SECURITIES EXCHANGE ACT OF 1934
Release No. 48566 / September 30, 2003
ADMINISTRATIVE PROCEEDING
File No. 3-11282
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ORDER INSTITUTING PUBLIC ADMINISTRATIVE PROCEEDINGS PURSUANT TO SECTIONS 19(h) AND 21C OF THE SECURITIES EXCHANGE ACT OF 1934, MAKING FINDINGS, AND IMPOSING A CENSURE, A CEASE-AND-DESIST ORDER AND OTHER RELIEF |
I.
The Securities and Exchange Commission ("Commission") deems it appropriate that public administrative proceedings be, and hereby are, instituted pursuant to Sections 19(h) and 21C of the Securities Exchange Act of 1934 ("Exchange Act") against the Chicago Stock Exchange (CHX).
II.
In anticipation of the institution of these proceedings, CHX has submitted an Offer of Settlement ("Offer") that the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceeding brought by or on behalf of the Commission or in which the Commission is a party, and prior to a hearing pursuant to the Commission's Rules of Practice,
17 C.F.R.Sec. 201.100 et seq., CHX, without admitting or denying the findings contained herein, except that CHX admits to the jurisdiction of the Commission over it and over the subject matter of these proceedings, consents to the issuance of this Order Instituting Public Administrative Proceedings Pursuant to Sections 19(h) and 21C of the Securities Exchange Act of 1934, Making Findings, and imposing a censure, a cease-and-desist order and other relief ("Order").
III.
The Commission makes the following findings:
A. Respondent
1. CHX is a self-regulatory organization registered with the Commission pursuant to Section 6(a) of the Securities Exchange Act of 1934. It was founded in 1892 and was formerly known as the Midwest Stock Exchange. CHX is the fourth largest stock exchange in the United States in terms of the dollar value of shares traded. During the relevant period, CHX was actively seeking to increase its trading volume in NASDAQ securities. CHX currently trades both listed and over-the-counter securities.
B. Summary
2. This matter involves CHX's failure adequately to enforce several of its important rules affecting trading by its members (consisting of specialist firms and co-specialists associated with the firms). 1 Specifically, from approximately 1998 to approximately parts of 2001, as CHX's Nasdaq trading volume was increasing, CHX did not adequately improve and increase its surveillance and disciplinary capabilities to match the increase in trading volume. CHX failed to implement adequate systems and procedures to detect and prevent violations of its firm quote, trading ahead and limit order display rules (the trading rules).2 In addition, when CHX was able to detect such violations, it often failed to take adequate disciplinary action against members who committed the violations. Furthermore, CHX often failed to take adequate disciplinary action against recidivists or violators of multiple rules.
3. During the relevant period, CHX failed to detect and prevent a large number of trading rule violations, in part, because it did not have adequate surveillance systems to detect possible violations. CHX failed to detect and prevent these violations even though there were reasonably available surveillance tools and programs to support an adequate surveillance system. Instead, CHX relied on ineffective, and often flawed, manual review processes to detect violations of these rules. In addition, CHX failed to detect violations because CHX staff that reviewed market data for possible violations of the trading rules did not have adequate and consistent standards and guidelines to assist them in determining whether violations actually took place.
4. Even when CHX detected violations of the trading rules, it often failed to take adequate disciplinary action.3 To the extent it took any action, the resulting sanctions were often minimal and untimely. In addition, CHX staff failed adequately to take into account recidivism, i.e., past violations by members of the same rules and violations of different rules by the same member.
C. Discussion
CHX Failed to Detect and Prevent Violations of the Trading Rules
Inadequate Surveillance System
5. CHX failed to detect and prevent violations of the trading rules in part because it did not install adequate surveillance systems and tools designed to detect and prevent violations, even though such systems were reasonably available. Instead, it relied on ineffective and often flawed manual processes to detect violations.
6. The Firm Quote Rule: Until early 2001, CHX's surveillance for intermarket firm quote rule violations relied solely on telephone complaints from the NASD alleging backing away violations in over-the-counter stocks.4 This surveillance process was time consuming and ineffective. Investigators spent up to 3 hours investigating each OTC backing away complaint and were forced to piece together data from several different sources to conduct these investigations. Prior to 2000, there were only a few investigators working in the surveillance department (sometimes as few as 2 individuals) who were required to investigate all types of violations, not just OTC backing away violations.5
7. CHX's reliance on a complaint-driven system for firm quote rule violations was unreasonable, particularly since the Commission had previously stated that such a system may not be adequate. For instance, in the 1996 21(a) report regarding the NASD, the Commission stated that the NASD failed to conduct routine surveillance for firm quote rule violations and maintained an ineffective complaint review process that provided a disincentive to other market participants to complain of firm quote rule violations.6 Further, in the Commission's 1999 administrative action against the NYSE for its failure to enforce Exchange Act and NYSE rules, the Commission distinguished complaint review processes from "surveillance," stating that "[i]nvestigations of tips and complaints, however, is not a sufficient substitute for a routine surveillance program."7 Even in the absence of instituting a fully automated system, CHX could reasonably have utilized other surveillance tools to identify instances of firm quote rule violations.
