Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 (“Act”), and Rule 19b-4 thereunder, notice is hereby given that on December 10, 2002, the National Association of Securities Dealers, Inc. (“NASD” or “Association”), through its subsidiary, The Nasdaq Stock Market, Inc. (“Nasdaq”), filed with the Securities and Exchange Commission (“Commission” or “SEC”) the proposed rule change as described in Items I, and II, below, which Items have been prepared by Nasdaq. On December 13, 2002, the NASD filed Amendment No. 1 to the proposed rule change. The Commission is publishing this notice to solicit comments on the proposed rule change, as amended, from interested persons and is approving the proposal, as amended, on an accelerated basis.
17 CFR 240.19b-4.
See letter John D. Nachmann, Senior Attorney, Nasdaq to Kathleen A. England, Assistant Director, Division of Market Regulation (“Division”), Commission, dated December 12, 2002 (“Amendment No. 1”). Amendment No. 1 provides for certain technical changes and clarification to the original proposal.
I. Self-Regulatory Organization's Statement of the Terms of the Substance of the Proposed Rule Change
Nasdaq proposes to list and trade Market Recovery Notes Linked to the Nasdaq-100 Index (the “Notes”) issued by Merrill Lynch & Co., Inc. (“Merrill Lynch”).
II. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change
In its filing with the Commission, Nasdaq included statements concerning the purpose of, and basis, for the proposed rule change and discussed any comments it received on the proposed rule change. The text of these statements may be examined at the places specified in Item III below. Nasdaq has prepared summaries, set forth in Sections A, B, and C below, of the most significant aspects of such statements.
A. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change
1. Purpose
Under NASD Rule 4420(f), the Nasdaq may approve for listing and trading innovative securities which cannot be readily categorized under traditional listing guidelines. Nasdaq proposes to list for trading the Notes, as described below, under NASD Rule 4420(f).
See Securities Exchange Act Release No. 32988 (September 29, 1993), 58 FR 52124 (October 6, 1993) (order approving File No. SR-NASD-93-15), (“1993 Order”).
Description of the Notes
The Notes are a series of senior non-convertible debt securities that will be issued by Merrill Lynch and will not be secured by collateral. The Notes will have a term of not less than two and not more than four years. The Notes will be issued in denominations of whole units (“Unit”), with each Unit representing a single Note. The original public offering price will be $10 per Unit. The Notes will not pay interest and are not subject to redemption by Merrill Lynch or at the option of any beneficial owner before maturity in 2005.
The actual maturity date will be determined on the day the Notes are priced for initial sale to the public.
At maturity, if the value of the Nasdaq-100 Index has increased, a beneficial owner will be entitled to receive a payment on the Notes based on triple the amount of that percentage increase, not to exceed a maximum payment per Unit (the “Capped Value”) that is expected to be between $11 and $16. Thus, the Notes provide investors the opportunity to obtain leveraged returns based on the Nasdaq-100 Index. Unlike ordinary debt securities, the Notes do not guarantee any return of principal at maturity. Therefore, if the value of the Nasdaq-100 Index has declined at maturity, a beneficial owner will receive less, and possibly significantly less, than the original public offering price of $10 per Unit.
The Nasdaq-100 Index is a modified capitalization-weighted index of 100 of the largest non-financial companies listed on The Nasdaq National Market tier of Nasdaq. The Index constitutes a broadly diversified segment of the largest securities listed on The Nasdaq Stock Market and includes companies across a variety of major industry groups. The securities in the Index must, among other things, have an average daily trading volume on Nasdaq of at least National Market. In order to initially be included in the Nasdaq National Market, an issuer must meet a number of financial criteria, including a minimum of: (1) 1.1 million publicly held shares; (2) $8 million in market value of publicly held shares; (3) shareholder's equity of 15 million, or market value of listetd securities of $75 million or total assets and total revenue of $75 million; and (4) a bid price of $1. An issuer may be required to meet higher listing standards depending on the Entry or maintenance Standard under which it qualifies for inclusion in The Nasdaq National Market. See Amendment No. 1, supra note 3.
