[Federal Register Volume 60, Number 58 (Monday, March 27, 1995)] [Notices] [Pages 15804-15807] From the Federal Register Online via the Government Publishing Office [www.gpo.gov] [FR Doc No: 95-7447] ======================================================================= ----------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION [Release No. 34-35518; File No. SR-AMEX-94-30] Self-Regulatory Organizations; American Stock Exchange, Inc.; Order Approving Proposed Rule Change Relating to the Listing and Trading of Commodity Linked Notes March 21, 1995. I. Introduction On August 22, 1994, the American Stock Exchange, Inc. (``Amex'' or ``Exchange'') submitted to the Securities and Exchange Commission (``SEC'' or ``Commission''), pursuant to Section 19(b) of the Securities Exchange Act of 1934 (``Act''),\1\ and Rule 19b-4 thereunder,\2\ a proposed rule change to list and trade Commodity Linked Notes (``COINs''), intermediate term notes whose value will be linked in part to changes in the levels of either the J.P. Morgan Commodity Excess Return Index (``JPMCIX'') or the J.P. Morgan Commodity Return Index (``JPMCI'' together with JPMCIX, ``Indexes''). \1\15 U.S.C. 78s(b)(1) (1988). \2\17 CFR Sec. 240.19b-4 (1993). --------------------------------------------------------------------------- Notice of the proposed rule change and Amendment No. 1 (defined herein) was published for comment and appeared in the Federal Register on December 2, 1994.\3\ No comments were received on the proposal. This order approves the proposal, as amended. \3\See Securities Exchange Act Release No. 35005 (November 23, 1994), 59 FR 61911. The Amex on November 16, 1994, submitted Amendment No. 1 (``Amendment No. 1'') to the proposal to allow the underwriter to link the value of the notes to either the JPMCI or JPMCIX, depending upon market conditions and investor interest at the time of the offering. Additionally, the Amendment provides that: only options approved accounts will be permitted to trade the notes; the notes will provide for a 75% guaranteed return of principal; the index value will be calculated at least once a day; the Amex has executed the necessary surveillance sharing agreements with the relevant commodities exchanges; and COINs will comply with the CFTC's hybrid instrument exemption (58 FR 5580 (Jan. 22, 1993)). See Letter from Benjamin Krause, Amex, to Michael Walinskas, Derivative Products Regulation, SEC, dated November 16, 1994. --------------------------------------------------------------------------- II. Description of Proposal The Amex proposes to list for trading under Section 107 of the Amex Company Guide (``Section 107'') a new hybrid product called COINS. COINs are intermediate term notes whose value will be linked in part to changes in the level of a commodity index consisting of base metals, precious metals and energy related commodities. More specifically, the value of COINs are based on an index that replicates a trading strategy whereby an investor holds a futures position in each of eleven exchange-traded commodities for a one-month period and then rebalances the positions of the commodities held for the following month to maintain a constant dollar weighting scheme. A. Description of the Indexes COINs will be linked to either the JPMCI or the JPMCIX, both of which measure the return from an investment in the same eleven industrial futures contracts.\4\ According to the Exchange, the JPMCI and JPMCIX are identical in all aspects except for the incorporation of ``collateral return,'' as more fully described below, into the JPMCI.\5\ Both Indexes are designed to replicate a trading strategy, described more fully below, that holds a futures position in each of the eleven futures for a one month period and then rebalances the volume of commodities held for the following month based upon a constant [[Page 15805]] dollar weighting scheme. Amex represents that J.P. Morgan desires the flexibility to determine at the time of offering, based upon investor demand and market conditions, which if the Indexes it will utilize for valuing COINs. \4\The commodities underlying the Indexes and their approximate weighting are: aluminum (9%), copper (8%), nickel (2%), zinc (3%), heating oil (10%), natural gas (7%), unleaded gas (5%), WTI Light Sweet Crude (33%), gold (15%), silver (5%) and platinum (3%). \5\See Amendment No. 1, supra note 3. --------------------------------------------------------------------------- COINs will conform to the Amex's listing guidelines under Section 107, which provide that such issues have: (1) A public distribution of one million trading units; (2) 400 holders; and (3) a market value of not less than $20 million. The Exchange also will require that the issuer have a minimum tangible net worth of $150 million. In addition, the Exchange will require that the total original issue price of the notes (when combined with all of the issuer's commodity linked notes which are listed on a national securities