8. Trading Ahead Prohibitions: CHX's inadequate surveillance systems and its reliance on ineffective manual processes also likely caused many trading ahead violations to go undetected for an extended period of time.8 For instance, from at least June 1998 through August 2001, CHX failed to conduct any surveillance for intra-day trading ahead violations. CHX's failure to conduct surveillance for intra-day trading ahead violations had been specifically identified as a problem by the Commission's inspection staff in the Office of Compliance Inspections and Examinations in 1998. At that time, the inspection staff recommended that CHX amend its surveillance procedures to ensure that all instances of potential trading ahead by co-specialists are reviewed. CHX failed to conduct surveillance for intra-day trading ahead until 3 years later, in August 2001.
9. CHX's ineffective manual procedures for reviewing exception reports to detect OTC trading ahead violations also likely caused trading ahead violations to remain undetected. During the period from approximately August 1999 through August 2000, CHX failed to ensure that specialist firms complied with CHX's procedures for reviewing, responding to and returning trading ahead exception reports. CHX was unaware that several firms failed to return their required responses during this period. Further, CHX failed to review many firm responses for accuracy during this period as required.9 As a result, possible OTC trading ahead violations went unchecked and violations went unsanctioned.10
10. CHX could have prevented or reduced a significant number of trading ahead violations through improved computer programs and functionalities.
11. LODR: CHX's inadequate LODR surveillance systems reduced CHX's ability to detect LODR violations. CHX uses 2 order exception reports to conduct surveillance for possible violations of the LODR. Neither exception report is fully automated. Although CHX has improved the data filters, the data captured by each report has historically been limited.
12. Many LODR violations were not detected due to CHX's reliance on a time-intensive, manual review process. These manual reviews often take many hours and involve the compilation and analysis of data from several different sources. As a result, there have been occasions in the past when CHX investigators were forced to reduce their sample sizes and the timeliness of the LODR reviews suffered. A backlog of LODR violations was presented to the Minor Rule Violation Panel (MRVP) several months after the violations were committed.11
13. Flaws in CHX's automated systems also permitted LODR violations to be undetected. One computer functionality used by CHX members, Book Quote, includes a feature whereby eligible customer limit orders are automatically displayed after a period of zero to 25 seconds for listed securities and zero to 30 seconds for OTC securities if the orders are not earlier quoted, executed, excluded from Book Quote or routed away. Although co-specialists may set this timer to any time within these ranges, the vast majority of CHX co-specialists trading listed securities had set their default timers to the maximum 25 seconds. In addition, many co-specialists trading OTC securities had set their default timers to 5 seconds, while some others had set them as high as 30 seconds. As the Commission has previously stated, co-specialists violate the immediacy requirement of the LODR by routinely relying on automated default systems.12
14. CHX did not regularly conduct surveillance for co-specialists' reliance on default timers until it developed a protocol in December 2001.
15. CHX did not adequately prevent the number of the LODR violations committed by its members. Although CHX's system has some automated features, such as Book Quote, they can be disabled by co-specialists at will. Once co-specialists disable the automatic functionalities, the co-specialists must manually display eligible limit orders in their quotes, which increases LODR violation rates.
CHX Lacked Adequate and Consistent Written Standards
for Its Surveillance Staff
16. During the relevant time period, CHX did not employ adequate or consistent parameters for compliance with the firm quote rule. It is unclear what standards CHX staff employed to investigate firm quote rule violations prior to November or December 2000 because there were no written procedures in place.
17. During at least a 3-month period in mid- to late-2000, CHX investigators used inconsistent time parameters in analyzing backing away complaints. They also accepted excuses by co-specialists for mitigating circumstances and erroneously determined that no violations occurred. As a result, during at least this time period, CHX failed to detect approximately 50% of the firm quote rule violations committed by CHX members.
18. The written backing away protocols also failed to provide any guidance to investigators and supervisors regarding how to track violations and recidivist behavior. CHX has failed to detect obvious patterns of violative behavior.
19. Trading Ahead: CHX's failure to implement adequate and consistent written standards reduced CHX's ability to detect numerous trading ahead violations. Before late 2000, CHX had no written protocols regarding surveillance for OTC trading ahead violations. Even when the protocols were finally drafted, they were deficient in many respects. For instance, although some oral instructions may have been given to some investigators, the trading ahead protocols failed to provide any guidance to investigators regarding appropriate sample sizes or how to properly document their reviews.
20. LODR: Prior to mid-2001, the protocols in place regarding the review of CHX's LODR exception reports were deficient and reduced CHX's ability to detect LODR violations. For example, these earlier protocols directed investigators to sample only executed orders. Although CHX implemented manual surveillance procedures in April 1999 to include unexecuted and cancelled orders in its listed sample of possible LODR violations and unexecuted orders in its OTC sample, the protocols used by regulatory staff did not reflect these procedures. CHX did not include cancelled orders in its OTC review until October 2001. Unexecuted and canceled orders are likely to consist of customer limit orders handled in violation of the LODR.
