[Federal Register Volume 71, Number 216 (Wednesday, November 8, 2006)]
[Notices]
[Pages 65555-65559]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E6-18798]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-54681; File No. SR-NASD-2006-103]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Notice of Filing of a Proposed Rule Change Relating to 
TRACE Requirements in Connection With the Exercise or Settlement of 
Options, Swaps, or Similar Instruments

 November 1, 2006.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'') \1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on August 28, 2006, the National Association of Securities Dealers, 
Inc. (``NASD'') filed with the Securities and Exchange Commission 
(``Commission'') the

[[Page 65556]]

proposed rule change as described in Items I, II, and III below, which 
items have been prepared by NASD. The Commission is publishing this 
notice to solicit comments on the proposed rule change from interested 
persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    NASD is proposing: (1) To adopt NASD IM-6230, which would provide 
exemptive relief from various reporting requirements for transactions 
in TRACE-eligible securities executed in connection with the 
termination or settlement of a credit default swap or a similar 
instrument; and (2) to amend NASD Rule 6250 to not disseminate 
information on certain transactions in TRACE-eligible securities 
executed in connection with the exercise or settlement of an option or 
similar instrument or the settlement or termination of a credit default 
swap, any other type of swap, or similar instrument.
    The text of the proposed rule change is available on NASD's Web 
site at http://www.nasd.com, at NASD's principal office, and at the 
Commission's Public Reference Room.

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

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

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

1. Purpose
    NASD is proposing NASD IM-6230, ``Reporting Transactions Executed 
in Connection with the Termination or Settlement of a Credit Default 
Swap,'' to provide exemptive relief from certain reporting requirements 
in NASD Rule 6230 for transactions in TRACE-eligible securities that 
occur in connection with the termination or settlement of CDSs or 
similar instruments. For certain transactions executed in connection 
with a broader class of instruments (options or similar instruments and 
CDSs, any other type of swaps, or similar instruments), NASD is 
proposing to amend its Rule 6250 to not disseminate information on 
transactions in TRACE-eligible securities executed in connection with 
the exercise, settlement, or termination of such instruments.

Background

    When a CDS is subject to physical settlement, the buyer effects 
contract settlement by communicating to the seller, in a single or the 
first of two or more Notice(s) of Physical Settlement (or a similar 
document(s)) (``First NOPS'') within a fixed period, the TRACE-eligible 
security or securities, by CUSIP, that the buyer will deliver to the 
seller. However, following delivery of the First NOPS, the buyer may 
have additional business days (for example, three additional business 
days) to change the specific TRACE-eligible securities the buyer will 
deliver. Once the TRACE-eligible securities to be delivered are 
determined, the buyer delivers the TRACE-eligible securities to the 
seller and the seller delivers cash (e.g., the par value of the 
securities or some other pre-determined amount per debt security).

Proposed NASD IM-6230

    In Notice to Members 05-77 (November 2005), NASD clarified that a 
member that is a party to a transaction in TRACE-eligible securities 
that occurs in connection with the termination or settlement of a CDS 
\3\ or a similar instrument must report the transaction to TRACE under 
NASD Rule 6230.\4\ Since publishing this Notice to Members, NASD has 
received inquiries regarding the application of certain reporting 
requirements, including requirements relating to the time of execution, 
the application of the 15-minute reporting period, and how to report 
transactions when, under certain often-used CDS documentation providing 
for termination or settlement, parties may be permitted to substitute 
one TRACE-eligible security for another.
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    \3\ In a CDS, one party purchases protection from third-party 
credit risk from a counterparty seller. The purchaser of the 
protection is referred to as the ``buyer'' and the provider of the 
credit protection is referred to as the ``seller'' in proposed NASD 
IM-6230. Under a standard CDS agreement, an event such as a default 
is deemed a ``credit event.'' When a credit event occurs, a ``credit 
event notice'' is delivered by either the buyer or seller. Within a 
fixed period from the date a credit event notice is received (e.g., 
30 days), the parties must communicate specific information needed 
to settle the CDS.
    \4\ NASD Notice to Members 05-77 (November 2005), among other 
things, clarified that the reporting requirement applies only to 
those CDSs that are terminated or settled in whole or in part by the 
physical settlement involving TRACE-eligible securities, and has no 
application to CDSs that are cash-settled. NASD also addressed the 
TRACE reporting requirements for TRACE-eligible securities 
transactions executed in connection with a broader class of 
instruments--options and similar instruments, and CDSs, any other 
type of swaps and similar instruments--and not just those TRACE-
eligible securities transactions executed in connection with CDSs.
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Timely Reporting

