[Federal Register Volume 70, Number 122 (Monday, June 27, 2005)]
[Notices]
[Pages 36982-36985]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E5-3326]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-51891; File No. SR-NASD-2004-139]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Order Approving Proposed Rule Change and Amendment No. 1 
and Notice of Filing and Order Granting Accelerated Approval to 
Amendment No. 2 Relating to the Listing and Trading of Leveraged Index 
Return Notes Linked to the Dow Jones Industrial Average

June 21, 2005.

I. Introduction

    On September 15, 2004, the National Association of Securities 
Dealers, Inc. (``NASD''), through its subsidiary, The Nasdaq Stock 
Market, Inc. (``Nasdaq''), filed with the Securities and Exchange 
Commission (``Commission''), pursuant to Section 19(b)(1) of the 
Securities Exchange Act of 1934 (``Act''),\1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change to list and trade Leveraged Index 
Return Notes Linked to the Dow Jones Industrial Average (``Notes'') 
issued by Merrill Lynch & Co., Inc. (``Merrill Lynch''). On March 21, 
2005, Nasdaq submitted Amendment No. 1.\3\ The proposed rule change, as 
modified by Amendment No. 1, was published for notice and comment in 
the Federal Register on March 30, 2005.\4\ The Commission received no 
comment letters regarding the proposed rule change. On May 31, 2005, 
Nasdaq submitted Amendment No. 2 to the proposal.\5\ This order 
approves the proposed rule change, as modified by Amendment No. 1. 
Simultaneously, the Commission provides notice of filing of Amendment 
No. 2 and grants accelerated approval of Amendment No. 2.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ In Amendment No. 1, Nasdaq provided additional details 
regarding the proposed index linked notes and underlying index.
    \4\ See Securities Exchange Act Release No. 51425 (March 23, 
2005), 70 FR 16322 (``Notice'').
    \5\ In Amendment No. 2, Nasdaq modified its proposal to include 
conditions under which it would commence delisting or removal 
proceedings with respect to the Notes.
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II. Description of Proposal

    Nasdaq proposes to list and trade the Notes, which provide for a 
return based upon the Dow Jones Industrial Average (``Index''). As set 
forth in the Notice, the Index is a price-weighted index published by 
Dow Jones & Company, Inc. A component stock's weight in the Index is 
based on its price per share,

[[Page 36983]]