exchange or traded through the facilities of NASDAQ), shall not be greater than 25% of the issuer's tangible net worth at the time of issuance. COINs are non-interest bearing notes with a term of one to three years and, upon maturity, holders will receive at least 75% of the original issue price plus an amount in U.S. dollars equal to a participation rate (i.e., a specified percentage) multiplied by any positive difference between the level of the appropriate index at the time of the offering and the average of the closing index level on the five business days preceding maturity. COINs may not be redeemed prior to maturity, and holders of the notes have no claim to the physical commodities or futures contracts underlying the linked index. B. Index Design and Calculation The JPMCIX and JPMCI are designed to replicate a trading strategy that measures both ``price'' return and ``roll'' return from an investment in certain commodities. Price return is the component of return that arises from changes in commodity futures prices. Roll return is the component of return that arises from the hypothetical rolling of a long futures position through time in a sloping forward price curve environment. When nearby dated futures contracts are more expensive than longer dated contracts, roll return is positive. When the reverse applies, roll return is negative. The relative weights of the Index components will be rebalanced at the end of trading on the fourth business day of every month to maintain the appropriate dollar weighting. In addition, due to the periodic expiration of the futures contracts used to compute the Index value, Amex states that it is necessary to ``roll'' out of expiring contracts and into the new nearby contracts. To minimize possible pricing volatility arising from conducting the ``roll'' on a single business day, the substitution of the new contract for the old is accomplished with 20% of the roll volume transacted on each of the five subsequent business days after the rebalance date. The futures contract to be used for the monthly hypothetical rebalancing and rolling of each commodity will be the nearest designated future contracts\6\ to be used in the appropriate Index, with a termination of trading date not earlier than ten business days into the following month.\7\ \6\The designated futures contracts for each commodity are specified in the Letter from Benjamin Krause, Capital Markets Group, Amex, to Stephen M. Youhn, Derivative Products Regulation, SEC, dated Oct. 4, 1994. \7\For energy and base metals, the new and old contracts will be different. For precious metals, the new and old contracts may be the same contract because of the absence of a designated contract for every month. In this instance, rebalancing and rolling will only involve an adjustment of the amount held of the old contracts. --------------------------------------------------------------------------- In addition to price return and roll return, the JPMCI is comprised of ``collateral return,'' which, according to the Amex, represents the risk free component of commodity returns afforded by full collateralization of the notional value of futures positions with Treasury bills. Essentially, it measures the return that an investor would receive if the investor were to margin fully a futures position (i.e., post 100% margin) with Treasury bills. Amex represents that according to J.P. Morgan, because stocks and bonds are collateralized investments, it is useful to treat commodities on the same basis in order to compare risk-return performance, even though some investors may choose not to fully collaterlize commodity investments. Accordingly, J.P./ Morgan believes that collateralization permits meaningful comparison with traditional assets in a portfolio allocation framework.\8\ \8\The return based upon the Treasury bill rate is calculated using a 13 week T-bill yield, compounded daily at the decompounded discount rate of the most recent weekly U.S. Treasury bill auction as found in the H.15 (519) report published by the Board of Governors of the Federal Reserve System, on the full (100%) value of the index. Interest accrues on an actual day basis over weekends and holidays at the previous day's rate. See Amendment No. 1, supra note 3. --------------------------------------------------------------------------- Prices utilized in the Indexes will be based on New York Mercantile Exchange (``NYMEX'') prices for platinum and energy related commodities; Commodity Exchange (``Comex'') prices for other precious metals (Comex is wholly-owned subsidiary of NYMEX); and London Metal Exchange (``LME'') prices for base metals. These prices are widely reported by vendors of financial information and the press. Index values will be comprised of readily ascertainable and verifiable futures contract settlement and closing prices and will be calculated once each trading day by J.P. Morgan (or an affiliate) and disseminated after 4:00 p.m. (New York time) to vendors of financial information by the issuer, J.P. Morgan.