    Under NASD Rule 6230, a member is required to provide timely 
reports for transactions in TRACE-eligible securities. In addition, in 
most instances, such transactions must be reported within 15 minutes of 
the time of execution to be considered timely.
    NASD is proposing to provide exemptive relief from certain 
provisions of NASD Rule 6230 under proposed NASD IM-6230 for 
transactions that are executed in connection with the termination or 
settlement of a CDS, subject to certain conditions. Under proposed NASD 
IM-6230(a), such transactions would be deemed to be timely reported if 
they are reported before 8:15:00 a.m. E.T. on the next business day 
following receipt of the First NOPS, if the First NOPS was received on 
a business day, or before 6:30:00 p.m. on the next business day, if the 
First NOPS was received on a non-business day. In addition, a member 
would have to report such transactions using the TRACE memo field and 
include a ``CDS'' memo.\5\ The CDS memo would allow NASD to properly 
categorize such transactions for purposes of examining the member for 
compliance with its reporting obligations and, as discussed below, for 
decisions to not disseminate the transaction information.
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    \5\ NASD also requires that such transactions be reported using 
the ``special price'' modifier or flag, which is appropriately used 
when a transaction is executed at a price based on arm's length 
negotiation and done for investment, commercial, or trading 
considerations, but does not appear to reflect current market 
pricing. See Notice to Members 05-77 (November 2005).
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    NASD also proposes that the ``time of execution'' be construed as 
the time the transaction report is submitted. Under proposed NASD IM-
6230(b), a member would enter as the ``time of execution'' the time 
that the member submits the transaction report.\6\
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    \6\ If a transaction is reported before 8:15:00 a.m. E.T., NASD 
would assume that the First NOPS was delivered the prior business 
day. If a transaction is reported on or after 8:15:00 a.m. E.T., 
NASD would assume that the transaction was not reported timely. 
Firms would be expected to retain documentation, including the First 
NOPS, for transactions reported in connection with the termination 
or settlement of CDSs.
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    NASD believes that the reporting scheme in proposed NASD IM-6230(a) 
and (b) is appropriate for several reasons. NASD believes that the 
``time

[[Page 65557]]

of execution'' for CDS-related transactions is of less regulatory 
importance than for other reported transactions in TRACE-eligible 
securities because the price of a transaction in a TRACE-eligible 
security executed pursuant to a CDS is arrived at under the terms of 
the CDS agreement that are established at the time the CDS is agreed 
upon by the parties. Consequently, NASD believes that a precise time of 
execution is not required for regulatory purposes because such 
transactions are terminations or settlements of executory contractual 
obligations that do not provide useful data in connection with price 
discovery, determining best execution, or assessing reasonable mark-ups 
(or mark-downs). Rather, NASD requires the reports of CDS-related 
transactions in order to facilitate NASD's surveillance of the 
corporate bond market for the detection of various fraudulent or 
manipulative acts and unfair practices. Therefore, NASD is proposing 
that the time of execution of such transactions mirror the time of 
reporting. Moreover, for the same reasons, NASD believes that applying 
the 15-minute reporting requirement to such transactions imposes an 
unnecessary regulatory burden at this time. In addition, NASD believes 
that waiving the 15-minute reporting requirement will allow CDS buyers 
and sellers to process the First NOPS in all cases efficiently at some 
time during the business day that the First NOPS is received or the 
following morning through the first 15 minutes that the TRACE system is 
open, or, if the First NOPS is received on a non-business day, 
throughout the next business day until 6:29:59 p.m. E.T. Finally, NASD 
represents that the substantial costs to NASD of receiving and 
reviewing for market surveillance purposes a large number of ``late'' 
transactions (and the related ``cancel/correct'' late reports, as 
discussed below) and the substantial costs to members in respect of 
transactions where the time of execution is not critical for the 
purposes of NASD's regulatory review are secondary, but significant, 
reasons for proposing the exemptive relief in proposed IM-6230(a) and 
(b).