21. In addition, the pre-2001 LODR protocols failed to direct investigators to look for compliance with all aspects of the rule. Although some oral instructions may have been given to some investigators, the protocols also failed to direct investigators to review whether the execution covered the full size of the customer's eligible limit order.
22. Although some oral instructions may have been given to some investigators, there was no written protocol to guide investigators in conducting reviews of one of the LODR exception reports until 7 months after it was created. One investigator responsible for LODR reviews admitted that he had never even seen a written protocol relating to LODR surveillance of OTC securities.
CHX Failed Adequately to Discipline Violators of the Trading Rules
23. Even when CHX detected violations of the trading rules, it often failed to take appropriate disciplinary action. To the extent it took any action, the resulting sanctions were often untimely and minimal. In addition, CHX staff failed adequately to consider recidivism or violations of other rules by its members.
Inadequate and Untimely Sanctions for Trading Rule Violations
24. Firm Quote Rule: Because the firm quote rule is not among the rules under the jurisdiction of the MRVP, the disciplinary options currently available to CHX are warning letters and formal disciplinary actions. CHX has rarely imposed either of these sanctions for firm quote rule violations.
25. CHX failed to detect obvious patterns of violative conduct relating to firm quote rule violations. For instance, one co-specialist violated the firm quote rule up to 76 times in a 12-month period, yet CHX took no disciplinary action against this individual. This same individual traded ahead of customer orders on 37 occasions during the same period with no disciplinary consequences.
26. CHX brought only one disciplinary action, in 1999, against a co-specialist arising out of firm quote rule violations. In addition, CHX discovered nearly 600 firm quote rule violations during the period from July 11, 2000 through June 15, 2001 alone. Yet, during the relevant time period, CHX only issued two warning letters against co-specialists who violated the firm quote rule.
27. Trading Ahead Prohibitions: CHX has failed adequately to discipline its members for OTC trading ahead violations. Several co-specialists repeatedly committed OTC trading ahead violations over several months with inadequate and/or untimely disciplinary consequences. For example, one co-specialist committed 43 OTC trading ahead violations between November 2000 and May 31, 2001 and had never been referred to the MRVP for this conduct. The only action taken by CHX relating to this conduct was a referral for further investigation in June 2001, which was 8 months after the initial violation and also subsequent to the receipt of the Commission's inspection staff's report and the Commission enforcement staff's involvement in this matter.
28. Over the past 5 years, CHX has brought a total of 9 formal disciplinary actions against its members for trading ahead violations. CHX brought 3 actions in 1998, 5 actions in 1999 and only 1 action in 2000. CHX did not bring any formal disciplinary actions for trading ahead violations in 2001.
29. During the relevant period, CHX's sanctions for trading ahead violations were often untimely and the fines were minimal. For instance, CHX merely logged OTC trading ahead violations for up to one and a half years in some cases without taking any enforcement action. One co-specialist committed 11 OTC trading ahead violations during the period from February 2000 through August 2001. These violations were all brought to a single MRVP meeting on September 25, 2001, 18 months after the initial violation.
30. The sanctions CHX levied for repeated trading ahead violations were inadequate during the relevant period. Although the fine schedule utilized by the MRVP was designed to penalize recidivism, the surveillance department presented multiple trading ahead violations committed by a co-specialist on multiple days at one MRVP meeting. This procedure typically resulted in a fine of $100 per violation, regardless of the number of violations committed. As a result, co-specialists with 1 trading ahead violation were fined $100, and co-specialists with 18 trading ahead violations committed over several days but were presented at a single MRVP meeting were fined $1800.13 During the relevant period, CHX rules did not require co-specialists who received a financial benefit for trading ahead of a customer order to disgorge the profits obtained through the violation.14
31. LODR: CHX failed adequately to discipline LODR violations. In particular, CHX's aggregation policy (described more fully below), which was contrary to their stated policy in their relevant rule filings, see Securities Exchange Act Release No. 40066 (June 4, 1998), 63 Fed. Reg. 31,817, 31,818 n. 15 (June 10, 1998), resulted in CHX's failure to take adequate disciplinary action on many LODR violations, and the sanctions imposed on many LODR violations were untimely and minimal.
32. CHX refers most of the detected LODR violations to the MRVP. No MRVP referrals were made for LODR violations until some time in 1999, following the Commission's inspection of CHX, and more than 2 years after the implementation of the rule.
33. CHX brought only 5 formal disciplinary actions against its members for LODR violations since the rule's effective date in January 1997. In 1998, CHX initiated 2 formal disciplinary actions for LODR violations. In 1999, CHX initiated 2 formal disciplinary actions for LODR violations. In 2000, CHX initiated one formal disciplinary action for LODR violations.
