[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