[Federal Register Volume 60, Number 193 (Thursday, October 5, 1995)]
[Notices]
[Pages 52234-52241]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-24794]



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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-36296; File No. SR-NASD-95-37]


Self-Regulatory Organizations; Notice of Filing and Order 
Granting Accelerated Approval of Proposed Rule Change and Amendments 
No. 1, 2 and 3 to the Proposed Rule Change by the National Association 
of Securities Dealers, Inc. Relating to Listing and Trading of Broad-
Based Index Warrants on The Nasdaq Stock Market

September 28, 1995.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''), 15 U.S.C. 78s(b)(1), notice is hereby given that on August 
28, 1995, the National Association of Securities Dealers, Inc. 
(``NASD'' or ``Association'') filed with the Securities and Exchange 
Commission (``Commission'' or ``SEC'') the proposed rule change as 
described in Items I, II, and III below, which Items have been prepared 
by the NASD. The NASD filed Amendment No. 1 (``Amendment No. 1'') to 
the proposed rule change on September 22, 1995.\1\ on September 27, 
1995, the NASD filed Amendment No. 2 (``Amendment No. 2'') to the 
proposal.\2\ On September 28, 1995, the NASD filed Amendment No. 3 
(``Amendment No. 3'') to the proposal.\3\ This Order approves the 
proposed rule change, as amended, on an accelerated basis and also 
solicits comments on the proposed rule change, as amended, from 
interested persons.

    \1\ Letter from Joan C. Conley, Corporate Secretary, NASD, to 
Michael Walinskas, SEC, dated September 22, 1995. Amendment No. 1, 
which is superseded, in part, by Amendment No. 2, raises position 
limits on the Russell 2000 Index and S&P MidCap 400 Index (``MidCap 
Index''). It also establishes that Section 13, Liquidation of 
Positions, will apply to short sales in warrants.
    \2\ Letter from T. Grant Callery, Vice President and General 
Counsel, NASD, to Michael Walinskas, SEC, dated September 27, 1995. 
Amendment No. 2 reduces the position limits on the MidCap Index to 
7.5 million warrants.
    \3\ Letter from Joan C. Conley, Corporate Secretary, NASD, to 
Michael Walinskas, SEC, dated September 28, 1995. Amendment No. 3 
clarifies the settlement methodology to be utilized for index 
warrants.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The NASD is proposing several changes to its rules to accommodate 
the trading of the index warrants based on broad-based indexes on The 
Nasdaq Stock Market (``Nasdaq''). The proposed changes augment and 
enhance the Association's regulatory requirements applicable to index 
warrants which were previously approved by the Commission in June 
1992.\4\ In addition, unlike the current regulatory structure for index 
warrants whereby the Commission separately approves each type of index 
warrant for trading (i.e., Hong Kong Index warrants or Nikkei Index 
warrants), the proposed changes streamline the approval process for 
index warrants by providing that an index is eligible to underlie an 
index warrant traded through the facilities of the Nasdaq system once 
the Commission has approved such index to underlie an index warrant or 
option.

    \4\ See Securities Exchange Act Release No. 30773 (June 3, 
1992), 57 FR 24835 (June 11, 1992) (``Index Warrant Approval 
Order'').
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    Specifically, the NASD proposes the following rule amendments. 
First, Section 2(c)(2) of Part III of Schedule D 

[[Page 52235]]
to the NASD's By-Laws is revised to add new listing standards 
applicable to the issuers of index warrants. Previously, issuers of 
index warrants were required to have assets in excess of $100 million. 
Under the revised standards:
    (1) issuers would be required to have a minimum tangible net worth 
in excess of $250 million or, in the alternative, have a minimum 
tangible net worth in excess of $150 million, provided the issuer has 
not issued warrants such that the aggregate original issue price of all 
of the issuer's stock index, currency index, and currency warrant 
offerings (combined with offerings by its affiliates) listed on Nasdaq 
or a national securities exchange exceeds 25% of the issuer's net 
worth;
    (2) the term of the index warrants must provide that unexercised 
in-the-money warrants will be automatically exercised on either the 
delisting date (if the issue is not listed on a national securities 
exchange) or upon expiration;
    (3) for warrant offerings where U.S. stocks constitute 25 percent 
or more of the index value, issuers must use the opening prices (``a.m. 
settlement'') of the U.S. stocks to determine the index warrant 
settlement value for expiring warrants on the final determination of 
settlement value date (``valuation date'') as well as during the two 
business days immediately preceding valuation date \5\;

