[Federal Register Volume 69, Number 161 (Friday, August 20, 2004)]
[Notices]
[Pages 51735-51738]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-19063]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-50197; File No. SR-ISE-2004-18]


Self-Regulatory Organizations; International Securities Exchange, 
Inc.; Notice of Filing of Proposed Rule Change and Amendments No. 1 and 
2 Thereto To Amend the Market Maker Information Barrier Requirements 
Under ISE Rule 810

August 13, 2004.
    Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on May 26, 2004, the International Securities Exchange, Inc. (``ISE'' 
or ``Exchange'') filed with the Securities and Exchange Commission 
(``Commission'') the proposed rule change as described in Items I, II, 
and III below, which Items have been prepared by the Exchange. The 
Exchange amended the proposal on August 6, 2004,\3\ and August 13, 
2004.\4\ The Commission is publishing this notice to solicit comments 
on the proposed rule change, as amended, from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ On August 6, 2004, the Exchange filed a Form 19b-4, which 
replaced the original filing in its entirety (``Amendment No. 1'').
    \4\ On August 13, 2004, the Exchange filed a Form 19b-4, which 
replaced the original filing and Amendment No. 1 in their entirety 
(``Amendment No. 2'').
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The Exchange proposes to replace the defined term ``Chinese Wall'' 
with the defined term, ``Information Barrier'' in ISE Rule 810. The 
Exchange also proposes to amend ISE Rule 810 to eliminate the 
requirement that a market maker maintain an Information Barrier in the 
limited circumstances where (i) a market maker, or broker-dealer 
affiliated with such market maker, engages solely in proprietary 
trading and does not, under any circumstances, maintain customer 
accounts or solicit orders or funds from or on behalf of Public 
Customers \5\ or broker-dealers; and (ii) the sole extent to which such 
market maker, or broker-dealer affiliated with such market maker, 
handles listed options orders as agent on behalf of Public Customers or 
broker-dealers consists of handling such orders

[[Page 51736]]

pursuant to an exchange sponsored Directed Order Program. Additionally, 
the Exchange proposes to make a non-substantive clarification and 
certain non-substantive technical changes to ISE Rule 810(a)(3).
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    \5\ ISE Rule 100(a)(32) defines ``Public Customer'' as ``a 
person that is not a broker-dealer in securities.'' ISE Rule 
100(a)(33) defines ``Public Customer Order'' as ``an order for the 
account of a Public Customer.''
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    The text of the proposed rule change appears below. New text is in 
italics. Deleted text is in brackets.