No one particular stock or group of stocks dominates the Nasdaq-100 Index. Id. As of December 9, 2002, the largest component security presented 13.13% of the Index and the five largest component securities represented 31.9% of the Index. Id. In order to limit domination of the Index by a few large stock stocks, the Index is calculated under a “modified capitalization-weighted” methodology, which is a hybrid between equal weighting and conventional capitalization weighting. Under the methodology employed, on a quarterly basis coinciding with Nasdaq's quarterly scheduled weight adjustment procedures, the Index Securities are categorized as either “Large Stocks” or “Small Stocks” depending on whether their current percentage weights (after taking into acocunt such scheduled weight adjustments due to stock repurchases, secondary offerings, or other corporate actions) are greater than, or less than or equal to, the average percentage weight in the Index (i.e., as a 100-stock index, the average percentage weight in the Index is 1.0%). Such quarterly examination will result in an Index rebalancing if either one or both of the following two weight distribution requirements are not met: (1) The current weight of the single largest market capitalization Index component security must be less than or equal to 24.0%, and (2) the “collective weight” of those Index component securities whose individual current weights are in excess of 4.5%, when added together, must be less than or equal to 48.0%. Index securities are ranked by market value and are evaluated annually to determine which securities will be included in th e Index. Moreover, if at any time during the yeaer an Index security is no longer trading on the Nasdaq Stock Market, or is otherwise determined by Nasdaq to become ineligible for continued inclusion in the Index, the security will be replaced with the largest market capitalization security not currently in the Index that meets the Index eligibility criteria. For a detailed description of the Nasdaq-100 Index, see the prospectus supplement that will be filed by Merrill Lynch with the Commission prior to the issuance of the Notes.
The actual Capped Value will be determined at the time of issuance of the Notes.
The payment that a beneficial owner will be entitled to receive (the “Redemption Amount”) depends entirely on the relation of the average of the values of the Nasdaq-100 Index at the close of the market on five business days shortly before the maturity of the Notes (the “Ending Value”) and the closing value of the Nasdaq-100 Index on the date the Notes are priced for initial sale to the public (the “Starting Value”).
If the Ending Value is less than or equal to the Starting Value, the Redemption Amount per Unit will equal:
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If the Ending Value is greater than the Starting Value, the Redemption Amount per Unit will equal:
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provided, however, the Redemption Amount cannot exceed the Capped Value.
The Notes are cash-settled in U.S. dollars and do not give the holder any right to receive a portfolio security, dividend payments or any other ownership right or interest in the portfolio or index of securities comprising the Nasdaq-100 Index. The Notes are designed for investors who want to participate or gain exposure to the Nasdaq-100 Index, subject to a cap, and who are willing to forego market interest payments on the Notes during such term. The Commission has previously approved the listing of options on, and securities the performance of which have been linked to or based on, the Nasdaq-100 Index.
See Securities Exchange Act Release Nos. 33428 (January 5, 1994), 59 FR 1576 (January 11, 1994) (approving the listing and trading of options on the Nasday-100 Index); 43000 (June 30, 2000), 65 FR 42409 (July 10, 2000) (approving the listing and trading of options based upon one-tenth of the value of the Nasdaqq-100 Index); 41119 (February 26, 1999), 64 FR 11510 (March 9, 1999) (approving the listing and trading of Portfolio Depositary Receipts based on the Nasdaq-100 Index).
As of November 30, 2002, the adjusted market capitalization of the securities included in the Nasdaq-100 Index ranged from a high of $200.6 billion to a low of $1.2 billion. The average daily trading volume for these same securities for the last eleven months, as of the same date, ranged from a high of 79.9 million shares to a low of 634,118 shares.
See Amendment No. 1, supra note 3.
The Nasdaq-100 Index is determined, composed, and calculated by Nasdaq. The value of the Nasdaq-100 Index is disseminated every 15 seconds over the Nasdaq Trade Dissemination System.
Id.
Criteria for Initial and Continued Listing
The Notes will initially be subject to Nasdaq's listing criteria for other securities under NASD Rule 4420(f). Specifically, under NASD Rule 4420(f)(1):
(A) The issuer shall have assets in excess of $100 million and stockholders' equity of at least $10 million. In the case of an issuer which is unable to satisfy the income criteria set forth in paragraph (a)(1), Nasdaq generally will require the issuer to have the following: (i) Assets in excess of $200 million and stockholders' equity of at least $10 million; or (ii) assets in excess of $100 million and stockholders' equity of at least $20 million;
(B) There must be a minimum of 400 holders of the security, provided, however, that if the instrument is traded in $1,000 denominations, there must be a minimum of 100 holders;
(C) For equity securities designated pursuant to this paragraph, there must be a minimum public distribution of 1,000,000 trading units;
(D) The aggregate market value/principal amount of the security will be at least $4 million.
