[Federal Register Volume 67, Number 124 (Thursday, June 27, 2002)]
[Rules and Regulations]
[Pages 43234-43247]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-16211]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 231 and 241

[Release Nos. 33-8107; 34-46101; File No. S7-23-02]


Commission Guidance on the Application of Certain Provisions of 
the Securities Act of 1933, the Securities Exchange Act of 1934, and 
Rules Thereunder to Trading in Security Futures Products

AGENCY: Securities and Exchange Commission.

ACTION: Interpretation; request for comments.

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SUMMARY: The Commission is publishing its views regarding the 
application of certain provisions of the federal securities laws to 
trading in security futures products. We also are soliciting comment.

DATES: Effective Date: The guidance is effective on June 27, 2002.

ADDRESSES: Comments should be submitted in triplicate to Jonathan G. 
Katz, Secretary, Securities and Exchange Commission, 450 5th Street, 
NW., Washington, DC 20549-0609. Comments also may be submitted 
electronically at the following E-mail address: [email protected]. 
All comment letters should refer to File No. S7-23-02; this file number 
should be included on the subject line if E-mail is used. All comments 
received will be available for public inspection and copying in the 
Commission's Public Reference Room, 450 5th Street, NW., Washington, DC 
20549-0102. Electronically submitted comment letters will be posted on 
the

[[Page 43235]]

Commission's Internet site (http://www.sec.gov).\1\
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    \1\ We do not edit personal, identifying information, such as 
name or e-mail addresses, from electronic submissions. Submit only 
information you wish to make publicly available.

FOR FURTHER INFORMATION CONTACT: With respect to discussions concerning 
Securities Act and director, officer, and principal stockholder issues 
administered by the Division of Corporation Finance, contact Robert 
Plesnarski, Special Counsel (Securities Act Rule 144) or Anne 
Krauskopf, Special Counsel (rules under Exchange Act Section 16), (202) 
942-2900, Office of Chief Counsel, Division of Corporation Finance, 
Securities and Exchange Commission, 450 Fifth Street, NW., Washington, 
DC 20549-0402.
    With respect to discussions concerning mergers and acquisitions 
issues administered by the Division of Corporation Finance, contact 
Pamela Carmody, Special Counsel, (202) 942-2920, Office of Mergers & 
Acquisitions, Division of Corporation Finance, Securities and Exchange 
Commission, 450 Fifth Street, NW., Washington, DC 20549-0303.
    With respect to general questions about the interpretive positions 
expressed by the Division of Corporation Finance in this release, 
contact N. Sean Harrison, Special Counsel, (202) 942-2910, Office of 
Rulemaking, Division of Corporation Finance, Securities and Exchange 
Commission, 450 Fifth Street, NW., Washington, DC 20549-0310.
    With respect to discussions concerning market supervision issues 
administered by the Division of Market Regulation contact Theodore 
Lazo, Senior Special Counsel, or Andrew Shipe, Special Counsel, (202) 
942-0160, Office of Market Supervision, Division of Market Regulation, 
Securities and Exchange Commission, 450 Fifth Street, NW., Washington, 
DC 20549-1001.
    With respect to discussions concerning trading practices issues 
administered by the Division of Market Regulation contact James 
Brigagliano, Assistant Director, Nancy Oremland, Special Counsel 
(Regulation M and Exchange Act Rule 14e-5), Kevin Campion, Special 
Counsel (Exchange Act Rule 14e-4), Joan Collopy, Special Counsel 
(Exchange Act Rule 10b-18), or Greg Dumark, Special Counsel (Exchange 
Act Rule 10a-1 and Rule 3b-3), (202) 942-0772, Office of Trading 
Practices, Division of Market Regulation, Securities and Exchange 
Commission, 450 Fifth Street, NW., Washington, DC 20549-1001.
    With respect to discussions concerning other broker-dealer issues 
administered by the Division of Market Regulation contact Catherine 
McGuire, Chief Counsel, Paula Jenson, Deputy Chief Counsel, Kenneth 
Rosen, Special Counsel, or Christina McGlosson, Special Counsel, (202) 
942-0073, Office of Chief Counsel, Division of Market Regulation, 
Securities and Exchange Commission, 450 Fifth Street, NW., Washington, 
DC 20549-1001.

SUPPLEMENTARY INFORMATION:

I. Background

    On December 21, 2000, Congress enacted the Commodity Futures 
Modernization Act of 2000 (``CFMA''),\2\ addressing the regulation of 
security futures products.\3\ Security futures products are securities 
for purposes of the federal securities laws, including the Securities 
Act of 1933 (``Securities Act'') and the Securities Exchange Act of 
1934 (``Exchange Act''), and are ``futures'' for purposes of the 
Commodity Exchange Act (``CEA'').\4\ Because these products are both 
securities and futures, the CFMA established a framework for the joint 
regulation of these products by the Securities and Exchange Commission 
(``SEC'' or ``Commission'') and the Commodity Futures Trading 
Commission (``CFTC'').
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    \2\ See Pub. L. 106-554, 114 Stat. 2763.
    \3\ See Exchange Act section 3(a)(56) (15 U.S.C. 78c(a)(56)), 
Securities Act Section 2(a)(16) (15 U.S.C. 77b(a)(16)), and CEA 
section 1a(32) (7 U.S.C. 1a(32)) define ``secruity futures product'' 
as a security future or an option on a security future.
    \4\ Exchange Act section 3(a)(10) (15 U.S.C. 78c(a)(10)) defines 
a ``security'' to include a security future. The Securities Act 
defines a ``security'' to include a security future in section 
2(a)(1) (15 U.S.C. 77b(a)(1)). The term ``security future'' is 
defined in Exchange Act section 3(a)(55) and in CEA section 1a(31) 
(7 U.S.C. 1a(31)) as a contract of sale for future delivery of a 
single security or of a narrow-based security index. See also 
Securities Act section 2(a)(16) (15 U.S.C. 77b(a)(16)).
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    In creating this framework, the CFMA exempted security futures 
products, as well as certain security futures products intermediaries 
and markets, from certain provisions of the Securities Act, the 
Exchange Act, and the CEA, and directed the Commission and the CFTC to 
coordinate in certain aspects the regulation of dually regulated 
persons.\5\ Accordingly, security futures products must be traded on 
trading facilities and through intermediaries that are registered with 
both the Commission and the CFTC. Given this new regulatory framework, 
various industry participants have requested guidance regarding the 
application of certain provisions of the federal securities laws to 
trading in security futures products.
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    \5\ Specifically, certain markets and intermediaries that are 
registered with only the CFTC may register with the SEC by 
submitting a written notice that is effective upon filing. Exchange 
Act Secs. 6(g) and 15(b)(11) (15 U.S.C. 78f(g) and 78o(b)(11)). Cf. 
CEA Secs. 5f and 4f(a)(2) (7 U.S.C. 7b-1 and 6f(a)(2)). A ``notice-
registered'' (as opposed to a fully registered) broker-dealer is 
exempt from provisions specified in section 15(b)(11)(B) of the 
Exchange Act. A ``notice-registered'' exchange is exempt from 
provisions specified in section 6(g)(4) of the Exchange Act, and 
certain floor brokers on such exchanges are exempt from broker-
dealer registration and the provisions specified in section 
15(b)(12) of the Exchange Act. The CFMA also requires the 
Commission, in consultation with the CFTC, to issue rules, 
regulations, or orders as necessary to avoid duplicative or 
conflicting regulations applicable to firms that are subject to all 
of the provisions of the Exchange Act and the CEA with respect to 
the treatment of customer funds, securities, or property, 
maintenance of books and records, financial reporting, or other 
financial responsibility rules involving security futures products. 
See Exchange Act section 15(c)(3)(B) [15 U.S.C. 78o(c)(3)(B)]; CEA 
section 4d(c) (7 U.S.C. 6d(c)).
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    Section II.A. below addresses some of the questions that may arise 
under certain statutory provisions and rules administered by the 
Commission's Division of Corporation Finance. Section II.B. addresses 
some of the questions that may arise under certain statutory provisions 
and rules administered by the Commission's Division of Market 
Regulation. Because security futures products are new products, the 
guidance provided is based on how we expect markets in these products 
to operate. As these markets develop and we learn more about their 
operations and security futures products themselves, we may need to 
revisit some of the guidance provided today or provide guidance on 
additional issues.\6\
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    \6\ In addition, some of the guidance provided in this release 
relates to security futures instead of all security futures 
products. As noted above, security futures products are a broader 
set of instruments that include options on security futures as well 
as security futures themselves. See supra note 3. Should the 
Commission in coordination with the CFTC permit the trading of such 
instruments in the future, see section 6(h)(6) of the Exchange Act 
(15 U.S.C. 78f(h)(6)), at that time, the Commission could look at 
the function of such instruments to determine whether this guidance 
for security futures is appropriate for options on security futures.
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II. Discussion

A. Guidance on Statutory Provisions and Rules Administered by the 
Division of Corporation Finance

1. Securities Act and Director, Officer, and Principal Stockholder 
Issues

a. Securities Act Registration and Exemptions From Registration: 
Securities Act Rule 144

    Every offer or sale of a security in interstate commerce or by use 
of the mails must either be registered under the Securities Act or 
exempt from

[[Page 43236]]

