valuation
date as well as during the two business days immediately preceding
valuation date.\12\ The NASD's proposal also provides for the
notification to the NASD of early exercises of stock index warrants and
disclosure of certain trading activities by issuers in response to such
early exercises.
\12\ See Amendment No. 3.
---------------------------------------------------------------------------
The proposal also imposes requirements with respect to the
percentage weighting of a multi-country or foreign stock index that
must be subject to an effective surveillance sharing arrangement and
establishes procedures governing the halting or suspension of trading
in an index warrant. The NASD believes that these requirements will
facilitate the orderly unwinding of index warrant positions and related
cash market positions upon the expiration of index warrants and enhance
the ability of the NASD to surveil trading in index warrants and
related markets.
Lastly, the NASD proposes to add Section 2(c)(2)(K) of Part III to
Schedule D of the NASD's By-Laws that will streamline the approval
process for index warrants. This section provides that once a broad-
based index has been approved by the SEC to underlie an index warrant
or option, the index is then eligible to underlie an index warrant
traded on Nasdaq without further Commission review or approval,
provided the NASD has obtained all the surveillance sharing agreements
mandated by the Commission. The NASD believes that this self-
effectuating listing process for index warrants will promote market
efficiency and allow the NASD to better meet the demands of investors
in the Nasdaq marketplace. At the same time, the NASD does not believe
that this approval process will compromise the protection of investors
in any way because the Commission will already have approved the
underlying index to underlie an index option or warrant.
Accordingly, the NASD believes the proposed rule change is
consistent with Section 15A(b)(6) of the Act. Section 15A(b)(6)
requires that the rules of a national securities association be
designed to prevent fraudulent and manipulative acts and practices, to
promote just and equitable principles of trade, to foster cooperation
and coordination with persons engaged in regulation, clearing,
settling, processing information with respect to, and facilitating
transactions in securities, to remove impediments to and perfect the
mechanism of a free and open market and a national market system and in
general to protect investors and the public interest. Listing index
warrants on Nasdaq will also facilitate members and investors desiring
to trade index warrants in a dealer environment. In addition, the sales
practice, margin, and position and exercise limit rules, among others,
that will be applicable to index, currency, and currency index warrants
will serve to protect investors and promote the public interest.
B. Self-Regulatory Organization's Statement on Burden on Competition
The NASD believes that the proposed rule change will not result in
any burden on competition that is not necessary or appropriate in
furtherance of the purposes of the Act.
C. Self-Regulatory Organization's Statement on Comments on the Proposed
Rule Change Received From Members, Participants, or Others
Comments were neither solicited nor received.
III. Date of Effectiveness of the Proposed Rule Change and Timing for
Commission Action
The NASD has requested that the proposed rule change given
accelerated effectiveness pursuant to Section 19(b)(2) of the Act in
view of the Commission's previous approval of substantially identical
rule changes submitted by the other SROs.\13\ These other proposals
were subject to the full notice and comment period and, in fact, were
modified partly in response to a comment letter received on the
proposals on behalf of several large broker-dealers.\14\ The NASD also
notes that the Commission has approved amendments to every other SRO's
stock index warrant proposal on an accelerated basis. In addition, the
NASD notes that a number of issuers, including Nasdaq listed companies,
have expressed an interest in listing index warrants on Nasdaq.
\13\ On August 29, 1995, the Commission approved uniform listing
and trading guidelines for stock index, currency and currency index
warrants for the New York Stock Exchange, Pacific Stock Exchange,
Philadelphia Stock Exchange, American Stock Exchange and Chicago
Board Options Exchange. See Securities Exchange Act Release Nos.
36165, 36166, 36167, 36168 and 36169 (Aug. 29, 1995), respectively.
\14\ See Letter from Paul M. Gottlieb, Seward & Kissel, to
Jonathan G. Katz, Secretary, Commission, dated January 10, 1995
(``Comment Letter'' or ``Seward & Kissel Letter''). The Seward &
Kissel Letter was submitted on behalf of PaineWebber Inc., Bear,
Stearns & Co. Inc., Lehman Brothers Inc., Smith Barney Inc., Salomon
Brothers Inc., Morgan Stanley & Co. Inc., and Hambrecht & Quist Inc.