rather than the total market capitalization of the issuer of that 
component stock. The value of the Index is the sum of the primary 
market prices of each of the 30 common stocks included in the Index, 
divided by a divisor that is designed to provide a meaningful 
continuity in the value of the Index. In order to prevent certain 
distortions related to extrinsic factors, the divisor may be adjusted 
appropriately. The current divisor of the Index is published daily in 
the WSJ and other publications. Other statistics based on the Index may 
be found in a variety of publicly available sources. The value of the 
Index is widely disseminated at least every 15 seconds by providers 
that are independent from Merrill Lynch. In the event the calculation 
or dissemination of the Index is discontinued, Nasdaq will delist the 
Notes.
    The Index is designed to provide an indication of the composite 
price performance of 30 common stocks of corporations representing a 
broad cross-section of U.S. industry. The corporations represented in 
the Index tend to be market leaders in their respective industries, and 
their stocks are typically widely held by individuals and institutional 
investors. The component stocks in the Index are selected (and any 
changes are made) by the editors of the Wall Street Journal (``WSJ''). 
Changes to the stocks included in the Index tend to be made 
infrequently. Historically, most substitutions have been the result of 
mergers, but from time to time, changes may be made to achieve what the 
editors of the WSJ deem to be a more accurate representation of the 
broad market of the U.S. industry.
    As of August 27, 2004, the market capitalization of the securities 
included in the Index ranged from a high of approximately $346 billion 
to a low of approximately $24 billion. The average daily trading volume 
for Index components (calculated over the previous thirty trading days) 
ranged from a high of approximately 24 million shares to a low of 
approximately 1.7 million shares.
    In its proposal, Nasdaq also provided the following information 
relevant to the listing and trading of the Notes:
    The Notes, which will be registered under Section 12 of the Act, 
will be subject to Nasdaq's initial listing criteria for other 
securities under Rule 4420(f).\6\ The Notes will be subject to Nasdaq's 
continued listing criterion for other securities pursuant to Rule 
4450(c). Under this criterion, the aggregate market value or principal 
amount of publicly held units must be at least $1 million. The Notes 
also must have at least two registered and active market makers as 
required by Rule 4310(c)(1). Nasdaq specifically represents that it 
will commence delisting or removal proceedings with respect to the 
Notes (unless the Commission has approved the continued trading of the 
Notes) if any of the following standards are not continuously 
maintained:
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    \6\ Under NASD Rule 4420(f), Nasdaq may approve for listing and 
trading innovative securities that cannot be readily categorized 
under traditional listing guidelines. See Exchange Act Release No. 
32988 (September 29, 1993); 58 FR 52124 (October 6, 1993).
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    (i) Each component security has a minimum market value of at least 
$75 million, except that for each of the lowest weighted component 
securities in the Index that in the aggregate account for no more than 
10% of the weight of the Index, the market value can be at least $50 
million;
    (ii) Each component security shall have trading volume in each of 
the last six months of not less than 500,000 shares, except that for 
each of the lowest weighted component securities in the Index that in 
the aggregate account for no more than 10% of the weight of the Index, 
the trading volume shall be at least 400,000 shares for each of the 
last six months;
    (iii) The total number of components in the Index may not increase 
or decrease by more than 33\1/3\% from the number of components in the 
Index at the time of the initial listing of the Notes, and in no event 
may be fewer than ten (10) components;
    (iv) As of the first day of January and July of each year, no 
underlying component security will represent more than 25% of the 
weight of the Index, and the five highest weighted component securities 
in the index do not in the aggregate account for more than 50% of the 
weight of the index;
    (v) 90% of the Index's numerical value and at least 80% of the 
total number of component securities meet the then current criteria for 
standardized option trading of a national securities exchange or a 
national securities association;
    (vi) Each component security (except foreign country securities) 
shall be issued by a 1934 Act reporting company and listed on a 
national securities exchange or Nasdaq; and
    (vii) Foreign country securities or American Depository Receipts 
(``ADRs'') that are not subject to comprehensive surveillance 
agreements do not in the aggregate represent more than 20% of the 
weight of the Index.
    Nasdaq will also commence delisting or removal proceedings with 
respect to the Notes (unless the Commission has approved the continued 
trading of the Notes) under any of the following circumstances:
    (i) If the aggregate market value or the principal amount of the 
Notes publicly held is less than $400,000;
    (ii) If the value of the Index is no longer calculated or widely 
disseminated on at least a 15-second basis; or
    (iii) If such other event shall occur or condition exists which in 
the opinion of Nasdaq makes further dealings on Nasdaq inadvisable.
    Nasdaq will also consider prohibiting the continued listing of the 
Notes if Merrill Lynch is not able to meet its obligations on the 
Notes.
    Because the Notes will be deemed equity securities for the purpose 
of Rule 4420(f), the NASD and Nasdaq's existing equity trading rules 
will apply to the Notes. Thus, Nasdaq states that, in accordance with 
NASD Rule 2310(a) and IM-2310-2, Nasdaq will advise members 
recommending a transaction in the Notes to have reasonable grounds for 
believing that the recommendation is suitable for such customer upon 
the basis of the facts, if any, disclosed by such customer as to his 
other security holdings and as to his financial situation and needs. In 
addition, pursuant to Rule 2310(b), prior to the execution of a 
transaction in the Notes that has been recommended to a non-
institutional customer, a member shall make reasonable efforts to 
obtain information concerning: (1) The customer's financial status; (2) 
the customer's tax status; (3) the customer's investment objectives; 
and (4) such other information used or considered to be reasonable by 
such member in making recommendations to the customer. Also, the Notes 
will be considered non-conventional investments for purposes of NASD's 
Notice to Members 03-71.\7\ Furthermore, the Notes will be subject to 
the equity margin rules. Lastly, the regular equity trading hours of 
9:30 a.m. to 4 p.m. will apply to transactions in the Notes.
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    \7\ See NASD, NTM 03-71 (November 2003), note 1.
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    The Notes are a series of senior non-convertible debt securities 
that will be issued by Merrill Lynch and will not be secured by 
collateral. The Notes will be issued in denominations of whole units 
(``Unit''), with each Unit representing a single Note. The original 
public offering price will be $10 per Unit. The Notes will not pay 
interest and are not subject to redemption by Merrill Lynch or at the 
option of any beneficial owner before