registration.\7\ Securities Act Rule 144 \8\ provides a nonexclusive 
safe harbor for the unregistered resale of restricted \9\ and other 
securities held by affiliates of an issuer, as well as for the 
unregistered resale of restricted securities by non-affiliates of the 
issuer. The Rule sets forth specific standards that, if met, permit 
persons who hold such securities to sell them publicly without being 
deemed to be ``underwriters'' under the Securities Act \10\ and in 
reliance on the Securities Act section 4(1) exemption from 
registration.\11\
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    \7\ See section 5 of the Securities Act (15 U.S.C. 77e).
    \8\ 17 CFR 230.144.
    \9\ The term ``restricted securities'' is defined in Rule 
144(a)(3) (17 CFR 230.144(a)(3)).
    \10\ Section 2(a)(11) of the Securities Act (15 U.S.C. 
77b(a)(11)) defines an ``underwriter'' as ``[a]ny person who has 
purchased from an issuer with a view to, or offers or sells for an 
issuer in connection with, the distribution of any security, or 
participates or has a direct or indirect participation in any such 
undertaking, or participates or has a participation in the direct or 
indirect underwriting of any such undertaking * * *'' The definition 
applies to any person. No distinction is made between professional 
securities dealers and individual investors; any person who performs 
one of the specified functions in relation to an offering of 
securities is an underwriter within the meaning of section 2(a)(11).
    \11\ Securities Act section 4(1) (15 U.S.C. 77d(1)) states that 
the section 5 registration requirements shall not apply to 
transactions by any person other than an issuer, underwriter, or 
dealer.
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    The CFMA amended the Securities Act in the following manner:
     It amended Section 2(a)(1) \12\ to include security 
futures products within the definition of ``security.''
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    \12\ 15 U.S.C. 77b(a)(1).
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     It added section 3(a)(14) \13\ to exempt the offer and 
sale of a security futures product from the registration requirements 
of Section 5 if the security futures product is: (1) Traded on a 
national securities exchange or a national securities association 
registered under section 15A(a) of the Exchange Act \14\ and (2) 
cleared by a clearing agency that is either registered under section 
17A of the Exchange Act \15\ or exempt from registration under section 
17A(b)(7) of the Exchange Act.\16\
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    \13\ 15 U.S.C. 77c(a)(14).
    \14\ 15 U.S.C. 78o-3(a).
    \15\ 15 U.S.C. 78q-1.
    \16\ 15 U.S.C. 78q-l(b)(7).
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     It amended section 2(a)(3) \17\ to ensure that security 
futures products could not be used by an issuer,\18\ its affiliates 
\19\ or underwriters to circumvent the registration requirements of 
Section 5 with respect to the issuer's securities underlying the 
security futures product. As amended, Section 2(a)(3) provides ``[a]ny 
offer or sale of a security futures product by or on behalf of the 
issuer of the securities underlying the security futures product, an 
affiliate of the issuer, or an underwriter, shall constitute a contract 
for sale of, sale of, offer for sale, or offer to sell the underlying 
securities.'' Accordingly, a transaction in a security futures product 
on a security of an issuer by such persons also is a transaction in the 
issuer's underlying security that must be registered unless an 
exemption from registration is available.\20\
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    \17\ 15 U.S.C. 77b(a)(3).
    \18\ The term ``issuer'' is defined in section 2(a)(4) of the 
Securities Act and includes ``every person who issues or proposes to 
issue any security * * *'' (15 U.S.C. 77b(a)(4)).
    \19\ An ``affiliate'' of an issuer is defined as a ``person that 
directly, or indirectly through one or more intermediaries, 
controls, or is controlled by, or is under common control with, such 
issuer'' (17 CFR 230.405).
    \20\ All security futures establish obligations on the purchaser 
and seller of the security futures to either: (i) Deliver the 
underlying securities (in the case of a seller of a security future) 
or accept delivery of the underlying securities (in the case of a 
purchaser of a security future); or (ii) make or accept a cash 
payment at maturity of the security future to settle any gains or 
losses based on the difference between the settlement price of the 
security future on the last trading day and the price of the 
security future when the security future was originated. The terms 
of the security future dictate whether it is settled by physical 
delivery of the underlying securities or by cash payment.
    Issues related to settlement method are raised throughout this 
interpretive release. However, settlement method may or may not 
affect the application of particular statutory provisions or rules. 
This release delineates where settlement method would affect the 
guidance provided. The Commission typically does not view settlement 
method of a derivative product as determinative of whether such 
product is or is not a security. See, e.g., infra note 97 (citing 
Caiola amicus curiae brief).
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    Q1: May an affiliate of an issuer rely upon Rule 144 in connection 
with the offer or sale of securities of that issuer that occurs by 
virtue of the affiliate's offer or sale of a security future?
    A1: Yes. Section 2(a)(3) provides that the offer or sale of the 
security future by the affiliate also is a concurrent offer or sale of 
the underlying securities. Accordingly, the concurrent offer or sale of 
the underlying securities would either have to be registered or satisfy 
the conditions of an exemption from registration. The affiliate may 
rely on Rule 144 to establish the availability of the section 4(1) 
exemption.
    Q2: May a person who is not an affiliate of the issuer rely upon 
Rule 144 in connection with the offer or sale of restricted securities 
of the issuer that occurs by virtue of the person's offer or sale of a 
security future?
    A2: Yes. If the non-affiliate is an ``underwriter'' of the 
underlying securities, its offer or sale of the security future also is 
a concurrent offer or sale of the underlying securities. Accordingly, 
the concurrent offer or sale of the underlying securities would either 
have to be registered or satisfy the conditions of an exemption from 
registration. The non-affiliate seller of restricted securities must, 
therefore, establish that it is not an ``underwriter'' of the 
underlying securities. The non-affiliate seller may rely on Rule 144 to 
establish that it is not an ``underwriter'' of the securities.
    Q3: In analyzing whether a seller of securities that are sold by 
virtue of the sale of a security future may rely on Rule 144 in 
connection with that sale, when should the sale of the underlying 
securities be deemed to have occurred?
    A3: The transaction in the underlying securities is deemed to have 
occurred at the same time as the transaction in the related security 
future. Accordingly, in determining the ability to rely on Rule 144, a 
seller should assess that reliance at the time of the sale of the 
security future.\21\
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    \21\ The provision in section 2(a)(3) stating that ``(a)ny offer 
or sale of a security futures product by or on behalf of the issuer 
of the securities underlying the security futures product, an 
affiliate of the issuer, or an underwriter, shall constitute a 
contract for sale of, sale of, offer for sale, or offer to sell the 
underlying securities(,)'' applies regardless of whether a security 
future calls for physical delivery of the underlying security or 
cash settlement.
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    Q4: How should a seller of a security future assess his or her 
reliance on Rule 144 in connection with the offer or sale of the 
securities underlying that security future?
    A4: The seller should analyze the transaction for purposes of Rule 
144 as if it were a transaction in the underlying securities 
themselves.
    Q5: May a non-affiliate settle a security future transaction with 
restricted securities?
    A5: A non-affiliate may settle a security future transaction with 
restricted securities only if it could rely upon Rule 144 to offer and 
sell the underlying restricted securities at the time it offered and 
sold the security future.
    Q6: What information should be provided in the Form 144 filed for 
securities of the issuer that underlie a security future?
    A6: The Form 144 should be completed to cover the sale of 
underlying securities. Persons filing the Form 144 should make 
reference to the security future in the ``Remarks'' section. For 
example, disclosure could read: ``This Form 144 reflects the intended 
deemed sale of 10,000 shares of ABC issuer's securities that underlie 
(describe security future's material terms).''

[[Page 43237]]

b. Disclosure Requirements and Short Swing Profit Recovery: Exchange 
Act Section 16

    The CFMA amended section 16 of the Exchange Act so that it covers 
ownership of, and transactions in, security futures products.\22\ 
Section 16 applies to every person who is the beneficial owner of more 
than 10% of any class of equity security registered under section 12 of 
the Exchange Act, and each officer and director (collectively 
``insiders'') of the issuer of such security. Generally:
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    \22\ Exchange Act section 16(f) (15 U.S.C. 78p(f)).
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     Section 16(a) requires an insider to file an initial 
report with the Commission disclosing his or her beneficial ownership 
of all equity securities of the issuer upon becoming an insider. To 
keep this information current, section 16(a) also requires insiders to 
report changes in such holdings with respect to each month in which 
such a change occurs.\23\
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    \23\ Exchange Act section 16(a) (15 U.S.C. 78p(a)).
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     Section 16(b) provides the issuer (or shareholders suing 
on behalf of the issuer) a private right of action to recover from an 
insider any profit realized by the insider from any purchase and sale 
(or sale and purchase) of any equity security of the issuer within any 
period of less than six months.\24\
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    \24\ Exchange Act section 16(b) (15 U.S.C. 78p(b)).
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     Section 16(c) makes it unlawful for an insider to sell any 
equity security of the issuer if the insider: (1) Does not own the 
security sold; or (2) owns the security, but does not deliver it 
against the sale within specified time periods.\25\

    \25\ Exchange Act section 16(c) (15 U.S.C. 78p(c)).
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    The following responses address how section 16 would apply to 
security futures in some common situations.\26\
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    \26\ These examples and other examples in this section are for 
purposes of section 16 of the Exchange Act only and do not address 
any other issues under the Exchange Act or the Securities Act. For a 
discussion of the Securities Act, see Section II.A.1.a.
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    Q7: Section 16 applies to every person who is directly or 
indirectly the beneficial owner of more than ten percent of any class 
of equity security (other than an exempted security) registered under 
section 12 of the Exchange Act.\27\ Exchange Act Rule 16a-1(a)(1) \28\ 
provides that for purposes of determining whether a person is a 
``beneficial owner'' of more than ten percent of any class of equity 
securities, the term ``beneficial owner'' shall mean any person who is 
deemed a ``beneficial owner'' pursuant to section 13(d) of the Exchange 
Act and the rules thereunder.\29\ Would the equity securities 
underlying a security future be counted for purposes of determining 
whether the purchaser of the security future is a ``beneficial owner'' 
of more than ten percent of a class of equity security?
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    \27\ 15 U.S.C. 78l.
    \28\ 17 CFR 240.16a-1(a)(1).
    \29\ See infra Section II.A.2.
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    A7: Yes. A person is deemed to be the beneficial owner of the 
equity securities underlying a security future that requires physical 
settlement \30\ of the long security future if the security future is 
held within 60 days of the last trading day of the security future.\31\ 
However, the purchaser of a cash-settled security future (i.e., a 
security future that, by its terms, must be settled by a cash payment) 
is not deemed to beneficially own the securities underlying that 
security future for purposes of determining whether the purchaser is a 
``beneficial owner'' of more than ten percent of the underlying class 
of equity security, because he or she does not have the right to 
acquire beneficial ownership of the underlying security.\32\
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    \30\ See supra note 20.
    \31\ The last trading day is the day on which the security 
future terminates trading, i.e., the last day in which an open 
position in a security future, either a long or short position, can 
be closed or liquidated either by buying or selling an opposite 
position. Any security future that has not been liquidated by the 
close of trading for that security future on the last trading day 
must be settled pursuant to the terms of the security future.
    \32\ See infra Section II.A.2 (discussing the application of the 
beneficial ownership rules of Regulation 13D).
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    Q8: Is a security future on an equity security or a narrow-based 
security index \33\ a ``derivative security'' under the Section 16 
rules?
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    \33\ The term ``narrow-based security index'' is defined in 
section 3(a)(55) of the Exchange Act [15 U.S.C. 78c(a)(55)].
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    A8: Yes. Exchange Act Rule 16a-1(c) \34\ generally defines the term 
``derivative securities'' as ``any option, warrant, convertible 
security, stock appreciation right or similar right with an exercise or 
conversion privilege at a price related to an equity security, or 
similar securities with a value derived from the value of an equity 
security,'' subject to specific exclusions. A security future on an 
equity security or a narrow-based security index would be a ``similar 
security with a value derived from the value of an equity security'' 
and thus a ``derivative security'' within the meaning of Rule 16a-1(c), 
regardless of whether the security future calls for physical or cash 
settlement.
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    \34\ 17 CFR 240.16a-1(c).
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    Q9: Exchange Act Rule 16a-1(b) \35\ defines a ``call equivalent 
position'' as a derivative security position that increases in value as 
the value of the underlying equity security increases, including, but 
not limited to, a long convertible security, a long call option, or a 
short put option position. Is the purchase of a security future by an 
insider, or a long security future position, a ``call equivalent 
position?''
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    \35\ 17 CFR 240.16a-1(b).
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    A9: Yes. Because the purchaser of a security future, regardless of 
whether the security future calls for cash or physical settlement, 
would benefit from an increase in value of the underlying equity 
security, the purchase of a security future establishes a call 
equivalent position.
    Q10: Exchange Act Rule 16a-1(h) \36\ defines a ``put equivalent 
position'' as a derivative security position that increases in value as 
the value of the underlying equity decreases, including, but not 
limited to, a long put option or a short call option position. Is the 
sale of a security future by an insider, or a short security future 
position, a put equivalent position?
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    \36\ 17 CFR 240.16a-1(h).
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    A10: Yes. Because the seller of a security future, regardless of 
whether the security future calls for cash or physical settlement, 
would benefit from a decrease in value in the underlying equity 
security, the sale of a security future establishes a put equivalent 
position.
    Q11: Exchange Act Rule 16b-6(a) \37\ states that the establishment 
of, or increase, in a call equivalent position, or liquidation of, or 
decrease, in a put equivalent position shall be deemed a purchase of 
the underlying security for purposes of section 16(b). Conversely, Rule 
16b-6(a) states that the establishment of, or increase, in a put 
equivalent position, or liquidation of, or decrease, in a call 
equivalent position shall be deemed a sale of the underlying securities 
for purposes of section 16(b). How would purchases and sales of 
security futures be subject to matching for Section 16(b) short-swing 
profit recovery purposes?
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    \37\ 17 CFR 240.16b-6(a).
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    A11: The purchase of a security future (``call equivalent 
position'') would be matchable with any of the following transactions 
within any period of less than six months:
     Any disposition of the equity security underlying the 
security future;
     Any liquidation or decrease in a ``call equivalent 
position'' on the same class of equity security underlying the security 
future; or
     Any establishment or increase of a ``put equivalent 
position'' on the same class of equity security underlying the security 
future.


