Regulatory enforcement continues to keep the Financial Industry Regulatory Authority (FINRA) busy. Another large set of fines imposed for alleged Regulation SHO violations was announced earlier this week for two broker dealers, Deutsche Bank Securities ($575,000) and National Financial Services ($350,000), respectively.
Simply stated, short sales are subject to Regulation SHO, which requires that brokers or dealers secure and document a "locate" prior to a short sale. The "locate" is necessary for a short sale to be accepted or ordered to ensure that the security can be borrowed and delivered.
Calling the locate "an essential component of ensuring that short sales are executed properly," James S. Shorris, FINRA Executive Vice President and Acting Chief of Enforcement, stated that "[t]he failure to design, implement and supervise systems that reasonably ensure that shares of a security are available to be borrowed before a short sale is executed significantly undermines the effectiveness of Regulation SHO."
The specific problem for these firms was similar, as was the end result of their system failures with regard to ensuring compliance with Regulation SHO. Each firm did maintain systems to block short sale orders that did not have a documented "locate." But in both cases there were exceptions to that which end up being fairly costly and had the effect of failing to block short sales that did not have a locate associated with them.
What FINRA found when sampling short sale orders for each of these firms, was a failure to ensure that a locate had been secured before such trades were executed. In Deutsche Bank's case the block was disabled in "certain instances" and in NFS' case, a separate system applied to "certain customers."
Ironically, because Deutsche Bank's systems had some outages that at times precluded data involving locates to be imported, the firm disabled the system altogether during outages. This occurred over a four-year period. No system was created to ensure that during the period when the system was disabled, another review was in place. This allowed short sales to go through that otherwise were not in compliance with the locate requirement.
Similarly, NFS maintained an automated system, but also excepted some firms that circumvented automatic blocks and allowed manual locate requests and approvals with account representatives. This occurred over a similar time-frame to that of the Deutsche Bank's challenges with regard to compliance with Regulation SHO. The FINRA press release called this a "flawed system."
In both instances, FINRA also found that the review processes for these firms on this type of trading was not adequate nor were the implementation of supervisory systems. The violations of Regulation SHO apparently could have been avoided had these systems been developed and reviewed for compliance.
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