[[Page 36984]]

maturity. The Notes' term to maturity is five years.
    At maturity, if the value of the Index has increased, a beneficial 
owner of a Note will be entitled to receive the original offering price 
($10), plus an amount calculated by multiplying the original offering 
price ($10) by an amount expected to be between 105% and 115% 
(``Participation Rate'') of the percentage increase in the Index.\8\ 
If, at maturity, the value of the Index has not changed or has 
decreased by up to 20%, then a beneficial owner of a Note will be 
entitled to receive the full original offering price.
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    \8\ The actual Participation Rate date will be determined on the 
day the Notes are priced for initial sale to the public and 
disclosed in the final prospectus supplement.
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    However, unlike ordinary debt securities, the Notes do not 
guarantee any return of principal at maturity. Therefore, if the value 
of the Index has declined at maturity by more than 20%, a beneficial 
owner will receive less, and possibly significantly less, than the 
original offering price: for each 1% decline in the Index below 20%, 
the redemption amount of the Note will be reduced by 1.25% of the 
original offering price.
    The change in the value of the Index will normally (subject to 
certain modifications explained in the prospectus supplement) be 
determined by comparing (a) the average of the values of the Index at 
the close of the market on five business days shortly before the 
maturity of the Notes to (b) the closing value of the Index on the date 
the Notes are priced for initial sale to the public. The value of the 
Participation Rate will be determined by Merrill Lynch on the date the 
Notes are priced for initial sale based on the market conditions at 
that time. Both the value of the Index on the date the Notes are priced 
and the Participation Rate will be disclosed in Merrill Lynch's final 
prospectus supplement, which Merrill Lynch will deliver in connection 
with the initial sale of the Notes.
    The Notes are cash-settled in U.S. dollars and do not give the 
holder any right to receive a portfolio security, dividend payments, or 
any other ownership right or interest in the portfolio of securities 
comprising the Index. The Notes are designed for investors who want to 
participate or gain exposure to the Index, and who are willing to 
forego market interest payments on the Notes during the term of the 
Notes.
    Pursuant to Securities Exchange Act Rule 10A-3 and Section 3 of the 
Sarbanes-Oxley Act of 2002, Public Law 107-204, 116 Stat. 745 (2002), 
Nasdaq will prohibit the initial or continued listing of any security 
of an issuer that is not in compliance with the requirements set forth 
therein.
    Nasdaq represents that the NASD's surveillance procedures are 
adequate to properly monitor the trading of the Notes. Specifically, 
the NASD will rely on its current surveillance procedures governing 
equity securities and will include additional monitoring on key pricing 
dates.

