[Federal Register Volume 60, Number 173 (Thursday, September 7, 1995)]
[Notices]
[Pages 46667-46674]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-22106]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-36167; File No. SR-Phlx-94-49]
Self-Regulatory Organizations; Philadelphia Stock Exchange, Inc.;
Order Approving Proposed Rule Change and Notice of Filing and Order
Granting Accelerated Approval of Amendments No. 1, 2, 3, and 4 to
Proposed Rule Change Relating to the Establishment of Uniform Listing
and Trading Guidelines for Stock Index, Currency and Currency Index
Warrants
August 29, 1995.
I. Introduction
On November 30, 1994, the Philadelphia Stock Exchange, Inc.
(``Phlx'' or ``Exchange'') submitted to the Securities and Exchange
Commission (``SEC'' or ``Commission''), pursuant to Section 19(b)
(``Section 19(b)'') of the Securities Exchange Act of 1934
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ a proposed rule change to
establish uniform rules for the listing and trading of stock index
(``index'' or ``stock index''), currency (``currency'') and currency
index (``currency index'') warrants (collectively ``warrants''). Notice
of the proposed rule change appeared in the Federal Register on
December 20, 1994.\3\ One comment letter was received in response to
the proposal.\4\
\1\ 15 U.S.C. 78s(b)(1) (1988 & Supp. V 1993).
\2\ 17 CFR Sec. 240.19b-4 (1994).
\3\ See Securities Exchange Act Release No. 35090 (Dec. 12,
1994), 59 FR 65556.
\4\ See Letter from Paul M. Gottlieb, Seward & Kissel, to
Jonathan G. Katz, Secretary, Commission, dated January 10, 1995
(``Comment Letter'' or ``Seward & Kissel Letter'').
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The Exchange subsequently filed four Amendments to the proposal.\5\
Amendment No. 1 brings several of Phlx's proposed rules and policies
into conformity with those previously filed by other markets. Amendment
No. 2, in addition to responding to several technical changes requested
by the staff, addresses currency and currency index warrant margin
levels and settlement methodology. Amendment No. 3, in addition to
addressing issues relating to reporting requirements and notification
of early exercises, removes certain surveillance procedures from the
Phlx's rules. Amendment No. 4 clarifies the settlement procedures for
index warrants which are exercised at or prior to expiration. This
order approves the proposal, as amended.
\5\ See Letters from Michele R. Weisbaum, Phlx, to Michael
Walinskas, SEC, dated May 24, 1995, (``Amendment No. 1'') and to
Stephen M. Youhn, SEC, dated June 26, 1995 (``Amendment No. 2''),
August 4, 1995 (``Amendment No. 3''), and August 25, 1995
(``Amendment No. 4'').
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II. Description of the Proposal
The Phlx proposes to establish uniform rules for the listing and
trading of stock index, currency and currency index warrants.\6\ Rule
803, Criteria for Listing, would be amended to provide uniform listing
criteria for index, currency and currency index warrants. First,
issuers would be expected to exceed minimum issuer listing standards.
In particular, the Exchange proposes that issuers 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 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 warrant offerings (combined
with offerings by its affiliates) listed on a national securities
exchange or that are National Market securities traded
[[Page 46668]]
through NASDAQ exceeds 25% of the issuer's net worth.\7\
\6\ The proposed rules would apply to both American-style
warrants (which may be exercised at any time prior to expiration)
and European-style warrants (which may only be exercised during a
specified period before expiration).
\7\ See amendments No. 1 and 2. The Exchange amended this
provision in response to the Seward & Kissell Letter.