Rule 810. Limitations on Dealings

    (a) General Rule. A market maker on the Exchange may engage in 
Other Business Activities, or it may be affiliated with a broker-dealer 
that engages in Other Business Activities, only if there is an 
Information Barrier [Chinese Wall] between the market making activities 
and the Other Business Activities. ``Other Business Activities'' means:
    (1) Conducting an investment or banking or public securities 
business;
    (2) Making markets in the stocks underlying the options in which it 
makes markets; or
    (3) [Functioning as an Electronic Access Member] handling listed 
options orders as agent on behalf of Public Customers or broker-
dealers;
    (4) Conducting non-market making proprietary listed options trading 
activities.
    (b) Information Barrier [Chinese Wall]. For the purposes of this 
rule, an Information Barrier [Chinese Wall] is an organizational 
structure in which:
    (1) The market making functions are conducted in a physical 
location separate from the locations in which the Other Business 
Activities are conducted, in a manner that effectively impedes the free 
flow of communications between DTRs and persons conducting the Other 
Business Activities. However, upon request and not on his own 
initiative, a DTR performing the function of a market maker may furnish 
to a person performing the function of an Electronic Access Member or 
other persons at the same firm or an affiliated firm (``affiliated 
persons''), the same sort of market information that the DTR would make 
available in the normal course of its market making activity to any 
other person. The DTR must provide such information to affiliated 
persons in the same manner that he would make such information 
available to a non-affiliated person.
    (2) There are procedures implemented to prevent the use of material 
non-public corporate or market information in the possession of persons 
on one side of the barrier [wall] from influencing the conduct of 
persons on the other side of the barrier [wall]. These procedures, at a 
minimum, must provide that:
    (i) The DTR performing the function of a market maker does not take 
advantage of knowledge of pending transactions, order flow information, 
corporate information or recommendations arising from the Other 
Business Activities; and
    (ii) All information pertaining to the market maker's positions and 
trading activities is kept confidential and not made available to 
persons on the other side of the Information Barrier [Chinese Wall].
    (3) Persons on one side of the barrier [wall] may not exercise 
influence or control over persons on the other side of the barrier 
[wall], provided that:
    (i) The market making function and the Other Business Activities 
may be under common management as long as any general management 
oversight does not conflict with or compromise the market maker's 
responsibilities under the Rules of the Exchange; and
    (ii) The same person or persons (the ``Supervisor'') may be 
responsible for the supervision of the market making and Electronic 
Access Member functions of the same firm or affiliated firms in order 
to monitor the overall risk exposure of the firm or affiliated firms. 
While the Supervisor may establish general trading parameters with 
respect to both market making and other proprietary trading other than 
on an order-specific basis, the Supervisor may not:
    (A) Actually perform the function either of market maker or 
Electronic Access Member;
    (B) Provide to any person performing the function of an Electronic 
Access Member any information relating to market making activity beyond 
the information that a DTR performing the function of a Primary Market 
Maker may provide under subparagraph (b)(1), above; nor
    (C) Provide a DTR performing the function of market maker with 
specific information regarding the firm's pending transactions or order 
flow arising out of its Electronic Access Member activities.
    (c) Documenting and Reporting of Information Barrier [Chinese Wall] 
Procedures. A Member implementing an Information Barrier [Chinese Wall] 
pursuant to this Rule shall submit to the Exchange a written statement 
setting forth:
    (1) The manner in which it intends to satisfy the conditions in 
paragraph (b) of this Rule, and the compliance and audit procedures it 
proposes to implement to ensure that the Information Barrier [Chinese 
Wall] is maintained;
    (2) The names and titles of the person or persons responsible for 
maintenance and surveillance of the procedures;
    (3) A commitment to provide the Exchange with such information and 
reports as the Exchange may request relating to its transactions;
    (4) A commitment to take appropriate remedial action against any 
person violating this Rule or the Member's internal compliance and 
audit procedures adopted pursuant to subparagraph (c)(1) of this Rule, 
and that it recognizes that the Exchange may take appropriate remedial 
action, including (without limitation) reallocation of securities in 
which it serves as a market maker, in the event of such a violation;
    (5) Whether the Member or an affiliate intends to clear its 
proprietary trades and, if so, the procedures established to ensure 
that information with respect to such clearing activities will not be 
used to compromise the Member's Information Barrier [Chinese Wall], 
which procedures, at a minimum, must be the same as those used by the 
Member or the affiliate to clear for unaffiliated third parties; and
    (6) That it recognizes that any trading by a person while in 
possession of material, non-public information received as a result of 
the breach of the internal controls required under this Rule may be a 
violation of Rules 10b-5 and 14e-3 under the Exchange Act or one or 
more other provisions of the Exchange Act, the rules thereunder or the 
Rules of the Exchange, and that the Exchange intends to review 
carefully any such trading of which it becomes aware to determine 
whether a violation has occurred.
    (d) Exchange Approval of Information Barrier [Chinese Wall] 
Procedures. The written statement required by paragraph (c) of this 
Rule must detail the internal controls that the Member will implement 
to satisfy each of the conditions stated in that Rule, and the 
compliance and audit procedures proposed to implement and ensure that 
the controls are maintained. If the Exchange determines that the 
organizational structure and the compliance and audit procedures 
proposed by the Member are acceptable under this Rule, the Exchange 
shall so inform the Member, in writing. Absent the Exchange finding a 
Member's Information Barrier [Chinese Wall] procedures acceptable, a 
market maker may not conduct Other Business Activities.
    (e) Clearing Arrangements. Subparagraph (c)(5) permits a Member or 
an affiliate of the Member to clear the Member's market maker 
transactions if

[[Page 51737]]

it establishes procedures to ensure that information with respect to 
such clearing activities will not be used to compromise the Information 
Barrier [Chinese Wall]. In this regard:
    (1) The procedures must provide that any information pertaining to 
market maker securities positions and trading activities, and 
information derived from any clearing and margin financing 
arrangements, may be made available only to those employees (other than 
employees actually performing clearing and margin functions) 
specifically authorized under this Rule to have access to such 
information or to other employees in senior management positions who 
are involved in exercising general managerial oversight with respect to 
the market making activity.
    (2) Any margin financing arrangements must be sufficiently flexible 
so as not to limit the ability of any market maker to meet market 
making or other obligations under the Exchange's Rules.
    (f) Exceptions to the Information Barrier [Chinese Wall] 
Requirement.
    (1) A market maker shall be exempt from paragraph (a)(3) of this 
Rule to the extent the market maker complies with the following 
conditions:
    (A)[(1)] such Member [functions as an Electronic Access Member] 
handles orders as agent only for the account of entities that are 
affiliated with the Member and solely in options classes [(i)] 
contained in Groups to which the Member is not appointed as a market 
maker pursuant to Rule 802 or [(ii)] in which the Member is prohibited 
from acting as a market maker pursuant to regulatory requirements; 
[and] or
    [(2) The Member enters orders as an Electronic Access Member only 
for (i) the proprietary account of the Member; or (ii) the account of 
entities that are affiliated with the Member.]
    (B) Such market maker handles orders as agent solely with respect 
to a Directed Order Program, as defined in Supplementary Material .01 
below.
    (2) A market maker shall be exempt from paragraph (a)(4) of this 
Rule to the extent the Member, or a broker-dealer with which such 
Member is affiliated:
    (A) Engages solely in proprietary trading and does not, under any 
circumstances, maintain customer accounts or solicit or accept orders 
or funds from or on behalf of Public Customers or broker-dealers; and
    (B) Does not participate in any Directed Order Programs, as defined 
in Supplementary Material .01 below, or utilize any other order types 
which call for the participation of, or interaction with, Public 
Customers or broker-dealers.