III. Commission Findings

    After careful consideration, the Commission finds that the proposed 
rule change is consistent with the requirements of Section 15A of the 
Act,\9\ applicable to a national securities association, and, in 
particular, with the requirements of Section 15A(b)(6) of the Act,\10\ 
in that it is designed to promote just and equitable principles of 
trade, to remove impediments to and perfect the mechanism of a free and 
open market, and, in general, to protect investors and the public 
interest.\11\
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    \9\ 9 15 U.S.C. 78o-3.
    \10\ 15 U.S.C. 78o-3(b)(6).
    \11\ In approving the proposed rule, the Commission has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. 15 U.S.C. 78c(f).
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    The Commission has previously approved the listing of securities 
with a structure similar to that of the Notes, which have been linked 
to, or based on, the Index or another broad-based index.\12\ The Notes, 
however, are different from prior products because their return does 
not directly correspond to the index performance when the index 
declines. Rather, for each 1% decline in the Index below 20%, the 
redemption amount of the Note will be reduced by 1.25% of the original 
offering price. However, NASD Rules 2310(a) and (b), along with NASD IM 
2310-2, and NASD NTM 03-71 address member obligations with respect to 
customers of the Notes. Consequently, the Commission believes that it 
is appropriate to permit investors to benefit from the flexibility 
afforded by trading these products.
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    \12\ See, e.g., Securities Exchange Act Release Nos. 49301 
(February 23, 2004), 69 FR 9665 (March 1, 2004) (approving the 
listing and trading of 97% principal protected notes linked to the 
Index); 48486 (September 11, 2003), 68 FR 54758 (September 18, 2003) 
(approving the listing and trading of contingent principal protected 
notes linked to the S&P 500 Index); 48152 (July 10, 2003), 68 FR 
42435 (July 17, 2003) (approving the listing and trading of partial 
principal protected notes linked to the S&P 500 Index); 46883 (Nov. 
21, 2002), 67 FR 71216 (Nov. 29, 2002) (approving the listing and 
trading of notes linked to the Index); 39525 (Jan. 8, 1998), 63 FR 
2438 (Jan. 15, 1998) (approving the listing and trading of DIAMONDS 
Trust Units, portfolio depositary receipts based on the Index); and 
39011 (Sept. 3, 1997), 62 FR 47840 (Sept. 11, 1997) (approving the 
listing and trading of options on the Index).
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    The hybrid listing standards set forth in NASD Rule 4420(f) were 
designed to address the concerns attendant to the trading of 
securities, like the Notes.\13\ The 30 component stocks that comprise 
the Index are reporting companies under the Act, and the Notes will be 
registered under Section 12 of the Act. Thus, by imposing the hybrid 
listing standards, heightened suitability, disclosure, and compliance 
requirements set forth in Nasdaq's proposal, the Commission should 
adequately address the potential problems that could arise from listing 
and trading the Notes.
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    \13\ See Securities Exchange Act Release No. 32988 (September 
29, 1993), 58 FR 52124 (October 6, 1993). For example, NASD Rule 
4420(f) provides that only issuers satisfying substantial asset and 
equity requirements may issue securities such as the Notes. In 
addition, Nasdaq's continued listing criteria require that the Notes 
maintain a market value of at least $1 million. See NASD Rule 
4450(c).
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    The Commission notes that Nasdaq will distribute a circular to its 
membership that provides guidance regarding member firm compliance 
responsibilities and requirements, including suitability 
recommendations, and highlights the special risks and characteristics 
associated with the Notes. Among other things, the circular should 
indicate that the Notes do not guarantee a total return of principal at 
maturity; that for each 1% decline in the Index below 20%, the 
redemption amount of the Note will be reduced by 1.25% of the original 
offering price; that the Participation Rate on the Notes is expected to 
be between 105% and 115% per unit; that the Notes will not pay 
interest; and that the Notes will provide exposure in the Index. The 
circular will also explain Merrill Lynch's calculation of the Notes' 
Participation Rate. Distribution of the circular should help to ensure 
that only customers with an understanding of the risks attendant to the 
trading of the Notes and who are able to bear the financial risks 
associated with transactions in the Notes will trade the Notes. In 
addition, the Commission notes that Merrill Lynch will deliver a 
prospectus in connection with the initial purchase of the Notes.
    In approving the product, the Commission recognizes that the Index 
is a price-weighted index of 30 of the largest and most active common 
stocks listed on Nasdaq and the NYSE. The Commission notes that the 
Index is determined, composed, and calculated by the editors of the 
WSJ, which is not a broker-dealer. The underlying stocks