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Second, the proposal requires that unexercised in-the-money
warrants be automatically exercised on either the delisting date (if
the issue is not listed upon another organized securities market) or
upon expiration. Third, the proposal provides that for warrant
offerings where U.S. stocks constitute 25% or more of the index value
(``domestic index''), issuers shall use opening prices (``a.m.
settlement'') for U.S. stocks to determine index warrant settlement
values during the 48 hour period prior to expiration of the
warrants.\8\ Fourth, Rule 803(e)(5) has been amended to provide that
foreign country securities or American Depositary Receipts (``ADRs'')
thereon that are not subject to a comprehensive surveillance sharing
agreement with the Exchange and that have less than 50% of their global
trading volume (in dollar value) within the U.S., shall not represent
more than 20% of the weight of the index.\9\ Finally, the Exchange
proposes to add Rule 803(e)(6), which is designed to assist in the
surveillance of index warrant trading. Specifically, the Exchange of
any early exercises by 4:30 p.m. (New York time) on the day that the
settlement value for the warrants is determined.\10\
\8\ See Amendments No. 2. The Exchange amended its proposal in
response to the Seward & Kissell Letter and notes that a warrant
based upon a domestic U.S. stock index may be settled using closing
prices (``p.m. settlement'') for the underlying stocks at all times
except for valuation day and the two business days immediately
preceding valuation day.
\9\ See Amendments No. 1 and 2.
\10\ See Amendment No. 3.
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Proposed Rule 722 (``Rule 22''), the Phlx margin rule, is being
amended to apply the current customer margin requirements for broad
based stock index and currency options to stock index, currency and
currency index warrants. Thus, all purchases of warrants will require
payment in full, and short sales of stock index warrants will require
initial margin of: (i) 100 percent of the current value of the warrant
plus (ii) 15 percent of the current value of the underlying broad stock
index less the amount by which the warrant is out of the money, but to
a minimum of ten percent of the index value. Short sales of currency
warrants will follow the margin requirements currently applicable to
listed currency options. Specifically, the Exchange 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% of the current
market value of each such warrant plus a four percent ``add-on.'' \11\
The margin required on currency index warrants would be an amount as
determined by the Exchange and approved by the Commission.\12\ The
Exchange also proposes that its stock index, currency and currency
index warrant margin requirements be permitted offset treatment for
spread and straddle positions. In this regard, the Exchange proposes
that index, currency and currency index warrants may be offset with
either warrants or Options clearing Corporation (``OCC'') issued
options on the same index, currency or currency index, respectively.
Furthermore, the Exchange has proposed that subsection (c)(2)(F)(i) of
Rule 722, to the extent that such rules concern spread and straddle
positions in warrants, be subject to a one year pilot basis.\13\
Finally, proposed Rule 722(c)(2)(G)(v) will also permit the use of
escrow receipts to cover a short call position in a broad-based stock
index warrant.\14\
\11\ See Amendment No. 2. Consistent with the treatment of
options on foreign currencies, warrants on the Canadian Dollar will
be subject to a one percent ``add-on.'' The margin required on any
other foreign currency would be subject to approval by the
Commission. See infra note 28.
\12\ See infra note 28.
\13\ Three months prior to the expiration of the pilot program,
the Exchange will submit a report to SEC staff analyzing the price
relationship between listed warrants and options on similar stock
indexes. See Amendment No. 1. The Exchange has also requested no-
action relief from the Commission in order to permit certain short
positions in stock index call and put warrants to be treated as
covered for margin purposes.
\14\ See Amendment No. 1. The Exchange notes that this treatment
is consistent with the rules that allow for the use of escrow
receipts to cover a short call position in broad-based stock index
options.
Proposed Rule 1024 states that no member or member organization
shall accept an order from a customer for the purchase or sale of
warrants unless the customer's account has been approved for options
trading. Furthermore, Rules 1025-1027 and 1070, pertaining to
suitability, discretionary account trading, supervision of accounts and
customer complaints will be applied to transactions in warrants.
Existing Rule 1049 will apply to warrants and require approval by a
Compliance Registered Options Principal of all advertisements, sales
literature and educational material issued by a member organization
pertaining to warrants. The rule further requires Exchange approval of
all advertisements and educational materials pertaining to warrants.
Finally, prior to trading index, currency or currency index warrants,
the Exchange will distribute circulars to its membership providing
guidance regarding member firm compliance responsibilities (including
suitability recommendations) when handling transactions in warrants.
