April 17 (Bloomberg) -- Three years of discussions between regulators and OptionsXpress Inc. culminated in a lawsuit yesterday, when the U.S. Securities and Exchange Commission alleged the brokerage helped facilitate illicit short sales.
The company, four executives and a customer violated SEC regulations with sham options trades from October 2008 to March 2010 designed to give the illusion of compliance with short-sale rules, the SEC said. Customers in the OptionsXpress trades accounted for an average of 48 percent of daily volume in one of the targets, Sears Holdings Corp., in January 2010.
U.S. regulators have faced added pressure to police short sellers since the financial crisis in 2008, when complaints by corporate executives prompted the SEC to temporarily ban bearish bets in almost 1,000 companies. Yesterday’s order involved options trading that the commission said was used to circumvent rules against so-called naked shorting, or speculating a stock will fall without borrowing it.
“The problems of naked short selling and settlement failures were ongoing for many years and it was pretty clear to the casual observer that something was going on,” James Angel, a finance professor at Georgetown University’s business school in Washington, said yesterday in a phone interview. “It’s good that the SEC is prosecuting this. I’m only asking what took them so long.”
In a short sale, an investor borrows a stock and sells it, with the goal of profiting from a price decline. The SEC’s Regulation SHO requires investors and their brokers to borrow shares within three days of making a short sale and bars firms from executing further bets until previous ones are settled.
OptionsXpress, its former Chief Financial Officer Thomas E. Stern, and the customer, Jonathan I. Feldman of Baltimore, are fighting the agency’s claims. Feldman was identified by the SEC as a senior vice president at a regional savings bank. OptionsXpress is a Chicago-based broker that was acquired by Charles Schwab Corp. last year.
“We believe the evidence at trial will demonstrate that OptionsXpress timely covered consistent with Reg SHO,” said Stephen Senderowitz, an attorney for the OptionsXpress. The company was in touch with regulators regarding the transactions, no one was defrauded, and the transactions “were not shams and were neither novel nor exotic,” Senderowitz said.
Greg Lawrence, a lawyer for Feldman, said his client “entered into legitimate open-market trades, and he believed, and still believes, that his brokers complied with all rules.” The SEC “is unfairly trying to change the rules through litigation,” Lawrence said.
A phone call to Vincent Schmeltz, Stern’s attorney, wasn’t immediately returned.
Cooperating With SEC
The SEC settled related claims against three OptionsXpress employees: Peter Bottini, Phillip Hoeh and Kevin Strine, according to a separate administrative order. Attorneys for Hoeh and Strine declined to comment. A phone call to Steven Biskupic, a lawyer for Bottini, wasn’t immediately returned. Bottini is in charge of trading and customer service at OptionsXpress, Hoeh is chief compliance officer and Strine is vice president of compliance, the SEC said.
In resolving the action, Bottini, Hoeh and Strine agreed to cooperate with the SEC’s investigation without admitting or denying wrongdoing or paying any financial penalties.
Charles Schwab, the San Francisco-based brokerage, agreed to buy OptionsXpress for about $1 billion in stock last year, adding the retail options brokerage founded in 2000 to its equity and mutual fund offerings. The acquisition was completed in September.
Difficult to Borrow
The SEC said six customer accounts at OptionsXpress targeted companies where demand to sell short was so high that it was difficult to borrow shares. To get around that, synthetic short bets were created by selling bullish options priced far below the level of the stock, known as deep-in-the-money calls.
That required those accounts to deliver shares to OptionsXpress within three days to meet securities rules, the SEC said. Instead, the broker let the customers enact so-called buy-write trades, which gave the appearance of meeting the delivery obligation without actually complying.
“While the daily use of buy-writes gave the impression that OptionsXpress was closing out the failures to deliver as required, OptionsXpress and the customers were simply kiting stock to maintain the naked short position,” the SEC wrote in its complaint.
The customers used the trading strategy between October 2008 and March 2010 on about 25 stocks, including Sears and American International Group Inc., the SEC said. In 2009, they bought about $5.7 billion of securities and sold about $4 billion of options, according to the regulator.
Feldman’s trades, involving at least $2.9 billion of purchases and $1.7 billion of options, occurred between July 2009 and March 2010, the SEC alleged.
OptionsXpress didn’t deliver shares associated with short sales for at least 236 continuous settlement days in the 2009-2010 period, the SEC said. It failed to deliver shares in at least 25 companies at least 1,317 times, the complaint said.
OptionsXpress executives should have known the reset trades violated Reg SHO, the SEC said. The commission issued guidance about stock-option trades that gave the appearance of circumventing rules in 2003. The American Stock Exchange issued fines in 2007 for activity similar to the OptionsXpress trades.
The Chicago Board Options Exchange sent a notice to members including the options broker later that year, cautioning them about similar strategies. The SEC in 2009 filed a case against other entities and individuals about “sham reset transactions,” the regulator said.
The SEC said OptionsXpress “knew early on that the trading was problematic.” Starting a month after the SEC updated short-sale rules in September 2008, the broker began internal discussions about customer short positions and related strategies that the client used to keep the trade open.
CBOE contacted OptionsXpress starting in November 2008 about its short-selling compliance, according to the suit. Back and forth communication between compliance officials, OptionsXpress traders and customers continued during 2009.
A discussion between an OptionsXpress lawyer and compliance officers at the SEC led to the broker providing an inaccurate and incomplete trading example, the agency said.
When electronic message boards included information about “mystery trades” and “faux trades” in Sears, Feldman told a friend that, “I read the latest thread on the SHLD ‘volume spikes.’ Very entertaining. (Until someone notifies the SEC and they shut down the strategy!!),” the SEC order said.
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