Substitution of Securities; Exemption From Reporting; Exemption From 
Correction

    NASD is also proposing that a limited group of transactions in 
TRACE-eligible securities that are executed in connection with the 
termination or settlement of a CDS be exempt from reporting and that a 
related group be exempt from the requirement to correct a previously 
transmitted erroneous trade report. Under proposed IM-6230(c), if a 
buyer submits the First NOPS and triggers the obligation of one or both 
parties to the CDS to report the TRACE-eligible securities 
transactions, and then substitutes another TRACE-eligible security for 
delivery, NASD would not require a member to submit a ``reversal'' 
trade report (to cancel the previously submitted report for a 
transaction in a TRACE-eligible security that did not occur as a result 
of the substitution and delivery of another TRACE-eligible security). 
In addition, NASD would not require the member to submit a transaction 
report (i.e., a ``cancel/correct'' trade report using an as/of date) to 
report the transaction in the substituted TRACE-eligible debt security.
    NASD believes that the proposed exemptive relief under NASD IM-
6230(c) recognizes the nature of CDS-related transactions and provides 
for reporting, but does not affect adversely the settlement process or 
the market in CDSs. Several factors informed NASD's proposed exemptive 
provision in NASD IM-6230(c). First, NASD notes that certain CDSs--
sometimes referred to as ``single name default swaps''--are not viewed 
as CDSs on a single debt security, but rather are considered a CDS on 
all of the issuer's debt securities of similar credit and seniority--
i.e., securities that are pari passu.\7\ For purposes of a CDS, such 
debt securities of similar credit and seniority are viewed as virtually 
fungible within the issuer's capital structure. As a result, a 
purchaser of a CDS often may be permitted to choose from among several 
debt securities that are pari passu to make good delivery. NASD 
believes that the reporting of transactions in TRACE-eligible 
securities in connection with the termination or settlement of a CDS 
provides important market surveillance information that is not changed 
materially even if, subsequently, one or more of the specific TRACE-
eligible securities reported initially to the TRACE system is 
substituted and a different TRACE-eligible security of the same issuer 
is delivered to effectuate settlement.
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    \7\ Securities that are pari passu are those that are entitled 
to be paid on an equal basis from the same pool of assets.
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    Also, NASD has determined that any additional regulatory 
information and regulatory benefit obtainable from the ``cancel/
correct'' trade reports and ``late'' reports (for any TRACE-eligible 
security delivered in substitution, as described above) are outweighed 
by the substantial costs that would be incurred by both NASD and 
members by requiring such follow-up reporting.