Phlx Rule 1001 is being amended to provide that position limits for
stock index warrants on the same index with original issue prices of
ten dollars or less will be fifteen million warrants covering all such
issues.\15\ The rule also provides that warrants with an original issue
price of ten dollars or more will be weighted more heavily than
warrants with an original issue price of ten dollars or less in
calculating position limits.\16\ The rule also gives the Exchange the
authority to require the liquidation of a position in stock index
warrants that is in excess of the position limits set forth in the
rule, and Commentary to the rule establishes procedures for allowing
limited exceptions to the position limits.
\15\ See infra note 41.
\16\ For example, if an investor held 100,000 warrants based
upon the Standard & Poor's 500 Index offered originally at $20 per
warrant, the size of this position for the purpose of calculating
position limits would be 200,000.
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Rule 1002 is being amended to provide for exercise limits on stock
index warrants that are analogous to those found in stock index options
and states that such limits are distinct from any exercise limits that
may be imposed by the issuers of stock index warrants. Accordingly, no
member may exercise a long position in warrants over a five consecutive
day period in excess of the permissible position limit.
In order to facilitate its review of compliance with position and
exercise limits, the Exchange is amending Rule 1003 to establish
reporting requirements for large warrant positions. Under the terms of
the rule, members will be required to file a report with the Exchange
whenever any account in which the member has an interest has
established an aggregate position of 100,000 warrants overlying the
same index, currency or currency index. For purposes of this rule, the
Exchange proposes that long positions in puts be combined with short
positions in call warrants, and that short positions in puts be
combined with long positions in call warrants.\17\ Finally, Rule 1047A
regarding trading halt provisions is being amended to indicate that it
also will apply to the trading of warrants.
\17\ See Amendment No. 2.
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Upon Commission approval of the foregoing rule amendments, the
Exchange proposes that it will only file rule changes for specific
stock index
[[Page 46669]]
warrant issuances where there is no corresponding option or warrant on
the same underlying stock index already listed on a national securities
exchange or NASDAQ. Accordingly, when a listed option overlies a
particular broad based index, the Exchange proposes it be allowed to
list warrants on that index without further Commission review and
approval pursuant to Section 19(b) of the Act, as long as the listing
complies with the warrant listing standards as approved in this
Order.\18\
\18\ See infra note 28.
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III. Comments Received
The Commission received one letter in response to its request for
comments on the Phlx proposal.\19\ The Comment Letter was generally
supportive of the Phlx's proposal, however, it recommended several
changes in the proposed regulatory structure applicable to stock index,
currency and currency index warrants. The Comment Letter was submitted
on behalf of the Firms, all of whom are represented to be major
participants in the issuance, underwriting and trading of warrants.
Because the proposed regulatory regime applicable to warrants will, to
some extent, be based upon the rules governing standardized options,
the Comment Letter states that the Firms' comments are driven, in part,
by the fact that fundamental differences exist between warrants and
standardized options which necessitate disparate regulatory treatment
in certain situations.\20\
\19\ See supra note 4. 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. (collectively the
``Firms'').
\20\ The Comment Letter lists several differences which it
perceives exist between warrants and standardized options. Chief
among these are: (1) warrants are separately registered, unsecured
obligations of their issuer while options are issued and guaranteed
by the Options Clearing Corp. (``OCC''); (2) during the prospectus
delivery period, warrant purchasers receive a product-specific
prospectus while options customers receive an options disclosure
document (``ODD'') at the time the account is opened; (3) each
warrant creates a fixed number of outstanding warrants while there
is theoretically no limit to the number of options that may be
issued by OCC; and (4) warrants are traded on an exchange in a
manner similar to stocks which, therefore, translates into superior
price transparency than for listed options.
