SEC Approves NASD Rules Concerning Index, Currency, And Currency Index Warrants

Executive Summary

On September 28, 1995, the Securities and Exchange Commission (SEC) approved proposed changes to NASD^® rules governing index, currency, and currency index warrants. The amended rules:

• revise the listing criteria for stock index warrants;
  
  
• specify the customer margin requirements for the purchase and short sale of stock index and currency warrants; and
  
  
• create a new Schedule J to the NASD By-Laws that consolidates all of the regulatory requirements applicable to the conduct of accounts, the execution of transactions, and the handling of orders in index warrants listed on Nasdaq^® and exchange-listed stock index warrants, currency index warrants, and currency warrants by members that are not members of the exchange on which the warrant is listed or traded.

The full text of the rule changes concerning index, currency, and currency index warrants is at the end of this Notice.

All currency and index warrants traded on a national securities exchange before the SEC's approval of the new rules are grandfathered.

Summary Of The Rule Changes

Account Approval, Trading, And Advertising Rules

New Schedule J to the By-Laws sets out various customer protection rules applicable to stock index, currency index, and currency warrants. Specifically, Schedule J makes existing options customer protection rules in Article III, Section 33 of the NASD Rules of Fair Practice applicable to stock index, currency, and currency index warrants. Where the options sales practice rules are made applicable by Schedule J to such warrants, the term "option" includes a stock index, currency index, or currency warrant.

Section 3 of Schedule J states that no member may accept an order from a customer to purchase or sell a stock index, currency index, or currency warrant unless the customer's account has been approved for options trading pursuant to Article III, Section 33(b)(16) of the Rules of Fair Practice.

Sections 4 through 7 and 9 of Schedule J apply the options rules for suitability (Section 33(b)(9)), discretionary accounts (Section 33(b)(18)), supervision of accounts (Sections 33(b)(17)(B) and (20)), and customer complaints (Section 33(b)(17)(A)) to stock index and currency warrants.

Section 8 of Schedule J generally applies the standards applicable to written communications regarding listed options (Section 35A) to stock index and currency warrants. The provisions of Section 35A as applied to stock index and currency warrants require that all advertisements, sales literature, and educational material issued by a member pertaining to stock index and currency warrants be approved by a Compliance Registered Options Principal, and all advertisements and educational materials pertaining to stock index warrants be approved by the NASD or by another self-regulatory organization.

The NASD cautions its members that any time they provide information to a customer regarding stock index warrants, they should provide the customer with information regarding the unique characteristics and risks of these instruments. In addition, any written communications to customers regarding stock index and currency warrants should state that these warrants share many of the risks of standardized options, but, unlike standardized options, they are backed only by the credit of the issuer (not The Options Clearing Corporation (OCC)) and each issue of warrants contains its own terms and conditions that may differ from those of other warrants, even other warrants on the same underlying index or issued by the same issuer.

Position And Exercise Limits And Reporting Requirements

Section 10 of Schedule J provides that position limits for stock index warrants on the same index with original issue prices of $10 or less will be 15 million warrants, except that for warrants on the Standard & Poor's MidCap 400 Index with an original issue price of $10 or less, the position limit will be 7.5 million warrants. The position limits are consolidated position limits, meaning that index warrants on the same index on the same side of the market must be aggregated for position-limit purposes.

The position limit rule also contains a provision that equalizes positions in index warrants that initially were priced above $10 with those that were priced at or below $10. In particular, positions will be equalized by dividing the original issue price of the index warrants priced above $10 by 10 and multiplying this number by the size of the index warrant position. For example, if an investor held 100,000 Nasdaq 100 Index^® warrants priced initially at $20, the size of this position for position-limit purposes would be 200,000, or 100,000 times 20 divided by 10.

Section 11 of Schedule J sets forth the exercise limits applicable to index warrants. Specifically, the exercise limits provide that no investor or group of investors acting in concert may, within five consecutive business days, exercise more index warrants on the same index on the same side of the market than the applicable index warrant position limit.

Section 12 of Schedule J provides that positions of 100,000 or more index warrants on the same index on the same side of the market must be reported to the NASD.

