[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]



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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).
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    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.
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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.
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    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.
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    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.
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    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'').
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    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.
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    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.
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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.
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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.
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    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.
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    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).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 95-7447 Filed 3-24-95; 8:45 am]
BILLING CODE 8010-01-M