[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