Request for Comments on the Proposed Rules and Regulations Governing the Registration and Trading of Structured Warrants

January 11, 2017 SEC MSRD NOTICE TO : Market Participants and the Investing Public All Other Interested Parties SUBJECT : Request for Comments on the Proposed Rules and Regulations Governing the Registration and Trading of Structured Warrants The Securities and Exchange Commission intends to issue Rules and Regulations Governing the Registration and Trading of Structured Warrants. Hence, the Commission is inviting market participants, the investing public and other interested parties to submit their views, comments and inputs to the proposed rules. HTcADC Please see attached documents for your reference and guidance: (1) Draft Memorandum Circular Proposed Rules and Regulations Governing the Registration and Trading of Structured Warrants. (2) Briefer on Structured Warrants. Commenters may submit, not later than 10 February 2017 , their views, comments and inputs by email to [emailprotected] and [emailprotected] . Issued on January 11, 2017. ATTACHMENT Draft as of January 11, 2017 SEC MEMORANDUM CIRCULAR NO. ____________ Series of 2017 SUBJECT : PROPOSED RULES AND REGULATIONS GOVERNING THE REGISTRATION AND TRADING OF STRUCTURED WARRANTS Section 1. Title of Rules and Regulations. These Rules and Regulations shall be known as the "Rules and Regulations Governing the Registration and Trading of Structured Warrants." Section 2. Interpretation of Rules. Any doubt in the interpretation of these rules shall be resolved in a manner which would establish a socially conscious free market that regulates itself, encourage the widest participation of ownership in the enterprises, enhance the democratization of wealth, promote the development of the capital market, protect investors and ensure full and timely disclosure of material information. aScITE The requirements under these rules shall be in addition to those provided under the following: (1) SRC and other related laws and their IRRs insofar as their provisions are applicable; (2) internal policies, procedures, conventions of brokers or dealers, and; (3) rules, procedures and conventions of the Exchange and SRO that shall regulate and supervise the brokers, dealers, salesmen or associated persons of broker or dealer, to the extent that such policies, rules, procedures and conventions do not contravene the SRC, its IRR and these rules. Section 3. Definition of Terms Used in the Rules and Regulations. When used herein, unless the context otherwise requires: A) American Style refers to an exercise style wherein the structured warrant may be exercised at any time up to and including its expiry date. B) Commission refers to the Philippine Securities and Exchange Commission. C) Exchange is an organized marketplace or facility that brings together buyers and sellers and executes trades of securities and/or commodities. D) Exercise Price means the pre-specified price or level of the underlying financial instrument at which the holder of structured warrant may exercise the right under such warrant. E) European Style refers to an exercise style wherein the structured warrant may only be exercised on the expiry date. F) Market Making means the act of entering bid and offer prices in the automated trading system of an exchange. G) SRC refers to the Securities Regulation Code or Republic Act No. 8799. H) Structured Warrant is a financial product issued by a third-party financial institution that gives the holder the right, but not the obligation, to either buy or sell an underlying asset at a predetermined price on or before a certain date in the future. I) Term Sheet refers to the document containing the specific terms and conditions and information on a particular series of structured warrants, to be issued by the issuer from time to time and which shall be supplemental to and should be read in conjunction with the prospectus. J) Underlying Share(s) refers to, in relation to a particular structured warrant, the shares which are the subject of a particular structured warrant. HEITAD Section 4. Eligible Issuers of Structured Warrants. 4.1 The following entities may qualify to issue structured warrants subject to compliance with the requirements imposed under these rules: A) Registered Broker Dealers; and B) Registered Investment Houses. 4.2 Issuers of structured warrants shall comply with the following requirements: A) Capitalization Requirement An issuer should have a minimum paid up capital of Five Hundred Million Pesos (Php500,000,000.00). B) Risk management practices B.1 In undertaking structured warrants issuance activities, an issuer must practice the basic principles of prudence and ensure that it has the following: (a) adequate infrastructure for risk management; (b) adequate risk management processes that integrate sound measurement and valuation procedures, prudent risk limits, continuous risk monitoring and regular management reporting; and (c) comprehensive internal controls and audit procedures. B.2 The board of directors and/or senior management of the issuer must ensure that they have effective oversight of the risk management practices of the issuer. B.3 The board of directors and/or senior management of the issuer must ensure that prior to any issuance of structured warrants, the issuer must already