[Federal Register Volume 59, Number 226 (Friday, November 25, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-29006]
[[Page Unknown]]
[Federal Register: November 25, 1994]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34- 34981; File No. SR-PSE-93-36]
Self-Regulatory Organizations; Pacific Stock Exchange, Inc.;
Order Granting Approval to Proposed Rule Change To Adopt Functional
Separation Procedures for Specialists and Affiliated Firms
November 16, 1994.
I. Introduction
On December 29, 1993, the Pacific Stock Exchange, Inc. (``PSE'' 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 upstairs
firm. On May 25, 1994, the Exchange submitted Amendment No. 1 to the
proposed rule change.\3\
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\1\15 U.S.C. Sec. 78s(b)(1) (1988).
\2\17 CFR 240.19b-4 (1991).
\3\See letter from Michael D. Pierson, Senior Attorney, PSE, to
Amy Bilbija, Attorney, Commission, dated May 23, 1994. This
amendment, which is available in the Commission's Public Reference
Room, codified a provision enabling the Exchange to request
information from specialists relating to transactions in a specialty
security.
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The proposed rule change was published for comment in Securities
Exchange Act Release No. 33751 (March 10, 1993), 59 FR 12631 (March 17,
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 upstairs firm\4\ will be expected to demonstrate to
provide for a functional separation (``Information Barrier'')\5\ of its
specialist activity from its retail and proprietary business.
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\4\The Proposal specifies that the functional separation must be
established (1) between a specialist firm and any associated
approved person; and (2) between a specialist and any associated
integrated member organization. The approved person or integrated
member organization are collectively referred to as an ``affiliated
upstairs firm.'' An ``approved person'' is defined in PSE Rule
4.1(n) as a party who is not an employee, a member or an allied
member of a member firm, and who is a director of a member firm, or
who beneficially owns, directly or indirectly, 5% or more of the
outstanding equity securities of a member firm, and who has been
approved by the Exchange as an approved person.
\5\Functional separation of specialist activity from its
affiliated upstairs firm business is often times referred to as a
``Chinese Wall.''
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In addition to requiring affiliated upstairs firms to establish a
Information Barrier, the proposal also requires that they establish,
maintain and enforce written procedures reasonably designed to prevent
the misuse of material, nonpublic information. Finally the proposal
requires an affiliated upstairs firm to obtain prior 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.\6\
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\6\In addition, a copy of these Chinese Wall procedures, and any
amendments thereto, must be filed with the Exchange Financial
Compliance 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 affiliated upstairs firm can have no influence on specific
specialist trading decisions. Third, material, non-public corporate or
market information obtained by the affiliated upstairs firm 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 affiliated upstairs firm and specialist
entities. Fifth, the Exchange may from time to time request that
specialists file information and reports in a specialty security.
In addition, the proposal places limitations on the information
which may pass between a broker associated with an affiliated upstairs
firm 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 his specialist duties
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 affiliated upstairs firm to popularize\7\ a
specialty stock provided it makes adequate disclosure about the
existence of possible conflicts of interest.
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\7\``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.\8\
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\8\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 Information Barrier procedures established hereunder and
will conduct surveillance of proprietary trades effected by an
affiliated upstairs firm and its affiliated specialist or specialist
firm. The Exchange will monitor specifically the trading activities of
affiliated upstairs firms 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 Information Barrier 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 affiliated upstairs firm,
specialist unit, or the customers of either, all in contravention of
Section 6(b) of the Act.\9\ The Commission further believes that the
procedures the Exchange intends to implement with respect to approving
and monitoring the Information Barrier 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 procedures proposed by
the PSE are designed to prevent the misuse of material, non-public
information by specialist units affiliated with an affiliated upstairs
firm. Further, the Commission believes the proposal is consistent with
the Section 11A(a)(1)(C)(ii) Congressional finding\10\ in that it aids
in assuring fair competition among brokers and dealers.
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\9\15 U.S.C. Sec. 78f(b) (1988).
\10\15 U.S.C. Sec. 78k-1(a)(C)(ii) (1988).
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The Commission initially addressed the necessity and viability of
Information Barriers in approving the amendments to New York Stock
Exchange (``NYSE'') and American Stock Exchange (``Amex'') Rules 98 and
193 respectively, which created the present Information Barrier scheme
in effect today on those exchanges.\11\ 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 Information Barrier and generally to
review the efficacy of their surveillance and compliance procedures
regarding those specialists. In this regard, the Commission thus far
has approved two filings submitted by regional exchanges to adopt such
procedures.\12\
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\11\See NYSE/Amex Order.
\12\See Securities Exchange Act Release Nos. 34076 (May 18,
1994), 59 FR 26822 (May 24, 1994) (approving the Boston Stock
Exchange Chinese Wall proposal); and 34449 (July 27, 1994), 59 FR
39611 (August 3, 1994) (approving the Cincinnati Stock Exchange
Chinese Wall proposal).
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Organizational separation between different departments of a
broker-dealer is one of several means of preventing the
interdepartmental communication of material, non-public
information.\13\ 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(e) of the Act\14\ and
Rules 10b-5 and 14e-3 thereunder. Moreover, two years after approval of
the Amex's and NYSE's Information Barrier procedures, Congress enacted
the Insider Trading and Securities Fraud Enforcement Act of 1988
(``ITSFEA''), designed primarily to prevent, deter, and prosecute
insider trading.\15\ Among other provisions, ITSFEA created a specific
requirement for broker-dealers to maintain procedures designed to
prevent the misuse of material, non-public information.\16\ In response
to the promulgation thereof, many firms redrafted their internal
Information Barrier procedures to ensure compliance.\17\
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\13\See e.g., Securities and 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.''
\14\15 U.S.C. Secs. 78j(b), 78n(e) (1982).
\15\Pub. L. No. 100-704.
\16\15 U.S.C. Sec. 78o(f).
\17\Several SRO's (Philadelphia Stock Exchange, Chicago Board
Options Exchange, Pacific Stock Exchange, and Boston Stock Exchange)
have adopted the substance of the ITSFEA procedures under their
rules applicable to members and member firms (See Securities and
Exchange Act Release Nos. 30122 (December 30, 1991), 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);
34284 (June 30, 1994) 59 34876 (July 7, 1994)
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The Commission notes that a number of firms with regional
specialist operations have established Information Barrier 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.
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 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 Information Barriers, with
effective controls, may be useful in restricting information flow
between the various departments of broker-dealers with affiliated
specialists. The Commission has monitored the NYSE and Amex Information
Barrier 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 PSE 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 PSE guidelines is reinforced by the
Exchange's existing surveillance of specialists 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 help to enhance the
effectiveness of the proposed Information Barrier.
Finally, the Commission notes that the structural adequacy of the
Information Barrier 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
Information Barrier is maintained. To this end, the Exchange has
submitted to the Commission proposed procedures for monitoring the
Information Barrier.\18\ 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.\19\
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\18\The Exchange has requested that these procedures be accorded
confidential treatment by the Commission.
\19\The Exchange believes that it will have its procedures in
place by February 1, 1995.
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IV. Conclusion
It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\20\ that the proposed rule change (SR-PSE-93-36) is approved.
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\20\15 U.S.C. Sec. 78s(b)(2)(1988).
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\21\
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\21\17 CFR 200.30-3 (a)(12)(1991).
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Jonathan G. Katz,
Secretary.
[FR Doc. 94-29006 Filed 11-23-94; 8:45 am]
BILLING CODE 8010-01-M