Self-Regulatory Organizations; Pacific Stock Exchange, Inc.; Order Approving Proposed Rule Change and Notice of Filing and Order Granting Accelerated Approval of Amendments No. 1, 2, 3, 4 and 5 to Proposed Rule Change Relating to the Establishment of Uniform Listing and Trading Guidelines for Stock Index, Currency and Currency Index Warrants

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-36166; File No. SR-PSE-94-28]

Self-Regulatory Organizations; Pacific Stock Exchange, Inc.;

Order Approving Proposed Rule Change and Notice of Filing and Order

Granting Accelerated Approval of Amendments No. 1, 2, 3, 4 and 5 to

Proposed Rule Change Relating to the Establishment of Uniform Listing

and Trading Guidelines for Stock Index, Currency and Currency Index

Warrants

August 29, 1995.

I. Introduction

On September 22, 1994, the Pacific Stock Exchange, Inc. (``PSE'' or

``Exchange'') submitted to the Securities and Exchange Commission

(``SEC'' or ``Commission''), pursuant to Section 19(b) (``Section

19(b)'') of the Securities Exchange Act of 1934 (``Act''),\1\ and Rule

19b-4 thereunder,\2\ a proposed rule change to establish uniform rules

for the listing and trading of stock index (``index'' or ``stock

index''), currency (``currency'') and currency index (``currency

index'') warrants (collectively ``warrants''). Notice of the proposed

rule change appeared in the Federal Register on December 20, 1994.\3\

One comment letter was received in response to the proposal.\4\

\1\ 15 U.S.C. 78s(b)(1) (1988 & Supp. V 1993).

\2\ 17 CFR 240.19b-4 (1994).

\3\ See Securities Exchange Act Release No. 35088 (Dec. 12,

1994), 59 FR 65554.

\4\ See Letter from Paul M. Gottlieb, Seward & Kissel, to

Jonathan G. Katz, Secretary, Commission, dated January 10, 1995

(``Comment Letter'' or ``Seward & Kissel Letter'').

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The Exchange subsequently filed five Amendments to the proposal.\5\

[[Page 46661]]

Amendment No. 1 brings several of PSE's proposed rules and policies

into conformity with those previously filed by other markets. Amendment

No. 2 addresses currency and currency index warrant margin levels.

Amendment No. 3, in addition to responding to several technical changes

requested by the staff, addresses issues relating to spread margin,

reporting requirements and notification of early exercises. Amendment

No. 4 removes certain surveillance procedures from the PSE's rules.

Amendment No. 5 clarifies the settlement procedures for index warrants

which are exercised at or prior to expiration. This order approves the

proposal, as amended.

\5\ See Letters from Michael Pierson, PSE, to Stephen M. Youhn,

SEC, dated March 24, 1995 (``Amendment No. 1''), June 8, 1995

(``Amendment No. 2''), June 23, 1995 (``Amendment No. 3''), August

1, 1995 (``Amendment No. 4''), and August 22, 1995 (``Amendment No.

5'').

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II. Description of the Proposal

The PSE proposes to establish uniform rules for the listing and

trading of stock index, currency and currency index warrants.\6\ Rule

8.3, Listing of Currency and Index Warrants, would be amended to

provide uniform listing criteria for index, currency and currency index

warrants. First, issuers would be expected to exceed minimum issuer

listing standards. In particular, the Exchange proposes that issuers be

required to have a minimum tangible net worth in excess of $250 million

or, in the alternative, have a minimum tangible net worth in excess of

$150 million, provided that the issuer does not have (including as a

result of the proposed issuance) issued outstanding warrants where the

aggregate original issue price of all such warrant offerings (combined

with offerings by its affiliates) listed on a national securities

exchange or that are National Market securities traded through NASDAQ

exceeds 25% of the issuer's net worth.\7\

\6\ The proposed rules would apply to both American-style

warrants (which may be exercised at any time prior to expiration)

and European-style warrants (which may only be exercised during a

specified period before expiration).

\7\ See Amendments No. 1 and 3. The Exchange amended this

provision in response to the Seward & Kissell Letter.

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Second, the proposal requires that unexercised in-the-money

warrants be automatically exercised on either the delisting date (if

the issue is not listed upon another organized securities market) or

upon expiration. Third, the proposal provides that for warrant

offerings where U.S. stocks constitute 25% or more of the index value

(``domestic index''), issuers shall use opening prices (``a.m.

settlement'') for U.S. stocks to determine index warrant settlement

values during the 48 hour period prior to expiration of the

warrants.\8\ Fourth, Rule 8.3(a)(7) has been amended to provide that

foreign country securities or American Depositary Receipts (``ADRs'')

thereon that are not subject to a comprehensive surveillance sharing

agreement with the Exchange and that have less than 50% of their global

trading volume (in dollar value) within the U.S., shall not represent

more than 20% of the weight of the index.\9\ Finally, the Exchange

proposes to add Rule 8.3(a)(8), which is designed to assist in the

surveillance of index warrant trading. Specifically, the Exchange will

require issuers of stock index warrants to notify the Exchange of any

early exercises by 1:30 p.m. (Pacific time) on the day that the

settlement for the warrants is determined.\10\

\8\ See Amendment No. 3. The Exchange amended its proposal in

response to the Seward & Kissell Letter and notes that a warrant

based upon a domestic U.S. stock index may be settled using closing

prices (``p.m. settlement'') for the underlying stocks at all times

except for valuation day and the two business days immediately

preceding valuation day.

\9\ See Amendment No. 1.

