[Federal Register Volume 60, Number 173 (Thursday, September 7, 1995)]
[Notices]
[Pages 46653-46660]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-22109]
-----------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-36165; File No. SR-NYSE-94-41]
Self-Regulatory Organizations; New York Stock Exchange, Inc.;
Order Approving Proposed Rule Change and Notice of Filing and Order
Granting Accelerated Approval of Amendment No. 1 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 9, 1994, the New York Stock Exchange, Inc. (``NYSE'' 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. 35095 (Dec. 12,
1994), 59 FR 65552.
\4\ See Letter from Paul M. Gottlieb, Seward & Kissell, to
Jonathan G. Katz, Secretary, Commission, dated January 10, 1995
(``Comment Letter'' or ``Seward & Kissell Letter'').
---------------------------------------------------------------------------
The Exchange subsequently filed Amendment No. 1 (``Amendment No.
1'') to the proposal on August 25, 1995. Amendment No. 1 proposes to
amend the filing in order to respond to the Comment Letter, the
Commission's comments and to conform certain of the Exchange's proposed
rules and policies to those filed by other securities markets. This
order approves the proposal, as amended.
II. Description of the Proposal
The NYSE proposes to establish uniform rules for the listing and
trading of stock index, currency and currency index warrants.\5\
Paragraphs 703.15 (Foreign Currency Warrants and Currency Index
Warrants) and 703.17 (Stock Index Warrants Listing Standards) of the
Listed Company Manual would be amended to provide uniform listing
criteria for index,
[[Page 46654]]
currency and currency index warrants. First, warrant 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 through NASDAQ exceeds 25% of the issuer's net
worth.\6\
\5\ 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).
\6\ See Amendment No. 1. The Exchange amended this provision in
response to the Seward & Kissell Letter.
---------------------------------------------------------------------------
Second, the proposal requires that each unexercised in-the-money
warrant 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 at expiration
of the warrants, as well as the two business days preceding
expiration.\7\ Fourth, a new paragraph has been added to Para. 703.17
of the Listed Company Manual to prohibit ``non-U.S. component
securities'' from constituting more than 20 percent of the weighted
value of an index stock group that underlies a stock index warrant. For
purposes of this provision, the term ``non-U.S. component security''
means, the stock, or an American Depositary Receipt on the stock, of a
company that is organized outside of the United States, where more than
50 percent of the dollar value of the global trading volume of the
security occurs outside of the United States and that are not subject
to a comprehensive surveillance agreement with the primary foreign
market.\8\ Finally, the Exchange proposes to add Rule 414(n), which is
designed to assist in the surveillance of index warrant trading.
Specifically, the Exchange will require issuers of stock index warrants
to notify the Exchange of any early exercises. For domestic index
warrants, this notice must occur by 4:30 p.m. (New York time) on the
day that the settlement value for the warrants is determined.\9\
\7\ See Amendment No. 1. The Exchange amended its proposal in
response to the Seward & Kissell Letter and will require the use of
opening prices in calculating index warrant settlement values during
the 48 hours prior to expiration. Before then, an issuer may use
either opening or closing prices.
\8\ See infra note 37 and accompanying text.
\9\ See Amendment No. 3.
Rule 431 (``Rule 431''), the NYSE 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.'' \10\ The margin
required on currency index warrants would be an amount as determined by
the Exchange and approved by the Commission.\11\ 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 subsections (f)(2)(F)(i), (f)(2)(G)(ii) and
(f)(2)(G)(iii) of Rule 431, to the extent that such rules concern
spread and straddle positions in warrants, be subject to a one year
pilot basis.\12\
\10\ 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 26.
\11\ See infra note 26.
\12\ 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.
---------------------------------------------------------------------------
Paragraph (f)(2)(H)(iv) of Rule 431 would be amended to permit the
carrying of ``short'' option positions against the use of letters of
guarantee or (in the case of a call) ``escrow receipts,'' without the
need for margin. The amendment proposes to expand that provision to
include stock index warrants as well as options. The use of ``escrow
receipts'' to offset a short call option or warrant position would be
new to the Exchange's margin rules, which currently only allow the use
of letters of guarantee. However, the margin rules of other U.S.
options exchanges provide that no margin is required on a short call
option where a customer has delivered to the firm carrying the
customer's account a satisfactory escrow receipt. Amendment No. 1 would
add the escrow receipt concept to the Exchange's margin rules in
respect of margin on options, as well as on stock index warrants, and
would do so in a way that generally parallels the permissible use of
letters of guarantee under the Exchange's margin rules.