Supplementary Material to Rule 810

    .01 For purposes of paragraph (f)(1)(B) and (f)(2)(B) of Rule 810 
only, a Directed Order Program means rules of an options exchange that 
(1) permit an options market maker to handle orders directed to it 
anonymously through an exchange system; (2) require the market maker to 
accept directed orders from all sources eligible to direct orders using 
such exchange system; and (3) require the options market maker to 
execute such directed orders on such exchange under specified order 
handling procedures. A Directed Order Program shall not include any 
rules of an exchange that permit a market maker to accept orders 
directly, without being routed through an exchange system, from 
customers or another broker-dealer, nor any rules or system that allows 
a market maker to handle orders on a disclosed or discretionary basis.
* * * * *

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, the Exchange included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. The Exchange has prepared summaries, set forth in 
sections A, B, and C below, of the most significant aspects of such 
statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

1. Purpose
    The Exchange proposes to replace the defined term ``Chinese Wall'' 
with the defined term ``Information Barrier'' in ISE Rule 810. The 
Exchange does not, however, propose to change the definition or meaning 
of the defined term. Under ISE Rule 810, a member must maintain an 
Information Barrier between its ISE market making operations and 
``Other Business Activities.'' Other Business Activities are defined as 
(i) conducting an investment or banking or public securities business; 
(ii) making markets in the stocks underlying the options in which it 
makes markets; or (iii) functioning as an Electronic Access Member 
(``EAM'').\6\ Requiring an Information Barrier between Other Business 
Activities and a member's market making activities assures that market 
makers compete on equal terms. Of particular importance is separating 
EAM and market making activity, as this assures that market makers do 
not use information regarding pending orders to their advantage.
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    \6\ See ISE Rule 810(a).
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    To comply with the Information Barrier requirement, a Member must 
physically locate its market making personnel separately from personnel 
conducting Other Business Activities. This means that the same person 
at a firm may not engage in ISE market making activities while also 
handling agency orders or trading for the firm's non-market making 
options proprietary account. ISE Rule 810 currently contains a narrow 
exemption to the Information Barrier requirement that allows a firm to 
place orders in options for which they are not making markets on the 
ISE, so long as such orders are proprietary orders (that is, not 
customer orders) or orders for an affiliate. ISE Rule 810 does not 
require that a member separate its ISE market making activities from 
its options market making activities that occur on other options 
exchanges.
    With the instant proposed rule change, the Exchange proposes two 
additional exemptions from the Information Barrier requirement:
    Proprietary Options Trading: Certain market makers, or broker-
dealers with whom such market makers are affiliated, engage solely in 
proprietary trading. Accordingly, such firms do not maintain customer 
accounts and do not solicit or accept orders from or on behalf of 
Public Customers or broker-dealers. As a result, the ISE believes that 
the market maker would not have access to non-public order flow 
information that might improperly influence its market making trading 
activities. Under these circumstances, the Exchange believes requiring 
an Information Barrier between the firm's market making and proprietary 
trading activity places an unnecessary burden on the member.\7\
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    \7\ The ISE believes that this section of its proposal is 
similar to a proposed rule change by the Pacific Exchange, Inc. that 
was approved by the Commission. See Securities Exchange Act Release 
No. 49264 (February 17, 2004), 69 FR 8510 (February 24, 2004) (SR-
PCX-2003-49).
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    Directed Order Programs: The Exchange also proposes to amend ISE 
Rule 810 to allow a market maker to handle orders as agent according to 
the rules of ``Directed Orders Programs.''\8\ Allowable Directed Order 
Programs are