34. CHX occasionally issues warning letters for LODR violations.
35. CHX's practice of aggregating LODR violations into a single violation resulted in inadequate disciplinary action for many LODR violations. During the relevant period, even when CHX referred a co-specialist's LODR violation(s) to the MRVP for sanctions, the surveillance group often aggregated several violations into a single violation before presenting the misconduct to the panel.15 In one example, a co-specialist committed 44 separate LODR violations during a 9-day period. CHX aggregated the violations committed each day into one violation before presenting a total of 9 LODR violations to the MRVP.16 Six months passed between the occurrence of the first LODR violation and the aggregated referral to the MRVP. Because these 44 LODR violations were consolidated into 9 violations and because they were brought before the MRVP at one meeting, the co-specialist was fined only $3000. Had each of the 44 violations been sanctioned individually, as was required by their stated rules, the co-specialist would have been fined a minimum of $1,000 per violation, or $44,000.
36. CHX's practice of aggregating violations resulted in inadequate sanctions, ineffective deterrence against future violations and inaccurate disciplinary histories.17
Failure to Address Repeated and Widespread Violations of the Trading Rules
37. CHX's deficient enforcement of the trading rules was exacerbated by the fact that CHX often focused merely on the individual violations and failed adequately to consider material ramifications of the violations or pattern of violations. For instance, CHX failed adequately to take into account recidivism, i.e., repeat violations of the same rules or violations of other trading rules. In addition, CHX failed to take into consideration whether or not violations by different co-specialists of the same firm signify supervisory failure by the firm.
38. CHX did not give additional scrutiny to members known to have committed and/or been sanctioned for violations of the trading rules. CHX's failure adequately to discipline recidivist behavior is evidenced by its inaction following repeated violations by known rule violators. For instance, with respect to the firm quote rule, one co-specialist committed 76 firm quote rule violations within 12 months without any disciplinary consequences.
39. CHX failed to focus on recidivism with respect to specialist firms. In early 2000, CHX accepted an Offer of Settlement by a specialist firm that included a $50,000 fine relating to numerous trading ahead violations committed in 1999 by 3 of the firm's co-specialists. According to CHX, it disciplined the firm rather than the individuals because it concluded that the violations were caused primarily by procedural and systemic failure of the firm. After the formal disciplinary action, however, the misconduct continued. One of the same three co-specialists committed 37 trading ahead violations between November 30, 2000 and May 30, 2001, and another of the three co-specialists committed 26 trading ahead violations between December 2000 and August 2001. These violations continued for a 6 to 8 month period with no disciplinary consequences to the co-specialists.
40. CHX did not focus on recidivism in disciplining its members for LODR violations. During the relevant period, CHX continued to refer repeat offenders of the LODR to the MRVP as opposed to initiating a formal disciplinary action.
41. CHX failed adequately to consider a member's disciplinary history when sanctioning additional violations committed by the same member. When determining appropriate enforcement action against a co-specialist for a particular rule, CHX staff did not take into account the co-specialist's violations of other CHX rules.
42. CHX failed adequately to consider whether individual co-specialists' violations of the trading rules reflect lack of adequate supervisory procedures or systems at the specialist firms with which the individual violators are associated.18 Specifically, CHX staff did not monitor the number of trading violations committed by firms (as opposed to individual co-specialists) and CHX did not have a procedure in place to track violations by firm. Until September 2001, CHX's policies did not require the Market Regulation Department to review firms' supervisory policies.
Action Taken by CHX After Receiving the Commission Staff's Inspection Report
43. Following an inspection of CHX's surveillance and enforcement programs, the Commission's inspection staff provided CHX with an inspection report identifying these deficiencies in its surveillance and enforcement programs. Thereafter, CHX made several improvements to its surveillance and enforcement programs. For instance, CHX has steadily increased its staffing.19 In addition, CHX implemented new protocols and formal guidelines regarding surveillance for and enforcement of violations of SEC and CHX rules.20 CHX has also offered training sessions regarding compliance with certain trading rules, such as the LODR. Further, CHX has enhanced its exception reports and computer logic.21 CHX has also employed outside professionals including attorneys and consultants to assist CHX in improving its surveillance and enforcement programs. CHX has also increased its budget for its regulation and enforcement activities.
44. In response to the Commission staff's requests, CHX expended significant resources to generate detailed analyses and summaries of trading records and data. CHX also produced privileged work product in responding to the Commission staff's inquiries.
D. Violations
45. Section 19(g)(1) of the Securities Exchange Act of 1934 (Exchange Act) requires any exchange, including CHX, "absent reasonable justification or excuse," to enforce compliance by its members with provisions of the Exchange Act, the rules and regulations thereunder, and CHX's own rules. See also Section 6(b) of the Exchange Act.