    \5\ See Amendment No. 3.
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    (4) in instances where the stock index underlying a warrant is 
comprised in whole or in part with securities traded outside the United 
States, the foreign country securities or American Depositary Receipts 
(``ADRs'') thereon that (i) are not subject to a comprehensive 
surveillance agreement, and (ii) have less than 50% of their global 
trading volume in dollar value within the U.S., shall not, in the 
aggregate, represent-more than 20% of the weight of the index, unless 
such index is otherwise approved for warrant or option trading; and
    (5) to assist in the surveillance of index warrant trading, as a 
condition of listing on Nasdaq, issuers would be required to notify the 
NASD of any early warrant exercises by 4:30 p.m., Eastern Standard 
Time, on the day the settlement value for the warrants is determined.
    Second, the proposal adds a new Schedule J to the NASD's By-Laws. 
This schedule consolidates all of the regulatory requirements 
applicable to the conduct of accounts, the execution of transactions, 
and the handling of orders in index warrants listed on Nasdaq and 
exchange-listed stock index warrants, currency index warrants, and 
currency warrants by members who are not members of the exchange on 
which the warrant is listed or traded. In particular, Schedule J 
provides that: (1) All customer accounts trading index warrants, 
currency index warrants, and currency warrants must be approved to 
trade options; \6\ (2) the options suitability rule applies to all 
recommendations to customers involving the purchase or sale of index 
warrants, currency index warrants, and currency warrants; and (3) the 
options rules contained in Article III, Section 33(b) of the NASD's 
Rules of Fair Practice regarding discretionary accounts, the 
supervision of accounts, customer complaints are applicable to index 
warrants, currency index warrants, and currency warrants. In addition, 
Schedule J provides that the NASD's rules governing options 
communications with the public shall apply to communications with the 
public concerning index, currency, and currency index warrants. To 
assist NASD members in complying with the regulatory requirements 
applicable to index warrants, currency index warrants, and currency 
warrants, the NASD proposes to distribute a Notice-to-Members providing 
guidance regarding member firm compliance responsibilities when 
handling transactions in warrants.

    \6\ In this connection, the NASD will permit NASD members to 
accept the representation of an investment adviser registered under 
the Investment Advisers Act of 1940 concerning the eligibility 
status of certain customers to engage in warrant trading even if the 
underlying documentation relating to the managed account is not 
provided to the member. The NASD's position would apply to the 
managed accounts of an institutional customer or where the 
investment adviser account represents the collective investment of a 
number of persons (e.g., an investment club account). Permitting 
member firms to accept the representation of an investment adviser 
in these instances will conform the handling of warrant accounts to 
the current practice for options accounts.
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    In addition, Schedule J provides for position limits, exercise 
limits, and reporting requirements applicable to index warrants. The 
position limits are consolidated position limits, meaning that index 
warrants on the same index on the same side of the market must be 
aggregated for position limit purposes. Specifically, for index 
warrants other than index warrants based on the MidCap Index, the 
position limit is 15 million warrants, provided the initial offering 
price of the warrants was at or below $10. For index warrants based on 
the MidCap Index, the position limit is 7.5 million warrants, provided 
the initial offering price of the warrants was at or below $10.\7\ The 
proposal also contains a provision that equalizes positions in index 
warrants that initially were priced above $10 with those that were 
priced at or below $10. In particular, positions will be equalized by 
dividing the original issue price of the index warrants priced above 
$10 by ten and multiplying this number by the size of the index warrant 
position. For example, if an investor held 100,000 Nasdaq 100 Index 
warrants priced initially at $20, the size of this position for 
position limit purposes would be 200,000, or 100,000 times 20 divided 
by 10.

    \7\ See Amendment No. 2.
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    The exercise limits provide that no investor or group of investors 
acting in concert may, within five consecutive business days, exercise 
more index warrants on the same index on the same side of the market 
than the applicable index warrant position limit. The reporting 
requirements provide that positions of 100,000 or more index warrants 
on the same index on the same side of the market must be reported to 
the Association. Schedule J also contains provisions setting forth the 
NASD's authority to mandate the liquidation of index warrant positions 
in excess of applicable position limits.\8\ In addition, proposed 
Schedule J provides that the NASD may halt or suspend trading in an 
index warrant if it concludes that such action is appropriate in the 
interests of a fair and orderly market and the protection of 
investors.\9\

    \8\ See Amendment No. 1.
    \9\ Among the factors that may be considered by the NASD are the 
following: (1) Trading has been halted or suspended in underlying 
stocks whose weighted value represents 20% or more of the index 
value; (2) the current calculation of the index derived from the 
current market prices of the stocks is not available; and (3) other 
unusual conditions or circumstances detrimental to the maintenance 
of a fair and orderly market are present.
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    Third, the NASD proposes to add a new Section 3(f)(10) to Article 
III, Section 30 of the NASD Rules of Fair Practice governing the margin 
treatment for index warrants, currency index warrants, and currency 
warrants. Specifically, these new requirements, provide that the 
initial and maintenance requirements for long positions in index 
warrants shall be 100% of the full purchase price of the warrants. For 
short positions in index warrants, the margin requirement is 100% of 
the current market value of the warrant plus 15% of the current value 
of the underlying index. The margin requirements for short positions 
can be decreased to the extent that they are out-of-the-money, however, 
the minimum requirement for each such warrant shall not be less than 
the current value of the warrant plus 10% of the current index value.