[[Page 43238]]


The sale of a security future (``put equivalent position'') would be 
matchable with any of the following transactions within any period of 
less than six months:
     Any acquisition of the equity security underlying the 
security future;
     Any liquidation or decrease in a ``put equivalent 
position'' on the same class of equity security underlying the security 
future; or
     Any establishment or increase of a ``call equivalent 
position'' on the same class of equity security underlying the security 
future.
    Examples. For purposes of the following four examples, assume that 
the common stock of Company XYZ is registered under section 12 of the 
Exchange Act.
    Example 1: On January 3, 2003, W, an officer of Company XYZ, 
purchases 10,000 shares of XYZ common stock. On September 3, 2003, W 
purchases 100 December delivery security futures on XYZ common stock. 
Each security future is on 100 shares of XYZ common stock. This 
purchase establishes a ``call equivalent position'' with respect to 
10,000 shares of XYZ common stock. On November 3, 2003, W sells 10,000 
shares of XYZ common stock. Interpretation: W's September purchase of 
the security futures would be matchable with W's November sale of the 
XYZ shares. Exchange Act Rule 16b-6(c)(2) \38\ would apply to the 
determination of recoverable profits.
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    \38\ 17 CFR 240.16b-6(c)(2). Exchange Act Rule 16b-6(c)(2) sets 
forth the methods for determining the profits recoverable under 
section 16(b) from short-swing transactions involving derivative 
securities with different characteristics but related to the same 
underlying security (e.g., the purchase and sale of call options 
with different strike prices and expiration dates), and from short-
swing transactions involving derivative securities and the 
underlying security. Under Rule 16b-6(c)(2), profits from short-
swing transactions involving derivative securities having different 
characteristics but related to the same underlying security, or 
involving derivative securities and the underlying security, cannot 
exceed the difference in price of the underlying security on the 
date of purchase or sale and the date of sale or purchase.
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    Example 2: On January 3, 2003, W purchases 100 September delivery 
security futures on XYZ common stock. On April 3, 2003, W sells call 
options on 5,000 shares of XYZ common stock. Interpretation: W's 
January purchase of the security futures established a ``call 
equivalent position'' with respect to 10,000 shares of XYZ common 
stock. W's subsequent sale of the call options established a ``put 
equivalent position'' with respect to 5,000 shares of XYZ common stock 
and is matchable with his purchase of 50 of the September delivery 
security futures.
    Example 3: For purposes of this example, assume that W owns 10,000 
shares of XYZ common stock. On January 3, 2003, W sells 100 June 
delivery security futures on XYZ common stock. On April 3, 2003, W 
sells put options overlying 10,000 shares of XYZ common stock. 
Interpretation: W's January sale of the security futures established a 
``put equivalent position'' with respect to 10,000 shares of XYZ common 
stock. W's subsequent sale of the put options established a ``call 
equivalent position'' (W is obligated to purchase the XYZ shares 
underlying the put options if the holder of the options exercises them) 
and is matchable with his January sale of the security futures.
    Example 4: On January 3, 2003, W purchases 100 September delivery 
security futures on XYZ common stock. On February 10, 2003, W purchases 
10,000 shares of XYZ common stock. On September 5, 2003, W sells 100 
September delivery security futures on XYZ common stock, to offset \39\ 
the security futures purchased in January. Interpretation: Because W's 
sale of the security futures occurred more than six months after both 
his January purchase of the security futures and his February purchase 
of the XYZ common stock, the offsetting sale would not be matchable 
with either purchase. However, the offsetting sale would be matchable 
with W's purchase of the XYZ shares in February, if it occurred within 
six months of the February purchase, and it would be matchable with 
either the January or February purchase (depending upon which 
transaction had the lowest purchase price) if it occurred within six 
months of the January purchase.\40\
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    \39\ Offset refers to the method of closing or liquidating an 
outstanding long or short security future position through an 
opposite trade (i.e., an equal and opposite transaction to the one 
that opened the position). Offset will occur only if the purchase or 
sale matches the original security future transaction with respect 
to the underlying security, number of security futures, and delivery 
month. Once a party has offset his or her outstanding security 
future position, the party has no further obligations with respect 
to the original transaction or the offsetting transaction.
    \40\ See, for example, Smolowe v. Delendo Corp., 136 F.2d 231 
(2d Cir. 1943), cert. denied 320 U.S. 751 (1943), regarding ``lowest 
price in highest price out'' profit computation. Under this method, 
recoverable profit is computed by matching the highest sale price 
with the lowest purchase price within six months, the next highest 
sale price with the next lowest purchase price within six months, 
and so on, until all shares have been included in the computation.
---------------------------------------------------------------------------

    Q12: Exchange Act Rule 16b-6(b) exempts from Section 16(b) the 
closing of a derivative security position as a result of its exercise 
or conversion, and the acquisition of underlying securities at a fixed 
exercise price due to the exercise or conversion of a call equivalent 
position, or the disposition of underlying securities at a fixed 
exercise price due to the exercise of a put equivalent position.\41\ 
The Rule further provides, however, that the acquisition of underlying 
securities from the exercise of an out-of-the-money \42\ option, 
warrant or right shall not be exempt.
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    \41\ 17 CFR 240.16b-6(b).
    \42\ For a person who has a long security future position, the 
security future would be ``out-of-the-money,'' as that term is used 
in Rule 16b-6(b), if the settlement price of the security future is 
above the market price of the underlying security on the settlement 
date. Conversely, a short security future position would be ``out-
of-the money'' if the settlement price of the security future is 
above the market price of the underlying security on the settlement 
date.
---------------------------------------------------------------------------

    (a) Would the settlement of a security future through delivery or 
receipt of the underlying equity security be exempted by Rule 16b-6(b)?
    (b) Would cash settlement of a security future be exempted by Rule 
16b-6(b)?
    A12: (a) The disposition of a security future and delivery or 
receipt of the underlying security upon settlement would be exempted by 
Rule 16b-6(b). The provision in Rule 16b-6(b) that excludes from the 
exemption the exercise of out-of-the-money options would not apply. 
Unlike certain option contracts, where the holder of the option can 
choose whether or not and (in the case of American style options) when 
to exercise the option, a security future creates an obligation either 
to purchase or sell the underlying securities at a specified future 
date. Accordingly, the physical settlement of a security future is more 
similar to a conversion for purposes of Rule 16b-6(b). An out-of-the-
money conversion that otherwise complies with Rule 16b-6(b) is exempt 
under that Rule.
    (b) For purposes of section 16, cash settlement of a security 
future, like the cash settlement of any other derivative security, 
involves the deemed sale of the underlying securities in addition to 
the transactions described in (a) above that take place upon physical 
settlement.\43\ Where an insider holds a long security future position, 
cash settlement would involve the insider's deemed sale of the 
underlying securities back to the counterparty. Where an insider holds 
a short security future position, cash settlement would involve the 
insider's deemed repurchase of the underlying securities from the 
counterparty. Rule 16b-6(b) exempts only the transactions described in 
(a) above, and does not

[[Page 43239]]

exempt either of these additional transactions.
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    \43\ See Securities Exchange Act Release No. 28869 (February 8, 
1991), 56 FR 7242 (February 21, 1991).
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    Q13: Generally, persons subject to the reporting requirements of 
section 16 must file a report on Form 4 within ten days after the close 
of any month in which a change in beneficial ownership has occurred in 
the equity securities of the subject issuer. Unlike most transactions 
exempt from section 16(b), which are eligible for deferred reporting on 
Form 5, exercises and conversions of derivative securities that are 
exempt from section 16(b) must be reported on Form 4.\44\ General 
Instruction 8 of Form 4 specifies transaction codes that should be used 
to identify the type of transaction being reported. What codes should 
be used to identify insiders' transactions in security futures?
---------------------------------------------------------------------------

    \44\ Exchange Act Rule 16a-3(f)(1)(i)(A) [17 CFR 240.16a-
3(f)(1)(i)(A)].
---------------------------------------------------------------------------

    A13: Transactions in security futures should be reported as 
follows:
     Purchase of a security future should be identified in 
Table II, column 4 of the form with transaction code ``P.''
     Sale of a security future should be identified in Table 
II, column 4 of the form with transaction code ``S.''
     Physical settlement of a long security future should be 
identified in Table I, column 3 and Table II, column 4 with transaction 
code ``C.''
     Physical settlement of a short security future should be 
identified in Table I, column 3 and Table II, column 4 with transaction 
code ``C.''
     Cash settlement of a long security future should be 
identified in Table I, column 3 and Table II, column 4 with transaction 
code ``C,'' and with transaction code ``S'' on a separate line in Table 
I, column 3 (to report the deemed sale of the underlying securities).
     Cash settlement of a short security future should be 
identified in Table I, column 3 and Table II, column 4 with the 
transaction code ``C,'' and with transaction code ``P'' on a separate 
line in Table I, column 4 (to report the deemed repurchase of the 
underlying security).
    Q14: Exchange Act Rule 16c-4 provides that establishing or 
increasing a put equivalent position is exempt from section 16(c) so 
long as the amount of securities underlying the put equivalent position 
does not exceed the amount of underlying securities otherwise owned by 
the insider. How would Rule 16c-4 apply to an insider's sale of a 
security future?
    A14: For the duration of the insider's put equivalent position 
pursuant to the security future, an insider who sells a security future 
must otherwise own an amount of the underlying securities sufficient to 
cover his or her delivery obligations under the security future. In 
computing the amount of underlying securities otherwise owned, an 
insider may include securities of the same class as the underlying 
securities on deposit in a margin account.
    Example: The common stock of Company XYZ is registered under 
section 12 of the Exchange Act. On May 5, 2003, S, an officer of 
Company XYZ, owns 10,000 shares of XYZ common stock. On May 5, 2003, S 
sells 100 December delivery security futures on XYZ common stock. This 
sale establishes a ``put equivalent position'' with respect to 10,000 
shares of XYZ common stock (each security future is on 100 shares of 
Company XYZ common stock). S deposits 2,000 shares of Company XYZ 
common stock as margin on the security futures. Interpretation: 
Including the 2,000 shares of XYZ common stock S deposited for margin, 
S otherwise owns a sufficient amount of XYZ shares to cover his 
obligation to deliver 10,000 XYZ shares upon settlement of the security 
futures within the meaning of Rule 16c-4. S must continue to otherwise 
own 10,000 shares of XYZ common stock for the duration of the put 
equivalent position with respect to the 100 December delivery security 
futures.
    Q15: Are the securities underlying a long security future that 
calls for physical settlement considered ``otherwise owned'' for 
purposes of Rule 16c-4?
    A15: An insider who is long a security future does not ``otherwise 
own'' the securities underlying the security future until he or she is 
obligated to accept delivery under the security future (i.e., if the 
security future is not offset prior to the close of trading for that 
security future on the last trading day). Once an insider is obligated 
to accept delivery, he or she may include the securities underlying the 
security future in computing the amount of underlying securities 
``otherwise owned.'' An insider who is long a cash-settled security 
future does not ``otherwise own'' the underlying securities.
    Example: The common stock of Company XYZ is registered under 
Section 12 of the Exchange Act. S, an officer of Company XYZ, does not 
own any shares of XYZ common stock. On May 5, 2003, S purchases 10 
December delivery security futures on XYZ common stock. Each security 
future is on 100 shares of XYZ common stock. The last trading day of 
the December delivery security futures is the third Friday in December 
(December 19, 2003). S wishes to buy put options on 1000 shares of XYZ 
common stock on or after December 19, 2003. Interpretation: S becomes 
obligated to accept delivery of the 1000 XYZ common shares underlying 
the 10 December delivery security futures after the close of trading on 
December 19, 2003. Accordingly, as of the close of trading on December 
19, 2003, S is deemed to otherwise own those 1000 XYZ common shares for 
purposes of Rule 16c-4. Therefore, S's purchase of put options on 1000 
shares of XYZ common stock after the close of trading on December 19, 
2003, would be exempt from Section 16(c) pursuant to Rule 16c-4.
2. Mergers and Acquisitions Issues