have in place personnel with the necessary skills and knowledge to perform the risk management function. aDSIHc B.4 The board and/or senior management of the issuer should approve written policies and procedures which describe the overall framework for managing product risks. These policies should cover the following aspects: (a) Investment objectives/purpose of issuing structured warrants; (b) Definition of the parameters for the authorization of the structured warrants; (c) Identification, measurement and management of risks including the credit, market, liquidity, legal, operational, regulatory and extraordinary risks associated with the product; (d) Risk measurements and reporting methodologies that commensurate with the issuer's business strategies, size and complexity of its operations and risk profile of the product on an ongoing basis; (e) Clear delineation of lines of responsibility for managing product-related risks; (f) Provision of sufficient resources, which include competent staff and information technology systems and infrastructure to support the risk management and daily operations of the new and existing derivatives products; (g) Regular reviews of product's risk exposures to ensure all material risks are identified and monitored when market condition changes; (h) Review of stress scenarios that measure the impact of market conditions that may cause volatility swings or reduced liquidity; and (i) Comprehensive and regular reports to the board and/or senior management that include the degree of compliance with policies and procedures for managing product risks, current assessment of product risks and any change in the direction of risks. B.5 The board and/or senior management of the issuer should ensure comprehensive internal controls and audit function which includes the following: (a) a review of the adequacy and effectiveness of the overall risk management system, including compliance with policies, procedures and risk limits; and (b) a check for adequacy of the various operational controls, including segregation of duties and staff's compliance with the established policies and procedures. ETHIDa (c) the board and/or senior management of the issuer should also ensure that all policies and procedures are in place and are effective in monitoring the product risks on an ongoing basis. C) Sales and Marketing practices C.1 Issuers may, after the issuance of Permit to Sell and Order of Registration by the Commission and subject to compliance with all relevant laws, rules and regulations, release publicity materials in relation to such structured warrants. C.2 Issuers must have a set of policies and procedures on the product marketing and sales activities for structured warrants. Issuers must ensure that customers are fully informed through the appropriate disclosures on the key features and risks associated with the product. C.3 Issuers must put in place a system for handling customer complaints. C.4 Issuers must have in place continuous educational programs which could include seminars, workshops, media briefings, interviews, and etc. to educate or create greater awareness on structured warrants among investors. The educational and/or marketing programs must clearly explain the characteristics of structured warrants and their inherent risks. C.5 Issuers must maintain a dedicated webpage or website on structured warrants which contains the following: (a) educational documents/materials; (b) the latest preliminary prospectus; (c) the term sheets; and (d) an explanation of the issuer's role and obligation as a market maker (if applicable). The webpage or website must be updated from time to time to reflect any new developments or current market practice. D) Managing conflict of interest D.1 An issuer must put in place supervisory and internal control procedures and systems to ensure that: (a) any potential conflict of interest is addressed; (b) there are adequate and effective chinese walls between the various divisions of the issuer's business; and (c) non-public information is not shared with unauthorized persons. D.2 Where the issuer reasonably believes that there is a potential conflict of interest, it must take all reasonable steps to resolve or adequately mitigate the conflict. D.3 The issuer must make full disclosure to the Commission of the nature of the conflict of interest and the steps taken to address such conflict. D.4 The issuer must also disclose any conflict of interest to its clients. cSEDTC Section 5. Registration of Structured Warrants under the SRC. 5.1 No person shall sell or offer for sale or distribute structured warrants unless such securities have been registered in accordance with the requirements of the SRC. 5.2 Relative to the above requirement, an eligible issuer shall file a Registration Statement ("RS") using SEC Form ___ signed by its principal executive officer, its principal operating officer, its principal financial officer, its controller, its principal accounting officer, its corporate secretary or persons performing similar functions. The eligible issuer shall file the SEC Form ___ with the prescribed filing fee. 5.3 The issuer shall disclose in its RS the terms and conditions of the structured warrant plan including the computational data relative thereto. 