Section 14 of Schedule J provides that the NASD may halt or suspend trading in an index warrant if it concludes that such action is appropriate in the interests of a fair and orderly market and the protection of investors. Among the factors that may be considered by the NASD are:

• trading has been halted or suspended in underlying stocks whose weighted value represents 20 percent or more of the index value;
  
  
• the current calculation of the index derived from the current market prices of the stocks is not available; or
  
  
• other unusual conditions or circumstances detrimental to the maintenance of a fair and orderly market are present.

Margin

New Section 3(f)(10) of Article III, Section 30 of the Rules of Fair Practice states the margin requirements applicable to index, currency, and currency index warrants.

For long warrant positions, the new requirements provide that the initial and maintenance requirements for long positions in index, currency, and currency index warrants will be 100 percent of the full purchase price of the warrants.

For short positions in index warrants, the margin requirement is 100 percent of the current market value of the warrant plus 15 percent of the current value of the underlying index. The margin requirements for short positions can be decreased to the extent that they are out-of-the-money, however, the minimum requirement for each such warrant cannot be less than the current value of the warrant plus 10 percent of the current index value.

For short positions in currency warrants, the margin requirements follow the margin requirements presently applicable to standardized currency options. Specifically, short sales of warrants on the German mark, French franc, Swiss franc, Japanese yen, British pound, Australian dollar, and European Currency Unit will each be subject to a margin level of 100 percent of the current market value of each such warrant plus a four percent "add on." Warrants on the Canadian dollar would be subject to a one percent "add on." The "add on" required on any other foreign currency would be such other percentage as specified by the national securities exchange listing the warrant and approved by the SEC on a case-by-case basis. The required margin can be decreased to the extent that the warrant is out-of-the-money, however, the minimum requirement for each such warrant must not be less than the current value of the warrant plus .75 percent (.0075) of the value of the underlying currency (or such other percentage as specified by the national securities exchange listing the warrant and approved by the SEC).

The margin required on currency index warrants would be an amount as determined by the national securities exchange listing the warrant and approved by the SEC.

Index, currency warrant, and currency index warrant margin requirements also receive offset treatment for spread and straddle positions. Specifically, stock index, currency, and currency index warrants may be offset with either warrants or OCC-issued options on the same stock index, currency, or currency index, respectively, in the same manner that standardized index and currency options may be offset with other standardized index and currency options. The rules governing the margin treatment for spreads and straddles involving stock index, currency, and currency index warrants are being implemented on a one-year pilot basis. The NASD also will allow market participants to use escrow receipts to cover a short-call position in broad-based stock index warrants.

Listing Standards

The NASD has substantially revised the listing standards applicable to stock index warrants. Under the revised standards, issuers must have a minimum tangible net worth exceeding $250 million or have a minimum tangible net worth exceeding $150 million, provided the issuer has not issued warrants such that the aggregate original issue price of all of the issuer's stock index, currency, and currency index warrant offerings (combined with offerings by its affiliates) listed on Nasdaq or a national securities exchange exceeds 25 percent of the issuer's net worth.

The term of the index warrants must provide that unexercised in-the-money warrants will be automatically exercised on the delisting date (if the issue is not listed on a national securities exchange) or upon expiration.

For warrant offerings where U.S. stocks constitute 25 percent or more of the index value, issuers must use the opening prices (a.m. settlement) of the U.S. stocks to determine the final index warrant settlement value and the index warrant settlement value on the two business days preceding the day on which the final index warrant settlement value is to be determined.

In instances where the stock index underlying a warrant is comprised of, in whole or in part, securities traded outside the United States, the foreign country securities or American Depositary Receipts (ADRs) that are not subject to a comprehensive surveillance agreement and have less than 50 percent of their global trading volume in dollar value within the United States, cannot, in the aggregate, represent more than 20 percent of the weight of the index, unless such index is otherwise approved for warrant or option trading.

Reporting Changes In The Number Of Warrants Outstanding

To assist in the surveillance of index warrant trading, as a condition of listing on Nasdaq, issuers would be required to notify (or make arrangements for the warrant transfer agent to notify) the NASD of any early warrant exercises by 4:30 p.m., Eastern Time, on the day the settlement value for the warrants is determined. Such notice must be filed in such form and manner as may be prescribed by the NASD from time to time.