Beneficial Ownership Disclosure Requirements: Exchange Act Regulation 
13D \45\
---------------------------------------------------------------------------

    \45\ Regulation 13D also encompasses the Schedule 13G 
requirements.
---------------------------------------------------------------------------

    Rule 13d-1 of the Exchange Act \46\ requires any person who becomes 
a beneficial owner of more than five percent of a class of equity 
security \47\ to file a statement containing the information required 
by either Schedule 13D or Schedule 13G.\48\ Under Exchange Act Rule 
13d-3(a),\49\ a person

[[Page 43240]]

is deemed to be the beneficial owner of a security, for purposes of 
sections 13(d) and 13(g) of the Exchange Act,\50\ if that person has or 
shares voting and/or investment power with respect to the security. The 
Rule deems a person to be the beneficial owner of a security if that 
person has the right to acquire beneficial ownership of the security 
within 60 days, including, but not limited to, a right to acquire it 
through exercise of an option, warrant, right or through the conversion 
of another security.\51\ Any person who acquires the right to acquire a 
security in this manner with the purpose or effect of changing or 
influencing control of the issuer of the security is immediately deemed 
to be the beneficial owner of the security upon acquisition of the 
right to acquire the security, regardless of when the right is 
exercisable.\52\
---------------------------------------------------------------------------

    \46\ 17 CFR 240.13d-1.
    \47\ For the purpose of Regulation 13D, the term ``equity 
security'' is defined in Rule 13d-1(i) (17 CFR 240.13d-1(i)) as any 
equity security of a class which is registered under section 12 of 
the Exchange Act (15 U.S.C. 78l), or any equity security of any 
insurance company which would have been required to be registered 
under the Exchange Act except for the exemption contained in section 
12(g)(2)(G) of the Exchange Act (15 U.S.C. 78l(g)(2)(G)), or any 
equity security issued by a closed-end investment company registered 
under the Investment Company Act of 1940 (15 U.S.C 80a et seq.). The 
term does not include securities of a class of non-voting 
securities.
    \48\ 17 CFR 240.13d-101 or 240.13d-102. Unless otherwise exempt, 
a person acquiring more than five percent of a class of equity 
security must file a Schedule 13D within 10 days of the acquisition. 
A Schedule 13D filer must disclose, among other things, his or her 
identity and background, the source and amount of funds used to 
acquire the securities, the purpose of the acquisition and any plans 
or proposals of the filer concerning the issuer. Institutional 
investors who acquire more than five percent of a class of equity 
security in the ordinary course of business, and not with the 
purpose or effect of changing or influencing control of the issuer, 
may file the short-form Schedule 13G, in lieu of the Schedule 13D, 
within 45 days after the end of the calendar year. Passive investors 
who acquire more than 5% of a class of equity security, but less 
than 20% of the class, and not with the purpose or effect of 
changing or influencing control of the issuer, may file the short-
form Schedule 13G, in lieu of the Schedule 13D, within 10 days after 
the acquisition. A Schedule 13G filer must disclose, among other 
things, his or her identity, residence and citizenship, and amount 
of securities beneficially owned.
    \49\ 17 CFR 240.13d-3(a). The Rule states that voting power 
includes the power to vote or to direct the voting of the security, 
and that investment power includes the power to dispose, or to 
direct the disposition of the security.
    \50\ 15 U.S.C. 78m(d) and (g).
    \51\ Rule 13d-3(d)(1)(i) (17 CFR 240.13d-3(d)(1)(i)). 
Additionally, the Rule deems a person to be the beneficial owner of 
a security if the person has the right to acquire beneficial 
ownership of the security within 60 days pursuant to the power to 
revoke a trust, discretionary account, or similar arrangement 
through the termination of a trust, discretionary account or similar 
arrangement. See Rule 13d-3(d)(1)(i)(C) and (D) (17 CFR 240.13d-
3(d)(1)(i)(C) and (D)).
    \52\ Rule 13d-3(d)(1) (17 CFR 240.13d-3(d)(1)).
---------------------------------------------------------------------------

    Q16: Is a security future an ``equity security'' that is reportable 
under Regulation 13D?
    A16: No. Security futures are not covered by the Rule 13d-1(i) 
definition of ``equity security'' \53\ because they are exempt from 
registration under section 12 of the Exchange Act.\54\
---------------------------------------------------------------------------

    \53\ See supra note .
    \54\ Exchange Act section 12(a) (15 U.S.C. 78l(a)) exempts 
security futures traded on a national securities exchange from 
registration under both sections 12(b) and section 12(g) of the 
Exchange Act (15 U.S.C. 78l(b) and (g)). Exchange Act section 12(g) 
clarifies that security futures are not equity securities of the 
issuer of the underlying securities.
---------------------------------------------------------------------------

    Q17: Would the equity securities underlying a security future that 
requires physical settlement of the security future be counted for 
purposes of determining whether the purchaser of the security future is 
subject to the Regulation 13D beneficial ownership reporting 
requirements?
    A17: Yes, but only during the period when there are 60 or fewer 
days before the last trading day, or immediately upon purchase of the 
security future if it was acquired for the purpose of changing or 
influencing control of the issuer of the underlying securities.\55\
---------------------------------------------------------------------------

    \55\ See supra note.
---------------------------------------------------------------------------

    Example 1: On June 3, 2002, W purchases 100 security futures for 
December delivery. Each security future calls for physical delivery of 
100 shares of Company XYZ common stock. The last trading day of the 
December delivery contracts is December 20, 2002. Before his 
acquisition of the security futures, W was not required to file a 
beneficial ownership report on either Schedule 13D or 13G. 
Interpretation: On the purchase date, June 3, 2002, W does not have to 
count the shares of Company XYZ common stock underlying the security 
futures contracts for purposes of determining beneficial ownership 
under Rule 13d-3 because this date is more than 60 days from the last 
trading day of the security futures.\56\ If W has not offset the 
security futures on or before October 21, 2002, W would count the 
shares of XYZ common stock underlying the security futures for purposes 
of determining whether he is subject to the Regulation 13D beneficial 
ownership reporting requirements.
---------------------------------------------------------------------------

    \56\ This example assumes that the security futures were not 
purchased with the purpose or effect of changing or influencing 
control of the issuer.
---------------------------------------------------------------------------

    Example 2: Same facts as in Example 1 above, except W purchases the 
December delivery security futures (with the last trading day of 
December 20, 2002) on Company XYZ common stock on October 23, 2002. The 
amount of Company XYZ common stock beneficially owned by W before his 
purchase of the security futures, combined with the shares of Company 
XYZ common stock underlying the contracts, brings W above the five 
percent beneficial ownership threshold. Interpretation: W must file a 
Schedule 13D or 13G within 10 days after his purchase of the security 
futures.\57\
---------------------------------------------------------------------------

    \57\ In this example, W would be eligible to file on the short-
form Schedule 13G if he is an institutional or passive investor and 
can certify that he did not purchase the security futures for the 
purpose of changing control of Company XYZ, and the purchase did not 
have the effect of changing control of Company XYZ. See Rule 13d-
1(b) and (c) (17 CFR 240.13d-1(b) and (c)).
---------------------------------------------------------------------------

    Q18: Would the equity securities underlying a security future that 
requires cash settlement be counted for purposes of determining whether 
the purchaser of the contract is subject to the Regulation 13D 
beneficial ownership reporting requirements?
    A18: No. A purchaser of a cash-settled security future (i.e., a 
security future that, by its terms, must be settled by a cash payment) 
would not count the equity securities underlying the contract for 
purposes of determining whether he or she is subject to the Regulation 
13D reporting requirements, because he or she does not have the right 
to acquire beneficial ownership of the underlying security.
    Q19: If the equity securities underlying a security future that 
requires physical settlement are counted for purposes of determining 
beneficial ownership under Regulation 13D, would the securities 
underlying a security future that is purchased to liquidate or offset 
an existing security future position be counted for purposes of 
determining beneficial ownership?
    A19: No, but only to the extent that the offsetting purchase does 
not establish a new security future position. If a purchaser buys a 
security future to offset an outstanding short position, the purchaser 
has no obligation to accept delivery of the securities underlying the 
long security future.\58\
---------------------------------------------------------------------------

    \58\ See supra note . A transaction is not an offsetting 
transaction if it does not liquidate the previously established 
security future position. Once a security future has been offset, 
the obligation to accept or make delivery of the underlying 
securities or to accept or make payment of the value of the 
underlying securities (in the case of a cash settled security 
future) is canceled.
---------------------------------------------------------------------------

    Q20: Other than for purposes of determining beneficial ownership, 
how does the purchase or sale of a security future affect Schedule 13D 
disclosure?
    A20: As with other derivative contracts overlying an ``equity 
security'' under Rule 13d-1(i), a purchaser or seller of a security 
future who is subject to Schedule 13D reporting requirements with 
respect to the underlying security may have to amend Schedule 13D to 
disclose his or her transactions in security futures on securities of a 
class of equity security beneficially owned by such person, whether 
settled by physical delivery or in cash. For example, the purchase or 
sale of a security future may represent a change in the source of funds 
under Item 3 of Schedule 13D, a possible shift in purpose under Item 4 
(particularly to the extent that the transaction is part of a plan or 
proposal to dispose of Company XYZ securities that W did not disclose 
previously), or a ``transaction'' in the subject security under Item 5. 
Furthermore, the security future would be a ``contract, agreement, 
understanding, or relationship * * * with respect to * * * securities 
of the issuer'' under Item 6. A Schedule 13G filer would disclose 
transactions in security futures in accordance with Regulation 13D and 
the item requirements of Schedule 13G.