46. The Commission has stated that "the obligation to enforce imposed by Section 19(g) on an exchange necessarily includes an obligation to monitor and maintain surveillance over its members."22 Exchanges violate Section 19(g) when they fail "to be vigilant in surveilling for, evaluating, and effectively addressing issues that could involve violations" of the securities laws.23
47. CHX failed adequately to enforce compliance with the firm quote rule (Rule 11Ac1-1(c)(2) of the Exchange Act and CHX Article XX, Rule 7.01), trading ahead prohibitions (CHX Article XXX, Rule 2) and the LODR (Rule 11Ac1-4 of the Exchange Act and CHX Article XX, Rule 7.05) in violation of Section 19(g)(1) of the Exchange Act. In particular, CHX should have implemented a regulatory program to ensure reasonable oversight of increased trading in a new product - NASDAQ listed securities.
IV.
In view of the foregoing, the Commission deems it appropriate in the public interest and for the protection of investors to impose the sanctions agreed to in CHX's Offer.
Accordingly, it is hereby ORDERED, effective immediately, that
A. CHX be, and hereby is, censured pursuant to Section 19(h) of the Exchange Act.
B. CHX be, and hereby is, ordered pursuant to Section 21C of the Exchange Act to cease and desist from committing or causing any violation and any future violations of Section 19(g) of the Exchange Act.
C. CHX shall comply with the following undertakings:
1. Create a Regulatory Oversight Committee
a. Within thirty (30) days of the entry of this Order, CHX shall create a Regulatory Oversight Committee to regularly advise CHX's Board of Governors about regulatory, compliance and enforcement matters. The Committee shall be composed of seven (7) members: five (5) Public Governors, one (1) On-Floor Member Governor and one (1) Off-Floor Member Governor. The terms "Public Governors," "Off-Floor Member Governor" and "On-Floor Member Governor" have the meanings set out in the CHX Constitution.24 The Committee shall be appointed by CHX's Vice Chairman, as required by the CHX Constitution, and approved by the Public Governors on CHX's Board.25 The Committee shall elect a Chairperson from among the five (5) Public Governors.
b. The function of the Regulatory Oversight Committee is to assist the Board in monitoring the design, implementation and effectiveness of CHX's programs to promote and enforce compliance with the federal securities laws and CHX and SEC rules including, but not limited to, the order handling rules, which include the firm quote rule, prohibitions against trading ahead and the limit order display rule. To fulfill its responsibilities, the Regulatory Oversight Committee has the duty and authority to:
i. Periodically review reports that shall be prepared by the Market Regulation Department and Listing Departments regarding their activities with respect to (a) compliance examinations, (b) member surveillance and investigations, (c) member disciplinary proceedings, (d) issuer listing and delisting proceedings, and (e) new member qualifications.
ii. Review any reports received by CHX from regulatory entities or third parties with respect to CHX's self-regulatory responsibilities (and any CHX responses thereto), as well as any other reports prepared by or at the direction of CHX in regard to its regulatory or enforcement programs.
iii. Consider any other matters bearing on the effectiveness and efficiency of CHX's surveillance, financial compliance, listings and enforcement programs.
iv. Make recommendations to the Board of Governors with respect to (a) staffing and other resources for regulatory programs; (b) disciplinary, listing and membership qualification rules and procedures; (c) disciplinary sanctioning guidelines; and (d) other matters bearing on the effectiveness and efficiency of CHX's surveillance, financial compliance, listings and enforcement programs.
v. Assess CHX's performance in its design and implementation of its surveillance, financial compliance, listings and enforcement programs.
vi. Directly retain outside counsel and/or other expert external resources to assist the Regulatory Oversight Committee in performing its oversight responsibilities.
vii. Hold regular meetings to engage in the activities described above, as well as any special meetings called by the Regulatory Oversight Committee chairman.
viii. Meet, on at least a quarterly basis, with appropriate Market Regulation Department staff members to discuss floor surveillance and enforcement issues. These discussions may occur either as part of the Committee's regular meetings or in special meetings. Prior to each of these quarterly discussions, CHX shall provide the Regulatory Oversight Committee with information relating to the Department's trading floor surveillance preliminary findings, investigations and related disciplinary proceedings in a form as directed by the Committee to allow it to monitor the effectiveness of the Department's trading floor enforcement program, including whether the department's enforcement staff is making appropriate decisions when exercising their prosecutorial discretion.
ix. Review the Regulatory Oversight Committee's activities and findings with the Board of Governors on a semi-annual basis. In addition to the items identified above, the Regulatory Oversight Committee shall advise the Board of Governors regarding the appropriateness of CHX's budget for surveillance and enforcement matters as well the number and expertise of CHX personnel.
c. In carrying out its responsibilities, the Regulatory Oversight Committee shall have full access to CHX employees, under such conditions as the Regulatory Oversight Committee deems appropriate, and shall have the right to request the preparation of reports by CHX staff. The Regulatory Oversight Committee shall also hear from any CHX employee, member, member's employee or member applicant that requests such an opportunity under such conditions as the Regulatory Oversight Committee deems appropriate.
