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SEC fines Chicago exchange for regulatory lapses

Bloomberg

Federal regulators Tuesday fined the Chicago Board Options Exchange $6 million, saying its staff interfered with its three-year investigation of short selling at a member firm in an unprecedented breakdown of trading supervision.

The settlement, which calls for immediate remedial actions, is the first ever assessed by the Securities and Exchange Commission for violations related to regulatory oversight, according to a statement. Four days ago, an administrative law judge ruled that CBOE member OptionsXpress Inc., a unit of Charles Schwab Corp., helped facilitate sham transactions that violated U.S. securities laws known as Regulation SHO.

While actions against traders and investors are common at the SEC, exchanges enjoy legal protections in their capacity of self-regulatory organizations (SRO). In the CBOE’s case, oversight suffered when it transferred responsibility for Regulation SHO enforcement from one department to another in 2008, the SEC wrote.

“CBOE put the interests of the firm ahead of its regulatory obligations by failing to properly investigate the firm’s compliance with Regulation SHO and then interfering with the SEC investigation,” the commission said. The failure reflected “an ineffective surveillance program that failed to detect wrongdoing despite numerous red flags,” it said.

During the investigation of OptionsXpress, it became apparent that CBOE staff didn’t know enough about the law to adequately enforce it, according to the SEC statement. Not only did they fail to detect violations, they “took misguided and unprecedented steps” to assist the firm that was under investigation.

Staff members didn’t have enough training in securities law and CBOE never ensured that they had read the appropriate rules, the order said. It cited the exchange for failing to respond quickly enough to requests for information. It credited the CBOE for beefing up its compliance staff and budget since the launch of the investigation.

“It sends a message that SROs need to be more vigilant in policing their member organizations,” said James Angel, a finance professor at Georgetown University’s business school. “The SEC doesn’t have the resources to police the markets as effectively as it should and it depends on the SROs.”

CBOE’s fine comes two weeks after Nasdaq OMX Group Inc. agreed to pay $10 million for its mishandling Facebook Inc.’s initial public offering in May 2012. The SEC complaint against Nasdaq cited securities law violations rather than breakdowns in its regulatory capacity.

As part of its response to the SEC inquiry, the CBOE said in January it planned to exclude trading industry directors from its board, bringing its governance in line with other exchange operators.

OptionsXpress and Thomas Stern helped a client, Jonathan Feldman, conduct trades designed to fake compliance with laws prohibiting so-called naked short sales, where investors sell a stock they don’t possess in hope of profiting from declines, according to the June 7 ruling by Brenda Murray, the chief administrative judge for the Securities and Exchange Commission.

Feldman’s use of so-called buy-write transactions, where a share purchase is immediately offset by selling an in-the-money call option, to cover short positions broke rules requiring all short sales to be backed by deliverable shares, the judge said in a 105-page initial decision issued June 7. OptionsXpress and Stern allowed the trades knowing the shares would never be delivered and knowing other rulings indicated the practice was illegal, the judge said.