[[Page 52236]]

    Short sales of currency warrants will follow the margin 
requirements currently applicable to standardized currency options. 
Specifically, the NASD proposes that short sales of warrants on the 
German Mark, French Franc, Swiss Franc, Japanese Yen, British Pound, 
Australian Dollar and European Currency Unit shall each be subject to a 
margin level of 100 percent of the current market value of each such 
warrant plus a four percent ``add-on.'' \10\ The required margin can be 
decreased to the extent that the warrant is out-of-the-money, however, 
the minimum requirement for each such warrant must not be less than the 
current value of the warrant plus .75% (.0075) of the value of the 
underlying currency (or such other percentage as specified by the 
national securities exchange listing the warrant and approved by the 
Commission). The margin required on currency index warrants would be an 
amount as determined by the national securities exchange listing the 
warrant and approved by the Commission.

    \10\ Warrants on the Canadian Dollar would be subject to a one 
percent ``add-on.'' The ``add-on'' required on any other foreign 
currency would be such other percentage as specified by the national 
securities exchange listing the warrant and approved by the 
Commission on a case-by-case basis.
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    The NASD also proposes that its index warrant, currency index 
warrant, and currency warrant margin requirements be permitted offset 
treatment for spread and straddle positions. In this regard, the NASD 
proposes that index, currency, and currency index warrants may be 
offset with either warrants or OCC-issued options on the same index, 
currency, or currency index, respectively, in the same manner that 
standardized index and currency options may be offset with other 
standardized index and currency options. The proposed rules governing 
the margin treatment for spreads and straddles involving index, 
currency, and currency index warrants are proposed to be implemented on 
a one-year pilot basis. The NASD also proposes to allow market 
participants to use escrow receipts to cover a short call position in 
broad-based stock index warrants. Specifically, no margin is required 
for a short position in an index call warrant where the customer 
promptly delivers an escrow receipt, issued by a bank or trust company, 
certifying that the issuer holds for the account of the customer (1) 
cash, (2) cash equivalents, (3) one or more qualified equity 
securities, or (4) a combination thereof.
    Fourth, the proposal makes two minor amendments to the NASD's rules 
that serve to clarify the Association's rules regarding index warrants. 
First, Section 19 of Part I of Schedule D to the NASD's By-Laws is 
amended to clarify that the term Nasdaq National Market System security 
includes all index warrants traded through Nasdaq. Second, the proposal 
replaces language currently contained in a policy of the NASD's Board 
of Governors issued under Article III, Section 2 of the Rule of Fair 
Practice with a cross-reference to new Schedule J. This change is made 
to eliminate duplicative and potentially confusing language in the 
NASD's rules. The text of the proposed rule change is available at the 
Office of the Secretary of the NASD and at the Commission.

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, the NASD included statements 
concerning the purpose of and basis for the purposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. The NASD has prepared summaries, set forth in Sections 
(A), (B), and (C) below, of the most significant aspects of such 
statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    The NASD is submitting this proposed rule change to enhance the 
NASD's regulatory scheme governing index warrants to ensure that, among 
other things, investors in index warrants traded on Nasdaq are 
adequately protected and that the trading of index warrants on Nasdaq 
does not have any adverse market impacts.\11\ To this end, the NASD has 
developed a new Schedule J to its By-Laws that consolidates all of the 
relevant rules, regulations, practices and procedures applicable to 
index warrants trading on Nasdaq and exchange-listed stock index 
warrants, currency index warrants, and currency warrants traded by 
members who are not members of the exchange on which the warrant is 
listed or traded. The NASD also proposes to impose more stringent 
standards on the issuers of index warrants, as well as certain 
requirements as to the terms of the index warrants themselves. Under 
the proposal, all exchange-traded index warrants and foreign currency 
warrants presently outstanding will be grandfathered from these 
provisions. Even though there currently are no index warrants listed on 
Nasdaq, NASD rules provide that issuers of Nasdaq-listed index warrants 
are required to have assets in excess of $100 million and members are 
obligated to comply with the NASD's options rules governing 
suitability, account opening, discretionary accounts, and account 
supervision when handling customer orders in index warrants. The NASD's 
current proposal expands these requirements in the following ways.

    \11\ Due to the current definition of ``security'' in Section 
3(a)(10) of the Act, 15 U.S.C. 78c(a)(10), the NASD, unlike the 
national securities exchanges, does not have authority to list 
issuances of currency and currency index warrants on Nasdaq. The 
NASD is proposing rules, however, that will apply to transactions in 
currency and currency index warrants entered into by NASD members 
(or customers thereof) who are not members of the exchange on which 
the currency or currency index warrant is listed or traded.
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    First, because index warrants are derivative in nature and closely 
resemble index options, the NASD believes it is appropriate to apply to 
index warrants, currency index warrants, and currency warrants the same 
or similar safeguards for customer protection that are applicable to 
exchange-traded standardized options. Accordingly, Schedule J is 
patterned after the NASD's options rules contained in Article III, 
Section 33 of the NASD's Rules of Fair Practice. In particular, 
proposed Sections 3 through 9 of Schedule J impose on index warrants, 
currency index warrants, and currency warrants the options rules 
governing account opening, suitability, discretionary accounts, 
supervision of accounts, customer complaints and communications with 
the public and customers. These provisions will ensure that members are 
adequately monitoring their customer accounts trading index, currency, 
and currency index warrants and that only customers with an 
understanding of these warrants and the financial capacity to bear the 
risks attendant thereto will be permitted to trade these instruments 
based on their broker's recommendation. In addition, as discussed 
above, the proposed margin rules for index, currency, and currency 
index warrants are comparable to those applicable to standardized index 
and currency options. Accordingly, the NASD believes that the special 
concerns attendant to the secondary trading of index warrants on Nasdaq 
have been adequately addressed by the NASD.
    Second, the NASD proposes to increase the listing standards 
applicable to issuers of index warrants to ensure that only substantial 
companies capable of meeting their warrant obligations are able to list 
index warrants on Nasdaq. In particular, by switching from a $100 