[[Page 36985]]

comprising the Index are well-capitalized, highly liquid stocks. Given 
the large trading volume and capitalization of each of the stocks 
underlying the Index, the Commission believes that the listing and 
trading of the proposed Notes should not unduly impact the market for 
the securities underlying the Index or raise manipulative concerns. 
Moreover, as noted above, the issuers of the underlying securities 
comprising the Index are subject to reporting requirements under the 
Act, and all of the component stocks are either listed or traded on, or 
traded through the facilities of, U.S. securities markets. In addition, 
NASD's surveillance procedures should serve to deter as well as detect 
any potential manipulation.
    Regarding the systemic concern that a broker-dealer, such as 
Merrill Lynch, or a subsidiary providing a hedge for the issuer will 
incur position exposure, the Commission finds, as in previous approval 
orders for hybrid instruments similar to Notes issued by broker-
dealers, that this concern is minimal given the size of the Notes 
issuance in relation to the net worth of Merrill Lynch.\14\
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    \14\ See supra note 12. See also Securities Exchange Act Release 
Nos. 44913 (October 9, 2001), 66 FR 52469 (October 15, 2001) 
(approving the listing and trading of notes issued by Morgan Stanley 
Dean Witter & Co. whose return is based on the performance of the 
Nasdaq-100 Index); 44483 (June 27, 2001), 66 FR 35677 (July 6, 2001) 
(approving the listing and trading of notes issued by Merrill Lynch 
whose return is based on a portfolio of 20 securities selected from 
the Amex Institutional Index); and 37744 (September 27, 1996), 61 FR 
52480 (October 7, 1996) (approving the listing and trading of notes 
issued by Merrill Lynch whose return is based on a weighted 
portfolio of the Healthcare/Biotechnology industry securities).
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    Nasdaq also represents that index value of the Index is widely 
disseminated at least every 15 seconds. The Commission finds that such 
public dissemination of the index valuation will provide investors with 
timely and useful information concerning the value of their Notes.
    The Commission finds good cause for approving proposed Amendment 
No. 2 before the thirtieth day of publication of notice of filing 
thereof in the Federal Register because Amendment No. 2 simply 
clarifies the continued listing criteria for the Notes.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment No. 2, including whether the amendment 
is consistent with the Act. Comments may be submitted by any of the 
following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml); or
     Send an e-mail to [email protected]. Please include 
File Number SR-NASD-2004-139 on the subject line.

Paper Comments

     Send paper comments in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 100 F Street, NE, 
Washington, DC 20549-0609.
    All submissions should refer to File Number SR-NASD-2004-139. This 
file number should be included on the subject line if e-mail is used. 
To help the Commission process and review your comments more 
efficiently, please use only one method. The Commission will post all 
comments on the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml). Copies of the submission, all subsequent amendments, 
all written statements with respect to the proposed rule change that 
are filed with the Commission, and all written communications relating 
to the proposed rule change between the Commission and any person, 
other than those that may be withheld from the public in accordance 
with the provisions of 5 U.S.C. 552, will be available for inspection 
and copying in the Commission's Public Reference Section, 100 F Street, 
NE, Washington, DC 20549. Copies of such filing also will be available 
for inspection and copying at the principal office of the NASD. All 
comments received will be posted without change; the Commission does 
not edit personal identifying information from submissions. You should 
submit only information that you wish to make available publicly. All 
submissions should refer to File Number SR-NASD-2004-139 and should be 
submitted on or before July 18, 2005.

V. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\15\ that the proposed rule change, as amended by Amendment No. 1 
(SR-NASD-2004-139), is hereby approved, and that Amendment No. 2 to the 
proposed rule change is approved on an accelerated basis.
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    \15\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\16\
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    \16\ 17 CFR 200.30-3(a)(12).
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Jill M. Peterson,
Assistant Secretary.
[FR Doc. E5-3326 Filed 6-24-05; 8:45 am]
BILLING CODE 8010-01-P