[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