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First, the Comment Letter suggested amending the Issuer Listing
Standards to eliminate the 25% test or, in the alternative, to adopt
hedging and/or netting standards designed to more accurately reflect
issuer-specific risk.\21\ Because warrants are sold by means of a
registration statement, the Firms believe that adequate disclosure of
the amount of an issuer's outstanding securities could be included in
the prospectus. Furthermore, the Comment Letter points out that issuers
of warrants are traditionally subject to outside evaluation by certain
credit rating agencies, which should assist investors in determining
undue issuer credit risk. Finally, the Firms do not believe the 25%
test bears any resemblance to an issuer's risk exposure since exposure
fluctuates with market changes at any given time and also because the
proposal provides no recognition for offsetting hedges or for warrants
subject to netting.
\21\ As originally proposed, an issuer would have been required
to have a tangible net worth of at least $150 million and the
aggregate original issue price of all of a particular issuer's
warrant offerings (combined with such offerings by its affiliates)
that are listed on a national securities exchange or that are
national market securities traded through NASDAQ were not to exceed
25% of the issuer's net worth (``25% test'').
In response to the Seward & Kissell Letter's comments respecting
issuer listings standards, the Phlx amended the filing to add an
alternative issuer qualification criteria.\22\ Under the new criteria,
an issuer will be required to either: (a) have a minimum tangible net
worth of $250 million; or (b) meet the existing criteria (i.e.,
tangible net worth of $150 million and meet the 25% test).
\22\ See Amendment No. 1.
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The Comment Letter also recommended allowing the use of p.m.
settlement for all American-style warrants exercised anytime except 48
hours prior to expiration, at which time a.m. settlement would be
required. According to the Comment Letter, unlike with listed options
(where OCC is the issuer and runs a balanced book), a warrant issuer
must hedge its exposure to maintain offsetting positions. Upon early
exercise of the warrants, the issuer that has hedged its exposure will
have to take action to ``unwind'' the portion of its hedge relating to
the exercised warrants. The Firms believe that requiring a.m.
settlement on the first day after an investor exercises the warrant
will place additional market risk upon them due to the difficulty in
managing the hedge. This increased hedging cost, the Firms argue, could
result in a higher issuance price for the warrant or could require that
the warrant settlement value date be postponed an additional day, with
warrant holders bearing additional market risk during this period.
In response to the Comment Letter, the Phlx amended its filing to
include a provision permitting p.m. settlement for stock index warrants
except for a short period before expiration.\23\ Under the terms of the
amendment, stock index warrants for which 25% or more of the value of
the underlying index is represented by securities that are traded
primarily in the U.S. shall, by their terms, provide that, on valuation
date, as well as for the two business days prior to valuation date, the
value of the stocks traded primarily in the U.S. which underlie such
warrants shall be determined by reference to the opening prices of such
underlying U.S. securities. For example, if the valuation date for an
issuance of index warrants occurs on a Friday, a.m. settlement must be
utilized for warrants that are valued on the preceding Wednesday or
Thursday, as well as on the valuation date.
\23\ See Amendments No. 2 and 4.
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Third, the Comment Letter recommended creating a special category
of ``warrant eligible'' customers (separate and distinct from options
eligibility criteria), who are authorized to trade warrants even if not
approved to trade options. The Firms believe it is inappropriate to
apply an options regulatory regime to warrants and that doing so may
prevent institutional customers who are not permitted to purchase
options products, yet who nevertheless meet all of the options
eligibility criteria, from purchasing warrants. In this regard, the
Firms propose to create a ``warrant eligible'' category with standards
mimicking those currently required for options approved accounts. As
such, ``warrant-approved'' accounts could purchase warrants, however,
they could not purchase options or other products requiring options
account approval. The Phlx did not amend its filing in response to this
comment.
Fourth, the Comment Letter urges the adoption of a rule permitting
firms to approve for warrant trading those accounts managed by an
investment adviser (``IA'') based upon the IA's representation
concerning the eligibility status of its customers to engage in warrant
trading, even if the underlying documentation relating to the managed
accounts is not provided to the brokerage firms. The Phlx has amended
its proposal to allow member firms to accept the representation of an
investment adviser registered under the Investment Advisers Act of 1940
concerning the eligibility status of its customers to engage in warrant
trading, even if the underlying documentation relating to the managed
account is not provided to the member firm, where the managed account
is for an institutional customer or the investment advisor account
represents the collective investment of a number of persons. The Phlx
states that this will conform the
[[Page 46670]]
handling of warrant accounts to the current practice with respect to
listed options accounts.\24\
\24\ See Amendment No. 1.