Proposed Rule 414(f) 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 pursuant to Exchange Rule 721. Furthermore, proposed Rules
414(g)-(k) require that the option rules pertaining to supervision of
accounts, suitability, discretionary account trading, customer
complaints and communications to customers be applied to transactions
in 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.
Proposed Rule 414(c) provides 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.\13\ The
rule provides that warrants with an original issue price of greater
than ten dollars will be weighted more heavily than warrants with an
original issue price of ten dollars or less in calculating position
limits.\14\ The rule also gives the Exchange the authority to require
the liquidation of a position in stock index warrants that is in excess
of
[[Page 46655]]
the position limits set forth in the rule, and Commentary to the rule
establishes procedures for allowing limited exceptions to the position
limits.
\13\ See infra note 39.
\14\ 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.
---------------------------------------------------------------------------
Proposed Rule 414(d) provides for exercise limits on stock index
warrants 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 has proposed Rule 414(c)(v) which
establishes 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.\15\ Finally, proposed
Rule 414(e) requires that the trading halt provisions of Rule 717 shall
be applied to the trading of stock index warrants.
\15\ See Amendment No. 1.
---------------------------------------------------------------------------
Upon Commission approval of the foregoing rule amendments, the
Exchange proposes that it will only file rule changes for specific
stock index warrant issuances where there is no corresponding option or
warrant on the same underlying stock index already listed on a national
securities exchange or included for quotation on 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.\16\
\16\ See infra note 26.
---------------------------------------------------------------------------
III. Comments Received
The Commission received one letter in response to its request for
comments on the NYSE proposal.\17\ The Comment Letter was generally
supportive of the NYSE'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.\18\
\17\ 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. (correctively the
``Firms'').
\18\ 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.
---------------------------------------------------------------------------
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.\19\ 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.
\19\ 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 & Kissel Letter's comments respecting
issuer listings standards, the NYSE amended the filing to add an
alternative issuer qualification criteria.\20\ 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).
\20\ See Amendment No. 1.
---------------------------------------------------------------------------
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 Firm's 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 NYSE amended its filing to
include a provision permitting p.m. settlement for stock index warrants
except for a short period before expiration.\21\ 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 be 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.
\21\ See Amendment No. 1.
---------------------------------------------------------------------------
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
[[Page 46656]]
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 NYSE 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 NYSE 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 represents
the collective investment of a number of persons. The NYSE states that
this will conform the handling of warrant accounts to the current
practice with respect to listed options accounts.\22\
\22\ See Amendment No. 1.
---------------------------------------------------------------------------
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 exemptions 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 NYSE 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).\23\ 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 NYSE'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.
\23\ 15 U.S.C. 78f(b)(5) (1982).
---------------------------------------------------------------------------
The NYSE'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.\24\ 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.
\24\ 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 a negative market
impact. In addition, these standards should address the special risks
to customers arising from the derivative products.\25\ For the reasons
discussed below, the Commission believes the NYSE'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.\26\
\25\ 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.
\26\ 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).
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.
[[Page 46657]]
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 NYSE'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 days prior to valuation date.\27\ 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.\28\ 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.
\27\ Currency and currency index warrants are not limited to
a.m. or p.m. settlement.
\28\ Foreign stock market based index warrants may utilize p.m.
settlement throughout their duration.
---------------------------------------------------------------------------
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
NYSE 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 the trading in these instruments, in accordance
with NYSE Rule 721, and that adequate disclosure of the risks of these
products must be made to investors.\29\ In addition, the NYSE 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 NYSE had
addressed adequately several of the potential customer protection
concerns that could arise from the options-like nature of warrants.
\29\ Pursuant to NYSE Rule 726, all options approved accounts
must receive an ODD, which discusses the characteristic 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 NYSE had 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
NYSE'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
[[Page 46658]]
involving the warrant market and the underlying foreign currencies.\30\
\30\ See Securities Exchange Act Release No. 24555 (June 5,
1987), 52 FR 22570 (June 12, 1987), and Securities 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 26. 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.
