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National Financial Services
Impartial Lottery Process for Partially Called Securities, Pre-refunded and Defeased Securities
When a security is subject to a partial redemption, pursuant to FINRA Rule 4340, NFS has procedures in place to conduct an impartial lottery process.
When an issuer initiates a partial call of securities, the depository holding such securities (typically, the Depository Trust Corporation, DTC) conducts an impartial computerized lottery using an incremental random number technique to determine the allocation of called securities to its participants (including NFS) for which it holds securities on deposit. Because DTC's lottery is random and impartial, in the case of a partial call, depository participants may or may not receive an allocation of called securities.
When NFS is notified that it has received an allocation of called securities, it conducts a similar computer-generated random lottery. The lottery determines the accounts that will be selected and the number of securities in the account that will be redeemed. Allocations are based on the number of trading units or lots that the accounts hold. The probability of any trading unit or lot held by an account being selected as called in a partial call is proportional to the total number of trading units or lots being held through NFS. Once the lottery is completed, NFS notifies correspondent firms for which it provides clearing services of the accounts that received an allocation. Securities registered in a customer's name, either in transit or held in custody, are excluded from the NFS lottery process.
In the event an issuer initiates a partial call of securities on or prior to a trade settlement date with respect to either a purchase or sale of the subject securities in a customer's account, NFS reserves the right to cancel the customer's trade. Customers are responsible for covering any outstanding short positions, as well as any other resulting costs in their account, that result from the lottery.
Through the lottery process, NFS's system identifies:
- All accounts that hold the called security.
- The number of trading units or lots assigned to each account which are subject to the call.
- The total par value of the called securities for each account which is derived by multiplying the # of trading units or lots by the unit size
Example (unit of trade = $25,000)
| Customer Account | Par Value | Number of Trading Units |
|---|---|---|
| ABC-123234 | $100,000 | 4 |
| DEF-325465 | $75,000 | 3 |
| EDR-567433 | $150,000 | 6 |
| EGT-876574 | $50,000 | 2 |
| EGT-888345 | $25,000 | 1 |
| FRT-435234 | $25,000 | 1 |
| FRT-658797 | $75,000 | 3 |
In brief, that allocation process involves the following steps:
- Each account gets identified with the number of trading units or lots held.
- Each trading unit or lot gets a sequential number assigned. (e.g., Acct EDR-567433 would get 6 numbers assigned to it).
- A random number is generated that will result in one of these trading units or lots being the first unit or lot in the selection process.
- Thereafter, the trading units or lots participating in the allocation are based on an incremental random number technique until the number of trading units or lots allocated for NFS is exhausted.
The allocation of called securities is not made on a pro rata basis. Therefore, it is possible that a customer may receive a full or partial redemption or may not have any securities selected for redemption at all.The lottery process may leave holders with an odd-lot position in their account.
When a partial call is deemed favorable to the holders of the called security, NFS will exclude its and correspondent firms' proprietary and employee accounts from the lottery and no allocation will be made to its or correspondent firms' proprietary and employee accounts until all other customer positions in such securities have been called. Generally when a partial call is deemed unfavorable to holders of the called security, NFS will not exclude its or correspondent firms' proprietary or employee accounts from the lottery.
If the partial call is made at a price equal to or above the current market price as captured in NFS's price reporting system, NFS will generally categorize the call as one that is favorable to the holders of such security. If the partial call is made at a price that is below the current market price of the security as captured in NFS's price reporting system, NFS will generally categorize that call as one that is unfavorable to holders of the security.
Redemption features, in addition to those disclosed on the trade confirmation, may exist for certain debt securities. The existence of special mandatory redemption features, such as sinking funds provisions, may not be disclosed on a trade confirmation. It is the customer's obligation to review all disclosure documents the customer may receive, and to understand the risks of extraordinary calls or early redemptions, which may affect yield. Issuers may, from time to time, publish notices of offers to redeem callable securities within limited time, price and tender parameters. NFS is not obligated to notify customers of such published calls.
Information about whether a municipal security is callable can be accessed via the Municipal Securities Rulemaking Board's Electronic Municipal Market Access ("EMMA") website (www.emma.msrb.org).