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Finally, the Comment Letter addressed the proposed position limits
applicable to warrants. Specifically, the Comment Letter noted that
position limits for warrants would be set at levels that are
approximately 75% of that allowed for similar broad-based indexes. The
Comment Letter recommended establishing position limits for warrants
that were equivalent to those established for listed options, allowing
a hedge exemption similar to listed option procedures and providing a
mechanism for specific waivers or exemptions of warrant position limits
for hedgers, market-makers and broker-dealers comparable to the
procedures in place for listed options. The Phlx did not amend its
filing in response to this comment.
IV. Discussion
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).\25\ Specifically, the
Commission finds that the Exchange's proposal to establish uniform
listing standards for broad-based stock index, currency and currency
index warrants strikes a reasonable balance between the Commission's
mandates under Section 6(b)(5) 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 Phlx's
proposed listing standards for warrants are consistent with the Section
6(b)(5) requirements that rules of an exchange 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.
\25\ 15 U.S.C. Sec. 78f(b)(5) (1982).
The Phlx's proposed generic listing standards for broad-based stock
index warrants, currency and currency indexes set forth a regulatory
framework for the listing of such products.\26\ Generally, listing
standards serve as a means for an exchange 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 to monitor the status and
trading characteristics of that issue to ensure that it continues to
meet the exchange's standards for market depth and liquidity so that
fair and orderly markets can be maintained.
\26\ 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.
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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 a negative market
impact. In addition, these standards should address the special risks
to customers arising from the derivative products.\27\ For the reasons
discussed below, the Commission believes the Phlx's proposal will
provide it with significant flexibility to list index, currency and
currency index warrants, without compromising the effectiveness of the
Exchange's listing standards or regulatory program for such
products.\28\
\27\ 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.
\28\ Issuances of warrants overlying a single currency may
currently be listed for trading without a rule filing provided that
the underlying currency is one of the original seven foreign
currencies approved for options trading: the Australian Dollar,
British Pound, Canadian Dollar, French Franc, German Mark, Japanese
Yen, Swiss Franc and the European Currency Unit. Issuances of
currency warrants overlying any other foreign currency would require
a rule filing pursuant to Section 19(b) of the Act. The Commission
notes that currency index warrants may only be established without a
further rule filing upon an index that has been previously approved
by the Commission pursuant to a Section 19(b) filing. To date, the
only currency index approved pursuant to Section 19(b) is an equal-
weighted index comprised of the British Pound, Japanese Yen and
German Deutsche Mark. See Securities Exchange Act Release No. 31627
(Dec. 21, 1992), 57 FR 62399 (Dec. 30, 1992). Accordingly, any other
currency index (as well as a broad-based stock index) not previously
approved by the Commission would require approval pursuant to
Section 19(b).
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A. Issuer Listing Standards and Product Design
As a general matter, the Commission believes that the trading of
warrants on a stock index, currency or currency index permits investors
to participate in the price movements of the underlying assets, and
allows investors holding positions in some or all of such assets to
hedge the risks associated with their portfolios. The Commission
further believes that trading warrants on a stock index, currency or
currency 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
clearinghouse 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 Exchange's 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. Moreover, the alternative
test addresses the Comment Letter's concerns on the 25% standard.
The Phlx'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 for expiring warrants as well as during the
last two business
[[Page 46671]]
days prior to valuation date.\29\ 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, in accordance with the Comment Letter's suggestions, the
use of p.m. settlement except during the last two business days prior
to a domestic index warrant's valuation date, as well as 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 designing their products.\30\ 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 of 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 Exchange 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 to make appropriate changes including
potentially limiting the number of index warrants with p.m. settlement.
\29\ Currency and currency index warrants are not limited to
a.m. or p.m. settlement.