5.4 An issuer shall provide the relevant prospectus which shall contain the data required under SRC Rule 12 and these Rules. In addition, the following information shall be provided in the prospectus: A) The prospectus should set out in detail the terms and conditions of the structured warrants, including but not limited to the following: (a) the issue size; (b) a full description of the nature of the structured warrants, e.g. , exercise style (American or European), underlying shares and settlement method; and (c) a summary of the terms of the structured warrants, including the issue price, strike price, exercise period, expiry date, the implied volatility, gearing, and premium. B) Description of all applicable exercise rights including: (a) automatic exercise at the expiry of the exercise of the structured warrants; (b) for physical settlement, the delivery of an exercise notice and payment of the exercise price, and the period in which the issuer may deliver the underlying by electronic transfer to the holder following a valid exercise; (c) the maximum number of underlying shares which the issuer is obliged to transfer upon exercise of the structured warrants; (d) for cash settlement, the method of calculating the settlement amount and the period in which the issuer may deliver the requisite cash settlement amount. The issuer's obligation to provide for automatic exercise upon expiry of the structured warrant should also be stated; and (e) the period during which the structured warrants in issue may be exercise and the date when the structured warrants expire. C) Rights of holders of structured warrants in the event of a take-over, liquidation, merger, dissolution or winding-up of the issuer or a scheme of arrangement involving the shareholders of the issuer; D) The prospectus should include the following information with respect to the underlying corporation: (a) description of the underlying corporation, its subsidiaries, its history and business, its directors, key management and substantial shareholders; (b) published audited financial statements for the past three years and the latest quarterly results; (c) formula for adjusting the amount payable on the exercise of such rights or the entitlement due upon exercise, where applicable, to take account of any rights issue, bonus issue, consolidation or other alteration to the share capital of the underlying corporation; SDAaTC (d) rights, if any, of holders of structured warrants to participate in any distribution and/or offers of further securities made by underlying corporation; (e) rights, if any, of the structured warrants holders in the event of a take-over, liquidation, merger or winding up of the underlying corporation; (f) market statistics of the underlying shares quoted on a securities exchange outside the Philippines such as the following, if applicable: (i) the quarterly highest and lowest market prices of the underlying shares and the composite index of the relevant securities exchange for the last three years immediately preceding the date of issuance of the prospectus; (ii) the closing price and the five-day volume-weighted average price of the underlying shares immediately preceding the date of issuance of the prospectus; (iii) the market capitalization based on the latest closing price immediately preceding the date of issuance of the prospectus; (iv) the price-earnings multiple based on the latest closing price immediately preceding the date of issuance of the prospectus and the latest published audited results; AaCTcI (v) the dividend yield based on the latest closing price immediately preceding the date of issuance of the prospectus and the latest annual dividend that was declared and paid; and (g) any other information which is necessary to enable an investor to make an informed assessment of the value of the structured warrants. E) Risks involved in purchasing the structured warrants. F) Risk Management practices, Sales and Marketing practices, and procedures for managing conflict of interest of the issuer. 5.5 A prospectus in relation to the issuance of structured warrants may be issued: A) in a single document; or B) by way of a base prospectus supported by term sheet(s). The base prospectus should contain information relating to the issuer while the term sheet should contain information concerning the specific issue. The base prospectus and term sheet(s) should each contain a statement that it should be read in conjunction with the other. 5.6 Nothing herein shall preclude the Commission from requiring other information that it may deem consistent with public interest. Section 6. Listing of the Structured Warrants in an Exchange. Structured warrants shall be listed in an Exchange pursuant to the listing rules of such Exchange. No Exchange shall accept the listing of the structured warrants unless said shares have been registered under the SRC. Section 7. Market Making of the Structured Warrants. An issuer shall comply with the following requirements: A) Disclose whether it intends to fulfill the spread requirement or provide liquidity for a structured warrant issue via market making or both; B) Where the issuer appoints a market maker for its issue of structured warrants, it should disclose the identity of the appointed market maker and explain the relationship between the issuer and the market maker; C) Where the issuer provides liquidity via market making, disclose the circumstances under which the market maker will not be able to and should not be obliged to provide liquidity in its structured warrants; D) Disclose the minimum quantity of structured warrants for which liquidity will be provided; E) Disclose the maximum spread between the bid and offer prices when liquidity is provided; F) Disclose the daily market presence of the market maker; G) Disclose whether the issuer has any intention to undertake a further issue of the structured warrants. Section 8. Expiration of the Structured Warrants. 