[Federal Register Volume 60, Number 58 (Monday, March 27, 1995)]
[Notices]
[Pages 15804-15807]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-7447]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-35518; File No. SR-AMEX-94-30]
Self-Regulatory Organizations; American Stock Exchange, Inc.;
Order Approving Proposed Rule Change Relating to the Listing and
Trading of Commodity Linked Notes
March 21, 1995.
I. Introduction
On August 22, 1994, the American Stock Exchange, Inc. (``Amex'' or
``Exchange'') submitted to the Securities and Exchange Commission
(``SEC'' or ``Commission''), pursuant to Section 19(b) of the
Securities Exchange Act of 1934 (``Act''),\1\ and Rule 19b-4
thereunder,\2\ a proposed rule change to list and trade Commodity
Linked Notes (``COINs''), intermediate term notes whose value will be
linked in part to changes in the levels of either the J.P. Morgan
Commodity Excess Return Index (``JPMCIX'') or the J.P. Morgan Commodity
Return Index (``JPMCI'' together with JPMCIX, ``Indexes'').
\1\15 U.S.C. 78s(b)(1) (1988).
\2\17 CFR Sec. 240.19b-4 (1993).
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Notice of the proposed rule change and Amendment No. 1 (defined
herein) was published for comment and appeared in the Federal Register
on December 2, 1994.\3\ No comments were received on the proposal. This
order approves the proposal, as amended.
\3\See Securities Exchange Act Release No. 35005 (November 23,
1994), 59 FR 61911. The Amex on November 16, 1994, submitted
Amendment No. 1 (``Amendment No. 1'') to the proposal to allow the
underwriter to link the value of the notes to either the JPMCI or
JPMCIX, depending upon market conditions and investor interest at
the time of the offering. Additionally, the Amendment provides that:
only options approved accounts will be permitted to trade the notes;
the notes will provide for a 75% guaranteed return of principal; the
index value will be calculated at least once a day; the Amex has
executed the necessary surveillance sharing agreements with the
relevant commodities exchanges; and COINs will comply with the
CFTC's hybrid instrument exemption (58 FR 5580 (Jan. 22, 1993)). See
Letter from Benjamin Krause, Amex, to Michael Walinskas, Derivative
Products Regulation, SEC, dated November 16, 1994.
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II. Description of Proposal
The Amex proposes to list for trading under Section 107 of the Amex
Company Guide (``Section 107'') a new hybrid product called COINS.
COINs are intermediate term notes whose value will be linked in part to
changes in the level of a commodity index consisting of base metals,
precious metals and energy related commodities. More specifically, the
value of COINs are based on an index that replicates a trading strategy
whereby an investor holds a futures position in each of eleven
exchange-traded commodities for a one-month period and then rebalances
the positions of the commodities held for the following month to
maintain a constant dollar weighting scheme.
A. Description of the Indexes
COINs will be linked to either the JPMCI or the JPMCIX, both of
which measure the return from an investment in the same eleven
industrial futures contracts.\4\ According to the Exchange, the JPMCI
and JPMCIX are identical in all aspects except for the incorporation of
``collateral return,'' as more fully described below, into the
JPMCI.\5\ Both Indexes are designed to replicate a trading strategy,
described more fully below, that holds a futures position in each of
the eleven futures for a one month period and then rebalances the
volume of commodities held for the following month based upon a
constant [[Page 15805]] dollar weighting scheme. Amex represents that
J.P. Morgan desires the flexibility to determine at the time of
offering, based upon investor demand and market conditions, which if
the Indexes it will utilize for valuing COINs.
\4\The commodities underlying the Indexes and their approximate
weighting are: aluminum (9%), copper (8%), nickel (2%), zinc (3%),
heating oil (10%), natural gas (7%), unleaded gas (5%), WTI Light
Sweet Crude (33%), gold (15%), silver (5%) and platinum (3%).
\5\See Amendment No. 1, supra note 3.