\30\ Foreign stock market based index warrants may utilize p.m.
settlement throughout their duration.
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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
Phlx 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, in accordance with
Phlx Rule 1024, and that adequate disclosure of the risks of these
products must be made to investors.\31\ In addition, the Phlx 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 Phlx has
addressed adequately several of the potential customer protection
concerns that could arise from the options-like nature of warrants.
\31\ Pursuant to Phlx Rule 1024, all options approved accounts
must receive an ODD, which discusses the characteristic and risks of
standardized options.
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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 Phlx 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, currency and currency 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. The Commission
believes that this will ensure that certain information about the
particular issuance and issuer is publicly available.
As noted above, the Comment Letter indicates that applying the
options disclosure framework to warrants is inappropriate. However, the
Commission believes that the combined approach of making available
general derivative product information (the ODD), product specific
information (the Exchange circular), and issuer specific information
(the prospectus) should provide an effective disclosure mechanism for
these products.
At this time, the Commission does not agree with the proposal
contained in the Comment Letter to create a special ``warrant
eligible'' classification of purchasers. As noted above, index,
currency and currency index warrants are very similar to standardized
options. They are so similar that a customer precluded from trading
options should not avoid the restriction indirectly by being designated
by Exchange rules as eligible for stock index, currency or currency
index warrants. Nevertheless, as the range of exchange-traded
derivative products increases, the SROs might consider in the future as
to whether a new derivatives eligibility classification is appropriate.
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 Exchange has developed
adequate surveillance procedures for the trading of index and currency
warrants. First, new issues of currency warrants will be subject to the
Phlx's existing surveillance procedures applicable to foreign currency
warrants, which the Commission previously has found to be adequate to
surveil for manipulation and other abuses involving the warrant market
and the underlying foreign currencies.\32\
\32\ See Securities Exchange Act Release No. 24555 (June 5,
1987), 52 FR 22570 (June 12, 1987), and Securities Exchange Act
Release No. 26152 (Oct. 3, 1988), 53 FR 39832 (Oct. 12, 1988). The
Commission notes that these surveillance procedures only apply to
the issuance of warrants overlying one of the approved foreign
currencies. See supra note 28. The issuance of warrants upon any
other foreign currency would necessitate a Section 19(b) rule filing
which, among other things, details applicable surveillance
procedures.
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Second, the Exchange 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.\33\ Among these enhanced
surveillance procedures, the Commission notes that issuers will be
required to report to the Exchange 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 Phlx in
its surveillance capacity and help it to detect and deter market
manipulation and other trading abuses.
\33\ In addition, the Commission notes that issuers will be
required to report to the Exchange all trades to unwind a warrant
hedge that are effected as a result of the early exercise of
domestic index warrants. This will enable the Exchange to monitor
the unwinding activity to determine if it was effected in a manner
that violates Exchange or Commission rules.
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Third, the Exchange 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.). \34\
The Commission believes
[[Page 46672]]
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 \35\
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.\36\ 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.\37\ In this regard, the
Phlx 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
Exchange has in place an effective surveillance agreement \38\ with the
primary exchange in the home country in which the security underlying
the ADR is traded; or (2) meets an existing alternative standard for
standardized options trading (e.g., satisfy the 50% U.S. trading volume
test).\39\ 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 Phlx has no surveillance
sharing agreement.
\34\ 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.
\35\ 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 ultimate purchasers for securities. See e.g.,
Securities Exchange Act Release No. 31529 (Nov. 27, 1992).
\36\ The ability to obtain relevant surveillance information,
including, among other things, the identify of the ultimate
purchasers and sellers of securities, is an essential and necessary
component of a comprehensive surveillance sharing agreement.
\37\ In the context of domestic index warrants, the Commission
notes that the U.S. exchanges 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.
\38\ See supra note 35.
\39\ See Securities Exchange Act Release Nos. 31529, 57 FR 57248
(Dec. 3, 1992) and 33555, 59 FR 5619 (Feb. 7, 1994).