---------------------------------------------------------------------------
Accordingly, because the NASD's proposed regulatory structure for
index warrants mirrors standards already approved by the Commission for
other SROs, the NASD believes no regulatory purpose would be served by
delaying the ability of Nasdaq to list index warrants. Similarly, the
NASD believes that investors in The Nasdaq Stock Market should be
afforded the opportunity to trade index warrants. Therefore, the NASD
believes that failure to grant accelerated effectiveness of the
proposed rule change would result in an unfair burden on competition
and regulatory confusion in that the margin and sales practice rules
applicable to index and currency warrants will not be uniform among
U.S. securities markets. In fact, absent accelerated approval,
customers of NASD members who are not members of an exchange will be
subject to one regulatory regime for warrants while customers of
members who are exchange members will be subject to another regime.
[[Page 52238]]
IV. Findings and Conclusions
The Commission finds that the proposed rule change is consistent
with the requirements of the Act and the rules and regulations
thereunder applicable to a national securities exchange, and, in
particular, the requirements of Section 15A(b)(6).\15\ Specifically,
the Commission finds that the NASD's proposal to establish uniform
listing standards for broad-based stock index warrants, as well as
standards applicable to the trading of stock index, currency and
currency index warrants by NASD members (or customers thereof) who are
not members of the exchange on which the warrant is listed or traded,
strikes a reasonable balance between the Commission's mandates under
Section 15A(b)(6) to remove impediments to and perfect the mechanism of
a free and open market and a national market system, while protecting
investors and the public interest. In addition, the NASD's proposed
listing standards for warrants are consistent with the Section
15A(b)(6) requirements that rules of a registered securities
association be designed to prevent fraudulent and manipulative acts, to
promote just and equitable principles of trade, and are not designed to
permit unfair discrimination among issuers.
\15\ 15 U.S.C. 78o-3(b)(6) (1988).
---------------------------------------------------------------------------
The NASD's proposed generic listing standards for broadbased stock
index warrants set forth a regulatory framework for the listing of such
products.\16\ Generally, lifting standards serve as a means for an
exchange or securities association to screen issuers and to provide
listed status only to bona fide issuances that will have sufficient
public float, investor base, and trading interest to ensure that the
market has the depth and liquidity necessary to maintain fair and
orderly markets. Adequate standards are especially important for
warrant issuances given the leveraged and contingent liability they
represent. Once a security has been approved for initial listing,
maintenance criteria allow an exchange or securities association to
monitor the status and trading characteristics of that issue to ensure
that it continues to meet the exchange's or securities association's
standards for market depth and liquidity so that fair and orderly
markets can be maintained.
\16\ The Commission notes that warrants issued prior to this
approval order will continue to be governed by the rules applicable
to them at the time of their listing.
---------------------------------------------------------------------------
In reviewing listing standards for derivative-based products, the
Commission also must ensure that the regulatory requirements provide
for adequate trading rules, sales practice requirements, margin
requirements, position and exercise limits and surveillance procedures.
These rules minimize the potential for manipulation and help to ensure
that derivatively-priced products will not have negative market impact.
In addition, these standards should address the special risks to
customers arising from the derivative products.\17\ For the reasons
discussed below, the Commission believes the NASD's proposal will
provide it with significant flexibility to list stock index warrants on
NASDAQ, without compromising the effectiveness of the NASD's listing
standards or regulatory program for such products.\18\
\17\ Pursuant to Section 6(b)(5) of the Act, the Commission is
required to find, among other things, that trading in warrants will
serve to protect investors and contribute to the maintenance of fair
and orderly markets. In this regard, the Commission must predicate
approval of any new derivative product upon a finding that the
introduction of such derivative instrument is in the public
interest. Such a finding would be difficult for a derivative
instrument that served no hedging or other economic function,
because any benefits that might be derived by market participants
likely would be outweighed by the potential for manipulation,
diminished public confidence in the integrity of the markets, and
other valid regulatory concerns. As discussed below, the Commission
believes warrants will serve an economic purpose by providing an
alternative product that will allow investors to participate in the
price movements of the underlying securities in addition to allowing
investors holding positions in some or all of such securities to
hedge the risks associated with their portfolios.
