The SEC found that “the Division of Enforcement has not met its burden to show” that a “retail” investor violated anti-fraud regulations by allegedly failing to make delivery when call options he wrote were exercised. The SEC found, however, that the broker-dealer, through which the investor had executed trades, had failed to close out “fail to deliver” positions in accordance with Reg. SHO Rules 204 and 204T, and ordered that it pay over $2 million in disgorgement and a $2 million penalty.
Regulation SHO Rule 204 generally requires broker-dealers to close out “fail to delivers” after a certain period. One strategy used to restart the clock, and thus avoid the buy-in requirement, is for a potentially failing investor to buy shares for delivery and at the same time, sell a call option that is certain to be exercised on the same shares. This so-called “buy-write” transaction has the effect of restarting the three-day buy-in period, but without actually resulting in any delivery of stock, since the purchase of the stock and the sale of the stock through the call option just net each other out.
In this case, the compliance officer for the broker-dealer firm was aware of the SEC position on the use of such transactions. The SEC opinion quoted a warning given by the compliance officer to the firm:
The troublesome part is that the SEC characterized, and found as a violation, the fail to deliver close-out process used [by other firms] as “sham reset transactions.” In both cases, the firms would either use married-put or buy-write transactions to close-out their Regulation SHO fails-to-deliver. Our customers have been engaging in buy-write transactions, or simply selling deep-in-the money calls after we process buy-ins in their accounts. The end result in all situations is similar: the shares are bought-in, but the subsequent exercise or assignment of the option that night results in a continuation of the fail.
(at page 35)
While the SEC found that the broker-dealer had tolerated misconduct by the firm’s retail customers, the SEC emphasized that the Division of Enforcement failed to provide sufficient evidence that the particular retail investor charged had ill-intent or knew that his conduct was improper. The SEC found, therefore, that the relevant scienter requirement under the anti-fraud provision was not met. The SEC further explained that:
. . . there is no evidence or allegation that [the investor] deceived his broker about his intent or ability to deliver shares. The only question is whether he knew or should have known that he was deceiving downstream purchasers about his ability or intent to deliver shares. The record does not provide sufficient evidence to make such a finding. Among other things, [the investor] was open about his trading strategy, even describing it in a public blog post. . .
The SEC also dismissed constitutional arguments raised by the defendants that the SEC administrative law judge was not properly “appointed” and that a dual “for-cause” removal restriction for an administrative law judge was inappropriate.
Lofchie Comment: The question that the case raises is not whether the strategy of avoiding a buy-in of a failed short delivery is legal – the SEC had previously established that it viewed the “buy [stock]-write [put option]” strategy, which is not inherently illegal, as improper when used as a device to evade, or in this case, to abet the evasion of, the requirement to buy-in failures to deliver on short sale trades. The question rather is who has responsibility to know that it is not permissible. Essentially, the SEC ruled that the “retail” customer entering into the trades could not be expected to know the SEC’s position on buy-write trading, but that the broker-dealer that was effecting the trades should have known that the strategy was improper and thus should not have effected the trades.
For broker-dealers, the takeaway lesson of this case is that they have an obligation to monitor for, and prevent, this type of trading by their customers, even where the broker-dealers are only acting as agents in effecting the trades.