[[Page 52237]]
million gross assets standard to a standard where issuers will be 
required to have a minimum tangible net worth in excess of $250 million 
or, in the alternative, have a minimum tangible net worth in excess of 
$150 million, provided the issuer has not issued warrants such that the 
aggregate original issue price of all of the issuer's stock index, 
currency index, and currency warrant offerings (combined with offerings 
by its affiliates) listed on Nasdaq or a national securities exchange 
exceeds 25% of the issuer's net worth, the NASD believes that issuers 
will be better able to satisfy their warrant obligations.
    Third, the NASD proposes to implement several safeguards designed 
to ameliorate any potential adverse market impacts resulting from the 
trading of index warrants. Specifically, the listing standards provide 
that only broad-based indexes can underlie index warrants traded 
through the facilities of the Nasdaq system. Sections 10 and 11 of 
Schedule J provide for consolidated position and exercise limits for 
index warrants on the same index on the same side of the market and 
Section 12 imposes a reporting requirement for positions of 100,000 
warrants on the same index on the same side of the market. In addition, 
the listing standards provide that the settlement values for stock 
index warrants overlying indexes with U.S. components greater than 25 
percent of the value of the index must be determined with reference to 
the opening prices of the U.S. securities in such indexes on valuation 
date as well as during the two business days immediately preceding 
valuation date.\12\ The NASD's proposal also provides for the 
notification to the NASD of early exercises of stock index warrants and 
disclosure of certain trading activities by issuers in response to such 
early exercises.

    \12\ See Amendment No. 3.
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    The proposal also imposes requirements with respect to the 
percentage weighting of a multi-country or foreign stock index that 
must be subject to an effective surveillance sharing arrangement and 
establishes procedures governing the halting or suspension of trading 
in an index warrant. The NASD believes that these requirements will 
facilitate the orderly unwinding of index warrant positions and related 
cash market positions upon the expiration of index warrants and enhance 
the ability of the NASD to surveil trading in index warrants and 
related markets.
    Lastly, the NASD proposes to add Section 2(c)(2)(K) of Part III to 
Schedule D of the NASD's By-Laws that will streamline the approval 
process for index warrants. This section provides that once a broad-
based index has been approved by the SEC to underlie an index warrant 
or option, the index is then eligible to underlie an index warrant 
traded on Nasdaq without further Commission review or approval, 
provided the NASD has obtained all the surveillance sharing agreements 
mandated by the Commission. The NASD believes that this self-
effectuating listing process for index warrants will promote market 
efficiency and allow the NASD to better meet the demands of investors 
in the Nasdaq marketplace. At the same time, the NASD does not believe 
that this approval process will compromise the protection of investors 
in any way because the Commission will already have approved the 
underlying index to underlie an index option or warrant.
    Accordingly, the NASD believes the proposed rule change is 
consistent with Section 15A(b)(6) of the Act. Section 15A(b)(6) 
requires that the rules of a national securities association be 
designed to prevent fraudulent and manipulative acts and practices, to 
promote just and equitable principles of trade, to foster cooperation 
and coordination with persons engaged in regulation, clearing, 
settling, processing information with respect to, and facilitating 
transactions in securities, to remove impediments to and perfect the 
mechanism of a free and open market and a national market system and in 
general to protect investors and the public interest. Listing index 
warrants on Nasdaq will also facilitate members and investors desiring 
to trade index warrants in a dealer environment. In addition, the sales 
practice, margin, and position and exercise limit rules, among others, 
that will be applicable to index, currency, and currency index warrants 
will serve to protect investors and promote the public interest.

B. Self-Regulatory Organization's Statement on Burden on Competition

    The NASD believes that the proposed rule change will not result in 
any burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants, or Others

    Comments were neither solicited nor received.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    The NASD has requested that the proposed rule change given 
accelerated effectiveness pursuant to Section 19(b)(2) of the Act in 
view of the Commission's previous approval of substantially identical 
rule changes submitted by the other SROs.\13\ These other proposals 
were subject to the full notice and comment period and, in fact, were 
modified partly in response to a comment letter received on the 
proposals on behalf of several large broker-dealers.\14\ The NASD also 
notes that the Commission has approved amendments to every other SRO's 
stock index warrant proposal on an accelerated basis. In addition, the 
NASD notes that a number of issuers, including Nasdaq listed companies, 
have expressed an interest in listing index warrants on Nasdaq.

