[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