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COINs will conform to the Amex's listing guidelines under Section
107, which provide that such issues have: (1) A public distribution of
one million trading units; (2) 400 holders; and (3) a market value of
not less than $20 million. The Exchange also will require that the
issuer have a minimum tangible net worth of $150 million. In addition,
the Exchange will require that the total original issue price of the
notes (when combined with all of the issuer's commodity linked notes
which are listed on a national securities exchange or traded through
the facilities of NASDAQ), shall not be greater than 25% of the
issuer's tangible net worth at the time of issuance.
COINs are non-interest bearing notes with a term of one to three
years and, upon maturity, holders will receive at least 75% of the
original issue price plus an amount in U.S. dollars equal to a
participation rate (i.e., a specified percentage) multiplied by any
positive difference between the level of the appropriate index at the
time of the offering and the average of the closing index level on the
five business days preceding maturity. COINs may not be redeemed prior
to maturity, and holders of the notes have no claim to the physical
commodities or futures contracts underlying the linked index.
B. Index Design and Calculation
The JPMCIX and JPMCI are designed to replicate a trading strategy
that measures both ``price'' return and ``roll'' return from an
investment in certain commodities. Price return is the component of
return that arises from changes in commodity futures prices. Roll
return is the component of return that arises from the hypothetical
rolling of a long futures position through time in a sloping forward
price curve environment. When nearby dated futures contracts are more
expensive than longer dated contracts, roll return is positive. When
the reverse applies, roll return is negative.
The relative weights of the Index components will be rebalanced at
the end of trading on the fourth business day of every month to
maintain the appropriate dollar weighting. In addition, due to the
periodic expiration of the futures contracts used to compute the Index
value, Amex states that it is necessary to ``roll'' out of expiring
contracts and into the new nearby contracts. To minimize possible
pricing volatility arising from conducting the ``roll'' on a single
business day, the substitution of the new contract for the old is
accomplished with 20% of the roll volume transacted on each of the five
subsequent business days after the rebalance date. The futures contract
to be used for the monthly hypothetical rebalancing and rolling of each
commodity will be the nearest designated future contracts\6\ to be used
in the appropriate Index, with a termination of trading date not
earlier than ten business days into the following month.\7\
\6\The designated futures contracts for each commodity are
specified in the Letter from Benjamin Krause, Capital Markets Group,
Amex, to Stephen M. Youhn, Derivative Products Regulation, SEC,
dated Oct. 4, 1994.
\7\For energy and base metals, the new and old contracts will be
different. For precious metals, the new and old contracts may be the
same contract because of the absence of a designated contract for
every month. In this instance, rebalancing and rolling will only
involve an adjustment of the amount held of the old contracts.
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In addition to price return and roll return, the JPMCI is comprised
of ``collateral return,'' which, according to the Amex, represents the
risk free component of commodity returns afforded by full
collateralization of the notional value of futures positions with
Treasury bills. Essentially, it measures the return that an investor
would receive if the investor were to margin fully a futures position
(i.e., post 100% margin) with Treasury bills. Amex represents that
according to J.P. Morgan, because stocks and bonds are collateralized
investments, it is useful to treat commodities on the same basis in
order to compare risk-return performance, even though some investors
may choose not to fully collaterlize commodity investments.
Accordingly, J.P./ Morgan believes that collateralization permits
meaningful comparison with traditional assets in a portfolio allocation
framework.\8\
\8\The return based upon the Treasury bill rate is calculated
using a 13 week T-bill yield, compounded daily at the decompounded
discount rate of the most recent weekly U.S. Treasury bill auction
as found in the H.15 (519) report published by the Board of
Governors of the Federal Reserve System, on the full (100%) value of
the index. Interest accrues on an actual day basis over weekends and
holidays at the previous day's rate. See Amendment No. 1, supra note
3.