    \13\ On August 29, 1995, the Commission approved uniform listing 
and trading guidelines for stock index, currency and currency index 
warrants for the New York Stock Exchange, Pacific Stock Exchange, 
Philadelphia Stock Exchange, American Stock Exchange and Chicago 
Board Options Exchange. See Securities Exchange Act Release Nos. 
36165, 36166, 36167, 36168 and 36169 (Aug. 29, 1995), respectively.
    \14\ See Letter from Paul M. Gottlieb, Seward & Kissel, to 
Jonathan G. Katz, Secretary, Commission, dated January 10, 1995 
(``Comment Letter'' or ``Seward & Kissel Letter''). The Seward & 
Kissel Letter was submitted on behalf of PaineWebber Inc., Bear, 
Stearns & Co. Inc., Lehman Brothers Inc., Smith Barney Inc., Salomon 
Brothers Inc., Morgan Stanley & Co. Inc., and Hambrecht & Quist Inc.
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    Accordingly, because the NASD's proposed regulatory structure for 
index warrants mirrors standards already approved by the Commission for 
other SROs, the NASD believes no regulatory purpose would be served by 
delaying the ability of Nasdaq to list index warrants. Similarly, the 
NASD believes that investors in The Nasdaq Stock Market should be 
afforded the opportunity to trade index warrants. Therefore, the NASD 
believes that failure to grant accelerated effectiveness of the 
proposed rule change would result in an unfair burden on competition 
and regulatory confusion in that the margin and sales practice rules 
applicable to index and currency warrants will not be uniform among 
U.S. securities markets. In fact, absent accelerated approval, 
customers of NASD members who are not members of an exchange will be 
subject to one regulatory regime for warrants while customers of 
members who are exchange members will be subject to another regime.

[[Page 52238]]


IV. Findings and Conclusions

    The Commission finds that the proposed rule change is consistent 
with the requirements of the Act and the rules and regulations 
thereunder applicable to a national securities exchange, and, in 
particular, the requirements of Section 15A(b)(6).\15\ Specifically, 
the Commission finds that the NASD's proposal to establish uniform 
listing standards for broad-based stock index warrants, as well as 
standards applicable to the trading of stock index, currency and 
currency index warrants by NASD members (or customers thereof) who are 
not members of the exchange on which the warrant is listed or traded, 
strikes a reasonable balance between the Commission's mandates under 
Section 15A(b)(6) to remove impediments to and perfect the mechanism of 
a free and open market and a national market system, while protecting 
investors and the public interest. In addition, the NASD's proposed 
listing standards for warrants are consistent with the Section 
15A(b)(6) requirements that rules of a registered securities 
association be designed to prevent fraudulent and manipulative acts, to 
promote just and equitable principles of trade, and are not designed to 
permit unfair discrimination among issuers.

    \15\ 15 U.S.C. 78o-3(b)(6) (1988).
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    The NASD's proposed generic listing standards for broadbased stock 
index warrants set forth a regulatory framework for the listing of such 
products.\16\ Generally, lifting standards serve as a means for an 
exchange or securities association to screen issuers and to provide 
listed status only to bona fide issuances that will have sufficient 
public float, investor base, and trading interest to ensure that the 
market has the depth and liquidity necessary to maintain fair and 
orderly markets. Adequate standards are especially important for 
warrant issuances given the leveraged and contingent liability they 
represent. Once a security has been approved for initial listing, 
maintenance criteria allow an exchange or securities association to 
monitor the status and trading characteristics of that issue to ensure 
that it continues to meet the exchange's or securities association's 
standards for market depth and liquidity so that fair and orderly 
markets can be maintained.

    \16\ The Commission notes that warrants issued prior to this 
approval order will continue to be governed by the rules applicable 
to them at the time of their listing.
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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 negative market impact. 
In addition, these standards should address the special risks to 
customers arising from the derivative products.\17\ For the reasons 
discussed below, the Commission believes the NASD's proposal will 
provide it with significant flexibility to list stock index warrants on 
NASDAQ, without compromising the effectiveness of the NASD's listing 
standards or regulatory program for such products.\18\