\10\ See Amendment No. 3.

Rule 2.16(d)(2) (``Rule 2.16(d)(2)''), the PSE margin rule, is

being amended to apply the current customer margin requirements for

broad based stock index and currency options to stock index, currency

and currency index warrants. Thus, all purchases of warrants will

require payment in full, and short sales of stock index warrants will

require initial margin of: (i) 100 percent of the current value of the

warrant plus (ii) 15 percent of the current value of the underlying

broad stock index less the amount by which the warrant is out of the

money, up to a maximum of five percent of the index value. Short sales

of currency warrants will follow the margin requirements currently

applicable to listed currency options. Specifically, the Exchange

proposes that short sales of warrants on the German Mark, French Franc,

Swiss Franc, Japanese Yen, British Pound, Australian Dollar and

European Currency Unit shall each be subject to margin level of 100% of

the current market value of each such warrant plus a four percent

``add-on.'' \11\ The margin required on currency index warrants would

be an amount as determined by the Exchange and approved by the

Commission.\12\ The Exchange also proposes that its stock index,

currency and currency index warrant margin requirements be permitted

offset treatment for spread and straddle positions. In this regard, the

Exchange proposes that index, currency and currency index warrants may

be offset with either warrants or Options Clearing Corporation

(``OCC'') issued options on the same index, currency or currency index,

respectively. Furthermore, the Exchange has proposed that subsections

(F)(3), (F)(4), and (G)(4)-(7) to Rule 2,16(d)(2), to the extent that

such rules concern spread and straddle positions in warrants, be

subject to a one year pilot basis.\13\ Finally, proposed Rule

2.16(d)(2)(H)(6) will also permit the use of escrow receipts to cover a

short call position in a broad-based stock index warrant.\14\

\11\ See Amendment No. 2. Consistent with the treatment of

options on foreign currencies, warrants on the Canadian Dollar will

be subject to a one percent ``add-on.'' The margin required on any

other foreign currency would be subject to approval by the

Commission. See infra note 28.

\12\ See infra note 28.

\13\ Three months prior to the expiration of the pilot program,

the Exchange will submit a report to SEC staff analyzing the price

relationship between listed warrants and options on similar stock

indexes. See Amendment No. 1. The Exchange has also requested no-

action relief from the Commission in order to permit certain short

positions in stock index call and put warrants to be treated as

covered for margin purposes.

\14\ See Amendment No. 1. The Exchange notes that this treatment

is consistent with the rules that allow for the use of escrow

receipts to cover a short call position in broad-based stock index

options.

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Proposed Rule 8.4 states that no member or member organization

shall accept an order from a customer for the purchase or sale of

warrants unless the customer's account has been approved for options

trading pursuant to Exchange Rule 9.18(b). Furthermore, proposed Rules

8.5-8.8 require that the option rules pertaining to suitability,

discretionary account trading, supervision of accounts and customer

complaints be applied to warrants.

Proposed Rule 8.9 requires approval by a Compliance Registered

Options Principal of all advertisements, sales literature and

educational material issued by a member organization pertaining to

warrants. The rule further requires Exchange approval of all

advertisements and educational materials pertaining to warrants.

Finally, prior to trading index, currency or currency index warrants,

the Exchange will distribute circulars to its membership providing

guidance regarding member firm compliance responsibilities (including

suitability recommendations) when handling transactions in warrants.

Proposed Rule 8.10 provides that position limits for stock index

warrants on the same index with original issues prices of ten dollars

or less will be fifteen million warrants covering all such issues.\15\

The rule provides that warrants with an original issue price of greater

than ten dollars will be weighted

[[Page 46662]]

more heavily than warrants with an original issue price of ten dollars

or less in calculating position limits.\16\ The rule also gives the

Exchange the authority to require the liquidation of a position in

stock index warrants that is in excess of the position limits set forth

in the rule, and Commentary to the rule establishes procedures for

allowing limited exceptions to the position limits.

\15\ See infra note 41.

\16\ For example, if an investor held 100,000 warrants based

upon the Standard & Poor's 500 Index offered originally at $20 per

warrant, the size of this position for the purpose of calculating

position limits would be 200,000.

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Proposed Rule 8.11 provides for exercise limits on stock index

warrants analogous to those found in stock index options and states

that such limits are distinct from any exercise limits that may be

imposed by the issuers of stock index warrants. Accordingly, no member

may exercise a long position in warrants over a five consecutive day

period in excess of the permissible position limit.

In order to facilitate its review of compliance with position and

exercise limits, the Exchange has proposed Rule 8.17 which establishes

reporting requirements for large warrant positions. Under the terms of

the rule, members will be required to file a report with the Exchange

whenever any account in which the member has an interest has

established an aggregate position of 100,000 warrants overlying the

same index, currency or currency index. For purposes of this rule, the

Exchange proposes that long positions in puts be combined with short

positions in call warrants, and that short positions in puts be

combined with long positions in call warrants.\17\ Finally, proposed

Rule 8.12 requires that the trading halt provisions in Rule 7.11 shall

be applied to the trading of stock index warrants.

\17\ See Amendment No. 3.

Upon Commission approval of the foregoing rule amendments, the

Exchange proposes that it will only file rule changes for specific

stock index warrant issuances where there is no corresponding option or

warrant on the same underlying stock index already listed on a national

securities exchange or included for quotation on NASDAQ. Accordingly,

when a listed option overlies a particular broad based index, the

Exchange proposes it be allowed to list warrants on that index without

further Commission review and approval pursuant to Section 19(b) of the

Act, as long as the listing complies with the warrant listing standards

as approved in this Order.\18\

\18\ See infra note 28.