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D. Market Impact
The Commission believes that the listing and trading of index
warrants, currency warrants and currency index warrants will not
adversely affect the U.S. securities markets or foreign currency
markets. First, with respect to currency and currency index warrants,
the Commission notes that the interbank foreign currency spot market is
an extremely large, diverse market comprised of banks and other
financial institutions worldwide. That market is supplemented by
equally deep and liquid markets for standardized options and futures on
foreign currencies and options on those futures. An active over-the-
counter market also exists in options, forwards and swaps for foreign
currencies. This minimizes the possibility that Exchange listed
warrants would be used to manipulate the spot currency markets. In
addition, the surveillance procedures for these products should allow
the Exchange to detect and deter potential manipulation involving
currency warrants and currency index warrants.
Second, with respect to index warrants, the Commission notes that
warrants may only be established upon indexes the Commission has
previously determined to be broad-based in the context of index options
or warrant 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 index
options or warrants 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 Phlx'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.
Third, the Exchange 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 Exchange 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.\40\
\40\ The Commission notes that the margin levels for currency
index warrants will be set at a level determined by the Exchange and
approved by the SEC. See Amendment No. 2. 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.
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Fourth, the Phlx has established reasonable position and exercise
limits for stock index warrants, which will serve to minimize potential
manipulation and other market impact concerns.\41\ Contrary to the
views expressed in the Comment Letter, the Commission believes that in
the absence of trading experience with domestic index warrants, it
would be imprudent to establish position limits for positions greater
than those currently applicable to domestic stock index options on the
same index.\42\
\41\ The Commission notes that there are no position or exercise
limits applicable to currency or currency index warrants, although
reporting requirments do apply. Nevertheless, the Commission may
review the need to establish foreign currency position limits if the
size of the currency or currency index warrant market increases
significantly.
\42\ WIth respect to the Comment Letter's suggestion that a
hedge exemption rule be established in order to allow participants
to readily acquire exemptions from the Exchange as needed, the
Commission does not believe that such an approach is appropriate at
this time. The hedge exemption for index options was adopted after
several years experience with index options trading. Until the SROs
gain some experience with domestic index warrant trading, it is
difficult to determine the need for a hedge exemption (i.e., that
speculative limits are insufficient to meet hedging needs).
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V. Conclusion
The Commission believes that the adoption of these uniform listing
and trading standards covering index, currency and currency index
warrants will provide an appropriate regulatory framework for these
products. These standards will also benefit the Exchange by providing
them with greater
[[Page 46673]]
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 or a non-
approved currency or currency index. 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.
The Commission finds good cause for approving Amendments No. 1, 2,
3 and 4 to the proposed rule change prior to the thirtieth day after
the date of publication of notice of filing thereof in the Federal
Register for the following reasons. As discussed below, the changes are
either: (1) Minor and technical in nature; (2) responsive to the
Comment Letter; (3) designed to conform to warrant proposals from other
markets; or (4) modifications to Exchange surveillance procedures.
Accordingly, the amendments do not raise new significant regulatory
issues or are responsive to prior comments. In order to enable the
Exchange to list new index, currency or currency index warrants as soon
as possible, the Commission believes it is necessity and appropriate to
approve the amendments on an accelerated basis.
Amendment No. 1 makes several changes to the filing which are
designed to bring it into conformity with the other options exchanges.
First, it revises Rule 803, Criteria for Listing, to permit alternative
issuer listing qualification criteria (as discussed above under Issuer
Listing Standards and Product Design). Second, it limits the number of
foreign securities that may comprise an underlying stock index. The
Commission notes that the issuer qualification amendment was made in
response to comments received from the Seaward & Kissell Letter and
further believes that both changes provide added flexibility to issuers
without compromising investor protection concerns.
Amendment No. 1 also revises Rule 722 to provide that the proposed
spread and straddle margin treatment for stock index warrants will be
effected as part of a one year pilot program, and to provide that
escrow receipts will be accepted to cover short positions in stock
index warrants. The Commission notes that these changes conform the
margin treatment afforded options and warrants and provide a basis for
evaluating pricing correlations between warrants and options overlying
the same index, currency or currency index.