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Prices utilized in the Indexes will be based on New York Mercantile
Exchange (``NYMEX'') prices for platinum and energy related
commodities; Commodity Exchange (``Comex'') prices for other precious
metals (Comex is wholly-owned subsidiary of NYMEX); and London Metal
Exchange (``LME'') prices for base metals. These prices are widely
reported by vendors of financial information and the press. Index
values will be comprised of readily ascertainable and verifiable
futures contract settlement and closing prices and will be calculated
once each trading day by J.P. Morgan (or an affiliate) and disseminated
after 4:00 p.m. (New York time) to vendors of financial information by
the issuer, J.P. Morgan.\9\
\9\See Letter from William Floyd-Jones, Amex, to Stephen M.
Youhn, SEC, dated December 16, 1994 (``December 16 Letter'').
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The design, composition and calculation of both Indexes are
expected to remain unchanged during the term of the COINs instruments;
however, market developments may necessitate changes to these aspects
of the product.\10\ Such decisions will be determined on the basis of a
``neutral'' business committee, the JPMCI Policy Committee. This
committee is composed of senior employees in the commodities and
research areas of J.P. Morgan as well as independent industry and
academic experts. Commodity Group personnel of J.P. Morgan are
restricted to an advisory, non-voting membership on the JPMCI Policy
Committee. J.P. Morgan will immediately notify the Exchange and vendors
of financial information that report the Index values in the event that
there is change in the relative weightings, calculation methodology or
composition of the COINs Index.\11\
\10\Such developments could include, among other things,
changing liquidity conditions or the discontinuation of existing
contracts, the emergence of new contracts on relevant commodities,
or major progress in substitution technology that renders obsolete
industrial processes that make use of a certain commodity.
\11\See infra note 17.
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Members of the NPMCI Policy Committee and employees of the
calculation agent who are involved in the calculation of, or data
collection for, any of the commodity interests underlying COINs or the
aggregate value of the commodity index underlying COINs will be
expressly prohibited from trading COINs. Additionally, the calculation
agent will adopt and maintain such reasonable and appropriate
procedures as to ensure that the calculation agent, its agents,
affiliates and employees, do not take advantage of or communicate to
any other person any knowledge concerning changes in the value of the
Indexes, or any commodity interest underlying the Indexes before such
information is made publicly available.
C. Surveillance Sharing Agreements
The Amex represents that it is able to obtain market surveillance
information, including customer identity information, with respect to
transactions [[Page 15806]] occurring on the NYMEX and Comex pursuant
to its information sharing agreement with NYMEX.\12\ The Exchange also
represents that it is able to obtain market surveillance information,
including customer identity information, with respect to transactions
occurring on LME under information sharing arrangements with the
Securities and Futures Authority (``SFA'') through the Intermarket
Surveillance Group (``ISG'').\13\
\12\See Letter from William Floyd-Jones, Amex, to Michael
Walinskas, SEC, dated August 26, 1994.
\13\Id. The ISG was formed on July 14, 1983 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 amendments made thereafter, was signed by
ISG members on January 29, 1990. See Second Amendment to the
Intermarket Surveillance Group Agreement, January 29, 1990. the
members of the ISG are the Amex; the Boston Stock Exchange, Inc.;
the Chicago Board Options Exchange, Inc.; the Chicago Stock
Exchange, Inc.; the National Association of Securities Dealers,
Inc.; the New York Stock Exchange, Inc.; the Pacific Stock Exchange,
Inc.; and the Philadelphia Stock Exchange, Inc. The SFA is an
affiliate member of ISG.
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D. Sales Practice and Trading Rules
The Exchange will require that only accounts approved for options
trading under Amex Rule 921 shall be permitted to engage in the
purchase and/or sale of COINs. In addition, the Amex will require that
recommendations in COINs transactions be subject to the heightened
suitability standards set forth in Amex Rule 923.\14\ Additionally, the
Exchange will distribute a circular to its membership prior to the
commencement of trading in COINs to provide guidance with regard to
member firm compliance responsibilities (including suitability
recommendations) when handling transactions in COINs and highlighting
the special risks and characteristics thereof. As with other hybrid
debt instruments, COINs will be subject to the equity margin and
trading rules of the Exchange.\15\
\14\Letter from William Floyd-Jones, Amex, to Stephen M. Youhn,
SEC, dated November 17, 1994.