---------------------------------------------------------------------------
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.\31\ 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 NYSE in
its surveillance capacity and help it to detect and deter market
manipulation and other trading abuses.
\31\ 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.
---------------------------------------------------------------------------
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.).\32\
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 \33\ 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.\34\ 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.\35\ In this regard, the NYSE 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 \36\ 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).\37\
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 NYSE has no surveillance
sharing agreement.
\32\ 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.
\33\ 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).
\34\ The ability to obtain relevant surveillance information,
including, among other things, the identity of the ultimate
purchasers and sellers of securities, is an essential and necessary
component of a comprehensive surveillance sharing agreement.
\35\ 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.
\36\ See supra note 33.
\37\ 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, 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 option 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 would 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 that NYSE'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.\38\
\38\ 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. 1. 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.
[[Page 46659]]
Fourth, the NYSE has established reasonable position and exercise
limits for stock index warrants, which will serve to minimize potential
manipulation and other market impact concerns.\39\ 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.\40\
\39\ The Commission notes that there are no position or exercise
limits applicable to currency or currency index warrants, although
reporting requirements 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.
\40\ 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).
---------------------------------------------------------------------------
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 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 Amendment No. 1 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 necessary and appropriate to approve the
amendment on an accelerated basis.
Amendment No. 1 proposes to make the following changes to the Index
Warrant Filing:
Changes to Trading Rules
A definition of ``cross currency'' would be added to Rule
414(a)(ii).
The position limit rule (Rule 414(c)(i)) would be amended
to provide that, in determining compliance with position limits,
``aggregate stock index warrant position'' refers to warrants ``on the
same side of the market''.
A new paragraph 414(c)(v) (``Reports of Index Warrant
Positions'') would be added to require members and member organizations
to report aggregate positions in excess of 100,000 warrants.
The Index Warrant Filing prescribes the use of opening
prices in determining settlement values for all settlement dates. This
Amendment No. 1 would amend Paragraph 414(l) (``Settlement Values'') to
require the use of opening prices in respect of the calculation of
settlement values on the day of expiration or on the two business days
prior to expiration. Before then, an issuer may use either opening or
closing prices in calculating settlement values.
A new paragraph 414(n) would be added to require the
reporting of changes in the number of outstanding warrants due to early
warrant exercises.
Changes to Margin Rules
A new paragraph would be added to Paragraph (f)(2)(C) of
Rule 431 (``Margin Requirements'') in order to define ``call'' and
``put'' in the currency, currency index and stock index warrant
context.
A new element would be added to the definition of ``index
group value'' (see Paragraph (f)(2)(C) of Rule 431): In calculating the
index group value, one must multiply by the index value (as in the
Index Warrant Filing), and divide by any applicable divisor for which
the warrant's prospectus may provide (a new addition).
Paragraph (f)(2)(D)(i) of Rule 431 contains a chart of
initial, maintenance and minimum margin requirements. The currency
warrant section of that chart would be amended so as to list the margin
requirements for specific currencies. The currency index warrant
section would be amended to provide that the Exchange will determine
currency index warrant margin requirements on a case-by-case basis.
The Index Warrant Filing proposes to provide margin
advantages to certain option and warrant positions (i.e., certain
spread and straddle positions) by adding second and third paragraphs to
Paragraph (f)(2)(F)(1). This Amendment No. 1 would revise the
permissible offset positions and restate those paragraphs to make them
easier to read.
Two paragraphs would be deleted from Paragraph (f)(2)(H).
The Index Warrant Filing proposes those paragraphs for the purpose of
addressing margin on ``short'' stock index warrant positions where the
holder of the position has hedged by replicating the underlying index
with appropriate positions in the component securities. The paragraphs
would be replaced by the ``letter of guarantee'' and ``escrow receipt''
provisions discussed in the next three bullets.
Paragraph (f)(2)(H)(iv) (which the Index Warrant Filing
proposes to renumber as (f)(2)(H)(v)) of Rule 431) would be amended
(although it was not amended in the Index Warrant Filing). That
paragraph permits the carrying of ``short'' option positions against
the use of letters of guarantee or (in the case of a call) escrow
receipts, without the need for margin. The amendment proposes to expand
that provision to include stock index warrants as well as options.