B. Guidance on Statutory Provisions and Rules Administered by the 
Division of Market Regulation

1. Market Supervision Issues

The Duty of Best Execution

    Broker-dealers have long been subject to a duty of best execution 
when effecting securities transactions for customers. This duty derives 
from

[[Page 43241]]

common law agency principles and fiduciary obligations, and has been 
incorporated in self-regulatory organization rules and, through 
judicial and Commission decisions, in the enforcement of the antifraud 
provisions of the federal securities laws. Questions have arisen as to 
the applicability of this duty to security futures products.
    Q21: Does the duty of best execution apply to security futures 
products?
    A21: Yes. The duty of best execution requires a broker-dealer ``to 
seek the most favorable terms reasonably available under the 
circumstances for a customer's transaction.''\59\ The duty of best 
execution is not limited by the type of transaction or security 
involved and applies equally to security futures products.
---------------------------------------------------------------------------

    \59\ Securities Exchange Act Release No. 37619A (September 6, 
1996), 61 FR 48290, 48322 (September 12, 1996).
---------------------------------------------------------------------------

    Q22: Are broker-dealers expected to comply with the duty of best 
execution in the absence of national market system mechanisms for 
security futures products?
    A22: Yes. While the national market system mechanisms adopted under 
the Exchange Act were designed in part ``to assure * * * the 
practicability of brokers executing investors'' orders in the best 
market,''\60\ the duty of best execution predates the national market 
system provisions of the federal securities laws. Accordingly, the 
Commission has never considered the duty of best execution to be 
contingent on the existence of such mechanisms.\61\ Best execution 
obligations, for example, also apply to securities for which national 
market system plans do not exist, such as government securities and 
corporate debt.\62\
---------------------------------------------------------------------------

    \60\ 15 U.S.C. 78k-1(a)(1)(C)(iv).
    \61\ See Securities Exchange Act Release No. 43591 (November 17, 
2000), 65 FR 75439, 75439-40 (December 1, 2000) (discussing best 
execution obligations with respect to exchange-listed options).
    \62\ See NASD Rule 2320.
---------------------------------------------------------------------------

    Q23: Are broker-dealers expected to comply with the duty of best 
execution with respect to instruments that may not be standardized or 
fungible across markets?
    A23: As noted above, the duty of best execution requires a broker-
dealer to seek the most favorable terms reasonably available under the 
circumstances for a customer's transaction. In the absence of specific 
instructions from a customer, a broker-dealer has an obligation to use 
reasonable efforts to execute customer orders in the market that 
maximizes the economic benefit to the customer.\63\ The Commission 
recognizes that it would be difficult to apply these principles to 
contracts that are materially different as to their terms. If the 
customer has specified the market or contract in which to trade, the 
broker-dealer must seek to achieve the best possible execution within 
that market. If the customer has not specified the market or contract, 
the Commission reminds broker-dealers that, even with respect to 
contracts that are materially different, they should consider the 
applicability of other agency or fiduciary duties, including 
suitability.
---------------------------------------------------------------------------

    \63\ See Newton v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 
135 F.3d 266, 270 (3d Cir. 1998) (en banc); NASD Rule 2320.
---------------------------------------------------------------------------

2. Trading Practices Issues \64\
---------------------------------------------------------------------------

    \64\ Exchange Act Rules 15c2-4 and 15c2-8 [17 CFR 240.15c2-4 and 
240.15c2-8] apply to sales of security futures by brokers and 
dealers that constitute distributions. We anticipate that security 
futures will be issued by clearing agencies, and brokers and dealers 
therefore will not participate in distributions of security futures. 
If brokers and dealers, however, participate in a distribution of 
security futures, we will address any questions regarding Rules 
15c2-4 and 15c2-8 at that time.
---------------------------------------------------------------------------

a. Short Sale Regulation: Exchange Act Rules 10a-1 and 3b-3

    A short sale is the sale of a security that the seller does not own 
or that the seller owns but does not deliver. The Commission has 
plenary authority to regulate short sales of securities registered on a 
national securities exchange (listed securities) as necessary to 
protect investors under Section 10(a) of the Exchange Act.\65\ The 
Commission adopted Exchange Act Rule 10a-1 \66\ to restrict short 
selling in a declining market.\67\ Specifically, Rule 10a-1(a)(1) 
provides that, subject to certain exceptions, a listed security may be 
sold short: (i) At a price above the price at which the immediately 
preceding sale was effected (plus tick), or (ii) at the last sale price 
if it is higher than the last different price (zero-plus tick). 
Conversely, short sales are not permitted on minus ticks or zero-minus 
ticks, subject to narrow exceptions. The operation of these provisions 
constitute what is commonly described as the ``tick test.''
---------------------------------------------------------------------------

    \65\ 15 U.S.C. 78j(a).
    \66\ 17 CFR 240.10a-1.
    \67\ See Securities Exchange Act Release No. 1548 (January 24, 
1938), 3 FR 213 (January 26, 1938).
---------------------------------------------------------------------------

    Exchange Act Rule 3b-3 defines the term ``short sale'' as any sale 
of a security that the seller does not own or any sale that is 
consummated by the delivery of a security borrowed by, or for the 
account of, the seller. Rule 3b-3 also defines specific instances when 
a person shall be deemed to own a security, i.e., a long position.
    Q24: Will sales of security futures be subject to Rule 10a-1?
    A24: No. In authorizing the trading of futures contracts involving 
single stocks and narrow-based security indices, Congress exempted 
security futures products from the operation of Section 10(a)(1) of the 
Exchange Act under which Rule 10a-1 is adopted.\68\
---------------------------------------------------------------------------

    \68\ See 15 U.S.C. 78j(a)(2).
---------------------------------------------------------------------------

    Q25: Does a security future convey ownership under Rule 3b-3 for 
the purposes of short sale regulation?
    A25: A person who holds a security future obligating him to take 
delivery of the underlying securities by physical settlement would not 
be considered long these securities for the purposes of Rule 3b-3 until 
the security future terminates trading.\69\ This interpretation is 
consistent with the way Rule 3b-3 addresses several instances where a 
person owns a security that entitles a person to acquire securities 
underlying the instrument, e.g., options, rights, warrants, and 
convertibles. In those instances, Rule 3b-3 requires the option, right, 
warrant, or convertible to be exercised, tendered, or converted before 
the person can be considered as having a long position in the 
underlying security. These provisions also implicitly contemplate that 
the person will shortly acquire the security being sold. For a 
physically-settled security future, the holder will obtain the 
underlying security only after the security future terminates trading. 
A security future settled by receipt of cash has no effect on a 
person's long position.
---------------------------------------------------------------------------

    \69\ Termination of trading is the moment at which an open 
position in a security future, either a long or short position, can 
no longer be closed or liquidated either by buying or selling an 
opposite position. Similarly, a person obligated to deliver would be 
considered short at the termination of trading.
---------------------------------------------------------------------------

b. Safe Harbor for Issuer Repurchases: Exchange Act Rule 10b-18

    Exchange Act Rule 10b-18 \70\ provides a non-exclusive ``safe 
harbor'' from liability for manipulation under sections 9(a)(2) and 
10(b) of the Exchange Act, and Rule 10b-5 under the Exchange Act, when 
an issuer or its affiliated purchaser bids for or purchases shares of 
the issuer's common stock in accordance with the Rule's manner, timing, 
price, and volume conditions. Because Rule 10b-18 is a voluntary safe 
harbor, an issuer is not required to comply with the provisions of the 
Rule when making market purchases, and no adverse inference about 
manipulation may be drawn if an issuer's purchases do not satisfy the 
Rule's conditions or are not covered by the Rule. Rule 10b-18's 
conditions are

[[Page 43242]]

designed to limit the market impact of the issuer's repurchase 
activity. In so doing, Rule 10b-18 provides a measure of assurance to 
investors that a security's market price is based on independent market 
forces and not influenced in a manipulative manner by the issuer.
---------------------------------------------------------------------------

    \70\ 17 CFR 240.10b-18.
---------------------------------------------------------------------------

    Q26: Is the Rule 10b-18 safe harbor available for issuer repurchase 
transactions involving security futures (including the receipt of 
securities underlying such futures)?
    A26: No. Rule 10b-18 only applies to what is defined as a ``Rule 
10b-18 purchase.'' \71\ A Rule 10b-18 purchase encompasses only 
purchases by an issuer or its affiliate of its common stock. It does 
not apply to any other type of security--even if related to the common 
stock (e.g., transactions in derivative securities such as warrants, 
options, or security futures that are physically-settled).\72\ Thus, 
consistent with the treatment of options under Rule 10b-18, we view the 
term ``Rule 10b-18 purchase'' as not including issuer repurchase 
transactions involving security futures (including the receipt of 
securities underlying such futures).
---------------------------------------------------------------------------

    \71\ See Exchange Act Rule 10b-18(a)(3) (17 CFR 240.10b-
18(a)(3)).
    \72\ Rule 10b-18 also would not apply to security futures that 
are cash-settled, as these products do not result in a purchase of 
the common stock for purposes of the Rule.
---------------------------------------------------------------------------

c. The Short Tender Rule: Exchange Act Rule 14e-4

    Exchange Act Rule 14e-4,\73\ commonly referred to as the ``short 
tender rule,'' is generally designed to preclude persons from tendering 
more shares than they own in order to avoid or reduce the risk of pro 
rata acceptance in a partial tender offer. A person may tender shares 
into a partial tender offer only if both at the time of tender and at 
the end of the proration period the person has a ``net long position'' 
in the subject security or an equivalent security equal to or greater 
than the amount tendered into the partial tender offer. Under Rule 14e-
4, a person's ``net long position'' in a subject security equals the 
excess, if any, of such person's ``long position'' over a person's 
``short position.'' The calculation of the net long position must be 
done both at the time of tender and at the end of the proration period, 
or period during which securities are accepted by lot, including any 
extension thereof.
---------------------------------------------------------------------------

    \73\ 17 CFR 240.14e-4.
---------------------------------------------------------------------------

    Q27: How should a security future be considered in calculating a 
person's long position for the purposes of Rule 14e-4 when the 
underlying security is the subject of a partial tender offer?
    A27: A person who holds a security future obligating him to take 
delivery of a subject security by physical settlement will be 
considered to be long the subject security for the purposes of Rule 
14e-4 only after the security future terminates trading.\74\ This 
interpretation is consistent with the treatment of standardized options 
positions in Rule 14e-4. The owner of a standardized option in a 
subject security is not considered to be long the underlying security 
under Rule 14e-4 for tendering purposes until the standardized option 
is exercised. A security future settled by receipt of cash has no 
effect on the shareholder's long position.
---------------------------------------------------------------------------

    \74\ See supra note 69 (explaining termination of trading).
---------------------------------------------------------------------------