\18\ See supra note 11.
---------------------------------------------------------------------------
A. Issuer Listing Standards and Product Design
As a general matter, the Commission believes that the trading of
warrants on a stock index permits investors to participate in the price
movements of the underlying securities, and allows investors holding
positions in some or all of such securities to hedge the risks
associated with their portfolios. The Commission further believes that
trading warrants on a stock index provides investors with an important
trading and hedging mechanism that is designed to reflect accurately
the overall movement of the component securities.
Warrants, unlike standardized options, however, do not have a
clearing house guarantee but are instead dependent upon the individual
credit of the issuer. This heightens the possibility that an exerciser
of warrants may not be able to receive full cash settlement upon
exercise. This additional credit risk, to some extent, is reduced by
the NASD's proposed issuer listing standards that require an issuer to
have either: (a) a minimum tangible net worth of $250 million; or (b) a
minimum tangible net worth of $150 million, provided that the issuer
does not have (including as a result of the proposed issuance) issued
outstanding warrants where the aggregate original issue price of all
such stock index, currency and currency index warrant offerings (or
affiliates) that are listed on a national securities exchange or traded
through the facilities of NASDAQ is in excess of 25% of the warrant
issuer's net worth. Furthermore, financial information regarding the
issuers of warrants will be disclosed or incorporated in the prospectus
accompanying the offering of the warrants.
The NASD's proposal will provide issuers flexibility by allowing
them to utilize either a.m. or p.m. settlement, provided, however,
domestic index warrants (i.e., warrants based on indexes for which 25%
or more of the index value is represented by securities traded
primarily in the U.S.) (``domestic index warrants'') are required to
utilize a.m. settlement of expiring warrants on valuation date
(''valuation date'') as well as during the last two business days prior
to valuation date. The Commission continues to believe that a.m.
settlement significantly improves the ability of the market to
alleviate and accommodate large and potentially destabilizing order
imbalances associated with the unwinding of index-related positions.
Nevertheless, the use of p.m. settlement except on valuation date, and
during the last two business days prior to the valuation date, strikes
a reasonable balance between ameliorating the price effects associated
with expirations of derivative index products and providing issuers
with flexibility in designating their products.\19\
\19\ Foreign stock market based index warrants may utilize p.m.
settlement throughout their duration.
---------------------------------------------------------------------------
In this context, the Commission notes that unlike standardized
index options whose settlement times are relatively uniform, index
warrants are issuer-based products, whose terms are individually set by
the issuer. In addition, while options may have unlimited open
interest, the number of warrants on a given index is fixed at the time
of issuance. Accordingly, it is not certain that there will be a
significant number or warrants in indexes with similar components
expiring on the same day. This may reduce the pressure from liquidation
of warrant hedges at settlement. Nevertheless, the Commission expects
the NASD to monitor this issue and, should significant market effects
occur as a result of early exercises from p.m. settled index warrants,
would expect it
[[Page 52239]]
to make appropriate changes including potentially limiting the number
of index warrants with p.m. settlement.
B. Customer Protection
Due to their derivative and leveraged nature, and the fact that
they are a wasting asset, many of the risks of trading in warrants are
similar to the risks of trading standardized options. Accordingly, the
NASD has proposed to apply its options customer protection rules to
warrants. In particular, the Commission notes that warrants may only be
sold to options approved accounts capable of evaluating and bearing the
risks associated with trading in these instruments, and that adequate
disclosure of the risks of these products must be made to
investors.\20\ In addition, the NASD will apply the options rules for
suitability, discretionary accounts, supervision of accounts and
customer complaints to transactions in warrants. By imposing the
special suitability and disclosure requirements noted above, the
Commission believes the NASD has addressed adequately several of the
potential customer protection concerns that could arise from the
options-like nature of warrants.