\9\ \9\See Letter from William Floyd-Jones, Amex, to Stephen M. Youhn, SEC, dated December 16, 1994 (``December 16 Letter''). --------------------------------------------------------------------------- The design, composition and calculation of both Indexes are expected to remain unchanged during the term of the COINs instruments; however, market developments may necessitate changes to these aspects of the product.\10\ Such decisions will be determined on the basis of a ``neutral'' business committee, the JPMCI Policy Committee. This committee is composed of senior employees in the commodities and research areas of J.P. Morgan as well as independent industry and academic experts. Commodity Group personnel of J.P. Morgan are restricted to an advisory, non-voting membership on the JPMCI Policy Committee. J.P. Morgan will immediately notify the Exchange and vendors of financial information that report the Index values in the event that there is change in the relative weightings, calculation methodology or composition of the COINs Index.\11\ \10\Such developments could include, among other things, changing liquidity conditions or the discontinuation of existing contracts, the emergence of new contracts on relevant commodities, or major progress in substitution technology that renders obsolete industrial processes that make use of a certain commodity. \11\See infra note 17. --------------------------------------------------------------------------- Members of the NPMCI Policy Committee and employees of the calculation agent who are involved in the calculation of, or data collection for, any of the commodity interests underlying COINs or the aggregate value of the commodity index underlying COINs will be expressly prohibited from trading COINs. Additionally, the calculation agent will adopt and maintain such reasonable and appropriate procedures as to ensure that the calculation agent, its agents, affiliates and employees, do not take advantage of or communicate to any other person any knowledge concerning changes in the value of the Indexes, or any commodity interest underlying the Indexes before such information is made publicly available. C. Surveillance Sharing Agreements The Amex represents that it is able to obtain market surveillance information, including customer identity information, with respect to transactions [[Page 15806]] occurring on the NYMEX and Comex pursuant to its information sharing agreement with NYMEX.\12\ The Exchange also represents that it is able to obtain market surveillance information, including customer identity information, with respect to transactions occurring on LME under information sharing arrangements with the Securities and Futures Authority (``SFA'') through the Intermarket Surveillance Group (``ISG'').\13\ \12\See Letter from William Floyd-Jones, Amex, to Michael Walinskas, SEC, dated August 26, 1994. \13\Id. The ISG was formed on July 14, 1983 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 amendments made thereafter, was signed by ISG members on January 29, 1990. See Second Amendment to the Intermarket Surveillance Group Agreement, January 29, 1990. the members of the ISG are the Amex; the Boston Stock Exchange, Inc.; the Chicago Board Options Exchange, Inc.; the Chicago Stock Exchange, Inc.; the National Association of Securities Dealers, Inc.; the New York Stock Exchange, Inc.; the Pacific Stock Exchange, Inc.; and the Philadelphia Stock Exchange, Inc. The SFA is an affiliate member of ISG. --------------------------------------------------------------------------- D. Sales Practice and Trading Rules The Exchange will require that only accounts approved for options trading under Amex Rule 921 shall be permitted to engage in the purchase and/or sale of COINs. In addition, the Amex will require that recommendations in COINs transactions be subject to the heightened suitability standards set forth in Amex Rule 923.\14\ Additionally, the Exchange will distribute a circular to its membership prior to the commencement of trading in COINs to provide guidance with regard to member firm compliance responsibilities (including suitability recommendations) when handling transactions in COINs and highlighting the special risks and characteristics thereof. As with other hybrid debt instruments, COINs will be subject to the equity margin and trading rules of the Exchange.\15\ \14\Letter from William Floyd-Jones, Amex, to Stephen M. Youhn, SEC, dated November 17, 1994. \15\See Letter from James McNeil, Chief Examiner, Financial Regulatory Services Department, Amex, to Sharon Lawson, Assistant Director, SEC, dated August 24, 1994, for more specific details concerning the margin treatment for COINs. --------------------------------------------------------------------------- III. Commission Findings and Conclusions 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). In particular, the Commission believes that the availability of exchange-traded COINs will provide a new instrument for investors to achieve desired investment objectives (e.g., inflation hedge and portfolio diversification) through the purchase of an exchange-traded securities product linked to an index of certain commodities.