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III. Comments Received

The Commission received one letter in response to its request for

comments on the PSE proposal.\19\ The Comment Letter was generally

supportive of the PSE's proposal, however, it recommended several

changes in the proposed regulatory structure applicable to stock index,

currency and currency index warrants. The Comment Letter was submitted

on behalf of the Firms, all of whom are represented to be major

participants in the issuance, underwriting and trading of warrants.

Because the proposed regulatory regime applicable to warrants will, to

some extent, be based upon the rules governing standardized options,

the Comment Letter states that the Firms' comments are drive, in part,

by the fact that fundamental differences exist between warrants and

standardized options which necessitate disparate regulatory treatment

in certain situations.\20\

\19\ See supra note 4. The Seward & Kissel Letter was submitted

on behalf of PaineWebber Inc., Bear, Stearns & Co. Inc., Lehman

Brothers Inc., Smith Barney Inc., Salomon Brothers Inc., Morgan

Stanley & Co. Inc., and Hambrecht & Quist Inc. (collectively the

``Firms'').

\20\ The Comment Letter lists several differences which it

perceives exist between warrants and standardized options. Chief

among these are: (1) Warrants are separately registered, unsecured

obligations of their issuer while options are issued and guaranteed

by the Options Clearing Corp. (``OCC''); (2) during the prospectus

delivery period, warrant purchasers received a product-specific

prospectus while options customers receive an options disclosure

document (``ODD'') at the time the account is opened; (3) each

warrant creates a fixed number of outstanding warrants while there

is theoretically no limit to the number of options that may be

issued by OCC; and (4) warrants are traded on an exchange in a

manner similar to stocks which, therefore, translates into superior

price transparency than for listed options.

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First, the Comment Letter suggested amending the Issuer Listing

Standards to eliminate the 25% test or, in the alternative, to adopt

hedging and/or netting standards designed to more accurately reflect

issuer-specific risk.\21\ Because warrants are sold by means of a

registration statement, the Firms believe that adequate disclosure of

the amount of an issuer's outstanding securities could be included in

the prospectus. Furthermore, the Comment Letter points out that issuers

of warrants are traditionally subject to outside evaluation by certain

credit rating agencies, which should assist investors in determining

undue issuer credit risk. Finally, the Firms do not believe that 25%

test bears any resemblance to an issuer's risk exposure since exposure

fluctuates with market changes at any given time and also because the

proposal provides no recognition for offsetting hedges or for warrants

subject to netting.

\21\ As originally proposed, an issuer would have been required

to have a tangible net worth of at least $150 million and the

aggregate original issue price of all of a particular issuer's

warrant offerings (combined with such offerings by its affiliates)

that are listed on a national securities exchange or that are

national market securities traded through NASDAQ were not to exceed

25% of the issuer's net worth (``25% test).

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In response to the Seward & Kissel Letter's comments respecting

issuer listings standards, the PSE amended the filing to add an

alternative issuer qualification criteria.\22\ Under the new criteria,

an issuer will be required to either: (a) have a minimum tangible net

worth of $250 million; or (b) meet the existing criteria (i.e.,

tangible net worth of $150 million and meet the 25% test).

\22\ See Amendment No. 3.

The Comment Letter also recommended allowing the use of p.m.

settlement for all American-style warrants exercised anytime except 48

hours prior to expiration, at which time a.m. settlement would be

required. According to the Comment Letter, unlike the listed options

(where OCC is the issuer and runs a balanced book), a warrant issuer

must hedge its exposure to maintain offsetting positions. Upon early

exercise of the warrants, the issuer that has hedged its exposure will

have to take action to ``unwind'' the portion of its hedge relating to

the exercised warrants. The Firms believe that requiring a.m.

settlement on the first day after an investor exercises the warrant

will place additional market risk upon them due to the difficulty in

managing the hedge. This increased hedging cost, the Firm's argue,

could result in a higher issuance price for the warrant or could

require that the warrant settlement value date be postponed an

additional day, with warrant holders hearing additional market risk

during this period.

In response to the Comment Letter, the PSE amended its filing to

include a provision permitting p.m. settlement for stock index warrants

except for a short period before expiration.\23\ Under the terms of the

amendment, stock index warrants for which 25% or more of the value of

the underlying index is represented by securities that are traded

primarily in the U.S. shall, by their terms, provide that, on valuation

date, as well as for the two business days prior to valuation date, the

value of the stocks traded primarily in the U.S. which underlie such

warrants shall be determined by reference to the opening prices of such

underlying U.S. securities. For example, if the valuation date for an

issuance of index warrants

[[Page 46663]]

occurs on a Friday, a.m. settlement must be utilized for warrants that

are valued on the preceding Wednesday or Thursday, as well as on the

valuation date.

\23\ See Amendments No. 3 and 5.

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Third, the Comment Letter recommended creating a special category

of ``warrant eligible'' customers (separate and distinct from options

eligibility criteria), who are authorized to trade warrants even if not

approved to trade options. The Firms believe it is inappropriate to

apply an options regulatory regime to warrants and that doing so may

prevent institutional customers who are not permitted to purchase

options products, yet who nevertheless meet all of the options

eligibility criteria, from purchasing warrants. In this regard, the

Firms propose to create a ``warrant eligible'' category with standards

mimicking those currently required for options approved accounts. As

such, ``warrant-approved'' accounts could purchase warrants, however,

they could not purchase options or other products requiring options

account approval. The PSE did not amend its filing in response to this

comment.