    Q28: How should a security future be considered in calculating a 
person's short position for the purposes of Rule 14e-4 when the 
underlying security is the subject of a partial tender offer?
    A28: In order to prevent hedged tendering and over-tendering, Rule 
14e-4 requires a person tendering into a partial tender offer to 
include in the calculation of his or her short position the amount of 
subject securities such person is obligated to deliver pursuant to a 
security future that was entered into on or after the date that a 
tender offer is first publicly announced or otherwise made known by the 
bidder to the holders of the security to be acquired, if the security 
future terminates trading at or before the end of the proration period. 
If one or more tender offers for the same security are ongoing on such 
date, the announcement date shall be that of the first announced offer. 
This requires inclusion of the amount of such subject securities in the 
person's short position, regardless of the price of the security future 
relative to the price of the subject security underlying the security 
future, because (in contrast to an option, discussed below) the 
security future requires the person to deliver the securities upon 
maturity.
    This interpretation is consistent with the treatment of 
standardized options positions in Rule 14e-4. Rule 14e-4 requires a 
person tendering into a partial tender offer to include in the 
calculation of his or her short position the amount of subject 
securities that the person is obligated to deliver upon exercise of a 
standardized in-the-money call option that was sold on or after the 
date that a tender offer is first publicly announced or otherwise made 
known by the bidder to the holders of the security to be acquired. For 
purposes of Rule 14e-4, in-the-money call options are those options 
with strike prices below the highest tender offer price or stated 
amount of consideration offered for the subject security. A security 
future settled by receipt of cash has no effect on the person's short 
position.\75\
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    \75\ Further, the holder of a cash-settled futures contract is 
not considered to own the subject securities underlying the contract 
for purposes of Rule 14e-4, and so cannot tender shares on the basis 
of the security future. As such, security futures settled by receipt 
of cash have no effect on the number of subject securities eligible 
to be tendered into an offer.
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d. Purchases Outside of a Tender Offer: Exchange Act Rule 14e-5

    In connection with a tender offer for equity securities, Rule 14e-5 
of the Exchange Act \76\ generally prohibits a covered person from 
directly or indirectly purchasing or arranging to purchase outside of 
the tender offer (i) the securities or class of securities that are 
sought to be acquired in the transaction or that are otherwise the 
subject of the transaction (``subject securities''), or (ii) securities 
that are immediately convertible into, exchangeable for, or exercisable 
for subject securities (``related securities'').\77\
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    \76\ 17 CFR 240.14e-5.
    \77\ Relevant terms are defined in paragraph (c) of Rule 14e-5.
---------------------------------------------------------------------------

    Q29: Would Rule 14e-5 apply to the purchase by a covered person of 
security futures during a tender offer for the securities underlying 
the security futures?
    A29: The security futures would not be subject securities. Nor 
would the security futures be related securities because they would not 
be ``immediately convertible into, exchangeable for, or exercisable 
for'' the subject securities (i.e., the underlying securities). 
However, if the security futures provide for physical settlement, and 
the security futures will terminate trading \78\ prior to expiration of 
the tender offer, the purchase of the security futures would be 
prohibited under Rule 14e-5 as an arrangement (i.e., the security 
future contract) to purchase subject securities (i.e., the underlying 
securities) during the tender offer.
---------------------------------------------------------------------------

    \78\ See supra note 69.
---------------------------------------------------------------------------

    Q30: Would Rule 14e-5 prohibit the physical settlement of a long 
security futures position by a covered person during a tender offer for 
the underlying security?
    A30: The acquisition of the underlying securities upon physical 
settlement of a long security futures position would be considered a 
purchase of subject securities. Rule 14e-5(b)(1), however, permits 
transactions by covered persons to convert, exchange, or exercise 
related securities owned before public announcement of

[[Page 43243]]

the tender offer into subject securities. Because the acquisition of 
subject securities upon the physical settlement of security futures is 
substantially similar to acquisitions of subject securities by 
conversion, exchange or exercise of other securities, the acquisition 
of underlying securities that are the subject of a tender offer upon 
physical settlement of a long security futures position is within the 
Rule 14e-5(b)(1) exception, if the covered person owned the security 
futures before public announcement of the tender offer.
    Q31: Would Rule 14e-5 prohibit the acquisition of subject 
securities to satisfy an obligation to deliver those securities upon 
physical settlement of a short position in security futures?
    A31: The acquisition of the underlying securities in order to 
physically settle a short position in security futures would be 
considered a purchase of subject securities. Rule 14e-5(b)(6), however, 
permits purchases that are made to satisfy an obligation to deliver a 
subject security arising from the exercise of an option by a non-
covered person or a short sale, provided that (i) the short sale or 
option was established before public announcement of the tender offer, 
and (ii) the short sale or option transaction was made in the ordinary 
course of business and not to facilitate the offer. Because the 
acquisition of subject securities upon the physical settlement of a 
short security futures position is substantially similar to the 
acquisition of subject securities in a covering transaction arising 
from a short sale or the exercise of an option by a non-covered person, 
the acquisition is within the Rule 14e-5(b)(6) exception, provided the 
obligation to settle by physical delivery was established before public 
announcement of the tender offer and the security future transaction 
was made in the ordinary course of business and not to facilitate the 
offer.
    Q32: Would Rule 14e-5 apply to the cash settlement by a covered 
person of a long security futures position?
    A32: No. The cash settlement of a long security futures position 
would not involve an acquisition of the securities underlying the 
security futures.

e. Anti-manipulation Rules Regarding Distributions: Regulation M

    Regulation M\79\ is intended to preclude manipulative conduct by 
persons with an interest in the outcome of an offering of securities. 
It governs the activities of underwriters, issuers, selling security 
holders, and others that participate in the offering, as well as their 
affiliated purchasers. Regulation M prohibits such persons from 
directly or indirectly bidding for, purchasing, or attempting to induce 
any person to bid for or purchase, any security that is the subject of 
a distribution (a ``subject security''), or any ``reference security'' 
(together, ``covered securities''), until after the applicable 
restricted period.\80\
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    \79\ 17 CFR 242.100-242.105.
    \80\ Relevant terms, including ``distribution,'' ``reference 
security,'' and ``restricted period,'' are defined in Rule 100 of 
Regulation M.
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    Q33: Would Regulation M apply to the purchase of security futures 
during a distribution of the securities underlying the security 
futures?
    A33: Yes. The purchase of the security futures would be considered 
within the prohibition against directly or indirectly bidding for, 
purchasing, or attempting to induce any person to bid for or purchase, 
a covered security (i.e., the underlying securities) because, at a 
minimum, the purchase of the security futures would be an indirect 
purchase of a covered security.
    Q34: Is the actively-traded securities exception available in 
connection with acquisitions of security futures during distributions 
of the underlying stock?
    A34: The actively-traded securities exception under Rule 101(c)(1) 
would be available to acquisitions of security futures by distribution 
participants and their affiliated purchasers where the underlying 
securities are actively-traded securities. However, that exception is 
not available to purchases of security futures by issuers, selling 
security holders, or affiliated purchasers of the underlying securities 
who are governed by Rule 102(d)(1).\81\
---------------------------------------------------------------------------

    \81\ See 17 CFR 242.102.
---------------------------------------------------------------------------

    Q35: Would Regulation M prohibit the physical settlement of a long 
security futures position during a distribution of the underlying 
security?
    A35: The acquisition of the underlying security upon physical 
settlement of a long security futures position would be considered the 
purchase of a covered security. Rules 101(b)(4) and 102(b)(4), however, 
permit distribution participants, and issuers and selling shareholders, 
respectively, to acquire a covered security through the exercise of any 
option, warrant, right, or any conversion privileges set forth in the 
instrument governing a security. In adopting these exceptions, the 
Commission stated that it believes that exercises or conversions of 
derivative securities generally have an uncertain and attenuated 
manipulative potential.\82\ Because the acquisition of underlying 
securities upon physical settlement of a long security future is 
substantially similar to the acquisition of a covered security upon the 
exercise of an option, warrant, right, or conversion privilege, the 
acquisition is within the exceptions in Rules 101(b)(4) and 102(b)(4).
---------------------------------------------------------------------------

    \82\ Securities Exchange Act Release No. 38067 (December 20, 
1996), 62 FR 520, 528 (January 3, 1997).
---------------------------------------------------------------------------

    Q36: Would Regulation M apply to the cash settlement of a long 
security futures position?
    A36: No. Regulation M would not prohibit the cash settlement of a 
long security futures position.
3. Other Broker-Dealer Issues

a. Eligible OTC Derivative Instruments: Exchange Act Rule 3b-13

    OTC derivatives dealers are a class of registered dealers that 
limit their trading to eligible over-the-counter derivative products 
and certain related transactions.\83\ Registration with the Commission 
as an OTC derivatives dealer is an alternative to registration as a 
full broker-dealer.\84\ OTC derivatives dealers may engage in dealer 
activities in ``eligible OTC derivative instruments,'' as that term is 
defined in Exchange Act Rule 3b-13.\85\ OTC derivatives dealers may 
also engage in certain additional securities activities related to 
conducting an OTC derivatives business.\86\
---------------------------------------------------------------------------

    \83\ See 17 CFR 240.3b-12.
    \84\ See Securities Exchange Act Release No. 40594 (October 23, 
1998), 63 FR 59362 (November 3, 1998).
    \85\ 17 CFR 240.3b-13.
    \86\ Id. In particular, an OTC derivatives dealer must limit its 
securities activities to: (1) Engaging in dealer activities in 
eligible OTC derivative instruments (as defined in Rule 3b-13) that 
are securities; (2) issuing and reacquiring securities that are 
issued by the dealer, including warrants on securities, hybrid 
securities, and structured notes; (3) engaging in cash management 
securities activities (as defined in Rule 3b-14); (4) engaging in 
ancillary portfolio management securities activities (as defined in 
Rule 3b-15); and (5) engaging in such other securities activities 
that the Commission designates by order pursuant to Rule 15a-
1(b)(1). 17 CFR 240.3b-12(a). In addition, such dealer's securities 
activities must consist primarily of those described in categories 
(1) through (3), 17 CFR 240.3b-12(b), and do not consist of any 
other securities activities, including engaging in any transaction 
in any security that is not an eligible OTC derivative instrument, 
except as permitted in categories (3) through (5). 17 CFR 240.3b-
12(c). Moreover, an OTC derivatives dealer must also be affiliated 
with a fully regulated broker-dealer. 17 CFR 240.3b-12.
---------------------------------------------------------------------------

    Q37: Would security futures products be eligible OTC derivative 
instruments as defined in Exchange Act Rule 3b-13?
    A37: No. Exchange Act Rule 3b-13(b)(2)(i) defines an eligible OTC 
derivative instrument, and specifically excludes from the definition of 
eligible OTC derivative instrument a security that is listed or traded 
on a securities exchange. Security futures products are