8.1 An issuer shall, not less than ten (10) business days prior to the date of expiry of its structured warrants, inform the Commission in writing and publish through its website and of the Exchange a notice containing the following: A) the date of expiry, the last expected date of dealings and the date of withdrawal from listing of the structured warrants; EcTCAD B) the exercise price; C) the expected date of payment or delivery (as the case may be); and D) such other information as the Commission may require. 8.2 An issuer shall not be required to publish a notice in respect of its structured warrants expiring on its normal expiry date if the terms and conditions in respect of that structured warrant provide for net cash settlement on an automatic basis. Section 9. Withdrawal of Listing of the Structured Warrants in an Exchange. An issuer applying to withdraw the listing of a structured warrant in an Exchange shall inform the Commission in writing not less than ten (10) business days prior to the expected delisting date. Section 10. Trading Halt or Suspension of Trading of the Structured Warrants. Where the underlying shares of the structured warrants listed on the Exchange are halted or suspended from trading for whatever reason, trading on the Exchange of the structured warrants relating to such shares shall also be halted or suspended. Section 11. Reports to be Filed by Issuer. An issuer shall file to the Commission the following: A) Periodic and current reports and records required under the SRC; and B) Other reports and records as may be required by the Commission from time to time. Section 12. Appointment of Warrant Registrar. An issuer shall appoint a warrant registrar which shall maintain an accurate Warrant Registry Book for recording of transfer of the structured warrants. Section 13. Administrative Sanctions. If the Commission finds that there is a violation of any provision of this Rule or any applicable rules under the SRC, or that any person, in a registration statement or its supporting papers and the prospectus, as well as in the periodic reports required to be filed with the Commission has made any untrue statement of a material fact or omitted to state any material fact required to be stated therein or necessary to make the statements therein not misleading or refuses to permit any lawful examination into its corporate affairs, the Commission shall, in its discretion impose additional sanctions provided by law aside from those established by existing regulations. Section 14. Effectivity. These rules shall take effect fifteen (15) days after the date of last publication in two (2) newspapers of general circulation in the Philippines. Pasay City, Metro Manila, __________ 2017. BRIEFER ON STRUCTURED WARRANTS Prepared by Markets and Securities Regulation Department January 2017 Definition A structured warrant is a form of structured investment product issued by a third-party financial institution over a wide range of assets, including the shares of an unrelated listed company, a basket of companies' shares or an index. It enables investors to participate in the price performance of an underlying asset at a fraction of its price. Therefore, structured warrants enable investors to free up their capital while maintaining a similar level of exposure to the underlying asset or otherwise increase their exposure for the same investment outlay. HSAcaE Differences between warrants issued by a company and structured warrants Company Warrants Structured Warrants Issuer Own company Third-party financial institutions Underlying Own company shares Any underlying asset that meets legal/regulatory requirements Exercise Style Usually American American or European. An American style warrant allows the warrant holder to exercise his right at any time before or on expiry date whereas European style warrant only allows the warrant holder to exercise his right on expiry date Dilution New shares issued; usually results in share dilution No new shares issued; no dilution of shares Expiry Period Usually 3-5 years Usually 6 months-2 years Liquidity Less liquidity. No market maker More liquidity. Designated market maker Settlement period Physical delivery of shares Either physical-settled or cash settled but usually cash settled. When a physical-settled Structured Warrant is exercised, the warrant holder receives the underlying security, which is bought at the Exercise Price. When a cash-settled Structured Warrant is exercised, the warrant holder receives a cash profit which is the difference between the price of the underlying security and the exercise price. Types of Structured Warrants Call Warrant A Call warrant gives the holder the right, but not the obligation, to buy from the issuer a given quantity of the underlying