Fourth, the Comment Letter urges the adoption of a rule permitting

firms to approve for warrant trading those accounts managed by an

investment adviser (``IA'') based upon the IA's representation

concerning the eligibility status of its customers to engage in warrant

trading, even if the underlying documentation relating to the managed

accounts is not provided to the brokerage firms. The PSE has amended

its proposal to allow member firms to accept the representation of an

investment adviser registered under the Investment Advisers Act of 1940

concerning the eligibility status of its customers to engage in warrant

trading, even if the underlying documentation relating to the managed

account is not provided to the member firm, where the managed account

is for an institutional customer or the investment adviser account

represents the collective investment of a number of persons. The PSE

states that this will conform the handling of warrant accounts to the

current practice with respect to listed options accounts.\24\

\24\ See Amendment No. 1.

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Finally, the Comment Letter addressed the proposed position limits

applicable to warrants. Specifically, the Comment Letter noted that

position limits for warrants would be set at levels that are

approximately 75% of that allowed for similar broad-based indexes. The

Comment Letter recommended establishing position limits for warrants

that were equivalent to those established for listed options, allowing

a hedge exemption similar to listed option procedures and providing a

mechanism for specific waivers or exemptions of warrant position limits

for hedgers, market-makers and broker-dealers comparable to the

procedures in place for listed options. The PSE did not amend its

filing in response to this comment.

IV. Discussion

The Commission finds that the proposed rule change is consistent

with the requirements of the Act and the rules and regulations

thereunder applicable to a national securities exchange, and, in

particular, the requirements of Section 6(b)(5).\25\ Specifically, the

Commission finds that the Exchange's proposal to establish uniform

listing standards for broad-based stock index, currency and currency

index warrants strikes a reasonable balance between the Commission's

mandates under Section 6(b)(5) to remove impediments to and perfect the

mechanism of a free and open market and a national market system, while

protecting investors and the public interest. In addition, the PSE's

proposed listing standards for warrants are consistent with the Section

6(b)(5) requirements that rules of an exchange be designed to prevent

fraudulent and manipulative acts, to promote just and equitable

principles of trade, and are not designed to permit unfair

discrimination among issuers.

\25\ 15 U.S.C. 78f(b)(5) (1982).

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The PSE's proposed generic listing standards for broad-based stock

index warrants, currency and currency indexes set forth a regulatory

framework for the listing of such products.\26\ Generally, listing

standards serve as a means for an exchange to screen issuers and to

provide listed status only to bona fide issuances that will have

sufficient public float, investor base, and trading interest to ensure

that the market has the depth and liquidity necessary to maintain fair

and orderly markets. Adequate standards are especially important for

warrant issuances given the leveraged and contingent liability they

represent. Once a security has been approved for initial listing,

maintenance criteria allow an exchange to monitor the status and

trading characteristics of that issue to ensure that it continues to

meet the exchange's standards for market depth and liquidity so that

fair and orderly markets can be maintained.

\26\ The Commission notes that warrants issued prior to this

approval order will continue to be governed by the rules applicable

to them at the time of their listing.

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In reviewing listing standards for derivative-based products, the

Commission also must ensure that the regulatory requirements provide

for adequate trading rules, sales practice requirements, margin

requirements, position and exercise limits and surveillance procedures.

These rules minimize the potential for manipulation and help to ensure

that derivatively-priced products will not have a negative market

impact. In addition, these standards should address the special risks

to customers arising from the derivative products.\27\ For the reasons

discussed below, the Commission believes the PSE's proposal will

provide it with significant flexibility to list index, currency and

currency index warrants, without compromising the effectiveness of the

Exchange's listing standards or regulatory program for such

products.\28\

\27\ Pursuant to Section 6(b)(5) of the Act, the Commission is

required to find, among other things, that trading in warrants will

serve to protect investors and contribute to the maintenance of fair

and orderly markets. In this regard, the Commission must predicate

approval of any new derivative product upon a finding that the

introduction of such derivative instrument is in the public

interest. Such a finding would be difficult for a derivative

instrument that served no hedging or other economic function,

because any benefits that might be derived by market participants

likely would be outweighed by the potential for manipulation,

diminished public confidence in the integrity of the markets, and

other valid regulatory concerns. As discussed below, the Commission

believes warrants will serve an economic purpose by providing an

alternative product that will allow investors to participate in the

price movements of the underlying securities in addition to allowing

investors holding positions in some or all of such securities to

hedge the risks associated with their portfolios.

\28\ Issuances of warrants overlying a single currency may

currently be listed for trading without a rule filing provided that

the underlying currency is one of the original seven foreign

currencies approved for options trading: the Australian Dollar,

British Pound, Canadian Dollar, French Franc, German Mark, Japanese

Yen, Swiss Franc and the European Currency Unit. Issuances of

currency warrants overlying any other foreign currency would require

a rule filing pursuant to Section 19(b) of the Act. The Commission

notes that currency index warrants may only be established without a

further rule filing upon an index that has been previously approved

by the Commission pursuant to a Section 19(b) filing. To date, the

only currency index approved pursuant to Section 19(b) is an equal-

weighted index comprised of the British Pound, Japanese Yen and

German Deutsche Mark. See Securities Exchange Act Release No. 31627

(Dec. 21, 1992), 57 FR 62399 (Dec. 30, 1992). Accordingly, any other

currency index (as well as a broad-based stock index) not previously

approved by the Commission would require approval pursuant to

Section 19(b).

