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From Securities Regulation Daily, August 9, 2013

SEC identifies options trading practices being used to circumvent Regulation SHO requirements

By John Filar Atwood

The SEC’s Office of Compliance and Inspections has issued a risk alert to highlight trading strategies by which some broker-dealers and clearing firms are circumventing the close-out requirements of Regulation SHO. The alert summarizes recent enforcement actions in this area, and points out effective practices that certain firms are using to identify risks and detect the questionable trading activities.

Reg. SHO. Regulation SHO requires, among other things, that fail-to-deliver positions resulting from short sale transactions be closed out by a specified date, either by borrowing or by purchasing securities of like kind and quantity (close-out requirement). In order to address potentially manipulative or abusive “naked” short selling, Reg. SHO also requires that broker-dealers borrow securities sold short, or have reasonable grounds to believe that such securities can be borrowed, prior to effecting a short sale for their own account or accepting a short sale order from another person (locate requirement).

The SEC staff has identified trading strategies being used to give the impression that purchases by the short seller have satisfied the close-out requirement of the clearing firm or the broker-dealer to whom a fail-to-deliver position was allocated. In reality, however, the purchased shares are often not delivered because of subsequent options trading used to re-establish or otherwise extend the broker-dealer’s fail position without any demonstrable legitimate economic purpose. In these instances, the SEC states that the clearing firm or broker-dealer allocated a fail-to-deliver position does not satisfy the close-out requirement.

The Reversal Strategy. The risk alert states that one strategy that could be designed to take advantage of the potential profit opportunities created by a stock becoming hard to borrow is to initiate a reversal. This is most often done by broker-dealers who claim to rely on the exception to the locate requirement for options market makers found in Rule 203(b)(2)(iii) of Reg. SHO.

The options market makers claim that they can enter into the short stock position without first locating the shares to borrow because it is part of bona fide market making activity. The SEC staff advises that although an options market maker engaged in bona fide market making activity may claim an exception to the locate requirement, to comply with Reg. SHO, the options market maker must still deliver shares in settlement of the short sale. If a fail-to-deliver position results at the clearing firm, the fail to deliver must be closed-out in accordance with Rule 204 of Reg. SHO.

The risk alert states that it may be a violation of Reg. SHO where the options market maker does not deliver shares, and instead engages in a second, subsequent transaction in order to give the appearance of satisfying the clearing firm’s obligation to purchase or borrow the security to close out the resulting settlement failure pursuant to Rule 204 close-out requirements. In addition, where a clearing firm subject to the close-out requirement purchases or borrows securities on the applicable close-out date and on that same date engages in sale transactions that can be used to re-establish or otherwise extend the clearing firm’s fail position, and for which the clearing firm is unable to demonstrate a legitimate economic purpose, the staff notes that the clearing firm will not be deemed to have satisfied the close-out requirement.

In addition, the staff advises that if the clearing firm or broker-dealer that was allocated the fail-to-deliver position enters into an arrangement with another person to purchase securities as required by Rule 204, and the clearing firm, or broker-dealer that was allocated a fail-to-deliver position, knows or has reason to know that the other person will not deliver securities in settlement of the purchase, then the transaction is a sham close-out in violation of Rule 204(f).

Reset Transactions. The risk alert provides a scenario where XYZ is a hard to borrow security, and Trader A, or its broker-dealer, is unable to borrow shares to make delivery on the short sale of actual shares, and the short sale may result in a fail-to-deliver position at Trader A’s clearing firm. Rather than paying the borrowing fee on the shares to make delivery, or unwinding the position by purchasing the shares in the market, Trader A might enter into a trade that gives the appearance of satisfying the broker-dealer’s close-out requirement, but in reality allows Trader A to maintain its short position without ever delivering on the short sale. The staff notes that these trades are commonly referred to as reset transactions, in that they have the effect of resetting the time that the broker-dealer must purchase or borrow the stock to close-out a fail.

The transactions could be designed solely to give the appearance of delivering the shares, when in reality the trader has no intention of meeting his delivery obligations, according to the staff. The price in these transactions is determined so that the short seller pays a small price to the other market-maker for the trade, resulting in no economic benefit to the short seller for the reset transaction other than to give the appearance of meeting his delivery obligations. Such transactions were alleged by the Commission to be sham transactions in recent enforcement cases. They have also been found to constitute a violation of a clearing firm’s responsibility to close out a fail-to-deliver.

Compliance Procedures. In the risk alert, the staff reminds broker-dealers that they must maintain adequate written supervisory procedures reasonably designed to achieve compliance with Reg. SHO and Rule 10b-21. These include procedures regarding correct marking of short sales and long sales, procedures to perform a locate and document a locate prior to a short sale, and procedures to ensure that fail to deliver positions are closed-out in accordance with Rule 204. As part of these procedures, clearing firms should consider having in place policies that will help them ensure that delivery is being made by the settlement date.

The staff states that adequate written supervisory procedures reasonably designed to achieve compliance with Rule 10b-21 include procedures to ensure that the broker-dealer, acting for its own account, including as a market maker, or the broker-dealer’s customer, does not commit fraud in violation of Rule 10b-21 by deceiving a broker or dealer, a participant of a registered clearing agency or a purchaser about their intention or ability to deliver the security on or before the settlement date, and failing to deliver the security.

MainStory: TopStory RiskManagement BrokerDealers ClearanceSettlement

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