    \17\ Pursuant to Section 6(b)(5) of the Act, the Commission is 
required to find, among other things, that trading in warrants will 
serve to protect investors and contribute to the maintenance of fair 
and orderly markets. In this regard, the Commission must predicate 
approval of any new derivative product upon a finding that the 
introduction of such derivative instrument is in the public 
interest. Such a finding would be difficult for a derivative 
instrument that served no hedging or other economic function, 
because any benefits that might be derived by market participants 
likely would be outweighed by the potential for manipulation, 
diminished public confidence in the integrity of the markets, and 
other valid regulatory concerns. As discussed below, the Commission 
believes warrants will serve an economic purpose by providing an 
alternative product that will allow investors to participate in the 
price movements of the underlying securities in addition to allowing 
investors holding positions in some or all of such securities to 
hedge the risks associated with their portfolios.
    \18\ See supra note 11.
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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 permits investors to participate in the price 
movements of the underlying securities, and allows investors holding 
positions in some or all of such securities to hedge the risks 
associated with their portfolios. The Commission further believes that 
trading warrants on a stock index provides investors with an important 
trading and hedging mechanism that is designed to reflect accurately 
the overall movement of the component securities.
    Warrants, unlike standardized options, however, do not have a 
clearing house guarantee but are instead dependent upon the individual 
credit of the issuer. This heightens the possibility that an exerciser 
of warrants may not be able to receive full cash settlement upon 
exercise. This additional credit risk, to some extent, is reduced by 
the NASD's proposed issuer listing standards that require an issuer to 
have either: (a) a minimum tangible net worth of $250 million; or (b) a 
minimum tangible net worth of $150 million, provided that the issuer 
does not have (including as a result of the proposed issuance) issued 
outstanding warrants where the aggregate original issue price of all 
such stock index, currency and currency index warrant offerings (or 
affiliates) that are listed on a national securities exchange or traded 
through the facilities of NASDAQ is in excess of 25% of the warrant 
issuer's net worth. Furthermore, financial information regarding the 
issuers of warrants will be disclosed or incorporated in the prospectus 
accompanying the offering of the warrants.
    The NASD's proposal will provide issuers flexibility by allowing 
them to utilize either a.m. or p.m. settlement, provided, however, 
domestic index warrants (i.e., warrants based on indexes for which 25% 
or more of the index value is represented by securities traded 
primarily in the U.S.) (``domestic index warrants'') are required to 
utilize a.m. settlement of expiring warrants on valuation date 
(''valuation date'') as well as during the last two business days prior 
to valuation date. The Commission continues to believe that a.m. 
settlement significantly improves the ability of the market to 
alleviate and accommodate large and potentially destabilizing order 
imbalances associated with the unwinding of index-related positions. 
Nevertheless, the use of p.m. settlement except on valuation date, and 
during the last two business days prior to the valuation date, strikes 
a reasonable balance between ameliorating the price effects associated 
with expirations of derivative index products and providing issuers 
with flexibility in designating their products.\19\

    \19\ Foreign stock market based index warrants may utilize p.m. 
settlement throughout their duration.
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    In this context, the Commission notes that unlike standardized 
index options whose settlement times are relatively uniform, index 
warrants are issuer-based products, whose terms are individually set by 
the issuer. In addition, while options may have unlimited open 
interest, the number of warrants on a given index is fixed at the time 
of issuance. Accordingly, it is not certain that there will be a 
significant number or warrants in indexes with similar components 
expiring on the same day. This may reduce the pressure from liquidation 
of warrant hedges at settlement. Nevertheless, the Commission expects 
the NASD to monitor this issue and, should significant market effects 
occur as a result of early exercises from p.m. settled index warrants, 
would expect it 

[[Page 52239]]
to make appropriate changes including potentially limiting the number 
of index warrants with p.m. settlement.

B. Customer Protection

    Due to their derivative and leveraged nature, and the fact that 
they are a wasting asset, many of the risks of trading in warrants are 
similar to the risks of trading standardized options. Accordingly, the 
NASD has proposed to apply its options customer protection rules to 
warrants. In particular, the Commission notes that warrants may only be 
sold to options approved accounts capable of evaluating and bearing the 
risks associated with trading in these instruments, and that adequate 
disclosure of the risks of these products must be made to 
investors.\20\ In addition, the NASD will apply the options rules for 
suitability, discretionary accounts, supervision of accounts and 
customer complaints to transactions in warrants. By imposing the 
special suitability and disclosure requirements noted above, the 
Commission believes the NASD has addressed adequately several of the 
potential customer protection concerns that could arise from the 
options-like nature of warrants.

    \20\ Pursuant to Article III, Section 33(b)(16) of the Rules of 
Fair Practice, all options approved accounts must receive an ODD, 
which discusses the characteristics and risks of standardized 
options.
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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 NASD has adequately addressed this issue by proposing to 
distribute a circular to its members that will call attention to the 
specific risks associated with stock index warrants that should be 
highlighted to potential investors. In addition, the issuer listing 
guidelines described above will ensure that only substantial companies 
capable of meeting their warrant obligations will be eligible to issue 
warrants. These requirements will help to address, to a certain extent, 
the lack of a clearinghouse guarantee for index warrants. Finally, 
warrant purchasers will receive a prospectus during the prospectus 
delivery period, which should ensure that certain information about the 
participating issuance and issuer is publicly available. The Commission 
believes that the combined approach of making available general 
derivative product information (the ODD), product specific information 
(the NASD circular), and issuer specific information (the prospectus) 
should provide an effective disclosure mechanism for these products.

C. Surveillance

    In evaluating proposed rule changes to list derivative instruments, 
the Commission considers the degree to which the market listing the 
derivative product has the ability to conduct adequate surveillance. In 
this regard, the Commission notes that the NASD has developed adequate 
surveillance procedures for the trading of index and currency warrants. 
First, the NASD has developed enhanced surveillance procedures to apply 
to domestic stock index warrants which the Commission believes are 
adequate to surveil for manipulation and other abuses involving the 
warrant market and component securities.\21\ Among these enhanced 
surveillance procedures, the Commission notes that issuers will be 
required to report to the NASD on settlement date the number and value 
of domestic index warrants subject to early exercise the previous day. 
The Commission believes that this information will aid the NASD in its 
surveillance capacity and help it to detect and deter market 
manipulation and other trading abuses.

