[Federal Register Volume 59, Number 99 (Tuesday, May 24, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-12575]
[[Page Unknown]]
[Federal Register: May 24, 1994]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-34076; File No. SR-BSE-93-17]
Self-Regulatory Organizations; Boston Stock Exchange, Inc.; Order
Granting Approval to Proposed Rule Change to Adopt Functional
Separation Procedures (``Chinese Wall'') for Specialist Firms
Affiliated with an Approved Person
May 18, 1994.
I. Introduction
On September 20, 1993 the Boston Stock Exchange, Inc. (``BSE'' or
``Exchange'') submitted to the Securities and Exchange Commission
(``SEC'' or ``Commission''), pursuant to section 19(b)(1) of the
Securities Exchange Act of 1934 (``Act'')\1\ and Rule 19b-4
thereunder,\2\ a proposed rule change to adopt a set of procedures
addressing specialist member organizations affiliated with an approved
person.
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\1\15 U.S.C. 78s(b)(1) (1988).
\2\17 CFR 240.19b-4 (1991).
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The proposed rule change was published for comment in Securities
Exchange Act Release No. 33090 (October 22, 1993), 58 FR 58206 (October
29, 1993). No comments were received on the proposal.
II. Description
The proposed rule change consists of Exchange guidelines that
outline the minimum requirements that an Exchange specialist firm
affiliated with an approved person\3\ will be expected to demonstrate
to provide for a functional separation (``Chinese Wall'') of its
specialist activity from its retail and proprietary business.
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\3\The Proposal defines the term ``approved person'' to mean a
person who is not a member or allied member of the Exchange or an
employee of a member organization, who has become an approved person
as provided in the rules of the Exchange and who is either: (1) A
person who controls a member or a member organization; or (ii) a
person engaged in a securities or kindred business who is controlled
by or under common control with a member or member organization.
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In addition to requiring approved persons to establish a Chinese
Wall, the proposal also requires that they establish, maintain and
enforce written procedures reasonably designed to prevent the misuse of
material, non-public information. Finally, the proposal requires an
approved person to obtain prior\4\ written approval of the Exchange
that it has complied with the requirements to establish functional
separation as appropriate to its operation and that it has established
proper compliance and audit procedures to ensure the maintenance of the
functional separation.\5\
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\4\Current Exchange upstairs firms will be given a grace period
of ninety days to come into compliance; those seeking to participate
in the Competing Specialist pilot, however, must demonstrate
compliance prior to approval. Thereafter, compliance must be
demonstrated to the Exchange before the applicant specialist firm
may function as a specialist on the floor of the Exchange.
Conversation between Karen Aluise, Assistant Vice President, Boston
Stock Exchange, and N. Amy Bilbija, Commission, on March 15, 1994.
\5\In addition, a copy of these Chinese Wall procedures, and any
amendments thereto, must be filed with the Exchange Surveillance
Department.
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The proposal identifies certain minimum procedural and maintenance
requirements. First the specialist's book must be kept confidential.
Second, the approved person can have no influence on specific
specialist trading decisions. Third, material, non-public corporate or
market information obtained by the approved person from the issuer may
not be made available to the specialist. Fourth, clearing and margin
financing information regarding the specialist may be routed only to
employees engaged in such work and managerial employees engaged in
overseeing operations of the approved persons and specialist entities.
In addition, the proposal places limitations on the information
which may pass between a broker affiliated with an associated approved
person and the specialist, such that they are limited to that exchange
of information which would occur in the normal course of business with
a comparable unaffiliated individual. Thus, the broker may make
available to the specialist only the market information he would make
available to an unaffiliated specialist in the normal course of his
trading and ``market probing'' activity. The specialist may divulge to
the broker only the information about market conditions in specialty
stocks that he would make available in the normal course of
specializing to any other broker, and in the same manner. The
specialist, however, is further restricted in that he may provide
market information to the broker only upon request of that broker and
not on his own initiative.
The proposal permits an approved person to popularize\6\ a
specialty stock provided it makes adequate disclosure about the
existence of possible conflicts of interest.
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\6\``Popularizing'' generally refers to the practice by
specialists, their member organizations and their corporate parents,
of making recommendations and providing research coverage regarding
their specialty securities. See Securities Exchange Act Release No.
23768, (November 3, 1986) 51 FR 41183 (November 13, 1986) (``NYSE/
Amex Order'').
