CBOE Ordered to Pay $6 Million by SEC for Oversight Flaws

Federal regulators fined the Chicago Board Options Exchange $6 million, saying staff interfered with their 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. 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.

CBOE shares slipped 0.2 percent to $42.14 as of 1:35 p.m. in New York. The stock has rallied 43 percent this year.

Misguided Steps

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 investigation was begun.

Policing Markets

“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, said in a phone interview. “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.

“This settlement marks a significant step in putting the SEC matter behind us,” CBOE said in an e-mailed statement. “All actions either required or recommended by the SEC, as well as those resulting from our rigorous self-review, have been or are now being implemented.”

Gail Osten, a spokeswoman for the Chicago-based market operator, declined to comment beyond the statement. CBOE said in a filing in February that it expected to pay as much as $10 million to settle the SEC’s investigation.

Short Sales

OptionsXpress and Thomas E. Stern helped a client, Jonathan I. 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 P. 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.

Securities Delivered

OptionsXpress says it did nothing wrong. Stephen Senderowitz, a lawyer representing OptionsXpress, disputed Murray’s interpretation today, and said OptionsXpress is reviewing the decision for the purposes of an appeal.

“We believe the evidence at trial demonstrated that OptionsXpress at all times acted consistent with all regulations and bought in the shorts and delivered securities as required,” said Senderowitz in an e-mailed statement. “The firm was in touch with regulators regarding the transactions, no one was harmed, and the transactions were neither novel nor exotic.”

Gregory Lawrence and Daniel McCartin, lawyers for Feldman, did not return calls seeking comment.

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 deliver shares within three days of making a short sale and bars firms from executing further bets until previous ones are settled.

Borrowing Costs

Feldman used OptionsXpress to target companies where demand to sell short was so high that it was difficult or expensive 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.

“Whenever the deep-in-the-money call options that Feldman wrote were assigned to him, Feldman ended up in a short position,” Murray said in the judgment. “This would have been true for any trader. What was different for Feldman and certain other customers was that it was not an infrequent or unplanned occurrence, rather it was their deliberate and consistent trading practice.”

Five customers including Feldman used the strategy between October 2008 and March 2010 on about 25 stocks, including Sears Holdings Corp. 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, the regulator alleged.

‘Very Entertaining’

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. Feldman estimated he made $3 million to $4 million on the trades he did through OptionsXpress, according to the judgment.

At one point, according to the judgment, Feldman messaged Dean Kolocouris, a friend who was also alleged to have engaged in the practice: “read the latest thread on the [Sears] ‘volume spikes.’ Very entertaining. (Until someone notifies the SEC, and they shut down the strategy!! Then we’ll need a real job.”

OptionsXpress didn’t levy extra fees on hard-to-borrow stock and was alone at the time in allowing the use of buy-writes to cover short positions, according to Judge Murray’s ruling.

“Feldman’s actions constitute fraud because by writing calls he represented to the market as a whole and to purchasers of his deep-in-the-money calls that he was going to make delivery if his calls were exercised and assigned when he had no intention of doing so, and, in fact, by entering buy-writes, he did not cover his short position,” Judge Murray said.

Charles Schwab, the San Francisco-based brokerage, agreed to buy OptionsXpress for about $1 billion of stock in 2011, adding the retail options brokerage founded in 2000 to its equity and mutual fund offerings. The acquisition was completed in September 2011.

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