    \21\ In addition, the Commission notes that issuers will be 
required to report to the NASD certain trades (as specified in the 
NASD's surveillance procedures) to unwind a warrant hedge that are 
effected as a result of the early exercise of domestic index 
warrants. This will enable the NASD to monitor the unwinding 
activity to determine if it was effected in a manner that violates 
NASD or Commission rules.
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    Second, the NASD has developed adequate surveillance procedures to 
apply to foreign stock index warrants (i.e., less than 25% of the index 
value is derived from stocks traded primarily in the U.S.).\22\ The 
Commission believes that the ability to obtain information regarding 
trading in the stocks underlying an index warrant is important to 
detect and deter market manipulation and other trading abuses. 
Accordingly, the Commission generally requires that there be a 
surveillance sharing agreement \23\ in place between an exchange 
listing or trading a derivative product and the exchange(s) trading the 
stocks underlying the derivative contract that specifically enables the 
relevant markets to surveil trading in the derivative product and its 
underlying stocks.\24\ Such agreements provide a necessary deterrent to 
manipulation because they facilitate the availability of information 
needed to fully investigate a potential manipulation if it were to 
occur.\25\ In this regard, the NASD will require that no more than 20% 
of an Index's weight may be comprised (upon issuance and thereafter) of 
foreign securities (or ADRs thereon) that do not satisfy one of the 
following tests: (1) The NASD has in place an effective surveillance 
agreement \26\ with the primary exchange in the home country in which 
the security underlying the ADR is traded; or (2) meets an existing 
alternative standard available for standardized options trading (e.g., 
satisfy the 50% U.S. trading volume test).\27\ The Commission believes 
that this standard will ensure that index warrants are not listed upon 
foreign indexes whose underlying securities trade on exchanges with 
whom the NASD has no surveillance sharing agreement.

    \22\ Each prior issuance of a foreign stock market based index 
warrant is subject to specific surveillance procedures. These 
procedures are generally tailored to the individual warrant issuance 
and are based upon several factors involving the primary foreign 
market, including the existence of surveillance or information 
sharing agreements.
    \23\ The Commission believes that a surveillance sharing 
agreement should provide the parties with the ability to obtain 
information necessary to detect and deter market manipulation and 
other trading abuses. Consequently, the Commission generally 
requires that a surveillance sharing agreement require that the 
parties to the agreement provide each other, upon request, 
information about market trading activity, clearing activity, and 
the identity of the purchasers for securities. See e.g., Securities 
Exchange Act Release No. 31529 (Nov. 27, 1992).
    \24\ The ability to obtain relevant surveillance information, 
including, among other things, the identity of the purchasers and 
sellers of securities, is an essential and necessary component of a 
comprehensive surveillance sharing agreement.
    \25\ In the context of domestic index warrants, the Commission 
notes that the U.S. exchanges and the NASD are members of the 
Intermarket Surveillance Group (``ISG''), which was formed to, among 
other things, coordinate more effectively surveillance and 
investigative information sharing arrangements in the stock and 
options markets. See Intermarket Surveillance Group Agreement, July 
14, 1983. The most recent amendment to the ISG Agreement, which 
incorporates the original agreement and all the amendments made 
thereafter, was signed by ISG members on January 29, 1990. See 
Second Amendment to the ISG Agreement.
    \26\ See supra note 23.
    \27\ See Securities Exchange Act Release Nos. 31529, 57 FR 57248 
(Dec. 3, 1992) and 33555, 59 FR 5619 (Feb. 7, 1994).
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D. Market Impact

    The Commission believes that the listing and trading of index 
warrants will not adversely affect the U.S. securities markets. First, 
with respect to index warrants, the Commission notes that warrants may 
only be established upon indexes the Commission has previously approved 
as broad-based in the context of index options or warrant 

[[Page 52240]]
trading. As part of its review of a proposal to list an index 
derivative product, the Commission must find that the trading of index 
options or warrants will serve to protect investors, promote the public 
interest, and contribute to the maintenance of fair and orderly 
markets. Accordingly, the Commission does not believe that the issuance 
of index warrants upon previously approved broad-based stock indexes 
will adversely impact the underlying component securities. In addition, 
because index warrants are issued by various individual issuers who set 
their own terms, it is likely that expirations among similar index 
products will be varied, thereby reducing the likelihood that unwinding 
hedge activities would adversely affect the underlying cash market. 
Finally, as discussed above, the Commission believes the NASD's 
enhanced surveillance procedures applicable to stock index warrants are 
adequate to surveil for manipulation and other abuses involving the 
warrant market, component securities and issuer hedge unwinding 
transactions.
    Second, the NASD has proposed margin levels for stock index and 
currency warrants equivalent to those in place for stock index and 
currency options. The Commission believes these requirements will 
provide adequate customer margin levels sufficient to account for the 
potential volatility of these products. In addition, options margin 
treatment is appropriate given the options-like market risk posed by 
warrants. The Commission notes that the customer spread margin 
treatment applicable to warrants is subject to a one year pilot 
program. This will allow the NASD to analyze the pricing relationships 
between listed options and warrants on the same index in order to 
determine whether to revise or approve on a permanent basis the 
proposed spread margin rules.\28\

    \28\ The Commission notes that the margin levels for currency 
index warrants will be set at a level determined by the NASD and 
approved by the SEC. Issuances of warrants listed prior to the 
approval of this order will continue to apply the margin level 
applicable to them at the time of their listing.
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    Third, the NASD has established reasonable position and exercise 
limits for stock index warrants, which will serve to minimize potential 
manipulation and other market impact concerns.