2. Engage an outside consultant
a. Within thirty (30) days of the entry of this Order, CHX shall engage an outside consultant (the "Consultant"), not unacceptable to the Commission, to conduct a comprehensive review of CHX's trading floor surveillance and enforcement programs to verify that CHX's trading floor surveillance and enforcement programs are appropriately designed and implemented to promote and enforce CHX member compliance with the federal securities laws and CHX and SEC rules including, but not limited to, the order handling rules, which include the firm quote rule, prohibitions against trading ahead and the limit order display rule. The Consultant shall recommend any changes necessary to enable CHX to better carry out its regulatory responsibilities relating to CHX's trading floor surveillance and enforcement programs.
b. In evaluating CHX's trading floor surveillance program, the Consultant's review shall consider both the Market Regulation Department's current surveillance work, as well as whether the Department should develop any additional surveillance capabilities. Regarding the Market Regulation's current surveillance efforts, the review shall assess, among other things, the Department's existing rules, protocols, reports and other materials and determine whether they effectively and efficiently identify violations of the rules that they are intended to surveil. The Consultant shall recommend any changes that would enhance the effectiveness or efficiency of these items. The review shall also include an examination of any internal audit reports describing the implementation of each of the protocols, as well as interviews or additional work needed to confirm whether audit recommendations have been undertaken and whether any additional changes are appropriate. In addition, the Consultant's review shall consider whether there are other trading floor surveillance efforts that should be instituted and shall include recommendations about the appropriate implementation of those new programs.
c. In assessing CHX's trading floor enforcement program, the Consultant's review shall consider whether CHX has efficient and effective procedures, tools and personnel in place to take appropriate disciplinary action after violations of CHX and SEC rules have been identified. The review shall consider whether the Market Regulation Department's guidelines help staff to appropriately and effectively identify how violations should be handled (such as through warning letters, under CHX's Minor Rule Violation Plan or through formal disciplinary proceedings) and should recommend any changes to those guidelines necessary to enhance their effectiveness. The review shall also include an examination of recent disciplinary actions to determine whether the Department's enforcement staff uses appropriate decision-making processes in determining how to handle particular violations under the guidelines, including multiple violations of a single rule as well as multiple violations of more than one rule. The Consultant shall also formulate recommendations regarding the type of information that the Regulatory Oversight Committee (discussed in Section C.1. above) should receive on a quarterly basis in order to discharge effectively the responsibilities described in Section C.1.b.viii. above. In addition, the Consultant's review shall consider whether the Market Regulation Department's procedures for processing violations are designed and implemented to effectively, efficiently and fairly enforce and promote member compliance with both CHX and SEC rules. In considering the implementation of existing procedures, the review shall include an examination of any internal audit reports describing the implementation of each of the Department's procedures, as well as interviews or additional work needed to confirm whether audit recommendations have been undertaken. The Consultant shall recommend any changes necessary to enhance the effectiveness, efficiency and fairness of the areas discussed in this paragraph.
d. The Consultant's review shall also consider whether any broader or structural issues exist that might impact CHX's efforts to use its trading floor surveillance and enforcement programs to enforce CHX member compliance with CHX and SEC rules. In this regard, the review shall include, among other things, an assessment of the Market Regulation Department structure, the qualification and professional expertise of its staff and its efforts to educate both Market Regulation Department investigators and CHX members about the requirements of SEC and CHX rules. The Consultant shall recommend any changes necessary to address the issues identified in this paragraph.
e. As part of his or her review, the Consultant shall consider whether CHX has committed an appropriate level of resources to its trading floor surveillance and enforcement programs (including staffing) and shall recommend any appropriate changes to those resource levels.
f. CHX shall direct its agents and employees to cooperate fully with the Consultant's review and to answer any questions he or she may have.
g. The Consultant shall submit a report of his or her findings and recommendations to the Regulatory Oversight Committee (discussed in Section C.1. above) and to the Board of Governors within nine (9) months of the Consultant's engagement. Within forty-five (45) days of the receipt of the report, the Board of Governors shall take steps necessary to commence implementation of all recommendations made in the report. If the Board of Governors determines that any of the Consultant's recommendations are unduly burdensome or impractical, it may propose an alternative reasonably designed to accomplish the same objectives. The Board of Governors shall submit any such alternative to the Consultant within forty-five (45) days of receipt of the report. The Consultant shall evaluate the Board's proposal and, if that proposal is reasonably designed to accomplish the same objectives, either approve the suggested alternative and/or amend the Consultant's recommendations within forty-five (45) days. Following such evaluation, the Consultant shall submit a revised report to the Board of Governors within forty-five (45) days. Within forty-five (45) days of the receipt of the revised report, the Board of Governors shall either (a) take steps necessary to commence implementation of all recommendations made by the Consultant, or (b) petition the Commission, with notice to the Consultant, Division of Market Regulation, Office of Compliance Inspections and Examinations and the Division of Enforcement (Midwest Regional Office), for relief from the Consultant's recommendation(s). Within thirty (30) days of receiving the Commission's determination on the petition, the Board of Governors shall accept and, if appropriate, take steps necessary to commence implementation of that determination.