\20\ Pursuant to Article III, Section 33(b)(16) of the Rules of
Fair Practice, all options approved accounts must receive an ODD,
which discusses the characteristics and risks of standardized
options.
---------------------------------------------------------------------------
The ODD, which all options approved accounts must receive,
generally explains the characteristics and risks of standardized
options products. Although many of the risks to the holder of an index
warrant and option are substantially similar, however, because warrants
are issuer-based products, some of the risks, such as the lack of a
clearinghouse guarantee and certain terms for index warrants, are
different. The NASD has adequately addressed this issue by proposing to
distribute a circular to its members that will call attention to the
specific risks associated with stock index warrants that should be
highlighted to potential investors. In addition, the issuer listing
guidelines described above will ensure that only substantial companies
capable of meeting their warrant obligations will be eligible to issue
warrants. These requirements will help to address, to a certain extent,
the lack of a clearinghouse guarantee for index warrants. Finally,
warrant purchasers will receive a prospectus during the prospectus
delivery period, which should ensure that certain information about the
participating issuance and issuer is publicly available. The Commission
believes that the combined approach of making available general
derivative product information (the ODD), product specific information
(the NASD circular), and issuer specific information (the prospectus)
should provide an effective disclosure mechanism for these products.
C. Surveillance
In evaluating proposed rule changes to list derivative instruments,
the Commission considers the degree to which the market listing the
derivative product has the ability to conduct adequate surveillance. In
this regard, the Commission notes that the NASD has developed adequate
surveillance procedures for the trading of index and currency warrants.
First, the NASD has developed enhanced surveillance procedures to apply
to domestic stock index warrants which the Commission believes are
adequate to surveil for manipulation and other abuses involving the
warrant market and component securities.\21\ Among these enhanced
surveillance procedures, the Commission notes that issuers will be
required to report to the NASD on settlement date the number and value
of domestic index warrants subject to early exercise the previous day.
The Commission believes that this information will aid the NASD in its
surveillance capacity and help it to detect and deter market
manipulation and other trading abuses.
\21\ In addition, the Commission notes that issuers will be
required to report to the NASD certain trades (as specified in the
NASD's surveillance procedures) to unwind a warrant hedge that are
effected as a result of the early exercise of domestic index
warrants. This will enable the NASD to monitor the unwinding
activity to determine if it was effected in a manner that violates
NASD or Commission rules.
---------------------------------------------------------------------------
Second, the NASD has developed adequate surveillance procedures to
apply to foreign stock index warrants (i.e., less than 25% of the index
value is derived from stocks traded primarily in the U.S.).\22\ The
Commission believes that the ability to obtain information regarding
trading in the stocks underlying an index warrant is important to
detect and deter market manipulation and other trading abuses.
Accordingly, the Commission generally requires that there be a
surveillance sharing agreement \23\ in place between an exchange
listing or trading a derivative product and the exchange(s) trading the
stocks underlying the derivative contract that specifically enables the
relevant markets to surveil trading in the derivative product and its
underlying stocks.\24\ Such agreements provide a necessary deterrent to
manipulation because they facilitate the availability of information
needed to fully investigate a potential manipulation if it were to
occur.\25\ In this regard, the NASD will require that no more than 20%
of an Index's weight may be comprised (upon issuance and thereafter) of
foreign securities (or ADRs thereon) that do not satisfy one of the
following tests: (1) The NASD has in place an effective surveillance
agreement \26\ with the primary exchange in the home country in which
the security underlying the ADR is traded; or (2) meets an existing
alternative standard available for standardized options trading (e.g.,
satisfy the 50% U.S. trading volume test).\27\ The Commission believes
that this standard will ensure that index warrants are not listed upon
foreign indexes whose underlying securities trade on exchanges with
whom the NASD has no surveillance sharing agreement.
\22\ Each prior issuance of a foreign stock market based index
warrant is subject to specific surveillance procedures. These
procedures are generally tailored to the individual warrant issuance
and are based upon several factors involving the primary foreign
market, including the existence of surveillance or information
sharing agreements.