[[Page 51738]]

narrowly defined rules of an options exchange that (1) permit an 
options market maker to handle orders directed to it anonymously 
through an exchange system; (2) require the market maker to accept 
directed orders from all sources eligible to direct orders using such 
exchange system; and (3) require the options market maker to execute 
such directed orders on such exchange under specified order handling 
procedures. A Directed Order Program specifically does not include any 
rules of an exchange that permit a market maker to accept orders 
directly, without being routed through an exchange system, from 
customers or another broker-dealer, nor any rules or system that allows 
a market maker to handle orders on a disclosed or discretionary basis. 
Such narrowly defined Directed Order Programs themselves contain rules 
designed to ensure that market makers do not gain an informational 
advantage in handling agency orders. The Exchange believes that this 
change is necessary to clarify that an ISE market maker need not have 
an Information Barrier between its ISE market making operations and 
options market making operations on other exchanges by virtue of their 
participation in a Directed Order Program, such as that currently 
approved for the Boston Options Exchange (``BOX''), a facility of the 
Boston Stock Exchange, Inc.\9\ The Exchange believes that requiring an 
Information Barrier in this situation would be unnecessarily burdensome 
to its Members because they are given little discretion in handling 
orders under these Commission approved Directed Order Programs.
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    \8\ ISE has proposed to define ``Directed Order Program'' under 
proposed Supplementary Material .01 to ISE Rule 810.
    \9\ See Securities Exchange Act Release No. 49068 (January 13, 
2004), 69 FR 2775 (January 20, 2004)(SR-2002-15). The ISE has 
proposed a similar rule. See SR-ISE-2004-16.
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    The Exchange also proposes to clarify the definition of ``Other 
Business Activities'' under ISE Rule 810(a). Currently, the definition 
includes ``functioning as an Electronic Access Member.'' The use of 
this term in ISE Rule 810(a) has caused confusion among its members. 
Therefore, the Exchange proposes to specify that Other Business 
Activities include: (i) handling listed options orders as agent on 
behalf of Public Customers or broker-dealers, and (ii) conducting non-
market making proprietary listed options trading activities. The 
Exchange believes that this proposed change is consistent with the 
interpretation that has been applied by the Exchange since adoption of 
ISE Rule 810.
2. Statutory Basis
    The Exchange believes that the basis under the Act for this 
proposed rule change, as amended, is the requirement under section 
6(b)(5) of the Act \10\ that the Exchange have rules that are designed 
to foster cooperation and coordination with persons engaged in 
regulating, clearing, settling, processing information with respect to, 
and facilitating transaction in securities, to remove impediments to 
and perfect the mechanism for a free and open market and a national 
market system, and, in general, to protect investors and the public 
interest. In particular, the Exchange believes the proposal would 
remove an unnecessary burden on its members to maintain information 
barriers in narrow circumstances where the Exchange believes there is 
no regulatory need to do so.
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    \10\ 15 U.S.C. 78f(b)(5).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    The proposed rule change does not impose any burden on competition 
that is not necessary or appropriate in furtherance of the purposes of 
the Act.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants, or Others

    The Exchange has not solicited, and does not intend to solicit, 
comments on this proposed rule change. The Exchange has not received 
any unsolicited written comments from members or other interested 
parties.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding, or (ii) as to 
which the Exchange consents, the Commission will:
    (A) By order approve such proposed rule change; or
    (B) Institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change, as amended, is consistent with the Act. Comments may be 
submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml); or
     Send an e-mail to [email protected]. Please include 
File Number SR-ISE-2004-18 on the subject line.

Paper Comments

     Send paper comments in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., 
Washington, DC 20549-0609.
    All submissions should refer to File Number SR-ISE-2004-18. This 
file number should be included on the subject line if e-mail is used. 
To help the Commission process and review your comments more 
efficiently, please use only one method. The Commission will post all 
comments on the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml). Copies of the submission, all subsequent amendments, 
all written statements with respect to the proposed rule change that 
are filed with the Commission, and all written communications relating 
to the proposed rule change between the Commission and any person, 
other than those that may be withheld from the public in accordance 
with the provisions of 5 U.S.C. 552, will be available for inspection 
and copying in the Commission's Public Reference Room, 450 Fifth 
Street, NW., Washington, DC 20549. Copies of such filing also will be 
available for inspection and copying at the principal office of the 
ISE. All comments received will be posted without change; the 
Commission does not edit personal identifying information from 
submissions. You should submit only information that you wish to make 
available publicly. All submissions should refer to File Number SR-ISE-
2004-18 and should be submitted on or before September 10, 2004.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\11\
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    \11\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 04-19063 Filed 8-19-04; 8:45 am]
BILLING CODE 8010-01-P