Finally, Amendment No. 1 provides that the Exchange will distribute
an information circular to its members upon new warrant listings and
that it will permit member firms to accept an IA's representation
concerning the options eligibility status of its customers, as
described above. The Commission notes that both of these practices are
consistent with the treatment of options and, therefore, raise no new
or unique regulatory issues. Accordingly, for the reasons discussed
above relating to each proposed revision of the Amendment, the
Commission believes it is appropriate to approve Amendment No. 1 to the
Exchange's proposal on an accelerated basis.
Amendment No. 2 to the proposal clarifies several issues relating
to a.m. settlement, currency index warrant margin and position
reporting for currency warrants. First, the Amendment clarifies that
a.m. settlement will be used during the 48 hour period prior to
expiration of index warrants.\43\ Second, the Amendment clarifies that
the applicable margin level for currency index warrants will be a
percentage as specified by the Exchange and approved by the Commission.
The Commission notes that this revision is consistent with the
treatment afforded currency index options, where margin levels are
established on a case by case basis. Finally, the Amendment establishes
that index, currency and currency index warrants will be subject to the
same reporting levels. The Commission notes that this revision helps to
provide uniformity in the regulatory treatment of warrants.
Furthermore, because currency and currency index warrants are not
subject to position and exercise limits, the Commission believes that
requiring investors to report to the Exchange when their holdings
exceed specified levels should aid the Exchange in its monitoring for
potential trading abuses involving currency and currency index
warrants. Accordingly, the Commission believes it is appropriate to
approve Amendment No. 2 on an accelerated basis.
\43\ Amendment No. 4 subsequently changes the language of this
provision to require a.m. settlement be used during the two business
days prior to valuation date.
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Amendment No. 3 requires issuers to notify the listing exchange of
any early exercises of index warrants by 4:30 p.m. (New York time) on
settlement date for the warrants. The Commission believes this changes
to the Phlx's surveillance procedures strengthens the Exchange's
monitoring of index warrants. Accordingly, the Commission believes it
is appropriate to approve Amendment No. 3 on an accelerated basis.
Amendment No. 4 clarifies the settlement procedures for index
warrants which are exercised prior to expiration. Specifically, the
Amendment clarifies that a.m. settlement will be required on valuation
date as well as during the last two business days prior to an index
warrant's valuation date. As discussed above, the Commission believes
that the use of a.m. settlement during this period will help to
ameliorate any potential price effects associated with expirations of
derivative index products. Accordingly, the Commission believes it is
appropriate to approve Amendment No. 4 on an accelerated basis.
Therefore, the Commission believes it is consistent with Sections
6(b)(5) and 19(b)(2) of the Act to approve Amendments No. 1, 2, 3 and 4
to the Phlx's proposal on an accelerated basis.
VI. Solicitation of Comments
Interested persons are invited to submit written data, views and
arguments concerning Amendments No. 1, 2, 3 and 4. Persons making
written submissions should file six copies thereof with the Secretary,
Securities and Exchange Commission, 450 Fifth Street, NW., Washington,
DC 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,
NW., Washington, DC. 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 September 28,
1995.
[[Page 46674]]
It therefore is ordered, pursuant to Section 19(b)(2) of the
Act,\44\ that the proposed rule change (SR-Phlx-94-49) is approved, as
amended.\45\ Furthermore, the portion of the rule change relating to
spread margin treatment is approved on a one year pilot program basis,
effective from the date of this Order.
\44\ 15 U.S.C. Sec. 78s(b)(2) (1988).
\45\ The Commission notes that prior to listing any stock index,
currency or currency index warrants, the Exchange will be required
to obtain approval from the staff of the Commission concerning the
Exchange's surveillance procedures applicable to the trading of
warrants.
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\46\
\46\ 17 CFR Sec. 200.30-3(a)(12) (1994).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 95-22106 Filed 9-6-95; 8:45 am]
BILLING CODE 8010-01-M