\23\ The Commission believes that a surveillance sharing
agreement should provide the parties with the ability to obtain
information necessary to detect and deter market manipulation and
other trading abuses. Consequently, the Commission generally
requires that a surveillance sharing agreement require that the
parties to the agreement provide each other, upon request,
information about market trading activity, clearing activity, and
the identity of the purchasers for securities. See e.g., Securities
Exchange Act Release No. 31529 (Nov. 27, 1992).
\24\ The ability to obtain relevant surveillance information,
including, among other things, the identity of the purchasers and
sellers of securities, is an essential and necessary component of a
comprehensive surveillance sharing agreement.
\25\ In the context of domestic index warrants, the Commission
notes that the U.S. exchanges and the NASD are members of the
Intermarket Surveillance Group (``ISG''), which was formed to, among
other things, coordinate more effectively surveillance and
investigative information sharing arrangements in the stock and
options markets. See Intermarket Surveillance Group Agreement, July
14, 1983. The most recent amendment to the ISG Agreement, which
incorporates the original agreement and all the amendments made
thereafter, was signed by ISG members on January 29, 1990. See
Second Amendment to the ISG Agreement.
\26\ See supra note 23.
\27\ See Securities Exchange Act Release Nos. 31529, 57 FR 57248
(Dec. 3, 1992) and 33555, 59 FR 5619 (Feb. 7, 1994).
---------------------------------------------------------------------------
D. Market Impact
The Commission believes that the listing and trading of index
warrants will not adversely affect the U.S. securities markets. First,
with respect to index warrants, the Commission notes that warrants may
only be established upon indexes the Commission has previously approved
as broad-based in the context of index options or warrant
[[Page 52240]]
trading. As part of its review of a proposal to list an index
derivative product, the Commission must find that the trading of index
options or warrants will serve to protect investors, promote the public
interest, and contribute to the maintenance of fair and orderly
markets. Accordingly, the Commission does not believe that the issuance
of index warrants upon previously approved broad-based stock indexes
will adversely impact the underlying component securities. In addition,
because index warrants are issued by various individual issuers who set
their own terms, it is likely that expirations among similar index
products will be varied, thereby reducing the likelihood that unwinding
hedge activities would adversely affect the underlying cash market.
Finally, as discussed above, the Commission believes the NASD's
enhanced surveillance procedures applicable to stock index warrants are
adequate to surveil for manipulation and other abuses involving the
warrant market, component securities and issuer hedge unwinding
transactions.
Second, the NASD has proposed margin levels for stock index and
currency warrants equivalent to those in place for stock index and
currency options. The Commission believes these requirements will
provide adequate customer margin levels sufficient to account for the
potential volatility of these products. In addition, options margin
treatment is appropriate given the options-like market risk posed by
warrants. The Commission notes that the customer spread margin
treatment applicable to warrants is subject to a one year pilot
program. This will allow the NASD to analyze the pricing relationships
between listed options and warrants on the same index in order to
determine whether to revise or approve on a permanent basis the
proposed spread margin rules.\28\
\28\ The Commission notes that the margin levels for currency
index warrants will be set at a level determined by the NASD and
approved by the SEC. Issuances of warrants listed prior to the
approval of this order will continue to apply the margin level
applicable to them at the time of their listing.
---------------------------------------------------------------------------
Third, the NASD has established reasonable position and exercise
limits for stock index warrants, which will serve to minimize potential
manipulation and other market impact concerns.
V. Conclusion
The Commission believes that the adoption of these uniform listing
and trading standards for broad-based index warrants will provide an
appropriate regulatory framework.\29\ These standards will also benefit
the NASD by providing them with greater flexibility in structuring
warrant issuances and a more expedient process for listing warrants
without further Commission review pursuant to Section 19(b) of the Act.