\16\ For the reasons discussed below, the Commission has concluded that the Amex listing standards applicable to COINs are consistent with the Act. \16\Pursuant to Section 6(b)(5) of the Act the Commission must predicate approval of exchange trading for new products upon a finding that the introduction of the product is in the public interest. Such a finding would be difficult with respect to a product that served no investment, hedging or other economic function, because any benefits that might be derived by market participants would likely be outweighed by the potential for manipulation, diminished public confidence in the integrity of the markets, and other valid regulatory concerns. --------------------------------------------------------------------------- COINs are a new version of hybrid securities debt instruments that are listed on various securities exchanges. These instruments involve publicly offered notes with interest return or a principal component linked to a particular asset or index of assets. For COINs, the interest return and part of the principal return will be derived and based upon the performance of either the JPMCI or JPMCIX, which, in turn, will be dependent upon the performance of the designated futures contracts related to the underlying physical commodities.\17\ Although COINs provide investors with a 75% principal guarantee, as discussed below, the value of COINs will be affected partially by certain risks that are associated with the purchase and sale of exchange-traded futures contracts. \17\In this respect, the Commission notes that Amex will promptly notify the Commission if there are significant changes in the weighings and composition or calculation methodology of the Indexes. Moreover, any proposed material changes to such features might require a separate rule filing pursuant to Rule 19b-4. Furthermore, a rule filing would be required in order to list any other derivative product based upon either of the Indexes or any other index comprised of commodity interests. Finally, a proposed issuer would have to ensure that its product complied with applicable CFTC exemptions or statutory interpretations regarding hybrid products before listing any such product. See supra note 3. The Commission notes that the prices of commodities (and overlying futures contracts), including the eleven commodities utilized for the Indexes, may be subject to volatile price movements caused by numerous factors.\18\ Accordingly, an investment in COINs may also be subject to volatile price movements due to price changes in the underlying commodities comprising the Index. In addition, COINs have many complex features, such as the incorporation of hypothetical roll return and collateral return. The Amex has proposed special suitability, disclosure, and compliance requirements to address the complex and risky nature of COINs. First, only accounts approved for options trading pursuant to Amex Rule 921 may engage in transactions in COINs. As a result, only those investors who have expressed an interest in options trading and are deemed qualified by a member to engage in options trading will be permitted to purchase COINs. This is important given the embedded derivative component of COINs. Second, the Amex will require that members who make recommendations in COINs must comply with the heightened suitability standards set forth in Amex Rule 923.\19\ Third, COINs provide for a principal return of at least 75% of their initial offering price. While this guaranteed return of principal is subject to the issuer's credit risk, i.e., the ability of J.P. Morgan to meet its repayment obligations upon maturity, this guarantee helps to reduce the likelihood that investors could sustain a substantial loss of their COINs investment due to adverse commodity price movements. Fourth, because COINs are cash-settled, holders will not receive, nor be required to liquidate, the underlying physical commodities or overlying futures contracts. The Commission notes that this provision will effectively terminate a COINs investor's exposure to commodity market risk at the note's maturity. Finally, the Exchange plans to distribute a circular to its membership calling attention to the specific risks associated with COINs.