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In addition, the proposal provides specific procedures that will
apply if a specialist becomes privy to material non-public information.
In such a case, the specialist must promptly inform his firm's
compliance officer, or other designated official, of such communication
and seek guidance from such officer or official as to what procedures
he should subsequently follow. Such officer or official must maintain
appropriate records, including the action taken and a summary of the
information received by the specialist. If the specialist is required
to give up the ``book,'' then such transfer must be done in a neutral
fashion to ensure that the transfer itself does not disclose the
information, and the Exchange must be informed.\7\
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\7\The compliance officer is also required to keep a record of
the time the specialist reacquired the book, reflecting
acknowledgement by the compliance officer that the reacquisition was
appropriate.
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Finally, with respect to compliance, the Exchange will periodically
examine the Chinese Wall procedures established hereunder and will
conduct surveillance of proprietary trades effected by an approved
person and its affiliated specialist member organization. The Exchange
will monitor specifically the trading activities of approved persons
and affiliated specialists in the specialist firm's specialty stock in
order to monitor the possible trading while in possession of material,
non-public information through the periodic review of trade and
comparison reports generated by the Exchange.
III. Discussion
The Commission recognizes that significant conflicts of interest
can arise between an approved person and the affiliated specialist unit
which, if not addressed by appropriate Chinese Wall procedures and the
monitoring and surveillance of the continuing adequacy of such
procedures, could result in potential manipulative market activity and
informational advantages benefitting the approved person, specialist
unit, or the customers of either, all in contravention of section 6(b)
of the Act.\8\ The Commission further believes that the procedures the
Exchange intends to implement with respect to approving and monitoring
the Chinese Wall address these concerns, and therefore are consistent
with the requirements of the Act and the rules and regulations
thereunder applicable to a national securities exchange. In particular,
the Commission believes the proposal is consistent with the section
6(b)(5) requirements that the rules of an exchange be designed to
promote just and equitable principles of trade, to prevent fraudulent
and manipulative acts, and, in general, to protect investors and the
public, in that the Chinese Wall is designed to prevent the misuse of
material, non-public information by specialist units affiliated with an
approved person. Further, the Commission believes the proposal is
consistent with the section 11A(a)(1)(C)(ii) Congressional finding\9\
in that it aids in assuring fair competition among brokers and dealers.
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\8\15 U.S.C. 78f(b) (1988).
\9\15 U.S.C. 78k-1(a)(1)(C)(ii) (1988).
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The Commission initially addressed the necessity and viability of
Chinese Walls in approving the amendments to New York Stock Exchange
(``NYSE'') and American Stock Exchange (``Amex'') Rules 98 and 193
respectively, which created the present Chinese Wall scheme in effect
today on those exchanges.\10\ At that time, the Commission expressed
its belief that it is also desirable for the regional exchanges to
consider requiring specialists affiliated with integrated firms to
establish an adequate Chinese Wall and generally to review the efficacy
of their surveillance and compliance procedures regarding those
specialists. The Commission previously had recognized the use of
Chinese Walls in a number of instances regarding the establishment of
an organizational separation between different departments of a broker-
dealer as one of several means of preventing the interdepartmental
communication of material, non-public information.\11\
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\10\See NYSE/Amex Order.
\11\See Securities Exchange Act Release No. 23768, (November 3,
1986) 51 FR 41183 (November 13, 1986), citing SEC Institutional
Investor Study, H.R. Doc No. 9264, 92d Cong., 1st Sess. 2539 (1971).
The Study urged financial institutions to ``consider the necessity
of segregating information flows arising from a business
relationship with a company as distinct from information received in
an investor or shareholder capacity.''
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The NYSE/Amex Order noted that, for example, in view of the diverse
functions performed by a multi-service firm and the material non-public
information that may be obtained by any one department of the firm, the
firm often may be required to restrict access to information the
department receiving it, in order to avoid potential liability under
sections 10(b) and 14(e) of the Act\12\ and Rules 10b-5 and 14e-3
thereunder. Moreover, two years after approval of the Amex's NYSE's
Chinese Wall procedures, Congress enacted the Insider Trading and
Securities Fraud Enforcement Act of 1988 (``ITSFEA''), designed
primarily to prevent, deter and prosecute insider trading.\13\ Among
other provisions ITSFEA created a specific requirement for broker-
dealers to maintain procedures designed to prevent the misuse of
material non-public information.\14\ In response to the promulgation
thereof, many firms redrafted their internal Chinese Wall Procedures to
ensure compliance.\15\
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\12\15 U.S.C. 78j(b), 78(e) (1982).