In addition, Nasdaq notes that Merrill Lynch satisfies the listed marketplace requirement set forth in NASD Rule 4420(f)(2). Lastly, pursuant to NASD Rule 4420(f)(3), prior to the commencement of trading of the Notes, Nasdaq will distribute a circular to the membership providing guidance regarding member firm compliance responsibilities and requirements, including suitability recommendations, and highlighting the special risks and characteristics of the Notes. In particular, Nasdaq will advise members recommending a transaction in the Notes to: (1) Determine that such transaction is suitable for the customer; and (2) have a reasonable basis for believing that the customer can evaluate the special characteristics of, and is able to bear the financial risks of, such transaction.
NASD Rule 4420(f)(2) generally requires that issuers of securities designated pursuant to NASD Rule 4420(e) be listed on Nasdaq or the New York Stock Exchange (“NYSE”) or be an affiliate of a company listed on Nasqad or the NYSE; provided, however, that the provisions of NASD Rule 4450 will be applied to sovereign issuers of “other” securities on a case-by-case basis.
The Notes will be subject to Nasdaq's continued listing criteria for other securities pursuant to NASD Rule 4450(c), which requires that the aggregate market value or principal amount of publicly-held units must be at least $1 million. Nasdaq will also consider prohibiting the continued listing of the Notes if Merrill Lynch is not able to meet its obligations on the Notes. The Notes also must have at least two registered and active market makers as required by NASD Rule 4450(a)(6).
See Amendment No. 1, supra note 3.
The Notes will be registered under Section 12 of the Act.
Rules Applicable to the Trading of the Notes
Since the Notes will be deemed equity securities for the purpose of NASD Rule 4420(f), the NASD and Nasdaq's existing equity trading rules will apply to the Notes. First, pursuant to NASD Rule 2310, “Recommendations to Customers (Suitability),” and NASD-IM-2310-2, “Fair Dealing with Customers,” NASD members must have reasonable grounds for believing that a recommendation to a customer regarding the purchase, sale or exchange of any security is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs. In addition, as previously mentioned, Nasdaq will distribute a circular to advise members and employees thereof recommending a transaction in the Notes to, among other things, have a reasonable basis for believing that the customer can evaluate the special characteristics of, and is able to bear the financial risks of, such transaction. Second, the Notes will be subject to the equity margin rules. Third, the regular equity trading hours of 9:30 a.m. to 4 p.m. will apply to transactions in the Notes.
NASD Rule 2310(b) requires members to make reasonable efforts to obtain information concerning a customer's financial status, a customer's tax status, a customer's investment objectives, and such other information used or considered to be reasonable by such member or registered representative in making recommendations to the customer.
Nasdaq represents that NASD's surveillance procedures are adequate to properly monitor the trading of the Notes. Specifically, NASD will rely on its current surveillance procedures governing equity securities, and will include additional monitoring on key pricing dates. In addition, Nasdaq has a general policy that prohibits the distribution of material, non-public information by its employees.
Disclosure and Dissemination of Information
Merrill Lynch will deliver a prospectus in connection with the initial purchase of the Notes. The procedure for the delivery of a prospectus will be the same as Merrill Lynch's current procedure involving primary offerings. In addition, Nasdaq will issue a circular to NASD members explaining the unique characteristics and risks of the Notes.
2. Statutory Basis
Nasdaq believes that the proposed rule change is consistent with Section 15A of the Act, in general, and with Section 15A(b)(6) of the Act, in particular, in that the proposal is designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to remove impediments to and perfect the mechanism of a free and open market and, in general, to protect investors and the public interest.
15 U.S.C. 78 o-3.
15 U.S.C. 78 o-3(b)(6).
B. Self-Regulatory Organization's Statement on Burden on Competition
Nasdaq does not believe that the proposed rule change, as amended, will result in any burden on competition that is not necessary or appropriate in furtherance of the purposes of the Act.
C. Self-Regulatory Organization's Statement on Comments on the Proposed Rule Change Received From Members, Participants, or Others
Written comments were neither solicited nor received.