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A. Issuer Listing Standards and Product Design

As a general matter, the Commission believes that the trading of

warrants on

[[Page 46664]]

a stock index, currency or currency index permits investors to

participate in the price movements of the underlying assets, and allows

investors holding positions in some or all of such assets to hedge the

risks associated with their portfolios. The Commission further believes

that trading warrants on a stock index, currency or currency index

provides investors with an important trading and hedging mechanism that

is designed to reflect accurately the overall movement of the component

securities.

Warrants, unlike standardized options, however, do not have a

clearinghouse guarantee but are instead dependent upon the individual

credit of the issuer. This heightens the possibility that an exerciser

of warrants may not be able to receive full cash settlement upon

exercise. This additional credit risk, to some extent, is reduced by

the Exchange's issuer listing standards that require an issuer to have

either; (a) a minimum tangible net worth of $250 million; or (b) a

minimum tangible net worth of $150 million, provided that the issuer

does not have (including as a result of the proposed issuance) issued

outstanding warrants where the aggregate original issue price of all

such stock index, currency and currency index warrant offerings (or

affiliates) that are listed on a national securities exchange or traded

through the facilities of NASDAQ is in excess of 25% of the warrant

issuer's net worth. Furthermore, financial information regarding the

issuers of warrants will be disclosed or incorporated in the prospectus

accompanying the offering of the warrants. Moreover, the alternative

test addresses the Comment Letter's concerns on the 25% standard.

The PSE's proposal will provide issuers flexibility by allowing

them to utilize either a.m. or p.m. settlement, provided, however,

domestic index warrants (i.e., warrants based on indexes for which 25%

or more of the index value is represented by securities traded

primarily in the U.S.) (``domestic index warrants'') are required to

utilize a.m. settlement for expiring warrants as well as during the

last two business days prior to valuation date.\29\ The Commission

continues to believe that a.m. settlement significantly improves the

ability of the market to alleviate and accommodate large and

potentially destabilizing order imbalances associated with the

unwinding of index-related positions. Nevertheless, in accordance with

the Comment Letter's suggestions, the use of p.m. settlement except

during the last two business days prior to a domestic index warrant's

valuation date, as well as the valuation date, strikes a reasonable

balance between ameliorating the price effects associated with

expirations of derivative index products and providing issuers with

flexibility in designing their products.\30\ In this context, the

Commission notes that unlike standardized index options whose

settlement times are relatively uniform, index warrants are issuer-

based products, whose terms are individually set by the issuer. In

addition, while options may have unlimited open interest, the number of

warrants on a given index is fixed at the time of issuance.

Accordingly, it is not certain that there will be a significant number

of warrants in indexes with similar components expiring on the same

day. This may reduce the pressure from liquidation of warrant hedges at

settlement. Nevertheless, the Commission expects the Exchange to

monitor this issue and, should significant market effects occur as a

result of early exercises from p.m. settled index warrants, would

expect it to make appropriate changes including potentially limiting

the number of index warrants with p.m. settlement.

\29\ Currency and currency index warrants are not limited to

a.m. or p.m. settlement.

\30\ Foreign stock market based index warrants may utilize p.m.

settlement throughout their duration.

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B. Customer Protection

Due to their derivative and leveraged nature, and the fact that

they are a wasting asset, many of the risks of trading in warrants are

similar to the risks of trading standardized options. Accordingly, the

PSE has proposed to apply its options customer protection rules to

warrants. In particular, the Commission notes that warrants may only be

sold to options approved accounts capable of evaluating and bearing the

risks associated with trading in these instruments, in accordance with

PSE Rule 9.18(b), and that adequate disclosure of the risks of these

products must be made to investors.\31\ In addition, the PSE will apply

the options rules for suitablilty, discretionary accounts, supervision

of accounts and customer complaints to transactions in warrants. By

imposing the special suitability and disclosure requirements noted

above, the Commission believes the PSE has addressed adequately several

of the potential customer protection concerns that could arise from the

options-like nature of warrants.

\31\ Pursuant to PSE Rule 9.18(b), all options approved accounts

must receive an ODD, which discusses the characteristic and risks of

standardized options.

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The ODD, which all options approved accounts must receive,

generally explains the characteristics and risks of standardized

options products. Although many of the risks to the holder of an index

warrant and option are substantially similar, however, because warrants

are issuer-based products, some of the risks, such as the lack of a

clearinghouse guarantee and certain terms for index warrants, are

different. The PSE has adequately addressed this issue by proposing to

distribute a circular to its members that will call attention to the

specific risks associated with stock index, currency and currency index

warrants that should be highlighted to potential investors. In

addition, the issuer listing guidelines described above will ensure

that only substantial companies capable of meeting their warrant

obligations will be eligible to issue warrants. These requirements will

help to address, to a certain extent, the lack of a clearinghouse

guarantee for index warrants. Finally, warrant purchasers will receive

a prospectus during the prospectus delivery period. The Commission

believes that this will ensure that certain information about the

particular issuance and issuer is publicly available.

As note above, the Comment Letter indicates that applying the

options disclosure framework to warrants is inappropriate. However, the

Commission believes that the combined approach of making available

general derivative product information (the ODD), product specific

information (the Exchange circular), and issuer specific information

(the prospectus) should provide an effective disclosure mechanism for

these products.

At this time, the Commission does not agree with the proposal

contained in the Comment Letter to create a special ``warrant

eligible'' classification of purchasers. As noted above, index,

currency and currency index warrants are very similar to standardized

options. They are so similar that a customer precluded from trading

options should not avoid the restriction indirectly by being designated

by Exchange rules as eligible for stock index, currency or currency

index warrants. Nevertheless, as the range of exchange-traded

derivative products increases, the SROs might consider in the future as

to whether a new derivatives eligibility classification is appropriate.