\13\Pub. L. No. 100-704.
\14\15 U.S.C. 78o(f).
\15\Several SRO's (Philadelphia Stock Exchange, Chicago Board
Options Exchange, and Pacific Stock Exchange) have adopted the
substance of the ITSFEA procedures under their rules applicable to
members an member firms (See Securities Exchange Release Nos. 30122
(December 30, 1992), 57 FR 729 (January 8, 1992); 30557 (April 6,
1992), 57 FR 13393 (April 16, 1992); 33171 (November 9, 1993 58 FR
60892 (November 18, 1993). In addition, the BSE's comparable rule
filing (SR-BSE-93-19) is still under consideration (See Securities
Exchange Act Release No. 33587 (February 7, 1994), 59 FR 6895
(February 14, 1994).
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The Commission restates its understanding that a number of firms
with regional specialist operations have established Chinese Wall
procedures between the specialist and its affiliated firm.
Nevertheless, such procedures have not necessarily been adopted by all
specialist affiliates, have not been adopted pursuant to any specific
regional exchange requirements, and have not been subject to specific
exchange surveillance and oversight. Consistent with the NYSE/Amex
Order, the Commission has continued to encourage the regional exchanges
to adopt Chinese Wall procedures.\16\
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\16\The Commission staff has specifically contacted the Pacific
Stock Exchange, Chicago Stock Exchange, Philadelphia Stock Exchange,
and BSE, requesting them to detail the procedures each exchange has
implemented for surveillance of compliance with the Chinese Wall
procedures adopted by firms affiliated with exchange specialists.
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The NYSE/Amex Order, in addressing the need for regional exchanges
to participate in the regulation of affiliations between specialist
operations and diversified broker-dealer firms, took into account the
fact that regional exchanges differ from the primary exchanges in terms
of order flow and market information. While noting that overall
regional exchange volume is small compared to primary market volume,
and regional exchange pricing of orders is generally derived from
primary market quotations, the Commission expressed its concern that
the diversion by a large retail broker-dealer of all or a significant
portion of order flow in speciality stocks to an affiliated regional
specialist could raise regulatory concerns similar to those raised by
such affiliations on the primary exchanges. Moreover the Commission
noted that even if regional exchange specialists continued to set their
prices based on primary market quotations, a regional specialist
affiliated with an integrated retail firm could obtain significant
access to material, non-public information.
The Commission continues to believe that Chinese Walls, with
effective controls, may be useful in restricting information flow
between the various departments of broker-dealers. The Commission has
monitored the NYSE and Amex Chinese Wall rules since their inception,
and generally believes they have proven effective in the context of
specialists and affiliated approved persons.
The Commission believes that the BSE proposal effectively addresses
the potential for market abuses resulting from the ongoing relationship
between specialists and affiliated approved persons. The effectiveness
of the procedures set forth in the BSE guidelines is reinforced by the
Exchange's existing surveillance of specialist and the marketplace as
well as the specialist's highly visible position in the marketplace.
These factors, along with the specialist's existing statutory duty to
maintain a fair and orderly market, should combine to enhance the
effectiveness of the proposed Chinese Wall.
Finally, the Commission notes that the structural adequacy of the
Chinese Wall is only one part of evaluating whether the procedures
established by the Exchange will detect and deter potential improper
activity by either the approved person or the specialist. Appropriate
surveillance procedures are critical to ensure that the Chinese Wall is
maintained. To this end, the Exchange has submitted to the Commission
proposed procedures for monitoring the Chinese Wall.\17\ The Commission
also notes that the Exchange has represented that it believes that it
has adequate staffing capacity to monitor compliance and conduct
independent reviews of member firms.
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\17\The Exchange has requested that these procedures be accorded
confidential treatment by the Commission.
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IV. Conclusion
It is therefore ordered, pursuant to section 19(b)(2) of the
Act,\18\ that the proposed rule change (SR-BSE-93-17) is approved.
\18\15 U.S.C. 78s(b)(2) (1988).
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For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\19\
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\19\17 CFR 200.30-3(a)(12) (1991).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-12575 Filed 5-23-94; 8:45 am]
BILLING CODE 8010-01-M