[[Page 43244]]

exchange listed instruments.\87\ Because a security futures product is 
a security that is listed on a registered national securities exchange, 
it is excluded from the definition of an eligible OTC derivative 
instrument.\88\ Accordingly, an OTC derivatives dealer that wishes to 
engage in activities involving security futures products would be 
limited to those activities permissible in securities that are not 
eligible OTC derivative instruments--activities such as ancillary 
portfolio management securities activities.\89\
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    \87\ See Exchange Act Sections 6(h)(1) [15 U.S.C. 78f(h)(1)].
    \88\ Exchange Act Rule 3b-13(b)(2)(i) specifically excludes from 
the definition of eligible OTC derivative instrument a contract, 
agreement or transaction that provides, in whole or in part, on a 
firm or contingent basis, for the purchase or sale of, or is based 
on the value of, or any interest in, any security, (or group or 
index of securities), and is listed on, or traded on or through, a 
national securities exchange or registered national securities 
association or a facility or market thereof. See 17 CFR 240.3b-
13(b)(2)(i).
    \89\ Exchange Act Rule 3b-15 defines ancillary portfolio 
management securities activities. As the Commission explained in 
adopting the Rule:
    These securities activities must be limited to transactions in 
connection with the OTC derivatives dealer's dealer activities in 
eligible OTC derivative instruments, the issuance of securities by 
the dealer, or such other securities activities that the Commission 
designates by order. They must also (1) be conducted for the purpose 
of reducing the dealer's market or credit risk or consist of 
incidental trading activities for portfolio management purposes; and 
(2) be limited to risk exposures within the market, credit, 
leverage, or liquidity risk parameters set forth in the trading 
authorizations granted to the associated person (or to the 
associated person's supervisor) who executes the transaction for the 
dealer, and in the written guidelines approved by the dealer's 
governing body and included in the dealer's internal risk management 
control system (as required under new (Exchange Act) Rule 15c3-4). 
Rule 3b-15 also requires that ancillary portfolio management 
securities activities be conducted only by associated persons of the 
dealer who perform substantial duties for the dealer in connection 
with its dealer activities in eligible OTC derivative instruments.
    See Securities Exchange Act Release No. 40594 (October 23, 
1998), 63 FR 59362 (November 3, 1998); 17 CFR 240.3b-15. See also 
supra note (noting generally other permissible activities).
---------------------------------------------------------------------------

b. Addressing Conflicts Associated With Proprietary Trading and Trading 
for Discretionary Accounts by Exchange Members: Exchange Act Section 
11(a)

    Section 11(a) of the Exchange Act \90\ prohibits a member of a 
national securities exchange (other than a notice-registered exchange) 
from effecting transactions on that exchange for its own account, the 
account of an associated person, or an account over which it or its 
associated person exercises investment discretion, unless an exemption 
applies. Members of notice-registered futures exchanges are exempt from 
section 11(a) for purposes of their activities on those notice-
registered exchanges, but are subject to a similar restriction.\91\
---------------------------------------------------------------------------

    \90\ 15 U.S.C. 78k(a).
    \91\ As directed by the CFMA, the CFTC recently adopted rules 
that prohibit futures intermediaries from trading for accounts in 
which they have any interest, during the same trading session that 
they also trade for the accounts of customers, the same security 
futures product on the same designated contract market or registered 
derivatives transaction execution facility. These rules also 
specifically require electronic markets to adopt rules to prohibit 
the execution of customer orders through systems that provide an 
unfair advantage to market intermediaries. That unfair advantage may 
be a time and place advantage, or the ability to influence or guide 
an order once the order enters the system. See Commodity Exchange 
Act Release No. 3038-AB83 (March 1, 2002), 67 FR 11223 (March 13, 
2002).
---------------------------------------------------------------------------

    Congress enacted section 11(a) to encourage fair dealing and fair 
access in the exchange markets by reducing the conflicts arising from 
an exchange member trading for its own account in the public exchange 
markets.\92\ Exempt from this prohibition are certain types of 
transactions that ``* * * contribute to the fairness and orderliness of 
exchange markets or which have not given rise to serious 
problems.''\93\ For instance, section 11(a)(1)(A) provides an exemption 
from the prohibitions of section 11(a) for any transaction by a dealer 
acting in the capacity of a market maker.\94\ Another type of 
transaction specifically exempted from section 11(a) is ``any bona fide 
hedge transaction involving a long or short position in an equity 
security and a long or short position in a security entitling the 
holder to acquire or sell such equity security. * * *''\95\ The 
Commission implemented this exemption in 1979 by adopting Exchange Act 
Rule 11a1-3(T).\96\
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    \92\ See Securities Act Amendments of 1975, Report of the Senate 
Comm. on Banking, Housing and Urban Affairs to Accompany S. 249, S. 
Rep. No. 94-75, 9th Cong., 1st Sess. 99 (1975).
    \93\ Securities Acts Amendments of 1975, Report of the Senate 
Comm. on Banking, Housing and Urban Affairs to Accompany S. 249, S. 
Rep. No. 94-75, 9th Cong., 1st Sess. 99 (1975).
    \94\ See Exchange Act section 11(a)(1)(A) (15 U.S.C. 
78k(a)(1)(A)); Exchange Act Section 3(a)(38) (15 U.S.C. 78c(a)(38)) 
(defining market maker).
    \95\ Exchange Act section 11(a)(1)(D) (15 U.S.C. 78k(a)(1)(D)).
    \96\ Exchange Act Rule 11a1-3(T) provides that:
    (a) bona fide hedge transaction effected on a national 
securities exchange by a member for its own account or an account of 
an associated person thereof and involving a long or short position 
in a security entitling the holder to acquire or sell an equity 
security, and a long or short position in one or more other 
securities entitling the holder to acquire or sell such equity 
security, shall be deemed to be of a kind which is consistent with 
the purposes of section 11(a)(1) of the Act, the protection of 
investors, and the maintenance of fair and orderly markets.
    17 CFR 240.11a1-3(T).
---------------------------------------------------------------------------

    Q38: Are both cash-settled and physically-settled security futures 
securities ``entitling the holder to acquire or sell an equity 
security'' so as to permit stock-to-futures, options-to-futures and 
futures-to-futures hedging transactions?
    A38: Yes. Security futures are classic futures contracts--
agreements to buy or sell a specific amount of a security at a 
particular price on a stipulated future date. Whether settlement on 
that date is done by cash or by physical delivery of the underlying 
securities, such an instrument can be used as a hedging vehicle.
    From a regulatory perspective, cash-settlement is not a 
determinative factor in this context. The Commission has long 
considered security options that are cash-settled, as opposed to 
physically-settled, to be ``options on securities'' within the 
definition of security in Exchange Act section 3(a)(10).\97\ Such an 
approach helps to ``meet the countless and variable schemes devised by 
those who seek the use of money of others on the promise of 
profits.''\98\ For similar reasons, whether cash or physically-settled, 
security futures are securities ``entitling the holder to acquire or 
sell an equity security'' as contemplated by Rule 11a1-3(T).
---------------------------------------------------------------------------

    \97\ Exchange Act section 3(a)(10) (15 U.S.C. 78c(a)(10)). See, 
e.g., Brief of the SEC, Amicus Curae, in Support of Appellant on 
Issues Addressed at 10-11, Louis S. Caiola v. Citibank, N.A., On 
Appeal from the United States District Court for the Southern 
District of New York (No. 01-7545) (explaining that Congress did not 
intend to exclude cash-settled options on securities from the 
definition of ``security'' in the Exchange Act).
    \98\ SEC v. W.J. Howey Co., 328 U.S. 293, 299 (1946).
---------------------------------------------------------------------------

    Moreover, Congress did not intend to impose excessively rigid 
limits on the activities of arbitrageurs and other specialized traders 
in connection with transactions of the types listed in section 
11(a)(1)(D), which includes bona fide hedge transactions.\99\ Section 
11(a)(1) was not designed to narrow or unduly complicate arbitrage 
activities and hedging transactions.\100\ Because

[[Page 43245]]

the bona fide hedge exemptions in section 11(a)(1)(D) and Rule 11a1-
3(T) were intended to be interpreted broadly to encompass the variety 
and complexity of hedging techniques, we interpret section 11(a)(1)(D) 
of the Exchange Act and Rule 11a1-3(T) to permit cash-to-futures, 
options-to-futures and futures-to-futures hedging with security 
futures.
---------------------------------------------------------------------------

    \99\ See Securities Acts Amendments of 1975, Report of the 
Senate Comm. on Banking, Housing and Urban Affairs to Accompany 
S.249, S. Rep. No. 94-75, 9th Cong., 1st Sess. 99 (1975).
    \100\ See id. The exemption for bona fide hedge transactions in 
Exchange Act Rule 11a1-3(T) was drafted broadly to encompass the 
variety and complexity of hedging techniques. As the Commission 
noted when it adopted Rule 11a1-3(T):
    The question whether particular combinations of stock positions 
and options positions result in risk reduction in each of the 
positions involves subjective judgments as to the volatility and 
risk characteristics of those positions. * * * The Commission 
recognizes that the calculation of volatility and risk can only be 
approximate, and believes that, for purposes of section 11(a)(1)(D), 
the determination of what constitutes an offset may be made by the 
use of any responsible method of calculating the risk of stock and 
options positions.
    Securities Exchange Act Release No. 15533 (January 29, 1979), 44 
FR 6093 (January 31, 1979).
---------------------------------------------------------------------------

    Q39: Would floor traders effecting transactions in security futures 
products on a fully registered national securities exchange qualify for 
the market making exemption under section 11(a)(1)(A)?
    A39: Section 11(a)(1)(A) of the Exchange Act exempts from the 
general prohibitions of section 11(a) any transaction by a dealer 
acting in the capacity of a market maker, as that term is defined in 
section 3(a)(38) of the Exchange Act.\101\ This exemption reflects the 
special role of market makers in our securities markets. Section 
3(a)(38) defines a market maker as ``any specialist permitted to act as 
a dealer, any dealer acting in the capacity of block positioner, and 
any dealer who, with respect to a security, holds himself out (by 
entering quotations in an interdealer communications system or 
otherwise) as being willing to buy and sell such security for his own 
account on a regular or continuous basis.'' As a practical matter, 
consistent with this definition of ``market maker,'' fully registered 
national securities exchanges--i.e., those not registered pursuant to 
Exchange Act section 6(g)\102\--have established both affirmative and 
negative obligations, including appropriate dual trading restrictions, 
for specialists and other market makers.\103\ Such obligations are 
significant, because floor traders generally buy and sell securities 
for their own benefit and interest, unless the market imposes 
obligations to serve the market or public interest. Thus, only to the 
extent a floor trader is acting subject to the type of exchange imposed 
obligations applicable to market makers in other securities, including 
dual trading restrictions, will such floor trader be deemed acting in a 
market making capacity in a security futures product on a fully 
registered national securities exchange.
---------------------------------------------------------------------------

    \101\ See 15 U.S.C. 78e(a)(38).
    \102\ 15 U.S.C. 78f(g).
    \103\ For example, registered traders in options on the American 
Stock Exchange (``Amex'') are subject to Amex Rule 958, prohibiting 
them from initiating options transactions for any account in which 
they have an interest except in accordance with the Rule's 
provisions. Moreover, section (c) of Rule 958 generally requires 
that when a registered trader enters a trading crowd in other than a 
floor brokerage capacity, or is called upon by a Floor Official or a 
Floor Broker acting in an agency capacity, the registered trader 
``is required to make competitive bids and offers as reasonably 
necessary to contribute to the maintenance of a fair and orderly 
market and shall engage, to a reasonable degree under the existing 
circumstances, in dealings for his own account when there exists a 
lack of price continuity, a temporary disparity between the supply 
of and demand for option contracts of a particular series, or a 
temporary distortion of the price relationships between option 
contracts of the same class.'' See Amex Rule 958(c); see also Amex 
Rule 958, cmt. .01 (designating registered trader engaging in 
Exchange options transactions as a Specialist for purposes of 
certain provisions of the Exchange Act and the rules and regulations 
thereunder); Amex Rule 111(c) (``No Registered Trader shall effect, 
on the Floor of the Exchange, a transaction for an account in which 
he has an interest and execute as broker an off-Floor order in the 
same stock during the same trading session.'') (incorporated into 
the option rules by Amex Rule 950(c)).
---------------------------------------------------------------------------

c. Extensions of Credit: Exchange Act Section 11(d) and Exchange Act 
Rule 10b-16