The use of ``escrow receipts'' to offset a position
carried short would be new to the Exchange's margin rules, which
currently only allow the use of letters of guarantee. However, the
margin rules of other United States options exchanges provide that no
margin is required on a call option where a customer has delivered to
the firm carrying the customer's account a satisfactory escrow receipt.
Amendment No. 1 would add the escrow receipt concept to the Exchange's
margin rules in respect of margin on options, as well as on stock index
warrants, and would do so in a way that generally parallels the
permissible use of letters of
[[Page 46660]]
guarantee under the Exchange's margin rules.
The definition of two terms that are found in existing
paragraph (f)(2)(H)(iv) of Rule 431 would be amended. The changed
definitions would apply in the ``letter of guarantee'' context, as well
as in the ``escrow receipt'' context.
The definition of ``qualified security'' would change to
``a security listed on a national securities exchange'', rather than
``a security that meets the listing criteria of the Exchange or of the
American Stock Exchange''.
The definition of ``cash equivalents'' would change to
``securities issued or guaranteed by the United States and having a
maturity of two years or less'', rather than ``those instruments
referred to in section 220.8(a)(3)(ii) of Regulation T''.
The changes to both definitions follow similar changes that the
American Stock Exchange has heretofore effected.
Paragraph (f)(2)(K) of Rule 431 would be amended to
specify that the Exchange may specify higher margin for ``warrants''
(stated generically) if the Exchange deems circumstances to warrant
higher margin.
New Supplementary Material .20 would be added to Rule 431
to specify that the Exchange will subject the spread and straddle
margin rules that the Index Warrant Filing proposes to add to
paragraphs (f)(2)(F)(i), (f)(2)(G)(ii) and (f)(2)(G)(iii) of Rule 431
to a one-year pilot program. The Exchange would submit to the
Commission three months prior to the expiration of the pilot programs a
report analyzing the price relationship between listed warrants and
options on similar stock indexes.
Changes to Listing Standards
The ``net worth''/``asset'' test applicable to issuers of
currency, currency index or stock index warrants would be amended. (See
paragraph (a) of Para. 703.15 of the Listed Company Manual in respect
of currency and currency index warrants and paragraph (a) of Para.
703.17 of the Listed Company Manual in respect of stock index
warrants.) Under the new test, an issuer may satisfy the test if it has
minimum tangible net worth in excess of $250 million. Alternatively, as
in the Index Warrant Filing, the issuer may have minimum tangible net
worth in excess of $150 million if its total currency, currency index
and stock index warrants do not exceed 25 percent of its net worth.
Para. 703.15 and Para. 703.17 of the Listed Company Manual
would limit the term of currency, currency index and stock index
warrants to between one and five years.
A new paragraph would be added to Para. 703.17 of the
Listed Company Manual to prohibit ``non-United States component
securities'' that are not subject to comprehensive surveillance
agreements from constituting more than 20 percent of the weighted value
of an index stock group that underlies a stock index warrant.
Finally, the Index Warrant Filing proposes to introduce Rule 414(h)
(``Suitability''), which would limit trading by customers in currency,
currency index or stock index warrants to options-approved accounts. In
the case of an institutional account or an investment club or other
collective account, the Exchange would allow a member organization to
accept the representation of a registered investment adviser as to the
eligibility of the institution or collective investment group, even if
the managed account is lacking the underlying documentation.
As mentioned above, because 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, the Commission
believes it is appropriate to approve Amendment No. 1 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 Amendment No. 1 to the
NYSE's proposal on an accelerated basis.
VI. Solicitation of Comments
Interested persons are invited to submit written data, views and
arguments concerning Amendment No. 1. 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.
It therefore is ordered, pursuant to Section 19(b)(2) of the
Act,\41\ that the proposed rule change (SR-NYSE-94-41) 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, ending
August 29, 1996.
\41\ 15 U.S.C. 78s(b)(2) (1988).
---------------------------------------------------------------------------
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\42\
\42\ 17 CFR Sec. 200.30-3(a)(12) (1994).
---------------------------------------------------------------------------
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 95-22109 Filed 9-6-95; 8:45 am]
BILLING CODE 8010-01-M
