[Federal Register Volume 59, Number 148 (Wednesday, August 3, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-18821]
[[Page Unknown]]
[Federal Register: August 3, 1994]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-34449; File No. SR-CSE-94-04]
Self-Regulatory Organizations; Cincinnati Stock Exchange, Inc.;
Order Approving Proposed Rule Change Concerning Chinese Wall Procedures
for Designated Dealers
July 27, 1994.
I. Introduction and Background
On March 17, 1994 the Cincinnati Stock Exchange, Inc. (``CSE'' or
``Exchange'') filed a proposed rule change with the Securities and
Exchange Commission (``Commission'') pursuant to section 19(b)(1) of
the Securities Exchange Act of 1934 (``Act'')\1\ and Rule 19b-4
thereunder.\2\ The proposed rule change would require specialists to
establish the appropriate functional separation to their operations
while maintaining and enforcing written procedures to prevent the
misuse of material, non-public information by employee, affiliated
individual and proprietary accounts.
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\1\15 U.S.C. Sec. 78s(b)(1) (1988).
\2\17 CFR 240.19b-4 (1992).
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Notice of the filing of this proposal appeared in the Federal
Register on June 21, 1994.\3\ No comment letters were received. For the
reasons discussed below, the Commission has determined to approve the
proposal.
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\3\ See Securities Exchange Act Release No. 34215, 59 FR 32031
(June 21, 1994).
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II. Description
The CSE is proposing to require Exchange Designated Dealers
(``specialist'') to establish the appropriate functional separation to
their operations while maintaining and enforcing written procedures
designed to prevent the misuse of material, non-public information by
employee, affiliated individual and proprietary accounts. The proposed
rule further requires that a copy of such procedures be provided to the
Exchange for review and approval, and sets forth specific guidelines
for designated dealers to follow in adopting, maintaining and enforcing
Chinese Wall procedures. Finally, the proposal requires that the
Exchange specialist firm obtain prior\4\ written approval of the
Exchange that it has complied with the requirements in establishing
functional separation as appropriate to the 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 members will be given a 90 day grace period
to come into compliance. Thereafter, as well as for now applicants
during such 90 day period, compliance must be demonstrated to the
Exchange before the applicant firm may function as a specialist on
the Exchange. Conversation between Robert P. Ackermann, Secretary
and Vice President Regulatory Services, Cincinnati Stock Exchange,
and Jill W. Ostergaard, Attorney, Office of Market Supervision,
Division of Market Regulation, Commission on July 12, 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 associated or affiliated person can have no
influence on specific specialist trading decisions. Second, material,
non-public corporate or market information obtained by the associated
or affiliated person from the issuer may not be made available to the
specialist. Third, clearing and margin financing information regarding
the specialist may be routed only to employees engaged in overseeing
operations of the affiliated or associated persons and specialist
entities.
In addition, the proposal places limitations on the information
which may pass between a broker affiliated with an associated or
affiliated person and the specialist, such that they are limited to
that exchange of information which would occur in the normal course of
his trading and ``market probing'' activity. The specialist may divulge
to such an affiliated broker information regarding market conditions in
speciality stocks that he would make available in the normal course of
specializing to any other broker, and in the same manner. The proposal
permits an affiliated or associated 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 speciality securities. See Securities Exchange Act Release No.
23768, 51 FR 41183 (November 13, 1986) (``NYSE/Amex Order'').
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The proposal, moreover, 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 the
communication and seek guidance from the officer or official as to what
procedures he should follow or what other action should subsequently be
followed. The compliance officer or official must maintain appropriate
records, including a summary of the information received by the
specialist and a description of the action taken by the compliance
officer or other official.
Finally, the Exchange has established certain procedures to monitor
compliance, including the examination of the Chinese Wall procedures
established by the Exchange specialist firms and surveillance of
proprietary trades effected by an affiliated or associated person and
its affiliated or associated specialist firm. The Exchange will also
monitor the trading activities of affiliated or associated persons and
affiliated or associated specialist in the specialist firms' speciality
stocks in order to monitor the possible trading while in possession of
material, nonpublic information through the periodic review of trade
and comparisons reports generated by the Exchange.