C. Surveillance

In evaluating proposed rule changes to list derivative instruments,

the Commission considers the degree to which the market listing the

derivative product has the ability to conduct adequate surveillance. In

this regard the

[[Page 46665]]

Commission notes that the Exchange has developed adequate surveillance

procedures for the trading of index and currency warrants. First, new

issues of currency warrants will be subject to the PSE's existing

surveillance procedures applicable to foreign currency warrants, which

the Commission previously has found to be adequate to surveil for

manipulation and other abuses involving the warrant market and the

underlying foreign currencies.\32\

\32\ See Securities Exchange Act Release No. 24555 (June 5,

1987), 52 FR 22570 (June 12, 1987), and Securities Exchange Act

Release No. 26152 (Oct. 3, 1988), 53 FR 39832 (Oct. 12, 1988). The

Commission notes that these surveillance procedures only apply to

the issuance of warrants overlying one of the approved foreign

currencies. See supra note 28. The issuance of warrants upon any

other foreign currency would necessitate a Section 19(b) rule filing

which, among other things, details applicable to surveillance

procedures.

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Second, the Exchange has developed enhanced surveillance procedures

to apply to domestic stock index warrants which the Commission believes

are adequate to surveil for manipulation and other abuses involving the

warrant market and component securities.\33\ Among these enhanced

surveillance procedures, the Commission notes that issuers will be

required to report to the Exchange on settlement date the number and

value of domestic index warrants subject to early exercise the previous

day. The Commission believes that this information will aid the PSE in

its surveillance capacity and help it to detect and deter market

manipulation and other trading abuses.

\33\ In addition, the Commission notes that issuers will be

required to report to the Exchange all trades to unwind a warrant

hedge that are effected as a result of the early exercise of

domestic index warrants. This will enable the Exchange to monitor

the unwinding activity to determine if it was effected in a manner

that violates Exchange or Commission rules.

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Third, the Exchange has developed adequate surveillance procedures

to apply to foreign stock index warrants i.e., less than 25% of the

index value is derived from stocks traded primarily in the U.S.).\34\

The Commission believes that the ability to obtain information

regarding trading in the stocks underlying an index warrant is

important to detect and deter market manipulation and other trading

abuses. Accordingly, the Commission generally requires that there be a

surveillance sharing agreement \35\ in place between an exchange

listing or trading a derivative product and the exchange(s) trading the

stocks underlying the derivative contract that specifically enables the

relevant markets to surveil trading in the derivatives product and its

underlying stocks.\36\ Such agreements provide a necessary deterrent to

manipulation because they facilitate the availability of information

needed to fully investigate a potential manipulation if it were to

occur.\37\ In this regard, the PSE will require that no more than 20%

of an Index's weight may be comprised (upon issuance and thereafter) of

foreign securities (or ADRs thereon) that do not satisfy one of the

following tests: (1) The Exchange has in place an effective

surveillance agreement \38\ with the primary exchange in the home

country in which the security underlying the ADR is traded; or (2)

meets an existing alternative standard available for standardized

options trading (e.g., satisfy the 50% U.S. trading volume test).\39\

The Commission believes that this standard will ensure that index

warrants are not listed upon foreign indexes whose underlying

securities trade on exchanges with whom the PSE has no surveillance

sharing agreement.

\34\ Each prior issuance of a foreign stock market based index

warrant is subject to specific surveillance procedures. These

procedures are generally tailored to the individual warrant issuance

and are based upon several factors involving the primary foreign

market, including the existence of surveillance or information

sharing agreements.

\35\ The Commission believes that a surveillance sharing

agreement should provide the parties with the ability to obtain

information necessary to detect and deter market manipulation and

other trading abuses. Consequently, the Commission generally

requires that a surveillance sharing agreement require that the

parties to the agreement provide each other, upon request,

information about market trading activity, clearing activity, and

the identity of the ultimate purchasers for securities. See e.g.,

Securities Exchange Act Release No. 31529 (Nov. 27, 1992).

\36\ The ability to obtain relevant surveillance information,

including, among other things, the identity of the ultimate

purchasers and sellers of securities, is an essential and necessary

component of a comprehensive surveillance sharing agreement.

\37\ In the context of domestic index warrants, the Commission

notes that the U.S. exchanges are members of the Intermarket

Surveillance Group (``ISG''), which was formed to, among other

things, coordinate more effectively surveillance and investigative

information sharing arrangements in the stock and options markets.

See Intermarket Surveillance Group Agreement, July 14, 1983. The

most recent amendment to the ISG Agreement, which incorporates the

original agreement and all the amendments made thereafter, was

signed by ISG members on January 29, 1990. See Second Amendment to

the ISG Agreement.

\38\ See supra note 35.

\39\ See Securities Exchange Act Release Nos. 31529, 57 FR 57248

(Dec. 3, 1992) and 33555, 59 FR 5619 (Feb. 7, 1994).

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D. Market Impact

The Commission believes that the listing and trading of index

warrants, currency warrants and currency index warrants will not

adversely affect the U.S. securities markets or foreign currency

markets. First, with respect to currency and currency index warrants,

the Commission notes that the interbank foreign currency spot market is

an extremely large, diverse market comprised of banks and other

financial institutions worldwide. That market is supplemented by

equally deep and liquid markets for standardized options and futures on

foreign currencies and options on those futures. An active over-the-

counter market also exists in options, forwards and swaps for foreign

currencies. This minimizes the possibility that Exchange listed

warrants would be used to manipulate the spot currency markets. In

addition, the surveillance procedures for these products should allow

the Exchange to detect and deter potential manipulation involving

currency warrants and currency index warrants.