\15\See Letter from James McNeil, Chief Examiner, Financial
Regulatory Services Department, Amex, to Sharon Lawson, Assistant
Director, SEC, dated August 24, 1994, for more specific details
concerning the margin treatment for COINs.
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III. Commission 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 6(b)(5). In particular, the
Commission believes that the availability of exchange-traded COINs will
provide a new instrument for investors to achieve desired investment
objectives (e.g., inflation hedge and portfolio diversification)
through the purchase of an exchange-traded securities product linked to
an index of certain commodities.\16\ For the reasons discussed below,
the Commission has concluded that the Amex listing standards applicable
to COINs are consistent with the Act.
\16\Pursuant to Section 6(b)(5) of the Act the Commission must
predicate approval of exchange trading for new products upon a
finding that the introduction of the product is in the public
interest. Such a finding would be difficult with respect to a
product that served no investment, hedging or other economic
function, because any benefits that might be derived by market
participants would likely be outweighed by the potential for
manipulation, diminished public confidence in the integrity of the
markets, and other valid regulatory concerns.
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COINs are a new version of hybrid securities debt instruments that
are listed on various securities exchanges. These instruments involve
publicly offered notes with interest return or a principal component
linked to a particular asset or index of assets. For COINs, the
interest return and part of the principal return will be derived and
based upon the performance of either the JPMCI or JPMCIX, which, in
turn, will be dependent upon the performance of the designated futures
contracts related to the underlying physical commodities.\17\ Although
COINs provide investors with a 75% principal guarantee, as discussed
below, the value of COINs will be affected partially by certain risks
that are associated with the purchase and sale of exchange-traded
futures contracts.
\17\In this respect, the Commission notes that Amex will
promptly notify the Commission if there are significant changes in
the weighings and composition or calculation methodology of the
Indexes. Moreover, any proposed material changes to such features
might require a separate rule filing pursuant to Rule 19b-4.
Furthermore, a rule filing would be required in order to list any
other derivative product based upon either of the Indexes or any
other index comprised of commodity interests. Finally, a proposed
issuer would have to ensure that its product complied with
applicable CFTC exemptions or statutory interpretations regarding
hybrid products before listing any such product. See supra note 3.
The Commission notes that the prices of commodities (and overlying
futures contracts), including the eleven commodities utilized for the
Indexes, may be subject to volatile price movements caused by numerous
factors.\18\ Accordingly, an investment in COINs may also be subject to
volatile price movements due to price changes in the underlying
commodities comprising the Index. In addition, COINs have many complex
features, such as the incorporation of hypothetical roll return and
collateral return. The Amex has proposed special suitability,
disclosure, and compliance requirements to address the complex and
risky nature of COINs. First, only accounts approved for options
trading pursuant to Amex Rule 921 may engage in transactions in COINs.
As a result, only those investors who have expressed an interest in
options trading and are deemed qualified by a member to engage in
options trading will be permitted to purchase COINs. This is important
given the embedded derivative component of COINs. Second, the Amex will
require that members who make recommendations in COINs must comply with
the heightened suitability standards set forth in Amex Rule 923.\19\
Third, COINs provide for a principal return of at least 75% of their
initial offering price. While this guaranteed return of principal is
subject to the issuer's credit risk, i.e., the ability of J.P. Morgan
to meet its repayment obligations upon maturity, this guarantee helps
to reduce the likelihood that investors could sustain a substantial
loss of their COINs investment due to adverse commodity price
movements. Fourth, because COINs are cash-settled, holders will not
receive, nor be required to liquidate, the underlying physical
commodities or overlying futures contracts. The Commission notes that
this provision will effectively terminate a COINs investor's exposure
to commodity market risk at the note's maturity. Finally, the Exchange
plans to distribute a circular to its membership calling attention to
the specific risks associated with COINs.\20\ This will assist members
in determining the customers eligible to trade COINs, formulating
recommendations in COINs, and in monitoring customer and firm
transactions in COINs.
\18\Such factors include, but are not limited to, international
economic, social and political conditions and levels of supply and
demand for the individual commodities.