Proposed Amendments to NASD Rule 6250

    NASD Rule 6250 currently requires that information on all 
transactions in TRACE-eligible securities be disseminated immediately 
upon receipt of the transaction report, except transactions in TRACE-
eligible securities that are purchased or sold pursuant to Rule 144A of 
the Securities Act of 1933 (``Rule 144A transactions''). NASD proposes 
to amend its Rule 6250 to not disseminate information on certain 
transactions in TRACE-eligible securities executed in connection with 
the exercise or settlement of an option or similar instrument or the 
settlement or termination of a CDS, any other type of swap, or similar 
instrument (hereinafter, the exercise, settlement or termination of 
such instruments is referred to collectively as ``option exercises and/
or swap settlements''). NASD proposes that such information not be 
publicly disseminated because it does not contribute to price discovery 
and may cause investor confusion. NASD also proposes to re-number 
current NASD Rule 6250(b), the exception from dissemination that 
applies to Rule 144A transactions, as new NASD Rule 6250(b)(1).
    As noted previously, NASD clarified that transactions in TRACE-
eligible securities occurring as a result of such option exercises and/
or swap settlements are required to be reported to TRACE.\8\ However, 
although reported, NASD believes that the dissemination of pricing and 
other information on such transactions does not appear to provide 
market participants with information useful for price discovery 
purposes. NASD believes that this is due primarily to the fact that 
such options, CDSs, other types of swaps, and similar instruments are 
generally entered into significantly earlier than the occurrence of the 
option exercise and/or swap settlement. NASD notes that the agreements 
setting out the terms for these transactions generally determine the 
price of the TRACE-eligible securities at arm's length for investment, 
commercial, or trading purposes in a manner that tends not to be 
reflective of the current market price of the TRACE-eligible security 
as of the day and time that the transaction or transactions in TRACE-
eligible securities occur (e.g., at the option exercises and/or swap 
settlement),

[[Page 65558]]

which may be several weeks, months, or years later.
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    \8\ See supra note 4.
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    In addition, NASD is concerned that for some investors, especially 
retail investors, the dissemination of such pricing information may 
cause significant investor confusion. If a significant number of 
transactions occur in a specific TRACE-eligible security as a result of 
option exercises and/or swap settlements and, at the same time, other 
market participants are executing transactions in the same TRACE-
eligible security, the pricing information that would be disseminated 
would reflect divergent prices for the same security during the same 
period. For example, if a credit event occurs with respect to the 
issuer of the TRACE-eligible security or securities that are the 
subject of a CDS, a number of transactions in such TRACE-eligible 
securities would be reported at par (i.e., a price of 100) to TRACE and 
disseminated to the public when one or more CDSs are settled. At the 
same time, other transactions in the same TRACE-eligible security might 
be reported as executed at a price substantially discounted from par 
(e.g., a price of 60) and immediately disseminated (unless they are 
Rule 144A transactions). NASD has seen several such scenarios unfold 
and believes that such price dissemination may confuse investors, 
particularly less sophisticated investors.
    For these reasons, NASD proposes an exception to the general 
principle stated in NASD Rule 6250(a) requiring dissemination of 
transaction information of all TRACE-eligible securities except Rule 
144A transactions. Proposed NASD Rule 6250(b)(2) provides that certain 
transactions that occur as a result of options exercises and/or swap 
settlements would not be disseminated. However, this proposed exception 
to dissemination is subject to certain important conditions. NASD 
represents that these conditions are intended to insure that the 
options, CDSs, other types of swaps, and similar instruments resulting 
in such transactions are bona fide and to limit the exception to TRACE 
transactions occurring as a result of instruments that, by the nature 
of their terms are not designed, at the time the agreement is entered 
into, to replicate, as option exercises and/or swap settlements, the 
then-current market price of the TRACE-eligible security.
    First, the proposed exception to dissemination would apply only to 
options, CDSs, other types of swaps, or similar instruments that are in 
writing and express legal and enforceable contractual obligations. 
Second, such instruments must have a term of at least 20 business days 
and could not be exercised, terminated, or settled earlier than the end 
of the 20th business day from the date of issuance. NASD represents 
that this condition is intended to limit the dissemination exception by 
excluding short-term options or similar instruments because they are 
more likely to be utilized as proxies for current market transactions 
in the underlying TRACE-eligible securities.
    The third condition is that the instrument must have an exercise or 
strike price that is fixed and out-of-the-money by at least 10 percent 
at the date of issuance, or a price formula that is fixed and results 
in an exercise or strike price that is out-of-the-money by at least 10 
percent at the date of issuance, or a price formula that is fixed and 
results in a final price--combining any premium, installment or similar 
payment, and any strike or exercise price or similar term--that is out-
of-the money by at least 10 percent at the date of issuance. Like the 
second condition above, NASD represents that this condition is intended 
to limit the dissemination exception to transactions that are not based 
on a current market price or negotiation or are not intended as a proxy 
for a current market transaction. For example, an option written deep 
in-the-money would be considered a proxy for a current market 
transaction and the exercise-related transaction would not be eligible 
for the TRACE dissemination exception. Similarly, the exercise-related 
transaction of an option with a pricing formula that at exercise 
utilizes the current market price or calls for a negotiation at the 
current market would not be eligible for the TRACE dissemination 
exception.\9\ NASD believes that such formulas may result in 
transactions that provide important price discovery information to the 
market when disseminated and also are not likely to cause investor 
confusion if an investor seeks to determine the current market price of 
a particular TRACE-eligible security. Thus, as part of the third 
condition, NASD is proposing that the instrument be out-of-the money by 
at least 10 percent at issuance to ensure that instruments not be 
written ``near the money'' to serve as proxies for current market 
transactions. This may occur when two parties enter into an instrument 
expecting that, after the option or similar instrument is in place, one 
of them (or another party, as directed) will be able to move the 
current market price of an illiquid TRACE-eligible security by 
executing one or a few transactions in the security, resulting in the 
option or similar instrument becoming ``in-the-money'' and being 
exercised.
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    \9\ For example, a transaction in a TRACE-eligible security 
occurring as a result of the exercise of a ``zero-strike'' option, 
an option which simply tracks the value of the underlying instrument 
(in this case, a TRACE-eligible security) and expires (or is 
exercised) at the then current market value of the instrument it is 
tracking, would not be eligible for the TRACE dissemination 
exception.
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    NASD also proposes to re-number current NASD Rule 6250(b), the 
exception to dissemination that applies to Rule 144A transactions, as 
new NASD Rule 6250(b)(1).