V. Conclusion

    The Commission believes that the adoption of these uniform listing 
and trading standards for broad-based index warrants will provide an 
appropriate regulatory framework.\29\ These standards will also benefit 
the NASD by providing them with greater flexibility in structuring 
warrant issuances and a more expedient process for listing warrants 
without further Commission review pursuant to Section 19(b) of the Act. 
As noted above, additional Commission review of specific warrant 
issuances will generally only be required for warrants overlying any 
non-approved broad-based index that has not been previously approved by 
the Commission for warrant or options trading. If Commission review of 
a particular warrant issuance is required, the Commission expects that, 
to the extent that the warrant issuance complies with the uniform 
criteria adopted herein, its review should generally be limited to 
issues concerning the newly proposed index. This should help ensure 
that such additional Commission review could be completed in a prompt 
manner without causing any unnecessary delay in listing new warrant 
products.

    \29\ As noted above, the NASD does not have the authority to 
list currency or currency index warrant issuances. See supra note 
11. Nevertheless, the regulatory framework adopted herein as also 
applicable to stock index, currency and currency index warrants 
which are traded by NASD members (or customers thereof) who are not 
members of the exchange on which the warrant is listed or traded.
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    Finally, the Commission finds good cause for approving the proposed 
rule change and Amendments No. 1, 2 and 3 to the proposed rule change 
prior to the thirtieth day after the date of publication of notice 
thereof in the Federal Register in order to allow the NASD to begin 
listing index warrants without delay. As discussed above, the proposal 
is substantially identical to those submitted by the other SROs.\30\ 
These other index warrant proposals were subject to the full notice and 
comment period and, as discussed above, were modified in response to 
the Seward & Kissell Letter. Furthermore, Amendment No. 1 to the 
proposal ensures that NASD members do not accept and/or execute an 
order to sell short any index warrants from any person that is the 
subject of an NASD order to liquidate a position in excess of 
applicable position limits. The Commission notes that this change also 
comports with rules currently in effect at other SROs applicable to the 
liquidation of index warrant positions in excess of applicable position 
limit rules. Amendment No. 2 to the proposal reduces the position 
limits on the MidCap Index to 7.5 million warrants. The Commission 
notes that this number is consistent with the level approved for the 
American Stock Exchange. Accordingly, the amendment does not raise any 
new or unique regulatory issues. Finally, Amendment No. 3 clarifies 
that opening price settlement will be utilized for warrants that are 
valued on valuation date or on either of the two business days 
preceding valuation date. The Commission notes that this change brings 
the NASD's proposal into conformity with those of the other exchanges 
and, therefore, does not believe the amendment raises any new or unique 
regulatory issues. For these reasons, the Commission believes it is 
consistent with Sections 15A(b)(6) \31\ and 19(b)(2) \32\ of the Act to 
approve the proposed rule change and Amendments No. 1, 2 and 3 to the 
proposal on an accelerated basis.

    \30\ See supra note 13.
    \31\ 15 U.S.C. Sec. 78o-3(b)(6) (1988).
    \32\ 15 U.S.C. Sec. 78s(b)(2) (1988).
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VI. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning the foregoing. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549. 
Copies of the submission, all subsequent amendments, all written 
statements with respect to the proposed rule change that are filed with 
the Commission, and all written communications relating to the proposed 
rule change between the Commission and any person, other than those 
that may be withheld from the public in accordance with the provisions 
of 5 U.S.C. 552, will be available for inspection and copying in the 
Commission's Public Reference Section, 450 Fifth Street, N.W., 
Washington, D.C. Copies of such filing will also be available for 
inspection and copying at the principal office of the above-mentioned 
self-regulatory organization. All submissions should refer to the file 
number in the caption above and should be submitted by October 26, 
1995.
    It therefore is ordered, pursuant to Section 19(b)(2) of the 
Act,\33\ that the proposed rule change (SR-NASD-95-37) is approved, as 
amended, with the portion of the rule change relating to spread margin 
treatment being approved on a one year pilot program basis, effective 
beginning September 28, 1995.

    \33\ 15 U.S.C. Sec. 78s(b)(2) (1988).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\34\

    \34\ 17 CFR Sec. 200.30-3(a)(12) (1994).

[[Page 52241]]

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Jonathan G. Katz,
Secretary.
[FR Doc. 95-24794 Filed 10-4-95; 8:45 am]
BILLING CODE 8010-01-M