Second, with respect to index warrants, the Commission notes that

warrants may only be established upon indexes the Commission has

previously determined to be broad-based in the context of index options

or warrant trading. As part of its review of a proposal to list an

index derivative product, the Commission must find that the trading of

index options or warrants will serve to protect investors, promote the

public interest, and contribute to the maintenance of fair and orderly

markets. Accordingly, the Commission does not believe that the issuance

of index warrants upon previously approved broad based stock index

options or warrants will adversely impact the underlying component

securities. In addition, because index warrants are issued by various

individual issuers who set their own terms, it is likely that

expirations among similar index products will be varied, thereby

reducing the likelihood that unwinding hedge activities would adversely

affect the underlying cash market. Finally, as discussed above, the

Commission believes the PSE's enhanced surveillance procedures

applicable to stock index warrants are adequate to surveil for

manipulation and other abuses involving the warrant market, component

securities and issuer hedge unwinding transactions.

Third, the Exchange has proposed margin levels for stock index and

currency warrants equivalent to those in place for stock index and

currency options. The Commission believes these requirements will

provide adequate customer margin levels sufficient to account for the

potential volatility of these products. In addition, options margin

treatment is appropriate given the options-like market risk posed by

warrants. The Commission notes that the customer spread margin

treatment applicable to warrants is subject to a one year pilot

program. This will allow the

[[Page 46666]]

Exchange to analyze the pricing relationships between listed options

and warrants on the same index in order to determine whether to revise

or approve on a permanent basis the proposed spread margin rules.\40\

\40\ The Commission notes that the margin levels for currency

index warrants will be set at a level determined by the Exchange and

approved by the SEC. See Amendment No. 2. Issuances of warrants

listed prior to the approval of this order will continue to apply

the margin level applicable to them at the time of their listing.

Fourth, the PSE has established reasonable position and exercise

limits for stock index warrants, which will serve to minimize potential

manipulation and other market impact concerns.\41\ Contrary to the

views expressed in the Comment Letter, the Commission believes that in

the absence of trading experience with domestic index warrants, it

would be imprudent to establish position limits for positions greater

than those currently applicable to domestic stock index options on the

same index.\42\

\41\ The Commission notes that there are no position or exercise

limits applicable to currency or currency index warrants, although

reporting requirements do apply. Nevertheless, the Commission may

review the need to establish foreign currency position limits if the

size of the currency or currency index warrant market increases

significantly.

\42\ With respect to the Comment Letter's suggestion that a

hedge exemption rule be established in order to allow participants

to readily acquire exemptions from the Exchange as needed, the

Commission does not believe that such an approach is appropriate at

this time. The hedge exemption for index options was adopted after

several years experience with index options trading. Until the SROs

gain some experience with domestic index warrant trading, it is

difficult to determine the need for a hedge exemption (i.e., that

speculative limits are insufficient to meet hedging needs).

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V. Conclusion

The Commission believes that the adoption of these uniform listing

and trading standards covering index, currency or currency index

warrants will provide an appropriate regulatory framework for these

products. These standards will also benefit the Exchange by providing

them with greater flexibility in structuring warrant issuances and a

more expedient process for listing warrants without further Commission

review pursuant to Section 19(b) of the Act. As noted above, additional

Commission review of specific warrant issuances will generally only be

required for warrants overlying any non-approved broad-based index or a

non-approved currency or currency index. If Commission review of a

particular warrant issuance is required, the Commission expects that,

to the extent that the warrant issuance complies with the uniform

criteria adopted herein, its review should generally be limited to

issues concerning the newly proposed index. This should help ensure

that such additional Commission review could be completed in a prompt

manner without causing any unnecessary delay in listing new warrant

products.

The Commission finds good cause for approving Amendments No. 1, 2,

3, 4 and 5 to the proposed rule change prior to the thirtieth day after

the date of publication of notice of filing thereof in the Federal

Register for the following reasons. As discussed below, the changes are

either (1) Minor and technical in nature; (2) responsive to the Comment

Letter; (3) designed to conform to warrant proposals from other

markets; or (4) modifications to Exchange surveillance procedures.

Accordingly, the amendments do not raise new significant regulatory

issues or are responsive to prior comments. In order to enable the

Exchange to list new index, currency or currency index warrants as soon

as possible, the Commission believes it is necessary and appropriate to

approve the amendments on an accelerated basis.

Amendment No. 1 makes several changes to the filing which are

designed to bring it into conformity with the other options exchanges.

First, it revises Rule 8.3, Listing of Currency and Index Warrants, in

several respects to provide uniform issuer listing standards. The first

two changes permit the use of p.m. settlement for domestic index

warrants (except during the last 48 hours preceding valuation date) and

provide an alternative issuer listing qualification criteria (as

discussed above under Issuer Listing Standards and Product Design). The

Commission notes that these changes were made in response to comments

received from the Seward & Kissell Letter and further believes these

changes provide added flexibility to issuers without compromising

investor protection concerns.

Amendment No. 1 also revises Rule 8.3 in two other respects: by

limiting the number of foreign securities that may comprise an

underlying stock index and by adding a provision requiring an issuer to

notify the listing Exchange of early exercises of domestic index

warrants. Taken together, the Commission believes these changes further

strengthen the issuer listing standards and the Exchange's surveillance

procedures to the benefit of warrant investors.