Effective Date

    NASD would announce the effective date of the proposed rule change 
in a Notice to Members to be published no later than 60 days following 
Commission approval, if the Commission approves this proposal. NASD 
represents that the effective date of the proposed rule change would be 
not more than 90 days following publication of the Notice to Members 
announcing any Commission approval.
2. Statutory Basis
    NASD believes that the proposed rule change is consistent with the 
provisions of Section 15A(b)(6) of the Act,\10\ which requires, among 
other things, that NASD rules must be designed to prevent fraudulent 
and manipulative acts and practices, to promote just and equitable 
principles of trade, and, in general, to protect investors and the 
public interest. NASD believes that the proposed limited, conditional 
exemptive provisions requiring the reporting of transactions executed 
in connection with the termination or settlement of a CDS or a similar 
instrument would protect investors and are in the public interest in 
that they would facilitate and enhance NASD's surveillance of the over-
the-counter corporate debt market, while recognizing the particular 
characteristics of such transactions and practices relating to 
execution and settlement, and providing sufficient flexibility to avoid 
adversely affecting the market in CDSs and similar instruments. 
Further, NASD believes that not disseminating information on TRACE-
eligible securities transactions executed in connection with the 
exercise or settlement of an option or similar instrument or the 
settlement or termination of a CDS, any other type of swap, or similar 
instrument is in the public interest and protects investors, 
particularly retail investors, because the dissemination of such 
information may cause significant investor confusion,

[[Page 65559]]

particularly for retail investors, and such information does not appear 
to contribute to price discovery by market participants.
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    \10\ 15 U.S.C. 78o-3(b)(6).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    NASD does not believe that the proposed rule change would impose 
any burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act.

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

    Written comments were neither solicited nor received.

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

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which NASD consents, the Commission will:
    (A) By order approve such proposed rule change, or
    (B) institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change 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-2006-103 on the subject line.

Paper Comments

     Send paper comments in triplicate to Nancy M. Morris, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-1090.

All submissions should refer to File Number SR-NASD-2006-103. 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 Room. Copies of such 
filing also will be available for inspection and copying at the 
principal office of 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-2006-103 and should be submitted on or before November 29, 
2006.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\11\
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    \11\ 17 CFR 200.30-3(a)(12).
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Nancy M. Morris,
Secretary.
[FR Doc. E6-18798 Filed 11-7-06; 8:45 am]
BILLING CODE 8011-01-P