asset at a predetermined price (exercise or strike price), on or before the expiry date, depending on the exercise style of the warrant. Put warrant A Put warrant gives the holder the right, but not the obligation, to sell to the issuer a given quantity of the underlying asset at a predetermined price, on or before the expiry date, depending on the exercise style of the warrant. Call Warrants Put Warrants Market View Potential Profit A bullish view of the price of the underlying asset If position is unwind before maturity Difference between sale price and purchase price of the warrant If position held till maturity date Difference between cash settlement amount ( i.e. , the difference between the current share price and the warrant exercise price) and purchase price of the warrant A bearish view of the prize of the underlying asset If position is unwind before maturity Difference between sale price and purchase price of the warrant If position held till maturity date Difference between cash settlement amount ( i.e. , the difference between the current share price and the warrant exercise price) and purchase price of the warrant Potential Loss Total premium paid Total premium paid Rights of Warrant Holders Holders have the right, but not the obligation, to buy the underlying assets from the issuer at a predetermined exercise or strike price on the expiry date Holders have the right, but not the obligation, to sell the underlying assets to the issuer at a predetermined exercise or strike price on the expiry date Factors Affecting Warrant Prices HESIcT Factor Movement Effect on Theoretical Value of Warrant Remarks Call Put Price of the Underlying Asset h h i The price of a warrant is derived from the related underlying asset price. A Call warrant is worth more as the underlying increases in value. Similarly, the value of a Put warrant will increase as the underlying decreases in value. Exercise Price of Structured Warrant h i h A Call warrant with lower strike price is more likely to be exercised than one with a higher strike. Thus, a higher strike Call warrant is usually cheaper. Similarly, a Put warrant with a higher strike price is more likely to be exercised than one with a lower strike price, hence a higher strike Put warrant is more expensive. Volatility of the Underlying Asset h h h A measurement of the frequency and intensity of price change of underlying asset. A higher price fluctuation of the underlying asset implies higher warrant value. Time to Expiry of Structured Warrant i i i The longer the time to expiry, the higher the probability that the underlying share price may move in favor of the warrant holder. Thus, a warrant with a longer time to expiry is usually more expensive. Interest Rates h h i For each Call warrant issued, issuers allocate funds to purchase underlying shares. If the cost of borrowing ( i.e. , the interest rate) increases, the cost will be reflected in a corresponding increase in the warrant price. Similarly, a Put warrant will decrease in value when interest rates rise. Dividend of Underlying Asset h i h Investors in warrants do not receive the dividends paid on the underlying shares, nor or do they directly participate in special dividends, rights or bonus issues. In valuing warrants, issuers estimate the expected dividend stream of the underlying shares. Thus, dividend yields of the underlying asset have little impact of the prices of structured warrants on ex-dividend dates. Generally, in the case of a special dividend, rights or bonus issue, the terms of the warrant are adjusted so that the investor is not disadvantaged. Features and Benefits of Investing in Structured Warrants Gearing/leverage : The main reason for trading warrants is gearing. Structured warrants are usually priced at a fraction of the share price. This allows you to trade more warrants than the underlying share for the same investment outlay. Trading warrants therefore, offers benefits of gearing. For instance, a small percentage gain in the underlying share price may lead to a larger percentage gain in the value of the call warrants. Conversely, a fall in the price of the underlying share may lead to a larger percentage loss in the value of the warrants. AcICHD Unlimited upside but limited downside : The maximum potential loss to you is the entire warrant price, which is usually a fraction of the share price. The potential gain of a warrant may be unlimited as it depends on the movements of the underlying share. Protects the value : A put warrant allows you to hedge against a fall in the price of a stock in your portfolio. You are therefore, assured of a minimum value equivalent to the exercise price for the stock in your portfolio. Market Exposure : Index and basket structured warrants with values linked to the performance of a benchmark index and pre-defined basket of shares respectively, will allow you to gain exposure to a sector or market. This eliminates the need of trading in a market portfolio of individual stocks. Releasing capital for other investments : Call warrants may be used to free up capital invested in shares. By selling existing share holdings and purchasing a corresponding number of call warrants for a fraction of the price, you can maintain exposure to the underlying share price increase while releasing capital from holding the shares. Settlement & Exercise How to Calculate Cash Settlement Amount? Settlement Calculations Formulas Types of Warrants Settlement Amount Call warrant [(Closing price - Strike price)/Exercise ratio] x no. of Warrants Put warrant [(Strike price - Closing price)/Exercise ratio] x no. of Warrants Determination of Closing Price 1. Exercise the warrants before expiry (Applicable to American Style Warrants Only) The closing price will be based on the closing market price of the underlying share or closing level of the underlying index on the exercise date or the next market day after the exercise date. caITAC 2. On the expiry date (Applicable to American and European Style Warrants) On the expiry date, In-the-money warrants are automatically exercised and the settlement price will be based on: (in Singapore) Equity Warrants 5-day VWAP (Volume-Weighted Average Price) of the underlying share for 5 market days prior to the expiry date; or Average closing price of underlying share for 5 market days prior to the expiry date; or Closing price of the underlying share before the expiry date, as specified by the relevant term sheet. Index Warrants Closing level of` the underlying index before the exercise date or expiry date; or Closing level of the corresponding index futures contract before the expiry date; or Average closing levels of the underlying index for 5 market days prior to the exercise date or expiry date, as specified by the relevant term sheet. If the structured warrants expired Out-of-the-money or worthless, there will be no settlement. Example Structured Warrant (SW) of ABC Co. issued by KGI Series A (Call Warrant) Detail as of 2 July 13 : ABC13C1312A Underlying Asset : ABC Exercise Price : P110.00 Exercise Ratio : 1 SW per 1 ABC Price of ABC : P100.00 Price of : P5.00 ABC13C1312A On 2 July 13, if an investor has P1,000,000.00, he can Option 1 Invest in ABC, buy 10,000 shares at P100.00 (10,000 x 100 = P1,000,000.00) or Option 2 Invest in ABC13C1312A, buy 200,000 units at P5.00 (200,000 x 5 = P1,000,000.00) On 13 Dec 13, if price of both securities are: Price of ABC : P120.00 Price of ABC13C1312A : P10.00 The investor can profit on each option as follows: Option 1 if investor sells ABC at P120.00, profit will be P200,000.00 (10,000.00 x (120-100)) or 20% Option 2 if investor sells ABC13C1312A at P10.00, profit will be P1,000,000.00 (200,000 x (10-5)) or 100% Basically, with the same amount invested, if the price of the stock goes up, investing in a structured warrant will give a higher return than investing in the stock. However, investor should aware when the price of the underlying stock goes down, investing in structured warrant will suffer a greater loss than investing in the stock too. Position of Structured Warrant Issuer The issuer does not take any view on the direction of the price of the underlying asset. SW issuer will time to time buy and/or sell the underlying asset to hedge their position in order to achieve a market risk neutral position. Example on how issuers hedge When an investor buys a call warrant from an issuer, all things being equal, that call warrant should increase in value as the share price increases. On this point, investors may have the perception that this means the issuer will lose money. However, when an issuer sells a call warrant they will typically go into the underlying market and buy the underlying shares. Accordingly, if the share price increases, in theory, not only should the call warrant increase in value and the investor make profits, but also the issuer should make a gain on their shareholding. The converse is also true. That is, if the share price declines instead of increasing, all things being equal, the value of the call warrant should decline. Thus if the issuer is holding shares as a hedge, the value of the issuer's shareholding will decline. This example shows that warrants are not a 'zero sum game' which pervades as a common misconception in the market. Risk Involved Credit Risk : It is the risk that the warrant issuer will not be able to fulfill its obligations. This occurs on the exercise of the warrant. Therefore, you should assess the credit risk associated with the warrant issuer. Liquidity Risk : It occurs when a warrant holder is unable to sell his warrant for a reasonable price in the market. This is due to insufficient buy orders which affect the market price of the warrant. Market Risk : Similar to other investments in the securities market, the market value of a warrant is susceptible to events that affect its demand and supply. Hence, the market value of your investment will fluctuate accordingly. Default on market making obligation : An issuer who has committed to make a market in a warrant issue may not fulfill its obligation due to unforeseen circumstances that may arise. Hence, you may experience liquidity risk despite a commitment from the issuer to make a market. Limited life of warrants : Warrants have an expiry date and therefore a limited life. A warrant may expire before your expectations are realized, making it worthless. Extraordinary event : The warrant issuer may declare a lapse of the warrant or bring forward the expiry date. This arises out of certain circumstances such as the delisting of the underlying asset. These circumstances are outlined in the Terms and Conditions of the warrant issue. cDHAES