III. Solicitation of Comments
Interested persons are invited to submit written data, views, and arguments concerning the foregoing, including whether the proposed rule change, as amended, is consistent with the Act. Persons making written submissions should file six copies thereof with the Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-0609. Copies of the submission, all subsequent amendments, all written statements with respect to the proposed rule change that are filed with the Commission, and all written communications relating to the proposed rule change between the Commission and any person, other than those that may be withheld from the public in accordance with the provisions of 5 U.S.C. 552, will be available for inspection and copying in the Commission's Public Reference Room. Copies of such filing will also be available for inspection and copying at the principal office of the NASD. All submissions should refer to file number SR-NASD-2002-175 and should be submitted by January 14, 2003.
IV. Commission's Findings and Order Granting Accelerated Approval of Proposed Rule Change
Nasdaq has asked the Commission to approve the proposal, as amended, on an accelerated basis to accommodate the timetable for listing the Notes. The Commission notes that it has previously approved the listing and trading of similar Enhanced Return Notes linked to the Nasdaq-100 Index.
See Securities Act Release Nos. 45024 (November 5, 2001), 66 FR 56872 (November 13, 2001); 45429 (February 11, 2002), 67 FR 7438 (February 19, 2002).
After careful consideration, 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 association, and, in particular, with the requirements of Section 15A(b)(6) of the Act in that it is designed to promote just and equitable principles of trade, to remove impediments to and perfect the mechanism of a free and open market, and, in general, to protect investors and the public interest. The Commission believes that the Notes will provide investors with a means to participate in any percentage increase in the Index that exist at the maturity of the Notes, subject to the Capped Value. Specifically, as described more fully above, if the value of the Nasdaq-100 Index has increased, a beneficial owner will be entitled to receive at maturity a payment on the Notes based on triple the amount of any percentage increase in the Index, not to exceed the Capped Value.
15 U.S.C 78 o-3(b)(6).
In approving the proposed rule, the Commission has considered the proposed rule's impact on efficiency, competition, and capital formation. 15 U.S.C. 78c(f).
The Notes are leveraged debts instruments whose price will be derived from and based upon the value of the Index. In addition, as discussed more fully above, the Notes do not guarantee any return of principal at maturity. Thus, if the Index has declined at maturity, a beneficial owner may receive significantly less than the original public offering price of the Notes. Accordingly, the level of risk involved in the purchase or sale of the Notes is similar to the risk involved in the purchase or sale of traditional common stock. Because the final rate of return on the Notes is derivatively priced and based upon the performance of an index of securities, because the Notes are debt instruments that do not guarantee a return of principal, and because investors' potential return is limited by the Capped Value, there are several issues regarding trading of this type of product. For the reasons discussed below, the Commission believes that Nasdaq's proposal adequately addresses the concerns raised by this type of product.
First, the Commission notes that the protections of NASD Rule 4420(f) were designed to address the concerns attendant to the trading of hybrid securities like the Notes. In particular, by imposing the hybrid listing standards, heightened suitability for recommendations, and compliance requirements, noted above, the Commission believes that Nasdaq has adequately addressed the potential problems that could arise from the hybrid nature of the Notes. The Commission notes that Nasdaq will distribute a circular to its membership that provides guidance regarding member firm compliance responsibilities and requirements, including suitability recommendations, and highlights the special risks and characteristics associated with the Notes. Specifically, among other things, the circular will indicate that the Notes do not guarantee any return of principal at maturity, that the maximum return on the Notes is limited to $11 and $16 per unit, that the Notes will not pay interest, and that the Notes will provide full exposure to any downside movement in the Index. Distribution of the circular should help to ensure that only customers with an understanding of the risks attendant to the trading of the Notes and who are able to bear the financial risks associated with transactions in the Notes will trade the Notes. In addition, the Commission notes that Merrill Lynch will deliver a prospectus in connection with the initial purchase of the Notes.
See 1993 Order, supra note 4.
As discussed above, Nasdaq will advise members recommending a transaction in the Notes to: (1) Determine that the transaction is suitable for the customer; and (2) have a reasonable basis for believing that the customer can evaluate the special characteristics of, and is able to bear the financial risks of, the transaction.
The actual Capped Value will be determined at the time of issuance of the Notes.
Second, the Commission notes that the final rate of return on the Notes depends, in part, upon the individual credit of the issuer, Merrill Lynch. To some extent this credit risk is minimized by the NASD's listing standards in NASD Rule 4420(f), which provide that only issuers satisfying substantial asset and equity requirements may issue these types of hybrid securities. In addition, the NASD's hybrid listing standards further require that the Notes have at least $4 million in market value. Financial information regarding Merrill Lynch, in addition to information concerning the issuers of the securities comprising the Index, will be publicly available.