\20\ This will assist members in determining the customers eligible to trade COINs, formulating recommendations in COINs, and in monitoring customer and firm transactions in COINs. \18\Such factors include, but are not limited to, international economic, social and political conditions and levels of supply and demand for the individual commodities. \19\Amex Rule 923 requires, among other things, that members have reasonable grounds for believing that a recommended transaction is not unsuitable on the basis of information furnished by the customer. \20\The COINs circular will be submitted to the Commission for its review and should include, among other things, a discussion of those risks which may cause commodities to experience volatile price movements in addition to details on the composition of the Indexes and how the rates of return will be computed. The Commission also believes that several factors significantly minimize the potential for manipulation of the Indexes. First, as discussed above, the Indexes represent a diverse cross- [[Page 15807]] section of exchange-traded industrial commodities. Second, each of the futures contracts overlying the commodities is relatively actively traded, and has considerable open interest. Third, the majority of futures contracts overlying the component commodities trade on exchanges that impose position limits on speculative trading activity, which are designed, and serve, to minimize potential manipulation and other market impact concerns. Fourth, as discussed below, the Amex has entered into certain surveillance sharing agreements with each of the futures exchanges upon which the underlying designated futures contracts trade. These agreements should help to ensure the availability of information necessary to detect and deter potential manipulations and other trading abuses, thereby making COINs less readily susceptible to manipulation.\21\ Fifth, the price of COINs will be comprised of readily ascertainable and verifiable futures contract settlement and closing prices and disseminated once each trading day after 4 p.m. (New York time) to vendors of electronic financial information and on the Amex tape.\22\ Sixth, adequate procedures are in place to prevent the misuse of information by members of the JPMCI Policy Committee.\23\ Accordingly, for the reasons discussed above, the Commission believes the Indexes are not readily susceptible to manipulation and that in any event, the surveillance procedures in place are sufficient to detect as well as deter potential manipulation. \21\The Amex has comprehensive surveillance sharing agreements with all of the exchanges upon which the futures contracts overlying COINs trade and is able to obtain market surveillance information, including customer identity information, for transactions occurring on NYMEX and Comex. Furthermore, under the ISG information sharing agreement, SFA will be able to provide, on request, surveillance information with respect to trades effected on the LME, including client identity information. Finally, if the composition of the applicable COINs Index changes or if a different market is utilized for purposes of calculating the value of the designated futures contracts, the Amex will ensure that it has entered into a surveillance sharing agreement with respect to the new relevant market. \22\See December 16 Letter. \23\As discussed above, members of the JPMCI Policy Committee are expressly prohibited from trading COINs and from communicating any knowledge concerning changes in the value of the Indexes to any other person. Amex will also have surveillance procedures in place to periodically review activity in the notes and/or underlying Index components. --------------------------------------------------------------------------- The Commission notes that COINs, unlike standardized options, do not contain a clearinghouse guarantee but are instead dependent upon the individual credit of the issuer, J.P. Morgan. This heightens the possibility that a purchaser of COINs may not be able to receive full principal cash payment upon maturity. To some extent this credit risk is minimized by the Exchange's listing guidelines requiring COINs issuers to possess at least $100,000,000 in assets and stockholders' equity of at least $10 million. In any event, financial information regarding J.P. Morgan will be disclosed or incorporated in the prospectus accompanying the offering of COINs. Finally, the Commission notes that the approval granted herein is limited to the issuance of COINs whose value is derived from the JPMCI or JPMCIX, as described in this Order. Accordingly, the use of either of the Indexes as an underlying value for any other derivative product, irrespective of the issuer, raises additional legal and/or regulatory issues which would necessitate a rule filing pursuant to Rule 19b-4. Based on the above, the Commission finds that the proposal to trade COINs is consistent with the Act, and, in particular, the requirements of Section 6(b)(5). It is therefore ordered, pursuant to Section 19(b)(2) of the Act,\24\ that the proposed rule change is approved. \24\15 U.S.C. 78s(b)(2) (1982). For the Commission, by the Division of Market Regulation, pursuant to delegated authority.\25\ \25\17 CFR Sec. 200.30-3(a)(12) (1994). --------------------------------------------------------------------------- Margaret H. McFarland, Deputy Secretary. [FR Doc. 95-7447 Filed 3-24-95; 8:45 am] BILLING CODE 8010-01-M