\19\Amex Rule 923 requires, among other things, that members
have reasonable grounds for believing that a recommended transaction
is not unsuitable on the basis of information furnished by the
customer.
\20\The COINs circular will be submitted to the Commission for
its review and should include, among other things, a discussion of
those risks which may cause commodities to experience volatile price
movements in addition to details on the composition of the Indexes
and how the rates of return will be computed.
The Commission also believes that several factors significantly
minimize the potential for manipulation of the Indexes. First, as
discussed above, the Indexes represent a diverse cross-
[[Page 15807]] section of exchange-traded industrial commodities.
Second, each of the futures contracts overlying the commodities is
relatively actively traded, and has considerable open interest. Third,
the majority of futures contracts overlying the component commodities
trade on exchanges that impose position limits on speculative trading
activity, which are designed, and serve, to minimize potential
manipulation and other market impact concerns. Fourth, as discussed
below, the Amex has entered into certain surveillance sharing
agreements with each of the futures exchanges upon which the underlying
designated futures contracts trade. These agreements should help to
ensure the availability of information necessary to detect and deter
potential manipulations and other trading abuses, thereby making COINs
less readily susceptible to manipulation.\21\ Fifth, the price of COINs
will be comprised of readily ascertainable and verifiable futures
contract settlement and closing prices and disseminated once each
trading day after 4 p.m. (New York time) to vendors of electronic
financial information and on the Amex tape.\22\ Sixth, adequate
procedures are in place to prevent the misuse of information by members
of the JPMCI Policy Committee.\23\ Accordingly, for the reasons
discussed above, the Commission believes the Indexes are not readily
susceptible to manipulation and that in any event, the surveillance
procedures in place are sufficient to detect as well as deter potential
manipulation.
\21\The Amex has comprehensive surveillance sharing agreements
with all of the exchanges upon which the futures contracts overlying
COINs trade and is able to obtain market surveillance information,
including customer identity information, for transactions occurring
on NYMEX and Comex. Furthermore, under the ISG information sharing
agreement, SFA will be able to provide, on request, surveillance
information with respect to trades effected on the LME, including
client identity information. Finally, if the composition of the
applicable COINs Index changes or if a different market is utilized
for purposes of calculating the value of the designated futures
contracts, the Amex will ensure that it has entered into a
surveillance sharing agreement with respect to the new relevant
market.
\22\See December 16 Letter.
\23\As discussed above, members of the JPMCI Policy Committee
are expressly prohibited from trading COINs and from communicating
any knowledge concerning changes in the value of the Indexes to any
other person. Amex will also have surveillance procedures in place
to periodically review activity in the notes and/or underlying Index
components.
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The Commission notes that COINs, unlike standardized options, do
not contain a clearinghouse guarantee but are instead dependent upon
the individual credit of the issuer, J.P. Morgan. This heightens the
possibility that a purchaser of COINs may not be able to receive full
principal cash payment upon maturity. To some extent this credit risk
is minimized by the Exchange's listing guidelines requiring COINs
issuers to possess at least $100,000,000 in assets and stockholders'
equity of at least $10 million. In any event, financial information
regarding J.P. Morgan will be disclosed or incorporated in the
prospectus accompanying the offering of COINs.
Finally, the Commission notes that the approval granted herein is
limited to the issuance of COINs whose value is derived from the JPMCI
or JPMCIX, as described in this Order. Accordingly, the use of either
of the Indexes as an underlying value for any other derivative product,
irrespective of the issuer, raises additional legal and/or regulatory
issues which would necessitate a rule filing pursuant to Rule 19b-4.
Based on the above, the Commission finds that the proposal to trade
COINs is consistent with the Act, and, in particular, the requirements
of Section 6(b)(5).
It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\24\ that the proposed rule change is approved.
\24\15 U.S.C. 78s(b)(2) (1982).
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\25\
\25\17 CFR Sec. 200.30-3(a)(12) (1994).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 95-7447 Filed 3-24-95; 8:45 am]
BILLING CODE 8010-01-M