The companies comprising the Index are reporting companies under the Act.
Third, the Notes will be registered under Section 12 of the Act. As noted above, the NASD's and Nasdaq's existing equity trading rules will apply to the Notes, which will be subject to equity margin rules and will trade during the regular equity trading hours of 9:30 a.m. to 4 p.m. NASD Regulation's surveillance procedures for the Notes will be the same as its current surveillance procedures for equity securities, and will include additional monitoring on key pricing dates.
Fourth, the Commission has a systemic concern that a broker-dealer, such as Merrill Lynch, or a subsidiary providing a hedge for the issuer will incur position exposure. However, as the Commission has concluded in previous approval orders for the hybrid instruments issued by broker-dealers, the Commission believes that this concern is minimal given the size of the Notes issuance in relation to the net worth of Merrill Lynch.
See, e.g., Securities Exchange Act Release Nos. 44913 (October 9, 2001), 66 FR 52469 (October 15, 2001) (order approving File No. SR-NASD-2001-73) (approving the listing and trading of notes issued by Morgan Stanley Dean Witter & Co. whose return is based on the performance of the Index); 44483 (June 27, 2001), 66 FR 35677 (July 6, 2001) (order approving File No. SR-Amex-2001-40) (approving the listing and trading of notes issued by Merrill Lynch whose return is based on a portfolio of 20 securities selected from the Amex Institutional Index); and 37744 (September 27, 1996), 61 FR 52480 (October 7, 1996) (order approving File No. SR-Amex-96-27) (approving the listing and trading of notes issued by Merrill Lynch whose return is based on a weighted portfolio of healthcare/biotechnology industry securities).
Finally, the Commission believes that the listing and trading of the proposed Notes should not unduly impact the market for the securities underlying the Index or raise manipulative concerns. In approving the product, the Commission recognizes that the Nasdaq-100 Index is a modified capitalization-weighted index of 100 of the largest, non-financial companies listed on The Nasdaq National Market tier of Nasdaq. The Commission notes that the Index is determined, composed, and calculated by Nasdaq. As of November 30, 2002, the adjusted market capitalization of the securities included in the Nasdaq-100 Index ranged in capitalization from a high of $200.6 billion to a low of $1.2 billion. In addition, the average daily trading volume for the component stocks for the last eleven months, as of the same date, ranged from a high of 79.9 million shares to a low of 634, 118 shares. Given the large capitalizations, liquid markets, and relative weightings of the Index's component stocks, the Commission continues to believe, as it has concluded previously, that the listing and trading of the Notes that are linked to the Nasdaq-100 Index, should not unduly impact the market for the underlying securities comprising the Nasdaq-100 Index or raise manipulative concerns. As discussed more fully above, the Commission also believes that the weighting and potential quarterly rebalancing of the Nasdaq-100 Index should ensure that no one stock or group of stocks significantly minimize the potential for manipulation of the Index. Moreover, the issuers of the underlying securities comprising the Nasdaq-100 Index, are subject to reporting requirements under the Act, and all of the component stocks are either listed on Nasdaq or the NYSE or be an affiliate of a company listed on Nasdaq or the NYSE. In addition, Nasdaq's surveillance procedures should serve to deter as well as detect any potential manipulation. The Commission also notes that the value of the Nasdaq-100 Index is disseminated every 15 seconds over the Nasdaq Trade Dissemination System.
See note 8, supra.
The Commission finds good cause for approving the proposed rule change, as amended, prior to the thirtieth day after the date of publication of notice of filing thereof in the Federal Register. The Commission believes that the Notes will provide investors with an additional investment choice and that accelerated approval of the proposal will allow investors to begin trading the Notes promptly. In addition, the Commission notes that it has previously approved the listing and trading of similar Notes and other hybrid securities based on the Nasdaq-100. Accordingly, the Commission believes that there is good cause, consistent with Sections 15A(b)(6) and 19(b)(2) of the Act, to approve the proposal, as amended, on an accelerated basis.
See supra note 16.
15 U.S.C. 78 o-3(b)(6) and 78s(b)(2).
V. Conclusion
It is therefore ordered, pursuant to Section 19(b)(2) of the Act, that the proposed rule change (SR-NASD-2002-175), as amended, is hereby approved on an accelerated basis.
For the Commission, by the Division of Market Regulation, pursuant to delegated authority.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02-32317 Filed 12-23-02; 8:45 am]
BILLING CODE 8010-01-P