An issuer comes to us and asks if it can link its debt security to an index. This seemingly simple question (if the index is the S&P® 500 Index, for example) progresses through layers of complication as the underlying index varies from a broad-based benchmark index (such as the SPX) to a proprietary index with a small number of constituents. We discuss below the principal issues to consider.
IS IT AN INDEX?
There is no definition of "index" under the U.S. securities laws, nor are there any regulations governing indices, other than the generic exchange listing rules discussed below.1 There are several definitions that come close to an index definition, but the focus of those definitions relates principally to the characteristics of the index as "broad" or "narrow."
An index is generally understood to represent a statistical aggregate that measures or reflects change; for our purposes, the change relates to groups of equity securities, commodities, bonds, currencies or futures contracts. From that overbroad definition, we can look to some regulatory sources for reference.
The NYSE has certain "generic" listing rules, which have been approved by the Securities and Exchange Commission (the "SEC").2 When listing a debt security, such as an exchange-traded note, on the NYSE Arca, the underlying index must meet these rules. In the case of an equity index, the following summarized requirements apply:
- Minimum of ten constituents;
- Minimum market value per component of at least $75 million;
- Minimum monthly trading volume above a threshold;
- No single component can be more than 25% of the dollar weight of the index, and the five highest dollar-weighted components cannot exceed 50% of the dollar weight (60% for an index of fewer than 25 components);
- 90% of the index's weight and at
least 80% of the number of components must be eligible for
standardized options trading on the NYSE
- This last requirement does not apply,
- No underlying component represents more than 10% of the dollar weight of the index; and
- The index has a minimum of 20 components;
- This last requirement does not apply, however, if:
- All component securities are either issued by a company required to file periodic reports under the Securities Exchange Act of 1934 (the "Exchange Act") or are non-U.S. securities or American depositary receipts, with such non-U.S. securities subject to certain limitations.3
Some general themes emerge from these rules, and one can define a spectrum of index characteristics, with bona fide indices on one end and indices that may be very customized (and, as a result, less "index like") on the other. The following indicia are helpful in characterizing an index as a bona fide index:
- More than 20-25 components;
- Not top-heavy;
- Actively traded components;
- The index and its methodology have been publicly available for some period of time;
- The index methodology is rules-based and can be replicated by third parties;
- There are listed options and/or ETFs linked to the index; and
- The index measures an objective market segment.
The following index characteristics may raise concerns warranting additional review:
- Fewer than 10 components;
- A small number of index components represent most of the index weighting;
- A narrow-based index (see below);
- The index methodology has discretionary elements;
- The index was created for the purpose of issuing a product or meeting the needs of a specific or a limited number of customers, rather than in order to objectively measure an identifiable market segment; or
- Embedded fees in the index negatively affect the index level.
NARROW VERSUS BROAD-BASED INDICES
The NYSE generic listing rules are similar to the definition of an index that is not a "narrow-based security index" in Section 3(a)(55)(C) of the Exchange Act (i.e., the index is a broad-based index). A broad-based index has the following characteristics:
It has at least nine component securities;
- No component security comprises more than 30% of the index's weighting; and
- Each component security is
- Registered under Section 12 of the Exchange Act;
- One of 750 securities with the largest market capitalization; and
- One of 675 securities with the largest dollar value of average daily trading volume.4
A narrow-based index likely would not satisfy the generic exchange listing rules. This is not to say that an index with a small number of components could not be a bona fide index. The NYSE FANG+" Index has ten components, meets the NYSE Arca generic listing requirements and has a recognized index administrator (ICE Data Indices, LLC, which is the index sponsor, index administrator and index calculation agent).
DESCRIBING AN INDEX
Indices operate pursuant to a methodology, and are administered by a small cast of characters with tightly defined roles. The methodology and the identities of the entities responsible for index administration must be clearly described in the index description portion of an offering document. There is no provision in Regulation S-K under the Securities Act of 1933 (the "Securities Act") setting out requirements related to index descriptions. Practitioners are left to analogize and to determine the type of information that a reasonable investor likely would find to be material.
There are a number of distinct roles performed in conjunction with the maintenance of an index, including the following:
- The index sponsor (or "administrator") manages the index. The index sponsor may or may not own the intellectual property underlying the index. Anyone who wants to reference the index, or link a security or derivative to the index, must license it from the index sponsor. The index sponsor is usually the entity that has created the index (i.e., wrote the methodology), although in recent years many banks have engaged third-party sponsors to administer indices that were created by the banks.5 S&P Dow Jones Indices LLC is the sponsor of many indices, including the SPX. FTSE Russell is the index sponsor of the Russell 2000® Index (the "RTY") and other indices. Disclosure relating to the offer of a debt security that references the performance of the SPX or the RTY will include a paragraph or two describing the license agreement between the issuer of the debt security and the index sponsor.
- The index calculation agent determines the level of the index pursuant to the methodology. Generally, the index calculation agent has very little discretion, subject to the exceptions described below. This role may also be performed by the index sponsor.
- The index publisher disseminates the index level and other related information. Many times this role is combined with that of the index calculation agent. Bloomberg L.P. disseminates the levels of many indices with respect to which it may or may not be the index calculation agent.
1 Benchmark regulation and related rules adopted outside of the United States are beyond the scope of this article.
2 See NYSE Arca Equity Rule 5.2-E(j)(6). The Nasdaq and Cboe BZX Exchange have substantially similar generic listing rules. See Nasdaq Rule 5710 and Cboe BZX Exchange Rule 14.11(d).
3 NYSE Arca Equity Rule 5.2-E(j)(6)(B)(I)
4 See also Section 3(a)(55)(B) of the Exchange Act (definition of a "narrow-based security index"); Section 1a(35)(A) of the Commodity Exchange Act (same); Section 1a(35)(B) of the Commodity Exchange Act (an index that is not a narrow-based security index).
5 An index sponsor may succeed to an index created by another index sponsor.
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