h. CHX shall direct the Consultant to provide copies of the written reports referenced above promptly to the Division of Enforcement (Midwest Regional Office).
i. CHX undertakes that for the period of engagement and for a period of two (2) years from completion of the engagement, the Consultant shall not enter into any other employment, consultant, attorney-client, auditing or other professional relationship with CHX or any of its present or former affiliates, directors, officers, employees or agents acting in their capacity as representatives of CHX. Any firm with which the Consultant is affiliated or of which he/she is a member, and any person engaged to assist the Consultant in performance of his/her duties under this Order shall not, without prior written consent of the Commission's Division of Market Regulation, enter in to any employment, consultant, attorney-client, auditing or other professional relationship with CHX, or any of its present or former affiliates, directors, officers, employees or agents acting in their capacity as representatives of CHX for the period of engagement and for a period of two (2) years after the engagement.
j. Notwithstanding Section C.2.i. above, after the Consultant has fully discharged his or her duties as set forth in this Order, CHX may engage the Consultant to provide additional guidance relating to matters within the scope of the Consultant's engagement, as CHX deems appropriate.
3. CHX undertakes to expend funds needed to allow the Regulatory Oversight Committee to discharge its duties, including, but not limited to, providing adequate funds for:
a. the retention of such outside counsel and/or experts as the Regulatory Oversight Committee engages pursuant to Section C.1.b.vi. and the retention of the Consultant as provided in Section C.2., and
b. the implementation of recommendations made by the Consultant and/or the Regulatory Oversight Committee.
4. Certify the Adequacy of CHX's Compliance with its Statutory Obligations
Within ninety (90) days of receipt of the Consultant's final report as described in Section C.2. above, CHX's Board of Governors shall certify in writing that it has reviewed the Consultant's report and has made reasonable inquiry about the issues raised in that report. In addition, twelve (12) months after this certification by the Board of Governors, and each year thereafter for two (2) years (for a total of 3 additional annual certifications), the Regulatory Oversight Committee shall certify in writing that it has reasonably discharged its duties as set forth in Section C.1. above and has made reasonable inquiry concerning CHX's trading floor surveillance and enforcement programs. In addition, upon the implementation of any and all recommendations associated with the Consultant's final report (as described in Section C.2. above), CHX's chief executive officer shall promptly certify whether, after reasonable inquiry and to the best of his or her knowledge, he or she reasonably believes that CHX's trading floor surveillance and enforcement programs are adequate to meet CHX's obligations under Section 19(g) of the Exchange Act. CHX shall provide each written certification to the staff of the Division of Enforcement (Midwest Regional Office), the Office of Compliance Inspections and Examinations, and the Division of Market Regulation.
5. Within thirty (30) days of the entry of this Order, CHX shall file an affidavit with the Commission stating that it has created the Regulatory Oversight Committee, as described in Section C.1. above, and has hired an Independent Consultant, as described in Section C.2. above. No later than twelve (12) months from the date of the issuance of this Order, CHX shall file an affidavit with the Commission setting forth the details of CHX's compliance with the remaining undertakings outlined herein. CHX shall file an affidavit with the Commission no later than three (3) years from the date of the issuance of this Order describing the state of its regulatory system and compliance with this Order.
By the Commission.Jonathan G. Katz
Secretary
1 A co-specialist is an individual CHX member who is accountable to CHX and the investing public for the quality of CHX markets in the securities in which he is registered. A co-specialist acts as both an agent and principal in the securities in which he is registered. See CHX Article XXX, Rule 1.
2 Rule 11Ac1-1(c)(2) of the Exchange Act and CHX Article XX, Rule 7.01 govern the firm quote rule; trading ahead prohibitions are set forth in CHX Article XXX, Rule 2; and the LODR is governed by Rule 11Ac1-4 of the Exchange Act and CHX Article XX, Rule 7.05.
3 CHX has only initiated 1 formal disciplinary action for firm quote rule violations, and that was in 1999. Moreover, in the relevant period, CHX has only issued 2 warning letters for firm quote rule violations. In 1998, CHX initiated 3 formal disciplinary actions for trading ahead violations and only 2 formal disciplinary actions for LODR violations. In 1999, CHX initiated 5 formal disciplinary actions for trading ahead violations and 2 formal disciplinary actions for LODR violations. In 2000, CHX initiated one formal disciplinary action for trading ahead violations and also one for LODR violations. CHX did not institute any formal disciplinary actions against members for violations of the trading rules in 2001.
4 In or about January 2001, CHX started receiving automated alerts from the NASD. However, during the relevant time period, these alerts were received on a time-lag basis of 2 days, and each week's worth of alerts were not reviewed until the following week. Accordingly, CHX only used these alerts for the purpose of detecting patterns of violations committed by co-specialists, patterns which CHX did not detect.
