SEC ISSUED RISK ALERT TO DETECT OPTIONS TRADES THAT CIRCUMVENT SHORT-SALE RULE

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION 
Washington D.C., Aug. 9, 2013 — 

The Securities and Exchange Commission issued a Risk Alert to help market participants detect and prevent options trading that circumvents an SEC short-sale rule.

The SEC’s Office of Compliance Inspections and Examinations (OCIE) issued the alert after its examiners observed options trading strategies that appear to evade certain requirements of the short-sale rule.  The alert describes the strategies used by some customers, broker-dealers and clearing firms, summarizes related enforcement actions, and notes practices that some firms have found to be effective in detecting and preventing trading intended to evade the rule, known as Regulation SHO.

Regulation SHO tightened requirements for short sales, which involve sales of borrowed securities. Short sellers profit from price declines by replacing borrowed securities at a lower price.  Under Regulation SHO, short sellers who fail to deliver securities after the settlement date are required to close out their position immediately, unless they qualify as bona fide market makers for a limited amount of extra time to close-out.  As noted in the alert, the trading strategies observed by the OCIE staff may give the impression of satisfying the Regulation SHO “close-out requirement,” while in effect evading it.  These sham close-outs violate the SEC rule, which aims to ensure that trades settle promptly, thereby reducing settlement failures.

“This Risk Alert encourages awareness of options trading activity used to avoid complying with the close-out requirements under Regulation SHO,” said OCIE Director Andrew Bowden.  “The alert describes these trading activities in detail to help broker-dealers and their correspondent clearing firms avoid the regulatory and reputational risks that are posed by these activities.”

In addition, the Risk Alert describes activities that the staff has observed that may indicate an attempt to circumvent Regulation SHO.  These include:

Trading exclusively or excessively in hard-to-borrow securities or threshold list securities, or in near-term listed options on such securities

Large short positions in hard-to-borrow securities or threshold list securities
Large failure to deliver positions in an account, often in multiple securities
Continuous failure to deliver positions

Using buy-writes, married puts, or both, particularly deep in-the-money buy-writes or married puts, to satisfy the close-out requirement

Using buy-writes with little to no open interest aside from that trader’s activity, resulting in all or nearly all of the call options being assigned

Trading in customizable FLEX options in hard-to-borrow securities or threshold list securities, particularly very short-term FLEX options

Purported market makers trading in hard-to-borrow or threshold list securities claiming the exception from the locate requirement of Regulation SHO; often these traders do not make markets in these securities, but instead make trades only to take advantage of the option mispricing

Multiple large trades with the same trader acting as a contra party in several hard-to-borrow or threshold list securities; often traders assist each other to avoid having to deliver shares

Eric Peterson and Tom Mester of the National Exam Program staff contributed substantially to the preparation of this Risk Alert.  They received valuable input from the Division of Trading and Markets and the Division of Economic and Risk Analysis.

SEC CHARGES OPTIONSXPRESS WITH FAILURE TO SATISFY CLOSE-OUT OBLICATIONS

FROM:  SECURITIES AND EXCHANGE COMMISSION
Washington, D.C., April 16, 2012 – The Securities and Exchange Commission today charged an online brokerage and clearing agency specializing in options and futures as well as four officials at the firm and a customer involved in an abusive naked short selling scheme.

The SEC’s Division of Enforcement alleges that Chicago-based optionsXpress failed to satisfy its close-out obligations under Regulation SHO by repeatedly engaging in a series of sham “reset” transactions designed to give the illusion that the firm had purchased securities of like kind and quantity. The firm and customer Jonathan I. Feldman engaged in these sham reset transactions in a number of securities, resulting in continuous failures to deliver. Regulation SHO requires the delivery of equity securities to a registered clearing agency when delivery is due, generally three days after the trade date (T+3). If no delivery is made by that time, the firm must purchase or borrow the securities to close out the failure-to-deliver position by no later than the beginning of regular trading hours on the next day (T+4).

The former chief financial officer at optionsXpress – Thomas E. Stern of Chicago – was named in the SEC’s administrative proceeding along with optionsXpress and Feldman. Three other optionsXpress officials – head of trading and customer service Peter J. Bottini and compliance officers Phillip J. Hoeh and Kevin E. Strine – were named in a separate administrative proceeding and settled the charges against them for their roles in the scheme.

“OptionsXpress used sham reset transactions to avoid, sometimes for months, its obligation to comply with Reg. SHO’s stock delivery requirements,” said Robert Khuzami, Director of the Division of Enforcement. “Illegally extending its naked short positions put optionsXpress in plain violation of the law and undermined Reg. SHO’s intent to reduce fails to deliver.”

Daniel M. Hawke, Chief of the Division of Enforcement’s Market Abuse Unit, added, “Reg. SHO compliance continues to be a high enforcement priority. Broker-dealers, their employees, and their customers must ensure that they comply with the close-out requirements of the short sale rules and regulations.”

According to the SEC’s order, the misconduct occurred from at least October 2008 to March 2010. In September 2011, optionsXpress became a wholly-owned subsidiary of The Charles Schwab Corporation.

The SEC’s Enforcement Division alleges that the sham reset transactions impacted the market for the issuers. For example, from Jan. 1, 2010 to Jan. 31, 2010, optionsXpress customers including Feldman accounted for an average of 47.9 percent of the daily trading volume in one of the securities. In 2009 alone, the optionsXpress customer accounts engaging in the activity purchased approximately $5.7 billion worth of securities and sold short approximately $4 billion of options. In 2009, Feldman himself purchased at least $2.9 billion of securities and sold short at least $1.7 billion of options through his account at optionsXpress.

According to the SEC’s order, by engaging in the alleged misconduct, optionsXpress violated Rules 204 and 204T of Regulation SHO; Feldman willfully violated Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934 and Rules 10b-5 and 10b-21 thereunder; optionsXpress and Stern caused and willfully aided and abetted Feldman’s violations of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rules 10b-5 and 10b-21 thereunder; and Stern caused and willfully aided and abetted optionsXpress’s violations of Rules 204 and 204T.

In the separate settled administrative proceeding, Bottini, Hoeh, and Strine consented to a cease-and-desist order finding that they caused optionsXpress’s violations of Rules 204 and 204T of Regulation SHO and ordering them to cease-and-desist from committing or causing violations of Rule 204. They neither admitted nor denied the SEC’s findings.

The SEC’s investigation was conducted by Deborah Tarasevich, Jill Henderson, and Paul Kim. Market Surveillance Specialist Brian Shute, Market Abuse Unit Trading Specialist Ainsley Fuhr, and Financial Economist Michael P. Barnes provided assistance with the investigation. The litigation will be led by Frederick Block.