III. Discussion
The Commission has determined that the CSE's proposal is consistent
with Section 6(b) of the Act in general and furthers the objectives of
Section 6(b)(5) in particular in that it promotes just and equitable
principles of trade and protects investors and the public interest.
Further, the Commission believes the proposal is consistent with
Section 11A(a)(1)(C)(ii)\7\ in that it aids in assuring fair
competition among brokers and dealers.
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\7\15 U.S.C. Sec. 78k-1(a)(1)(C)(ii)(1988).
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The Commission recognizes that significant conflicts of interest
can arise between a specialist operation and any associated or
affiliated persons, which, if not addressed by appropriate Chinese Wall
procedures and the adequate surveillance of such procedures, could
result in potential manipulative market making activity and
informational advantages benefitting the specialist, specialist unit,
or 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.
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\8\15 U.S.C. Sec. 78f(b) (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
on those exchanges.\9\ 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
adequate Chinese Walls and generally to review the efficacy of their
surveillance and compliance 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 the several
means of preventing the interdepartment communication of material, non-
public information.\10\
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\9\See NYSE/Amex Order.
\10\See Securities Exchange Act Release No. 23768, 51 FR 41183
(Nov. 13, 1986), citing SEC Institutional Investor Study, H.R. Doc.
No. 9264, 92nd 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
to the department receiving it, in order to avoid potential liability
under Sections 10(b) and 14(c) of the Act\11\ and Rules 10b-5 and 14e-3
thereunder. Moreover, two years after approval of the Amex's and NYSE's
Chinese Wall procedures, Congress enacted the Insider Training and
Securities Fraud Enforcement Act of 1988 (``ITSFEA''), designed
primarily to prevent, deter, and prosecute insider trading.\12\ Among
other provisions, ITSFEA created a specific requirement for broker-
dealers to maintain procedures designed to prevent the misuse of
material, non-public information.\13\ In response to the promulgation
thereof, many firms redrafted their internal Chinese Wall procedures to
ensure compliance.\14\
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\11\15 U.S.C. Sec. 78j(b), 78n(e) (1982).
\12\Pub. L. No. 100-704.
\13\15 U.S.C. Sec. 78o(f).
\14\Several SRO's (Philadelphia Stock Exchange, Chicago Board
Options Exchange, Pacific Stock Exchange and Boston Stock Exchange)
have adopted the substance of ITSFEA procedures under their rules
applicable to members and member firms (See Securities Exchange Act
Release Nos. 30122, 57 FR 729 (Jan. 8, 1992); 30557, 57 FR 13393
(April 16, 1992); 33171, 58 FR 60892 (Nov. 18, 1993); and 34284
(June 30, 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.\15\
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\15\The Commission, in the past, has requested the regional
stock exchanges 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 exchange
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 that regional exchange pricing of orders is generally derived from
primary market quotations, the Commission expressed its concern that
the diversion by a large broker-dealer of all or a significant portion
of order flow in specialty stocks to an affiliated regional specialist
could raise certain regulatory concerns similar to those raised by such
affiliations on the primary exchanges. Moreover, the Commission noted
that even if regional exchange specialists continue 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 had
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 the CSE proposal effectively addresses the
potential for market abuses resulting from the ongoing relationship
between specialists and associated or affiliated persons. 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 the Chinese Wall is
maintained. To this end, the Exchange has submitted to the Commission
proposed procedures for monitoring the Chinese Wall.\16\ 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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\16\The Exchange has requested that these procedures be accorded
confidential treatment by the Commission.
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IV. Conclusion
In view of the above, the Commission has concluded that the
proposed rule change is consistent with Section 6(b) of the Act, and
that it is appropriate to approve the Chinese Wall Procedures for
Designated Dealers.
It is therefore ordered, pursuant to Section 19(b)(2) of the Act,
that the proposed rule change be, and is hereby approved.
For the Commission, by the Division of Market Regulation,
pursuant to the delegated authority, 17 CFR 200.30-3(A)(12).
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-18821 Filed 8-2-94; 8:45 am]
BILLING CODE 8010-01-M