5 At times CHX investigators delayed or, in some cases, did not complete their reviews of other exception reports in order to handle these telephone complaints. As a result, other exception reports were not always reviewed to the extent required, if at all.
6 Report Pursuant to Section 21(a) of the Securities Exchange Act of 1934 Regarding the NASD and the Nasdaq Market, Securities and Exchange Commission (Aug. 8, 1996).
7 In the Matter of New York Stock Exchange, Inc., Admin. Proc. File No. 3-9925, 1999 SEC LEXIS 1290, pg. 18 (June 29, 1999).
8 Due to a lack of adequate surveillance systems for the trading rules, it is difficult to quantify an exact number of violations.
9 At times CHX personnel failed to conduct trading ahead surveillance required by CHX's protocols. Tracking sheets maintained by CHX investigators indicate that reviews of the exception reports were often not completed and, at least during the week of October 9, 2000, not at all.
10 Poorly prepared exception reports that contained a significant number of false positives also hindered CHX's ability to detect trading ahead violations.
11 The MRVP is a panel of 3 to 4 CHX members appointed by the CHX chief executive officer on an annual basis. The panel meets every 4 to 6 weeks to address what CHX considers to be minor rule violations presented to the panel by the Director and/or Vice President of the Market Regulation Department.
12 Report Concerning Display of Customer Limit Orders, Office of Compliance Inspections and Examinations, Office of Economic Analysis, United States Securities and Exchange Commission (May 4, 2000).
13 In addition, if a co-specialist is sanctioned by the MRVP for trading ahead violations and subsequently appears before the panel for a LODR violation, the trading ahead violation is not considered as a prior occurrence in setting the fine for the LODR violation.
14 CHX encouraged co-specialists to disgorge profits obtained through trading ahead violations, and most co-specialists did so.
15 CHX staff has aggregated as many as 15 LODR violations into 1 violation.
16 The violations committed by this co-specialist occurred over a period of time each day.
17 Although it may be the practice of some SROs to aggregate some LODR violations, this is not always appropriate, particularly if the SRO uses a sampling method from only a partially automated system, as does CHX.
18 CHX Rule 5(c) requires each member and member organization to "establish written procedures, and a system for applying such written procedures, to assure that its registered representatives and other employees are adequately supervised. No such system shall be deemed adequate unless it is reasonably designed to prevent and detect, insofar as practicable, violations of the applicable securities laws, the rules and regulations thereunder, and the Constitution and Rules of the Exchange."
19 For instance, the surveillance department had 2 investigators as of June 1998. CHX has since increased this number to 11.
20 These protocols and guidelines relate to surveillance for and enforcement of the trading rules, as well as for supervisory reviews and disciplinary actions. The disciplinary guidelines specifically provide that recidivists should be sanctioned through a formal disciplinary process (as opposed to referring them to the MRVP). In addition, in September 2001, CHX created procedures and guidelines requiring the MRVP to document that it has considered a member's disciplinary history. CHX is also requiring that multiple rule violations result in increased sanctions.
21 In particular, CHX created an exception report to detect intra-day trading ahead, which monitors when co-specialists disable the order match function, and it has reduced the number of false positives appearing in exception reports. CHX has also implemented REDS-related and NQDS quotation data enhancements (which are automated computer functions used to aid CHX investigators in possible LODR violation analyses). In addition, CHX has begun monitoring for co-specialists' over-reliance on automated quotation systems, such as Book Quote, to update quotes. In July 2001, SUPERSOES was implemented which effectively eliminated OTC firm quote rule violations at CHX.
22 Boston Stock Exch., Inc., 21 S.E.C. Docket 22, Release No. 34-17183, 1980 WL 25454 at *3 (Oct. 1, 1980).
23 National Ass'n of Sec. Dealers, Inc., 62 S.E.C. Docket 1346, Release No. 34-37538, 1996 WL 447193, at *2 (Aug. 1996).
24 A "Public Governor" is a person who has no material business relationship with a broker or dealer or CHX. See CHX Constitution, Article III, Section 10(2). An "Off-Floor Member Governor" is a member who is not primarily engaged in business on CHX's trading floor or a general partner or officer of a member organization that is not primarily engaged in business on CHX's trading floor. See CHX Constitution, Article III, Sections 10(4) and 10(5). Off Floor Member governors typically are officers of CHX order-sending firms. An "On-Floor Member Governor" is a member primarily engaged in business on CHX's trading floor or a general partner or officer of a member organization that is primarily engaged in business on CHX's trading floor. On-Floor Member Governors typically are officers of CHX specialist, market maker or floor broker firms.
25 Although CHX Constitution requires that the entire Board of Governs approve committee appointments, the Board generally has the authority to delegate its powers, including its authority to approve committee appointments, to others. In this instance, the Board would delegate this committee approval authority to the Public Governors on the Board.