Reporting The Execution Of Hedging Transactions Due To Early Exercise

The NASD will require any issuer of a stock index warrant (for which 25 percent or more of the value of the underlying index is represented by securities traded primarily in the United States) to file a report with the NASD concerning certain trades the issuer effects as a result of the early exercise of a stock index warrant to adjust a hedge that the issuer has established in connection with the issuance of such warrants. The threshold reporting level for issuer hedge transactions in stock will be set at the reporting level of the New York Stock Exchange's Daily Program Trading Report (DPTR), which is a program trade involving at least 15 stocks of $1 million or more in value. Any issuer hedge transaction effected in another market (such as options market, futures market, OTC derivatives market) must be reported regardless of its size.

These reports will be submitted to the NASD by the close of business on the second business day following the trade date of the transaction subject to the report. All such reports must be filed as required by the NASD from time to time and must include the following information with respect to each reportable trade:

• order-entry time;
  
  
• product type (stock, stock option, futures contract, futures option);
  
  
• order type (market maker on close, limit);
  
  
• market action (buy/open, buy/close, sell/option);
  
  
• account identifier;
  
  
• size (total number of shares or contracts);
  
  
• total dollar value of trade;
  
  
• market where executed; and
  
  
• the warrant issue hedged.

Questions regarding the new rules applicable to stock index, currency, and currency index warrants may be directed to Thomas R. Gira, Assistant General Counsel, at (202) 728–8957; questions concerning the sales practice and margin rules applicable to index warrants may be directed to the NASD Compliance Department, at (202) 728–8221; questions regarding the listing standards applicable to Nasdaq-listed index warrants may be directed to David Irwin, Assistant Director, Policy and Practices, Nasdaq Issuer Services, at (202) 728–8102; and questions concerning the position and exercise limits and reporting requirements applicable to index warrants may be directed to NASD Market Surveillance, at (800) 925–8156.

Text Of New Schedule To The By-Laws And Amendments To The By-Laws And Rules Of Fair Practice

Below is the text of new Schedule J to the NASD By-Laws and the amendments to: Schedule D to the NASD By-Laws; Section 30 of the NASD Rules of Fair Practice; and the NASD Board's Policy issued under Section 2 of the NASD Rules of Fair Practice concerning Fair Dealing with Customers with Regard to Derivative Products or New Financial Products.

(Note: New text is underlined; deletions are bracketed.)

SCHEDULE J

TRADING IN INDEX WARRANTS, CURRENCY INDEX WARRANTS, AND CURRENCY WARRANTS

Sec. 1. General

Sec. 2. Definitions

Sec. 3. Account Approval

No member or person associated with a member shall accept an order from a customer to purchase or sell an index warrant, currency index warrant, or currency warrant unless the customer's account has been approved for options trading pursuant to Article III. Section 33(b)(16) of the Rules of Fair Practice.

Sec. 4. Suitability

The provisions of Article III. Section 33(b)(19) of the Rules of Fair Practice shall apply to recommendations by members and persons associated with members regarding the purchase or sale of index warrants, currency index warrants, or currency warrants. The term "option" as used therein shall be deemed to include such warrants for purposes of this Section.

Sec. 5. Discretionary Accounts

Insofar as a member or person associated with a member exercises discretion to trade in index warrants, currency index warrants, or currency warrants in a customer's account, such account shall be subject to the provisions of Article III. Section 33(b)( 18) of the Rules of Fair Practice. The term "option" as used therein shall be deemed to include such warrants for purposes of this Section.

Sec. 6. Supervision of Accounts

The provisions of Article III. Section 33(b)(20) of the Rules of Fair Practice shall apply to all customer accounts of a member in which transactions in index warrants, currency index warrants, or currency warrants are effected. The term "option" as used therein shall be deemed to include such warrants for purposes of this Section.

Sec. 7. Customer Complaints

The record-keeping requirements of Article III. Section 33(b)(17)(A) of the Rules of Fair Practice concerning the receipt and handling of customer complaints relating to options shall also apply to customer complaints relating to index warrants, currency index warrants, or currency warrants and the required records of such complaints shall be maintained together with the records pertaining to options related complaints, provided that complaints related to index warrants, currency index warrants, or currency warrants shall be clearly identified as such. The term "option" as used therein shall be deemed to include such warrants for purposes of this Section.

Sec. 8. Communications with the Public and Customers Concerning Index Warrants. Currency Index Warrants, and Currency Warrants

The provisions of Article III. Section 35 A of the Rules of Fair Practice shall be applicable to communications to customers regarding index warrants, currency index warrants, or currency warrants. The term "option" as used therein shall be deemed to include such warrants for purposes of this Section and the term "The Options Clearing Corporation" shall be deemed to mean the issuer of such warrants. Sections 35A(c)(5) and (d)(2XC)(v) shall also not be applicable to communications with the public regarding index warrants, currency index warrants, or currency warrants.

