The Securities and Exchange Commission (SEC) has issued a statement on a matter involving a Chicago option trader who has agreed to pay $2 million to settle allegations that he violated short selling restrictions. The SEC administrative proceeding under Sections 15(b) and 21C of the Securities Exchange Act of 1934 ("Exchange Act") involved a cease-and-desist proceeding against the trader. In anticipation of this proceeding, an Offer of Settlement was made and accepted by the SEC.
The trader was alleged to have violated requirements of Regulation SHO -- which the Securities Lawyer Blog has highlighted in past posts. In this case, the trader was ordered to cease and desist from violations of Rules 203(b)(1) and 203(b)(3) of Regulation SHO.
Specifically, the "locate" and "close out" requirements were said by the SEC to have been violated. These provisions require that before selling short, traders locate a source of borrowable shares. The shares must be deliverable by a date certain and only those market makers engaged in bona-fide market making in the excepted security are permitted to operate under the exception.
In this case, the allegations center on the SEC's conclusion that this particular trader used the "market maker exception" improperly. His business loaned certain stocks to broker-dealers that are generally "hard-to-borrow." Those broker's customers received locates and stock loans on those shares. The stock provided was actually not available for delivery, which amounted to illegal naked short sales that were effectuated between late 2006 to June 2007.
As noted by George S. Canellos, Director of the SEC's New York Regional Office, the Commission intends to aggressively " 'pursue and punish abusive short sellers who attempt to circumvent regulatory requirements to make more money.' " The trader in this matter was alleged to have "avoided the cost of borrowing shares while engaging in complex short selling transactions," which resulted in great profits, lower risks and advantages over legitimate market participants.
Delineating two types of transactions in the alleged practices, the Commission's allegations centered on a "reverse conversion" or "reversal" in which stocks are sold short with a simultaneous put option sale and a call option buy. The other transaction involved a sham that combined stock-and-option transactions that created "the illusion that the party subject to a close-out obligation has satisfied that obligation by buying the same kind and quantity of securities it has sold short."
The trader sought to create an appearance of Regulation SHO compliance when in fact the shares purchased were not delivered. This naked short selling practice meant that the trader and his former firm failed to deliver shares resulting in what the Commission noted as "persistent 'fail-to-deliver' positions." The attempt to take advantage of the market maker exception to Regulation SHO was improper since in fact these parties were not involved in bona-fide market making with the securities they traded.
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