Amendment No. 1 also revises Rule 2.16 to provide that the proposed

spread and straddle margin treatment for stock index warrants will be

effected as part of a one year pilot program, and to provide that

escrow receipts will be accepted to cover short positions in stock

index warrants. The Commission notes that these changes conform the

margin treatment afforded options and warrants and provide a basis for

evaluating pricing correlations between warrants and options overlying

the same index, currency or currency index.

Finally, Amendment No. 1 provides that the Exchange will permit

member firms to accept an IA's representation concerning the options

eligibility status of its customers, as described above. The Commission

notes that this practice is consistent with the treatment of options

and, therefore, raises no new or unique regulatory issues. Accordingly,

for the reasons discussed above relating to each proposed revision of

the Amendment, the Commission believes it is appropriate to approve

Amendment No. 1 to the Exchange's proposal on an accelerated basis.

Amendment No. 2 addresses currency or currency index warrant margin

to clarify which currencies are subject to a four percent ``add-on''

for margin purposes. The Commission notes that this revision simply

harmonizes the treatment afforded currency options and warrants.

Second, the amendment states that the applicable margin level for

currency index warrants will be a percentage as specified by the

exchange and approved by the Commission. This change is also consistent

with the treatment afforded currency index options, where margin levels

are established on a case by case basis. Accordingly, the Commission

believes it is appropriate to approve Amendment No. 2 on an accelerated

basis.

Amendment No. 3 to the proposal clarifies several issues relating

to a.m. settlement, position reporting and notification of early

exercise of warrants. First, the Amendment clarifies in PSE Rule

8.3(a)(5) that a.m. settlement will be used during the 48-hour period

prior to expiration of index warrants. The Commission notes that this

change simply codifies a provision the PSE previously agreed to in

Amendment No. 1.\43\ Next, the Amendment establishes that warrant

positions will be subject to reporting levels, initially set at 100,000

warrants. The Commission believes that requiring investors to report to

the Exchange when their holdings exceed specified levels should aid the

Exchange in its monitoring for potential trading abuses involving

index, currency and currency

[[Page 46667]]

index warrants. Also, the Amendment addresses surveillance related

matters. In particular, it provides that issuers must report all hedge

unwinding transactions related to the early exercise of domestic index

warrants to the listing exchange by the business day following trade

date (``T+1'').\44\ In addition, it requires issuers to notify the

listing exchange of any early exercises of index warrants by 4:30 p.m.

(New York time) on settlement date for the warrants. The Commission

believes this change to the PSE's surveillance procedures strengthens

the Exchange's monitoring of index warrants. Accordingly, the

Commission believes it is appropriate to approve Amendment No. 3 on an

accelerated basis.

\43\ Amendment No. 5 subsequently changes the language of this

provision to require a.m. settlement be used during the two business

days prior to valuation date.

\44\ The Commission notes that Amendment No. 4 removes this

transaction reporting requirement which will be incorporated into

the Exchange's surveillance procedures.

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Amendment No. 4 deletes a transaction reporting requirement which

will be revised and incorporated into the Exchange's surveillance

procedures and also makes other minor changes. As such, the Commission

does not believe the Amendment raises any new or unique regulatory

issues. Accordingly, the Commission believes it is appropriate to

approve Amendment No. 4 on an accelerated basis.

Amendment No. 5 clarifies the settlement procedures for index

warrants which are exercised at or prior to expiration. Specifically,

the Amendment clarifies that a.m. settlement will be required on

valuation date as well as during the last two business days prior to an

index warrant's valuation date. As discussed above, the Commission

believes that the use of a.m. settlement during this period will help

to ameliorate any potential price effects associated with expirations

of derivative index products. Accordingly, the Commission believes it

is appropriate to approve Amendment No. 5 on an accelerated basis.

Therefore, the Commission believes it is consistent with Sections

6(b)(5) and 19(b)(2) of the Act to approve Amendments No. 1, 2, 3, 4

and 5 to the PSE's proposal on an accelerated basis.

VI. Solicitation of Comments

Interested persons are invited to submit written data, views and

arguments concerning Amendments No. 1, 2, 3, 4 and 5. Persons making

written submissions should file six copies thereof with the Secretary,

Securities and Exchange Commission, 450 Fifth Street, NW., Washington,

DC 20549. Copies of the submission, all subsequent amendments, all

written statements with respect to the proposed rule change that are

filed with the Commission, and all written communications relating to

the proposed rule change between the Commission and any person, other

than those that may be withheld from the public in accordance with the

provisions of 5 U.S.C. 552, will be available for inspection and

copying in the Commission's Public Reference Section, 450 Fifth Street,

NW., Washington, DC. Copies of such filing will also be available for

inspection and copying at the principal office of the above-mentioned

self-regulatory organization. All submissions should refer to the file

number in the caption above and should be submitted by September 28,

1995.

It therefore is ordered, pursuant to Section 19(b)(2) of the

Act,\45\ that the proposed rule change (SR-PSE-94-28) is approved, as

amended, with the portion of the rule change relating to spread margin

treatment being approved on a one year pilot program basis, ending

August 29, 1996.

\45\ 15 U.S.C. 78s(b)(2) (1988).

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For the Commission, by the Division of Market Regulation,

pursuant to delegated authority.\46\

\46\ 17 CFR 200.30-3(a)(12) (1994).

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Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 95-22194 Filed 9-6-95; 8:45 am]

BILLING CODE 8010-01-M