Sec. 9. Maintenance of Records

The record-keeping provisions of Article HI. Section 33(b)(17)(B) shall be applicable to customer accounts approved to trade index warrants, currency index warrants, or currency warrants. The term "option" as used therein shall be deemed to include such warrants for purposes of this

Sec. 10. Position Limits

Except with the prior written approval of the Corporation in each instance, no member shall effect for any account in which such member has an interest, or for the account of any partner, office, director or employee thereof, or for the account of any customer, a purchase or sale transaction in an index warrant listed on Nasdaq or on a national securities exchange if the member has reason to believe that as a result of such transaction the member, or partner, officer, director or employee thereof, or customer would, acting alone or in concert with others, directly or indirectly, hold or control an aggregate position in an index warrant issue on the same side of the market, combining such index warrant position with positions in index warrants overlying the same index on the same side of the market, in excess of the position limits established by the Corporation, in the case of Nasdaq-listed index warrants, or the exchange on which the index warrant is listed.

In determining compliance with this Section, the position limits for Nasdaq-listed index warrants are as follows:

Sec. 11. Exercise Limits

Except with the prior written approval of the Corporation, in each instance, no member or person associated with a member shall exercise, for any account in which such member or person associated with such member has an interest, or for the account of any partner, officer, director or employee thereof, or for the account of any customer, a long position in any index warrant if as a result thereof such member or partner, officer, director or employee thereof or customer, acting alone or in concert with others, directly or indirectly: (1) has or will have exercised within any five (5) consecutive business days a number of index warrants overlying the same index in excess of the limits for index warrant positions contained in Section 10 of this Schedule J: or (21 has or will have exceeded the applicable exercise limit fixed from time to time by an exchange for an index warrant not dealt in on Nasdaq. The Corporation may institute other limitations concerning the exercise of index warrants from time to time by action of the Corporation. Reasonable notice shall be given of each new limitation fixed by the Corporation. These exercise limitations are separate and distinct from any other exercise limitations imposed by the issuers of index warrants.

Sec. 12. Reporting Requirements

Sec. 13. Liquidation of Index Warrant Positions

Whenever the Corporation determines that a person or group of persons acting in concert holds or controls an aggregate position (whether short or long) in index warrants overlying the same index in excess of the position limitations established by Section 10 of this Schedule J. it may, when deemed necessary or appropriate in the public interest and for the protection of investors, direct any member or all members carrying a position in index warrants overlying such index for such person or persons to liquidate such position or positions, or portions thereof, as expeditiously as possible and consistent with the maintenance of an orderly market, so as to bring such person or persons into compliance with the position limitations contained in Section 10.

Whenever such a directive is issued by the Corporation no member receiving notice thereof shall accept and/or execute for any person or persons named in such directive any order to purchase or sell short any index warrants based on the same index, unless in each instance express approval therefore is given by the Corporation, or the directive is

Sec. 14. Trading Halts or Suspensions

SCHEDULE D

PART I – DEFINITIONS

PART II No change.

PART III

Introduction No change.

DESIGNATION OF NASDAQ NATIONAL MARKET SECURITIES

Sec. 1. No change.

Sec. 2. Quantitative Designation Criteria

SECTION 30 OF THE RULES OF FAIR PRACTICE

Sec. 1. and Sec. 2. No change.

Sec. 3(a) through (f)(9) No change.

Sec. 3(f)(10)

Notwithstanding the foregoing:

RULES OF FAIR PRACTICE

Sec. 1. No change.

Sec. 2. Recommendations To Customers

Policy of the Board of Governors—Fair Dealing with Customers with Regard to Derivative Products or New Financial Products

The Board emphasizes members' obligations for fair dealing with customers when making recommendations or accepting orders for new financial products. As new products are introduced from time to time, it is important that members make every effort to familiarize themselves with each customer's financial situation, trading experience, and ability to meet the risks involved with such products and to make every effort to make customers aware of the pertinent information regarding the products. Members must follow specific guidelines, set forth below, for qualifying the accounts to trade the products and for supervising the accounts thereafter.