As noted above, additional Commission review of specific warrant
issuances will generally only be required for warrants overlying any
non-approved broad-based index that has not been previously approved by
the Commission for warrant or options trading. If Commission review of
a particular warrant issuance is required, the Commission expects that,
to the extent that the warrant issuance complies with the uniform
criteria adopted herein, its review should generally be limited to
issues concerning the newly proposed index. This should help ensure
that such additional Commission review could be completed in a prompt
manner without causing any unnecessary delay in listing new warrant
products.
\29\ As noted above, the NASD does not have the authority to
list currency or currency index warrant issuances. See supra note
11. Nevertheless, the regulatory framework adopted herein as also
applicable to stock index, currency and currency index warrants
which are traded by NASD members (or customers thereof) who are not
members of the exchange on which the warrant is listed or traded.
---------------------------------------------------------------------------
Finally, the Commission finds good cause for approving the proposed
rule change and Amendments No. 1, 2 and 3 to the proposed rule change
prior to the thirtieth day after the date of publication of notice
thereof in the Federal Register in order to allow the NASD to begin
listing index warrants without delay. As discussed above, the proposal
is substantially identical to those submitted by the other SROs.\30\
These other index warrant proposals were subject to the full notice and
comment period and, as discussed above, were modified in response to
the Seward & Kissell Letter. Furthermore, Amendment No. 1 to the
proposal ensures that NASD members do not accept and/or execute an
order to sell short any index warrants from any person that is the
subject of an NASD order to liquidate a position in excess of
applicable position limits. The Commission notes that this change also
comports with rules currently in effect at other SROs applicable to the
liquidation of index warrant positions in excess of applicable position
limit rules. Amendment No. 2 to the proposal reduces the position
limits on the MidCap Index to 7.5 million warrants. The Commission
notes that this number is consistent with the level approved for the
American Stock Exchange. Accordingly, the amendment does not raise any
new or unique regulatory issues. Finally, Amendment No. 3 clarifies
that opening price settlement will be utilized for warrants that are
valued on valuation date or on either of the two business days
preceding valuation date. The Commission notes that this change brings
the NASD's proposal into conformity with those of the other exchanges
and, therefore, does not believe the amendment raises any new or unique
regulatory issues. For these reasons, the Commission believes it is
consistent with Sections 15A(b)(6) \31\ and 19(b)(2) \32\ of the Act to
approve the proposed rule change and Amendments No. 1, 2 and 3 to the
proposal on an accelerated basis.
\30\ See supra note 13.
\31\ 15 U.S.C. Sec. 78o-3(b)(6) (1988).
\32\ 15 U.S.C. Sec. 78s(b)(2) (1988).
---------------------------------------------------------------------------
VI. Solicitation of Comments
Interested persons are invited to submit written data, views and
arguments concerning the foregoing. Persons making written submissions
should file six copies thereof with the Secretary, Securities and
Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549.
Copies of the submission, all subsequent amendments, all written
statements with respect to the proposed rule change that are filed with
the Commission, and all written communications relating to the proposed
rule change between the Commission and any person, other than those
that may be withheld from the public in accordance with the provisions
of 5 U.S.C. 552, will be available for inspection and copying in the
Commission's Public Reference Section, 450 Fifth Street, N.W.,
Washington, D.C. Copies of such filing will also be available for
inspection and copying at the principal office of the above-mentioned
self-regulatory organization. All submissions should refer to the file
number in the caption above and should be submitted by October 26,
1995.
It therefore is ordered, pursuant to Section 19(b)(2) of the
Act,\33\ that the proposed rule change (SR-NASD-95-37) is approved, as
amended, with the portion of the rule change relating to spread margin
treatment being approved on a one year pilot program basis, effective
beginning September 28, 1995.
\33\ 15 U.S.C. Sec. 78s(b)(2) (1988).
---------------------------------------------------------------------------
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\34\
\34\ 17 CFR Sec. 200.30-3(a)(12) (1994).
[[Page 52241]]
---------------------------------------------------------------------------
Jonathan G. Katz,
Secretary.
[FR Doc. 95-24794 Filed 10-4-95; 8:45 am]
BILLING CODE 8010-01-M