    Section 11(d) of the Exchange Act \104\ generally prohibits any 
person that does business as both a broker and a dealer from extending 
credit to a customer on any security that was part of a new issue when 
the broker-dealer participated in the distribution of the new issue 
within thirty days prior to the customer's transaction.\105\ Exchange 
Act Rule 10b-16 \106\ prohibits the extension of credit by a broker-
dealer to a customer in connection with any securities transaction 
unless the broker-dealer has established procedures to ensure that the 
customer is given, at the time the account is opened and periodically 
thereafter, specified information with respect to the amount of and 
reasons for credit charges.\107\
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    \104\ 15 U.S.C. 78k(d).
    \105\ See H. R. Rep. No. 1383, 73d Cong., 2d Sess. (1934) 22; 
see also S. Rep. No. 792, 73d Cong., 2d Sess. (1934) 12. Congress 
stated that section 11(d) ``* * * strikes at one of the greatest 
potential evils inherent in the combination of the broker and dealer 
function in the same person, by assuring that he will not induce his 
customers to buy on credit, securities which he has undertaken to 
distribute to the public.'' Id. This prohibition applies to the 
direct or indirect extension or maintenance of credit, as well as 
arranging for the extension or maintenance of credit. See also supra 
note (concerning expectation that security futures will be issued by 
clearing agencies and not broker-dealers).
    \106\ 17 CFR 240.10b-16.
    \107\ See Securities Exchange Act Release No. 8773 (December 8, 
1969), 34 FR 19717 (December 16, 1969).
---------------------------------------------------------------------------

    A security future potentially raises various issues related to the 
extension of credit. For instance, questions may arise as to whether 
the contract should be viewed as an instrument in and of itself, or 
viewed as a down payment on ownership of the underlying security. We 
provide guidance about the security future itself and extensions of 
credit in relation to that instrument.
    Q40: Would a security future constitute an extension of credit 
under section 11(d) of the Exchange Act and for purposes of the 
disclosure requirements of Rule 10b-16?
    A40: A security future itself is not an extension of credit. The 
value of a security future can fluctuate throughout the life of the 
contract based on the value of the underlying security, with each party 
to the contract exposed to such fluctuations. Traditionally, marking to 
market of futures contracts allows gains and losses on futures 
contracts to be transferred regularly between contract parties 
throughout the life of the contract. While this practice could in a 
sense be viewed as involving only partial payment for a security, we 
believe that it actually reflects the nature of a futures contract, and 
not an attempt to extend credit in the sense contemplated by section 
11(d) or Rule 10b-16. As one commentator on futures explained, ``margin 
in futures accounts does not represent partial payment of the security 
as it does in stock transactions. No loan is involved. Margin in 
futures contracts simply represents a good faith deposit against 
performance.''\108\
---------------------------------------------------------------------------

    \108\ See New York Institute of Finance, Stocks Bonds Options 
Futures, Investments and Their Markets 184 (Stuart R. Veale, ed. 
1987).
---------------------------------------------------------------------------

    Q41: Would extensions of credit in relation to a security future be 
considered extensions of credit in relation to a new issue for purposes 
of section 11(d)(1)?
    A41: No. We expect security futures to be issued by clearing 
agencies and not underwritten or distributed by broker-dealers. 
Although credit may be extended in relation to security futures (e.g., 
advance funds to meet margin calls or make periodic variation 
payments), such extensions of credit are intended to support the 
margining system for futures contracts, a system set up to manage risk 
in the clearance and settlement system for this particular type of 
instrument. It is generally recognized that section 11(d)(1) is 
primarily intended to prohibit ``share pushing'' by broker-dealers 
engaged in a distribution of a new issue of non-exempted 
securities.\109\ Further, section 11(d)(1) serves a related customer 
protection purpose by precluding the overextension of customers with 
respect to new issue securities. As stated by the staff of the Federal 
Reserve Bank of New York, ``inducing customers to buy new issues on 
margin was perceived as a sales technique used by underwriters to 
reduce rapidly their exposure to risk

[[Page 43246]]

and as a technique that had resulted in credit-financed purchases which 
were not always appropriate for the buyers of new issues.''\110\ For 
purposes of section 11(d)(1), we expect markets in security futures 
issued by clearing agencies to operate more like secondary markets than 
markets in new issues. Moreover, leverage in such markets should derive 
more from the nature of the instrument than from a desire for broker-
dealers to extend credit to induce additional sales to deplete an 
underwriting inventory. Thus, the traditional public policy concerns 
underlying section 11(d)(1)'s limitations on credit activities in 
relation to new issues do not appear to be present for security 
futures. In the event private parties or broker-dealers begin to issue 
security futures, we might revisit extensions of credit in relation to 
such instruments.
---------------------------------------------------------------------------

    \109\ See VII Loss & Seligman, Securities Regulation 3290 n.420 
(3d ed. 1991).
    \110\ See Federal Reserve Bank of New York Staff Study: 
Securities Credit Regulations of the Board of Governors of the 
Federal Reserve System, pt. 1, at 126 (1979).
---------------------------------------------------------------------------

    Q42: Does Rule 10b-16 apply to extensions of credit related to 
security futures, including an extension of credit to fund a margin 
obligation?
    A42: Yes. While the future itself is not an extension of credit, 
Rule 10b-16 applies to all extensions of credit, directly or 
indirectly, to any customer in connection with any securities 
transaction, including a security future. Investors in security 
futures, including those extended credit in connection with margining, 
should benefit from the transparency of credit terms fostered by this 
Rule.

d. Ancillary Securities Activities by Notice-Registered Broker-Dealers

    Under the Exchange Act, only broker-dealers that limit their 
securities activities to security futures products and government 
securities pursuant to Exchange Act Rules 3a43-1 \111\ and 3a44-1 \112\ 
can be ``notice-registered,'' as opposed to fully registered broker-
dealers.\113\ Some have suggested identifying additional securities 
activities that would not trigger the need to fully register.
---------------------------------------------------------------------------

    \111\ 17 CFR 240.3a43-1.
    \112\ 17 CFR 240.3a44-1.
    \113\ See supra note 5.
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    Q43: Will the Commission provide an exemption from full broker-
dealer registration for notice-registered broker-dealers that engage in 
ancillary activities in securities other than, but in relation to, 
security futures products?
    A43: At this time, we do not believe broad exemptive relief is 
necessary for any additional ancillary securities activities of notice-
registered broker-dealers.\114\ In providing for notice registration, 
Congress envisioned that a notice-registered broker-dealer would engage 
in only security futures product activities.\115\ Limiting the scope of 
such notice registrants' activities serves the public interest because 
a wide array of broker-dealer regulations aimed at protecting investors 
and maintaining fair and orderly securities markets are not applied to 
notice-registered broker-dealers.\116\ Moreover, protections afforded 
by those notice registrants' other regulator, the CFTC, focus on 
futures, not securities markets.\117\ Should additional securities 
activities be necessary in conjunction with security futures products 
transactions, a notice-registered broker-dealer could direct customers 
to a fully registered broker-dealer or could fully register 
itself.\118\
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    \114\ The Commission already has addressed the issue of a 
notice-registered broker-dealer handling certain securities upon 
expiration of a security future that is physically-settled. As we 
stated when we adopted rules to permit notice registration, a 
notice-registered broker-dealer that accepts and occasionally 
delivers the underlying securities upon the expiration of a security 
future is not acting as a broker or a dealer with respect to those 
securities. It therefore is not required to register as a full 
broker-dealer. Because most futures transactions are generally 
closed out by offsetting transactions, and not by physical 
settlement, this should not be an issue for most notice-registered 
broker-dealers. A futures commission merchant that routinely closes 
out its transactions in security futures products by physical 
delivery, however, should register as a full broker-dealer. See 
Securities Exchange Act Release No. 44730 (August 21, 2001), 66 FR 
45138 (August 27, 2001).
    \115\ See 15 U.S.C. 78o(b)(11)(A). The fact that certain 
financial intermediaries could want to engage in a wider range of 
activities that would require both full broker-dealer and full 
futures commission merchant registration is reflected in the statute 
as well. See, e.g., 15 U.S.C. 78o(c)(3)(B); supra note 5.
    In addition, previously when Congress specifically envisioned 
the exemption of CFTC registrants from broker-dealer registration 
solely for government securities activities incidental to their 
futures business, Congress explicitly provided a statutory basis for 
such action. See Securities Exchange Act Release No. 24726 (July 22, 
1987), 52 FR 27962 (July 24, 1987) (adopting Exchange Act Rules 
3a43-1 and 3a44-1 implementing amendments to Section 3(a)(43) and 
3(a)(44) of the Exchange Act defining government securities broker 
and government securities dealer contained in the Government 
Securities Act of 1986).
    \116\ See supra note 5.
    \117\ See, e.g., CEA Section 16(e) [7 U.S.C. 20(e)].
    \118\ In addition, in connection with the management of its 
proprietary account, a notice-registered broker-dealer itself could 
effect transactions in equity securities in its own account with a 
fully registered broker-dealer. Such activities generally would not 
independently trigger the need to fully register as a broker-dealer 
unless they constituted activities of a ``dealer'' as that term is 
defined in the federal securities laws.
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    Of note, futures commission merchants already offer futures on 
broad-based stock indexes without special relief to engage in 
activities in the equity securities underlying such indexes without 
registering as broker-dealers.\119\ The intermediaries themselves may 
determine whether to register fully as broker-dealers in order for them 
to expand the scope of their securities activities. The Commission 
stands ready to address requests for exemptive relief, consistent with 
the public interest and the protection of investors, for highly 
delineated securities activities, where the services of a fully 
registered broker-dealer are unavailable and full registration is 
impractical.
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    \119\ Exchange Act Rules 3a43-1 and 3a44-1 provide some relief 
from broker-dealer registration related to a future commission 
merchant's ancillary government securities activities. See 17 CFR 
240.3a43-1; 240.3a44-1. However, such rules are inapposite to 
notice-registered broker-dealers wishing to engage in equity 
securities activities in addition to activities in security futures 
products. See supra note 115.
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III. Solicitation of Comments

    As noted above, security futures products are new products and 
markets in these products have only begun to develop. Guidance provided 
necessarily is based on how we expect security futures products markets 
to operate. Accordingly, we solicit comment to identify market 
developments that might make it necessary to revisit our guidance or to 
provide guidance on additional issues.

List of Subjects in 17 CFR Parts 231 and 241

    Securities.

Amendments to the Code of Federal Regulations

    For the reasons set forth above, the Commission is amending title 
17, chapter II of the Code of Federal Regulations as set forth below:

PART 231--INTERPRETATIVE RELEASES RELATING TO THE SECURITIES ACT OF 
1933 AND GENERAL RULES AND REGULATIONS THEREUNDER

    1. Part 231 is amended by adding Release No. 8107 and the release 
date of June 21, 2002, to the list of interpretive releases.

PART 241--INTERPRETIVE RELEASES RELATING TO THE SECURITIES EXCHANGE 
ACT OF 1934 AND GENERAL RULES AND REGULATIONS THEREUNDER

    2. Part 241 is amended by adding Release No. 46101 and the release 
date of June 21, 2002 to the list of interpretive releases.


[[Page 43247]]


    By the Commission.

    Dated: June 21, 2002.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02-16211 Filed 6-26-02; 8:45 am]
BILLING CODE 8010-01-P