SEC Puts Exchanges in Sights Charging CBOE Regulatory Lapses

Exchange executives, long shielded from legal scrutiny in the U.S., have been put on notice that may be changing after federal regulators fined CBOE Holdings Inc. $6 million for unprecedented lapses in supervision.

The levy, disclosed yesterday in a settlement with the biggest American options venue, marks the third time in nine months the Securities and Exchange Commission has announced financial sanctions against a market operator. Before collecting $5 million from NYSE Euronext in September for data dissemination violations, the commission had never imposed a monetary penalty on an exchange.

More than a decade of evolution in the way stocks, options, futures and derivatives trade in the U.S. has raised scrutiny of exchanges, which compete against each other for profits while supervising members as self-regulatory organizations. The role, dating from a period when markets were owned by the firms that used them, has been questioned following lapses in technology and oversight.

“This is something that’s been percolating at the SEC for a number of years,” said Paul Huey-Burns, a lawyer who worked at the agency from 1986 to 1998, in a phone interview yesterday. “There’s a perception at the agency that while the exchanges, as SROs, are an important part of the regulatory framework, that particular leg has not been holding up its side of the stool.”

CBOE added 0.5 percent to $42.02 as of 10:37 a.m. in New York.


Legislation that created the SEC in 1934 also deemed the main venues self-regulatory organizations, or SROs. The status gives them immunity for most actions taken as part of their supervisory duties, protecting them from lawsuits related to the exercise of those powers and preventing losses that could jeopardize institutions seen as vital to the U.S. economy.

Those shields were publicly challenged last year in the aftermath of Nasdaq OMX Group Inc.’s mishandling of Facebook Inc.’s initial public offering. Brokerages such as Citigroup Inc., which claim to have lost tens of millions of dollars when Nasdaq’s computers malfunctioned, said exchanges should be forbidden from hiding behind SRO rules when their mistakes reflected attempts to maximize profits.

The SEC didn’t cite New York-based Nasdaq for errors of regulation, charging the company instead with securities laws violations in a complaint settled last month. Nasdaq’s $10 million payment marked the second time the SEC had secured cash compensation from a market operator.

Compliance Cultures

“SROs must have strong compliance cultures and adequate and dedicated compliance resources to provide the first line of defense,” SEC Commissioner Luis Aguilar said in prepared remarks for a conference published on May 8. “However, when SROs fall short, the SEC needs to stand ready to take action.”

The CBOE was fined after its staff was found to have interfered with a three-year SEC investigation of short selling at a member firm, OptionsXpress Inc., according to yesterday’s order. The settlement came four days after an administrative law judge ruled the Charles Schwab Corp. unit helped facilitate sham transactions that violated U.S. securities laws known as Regulation SHO.

OptionsXpress broke SEC rules between 2008 and 2010, according to the regulator’s statement. Schwab bought the company in 2011.

“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.”

SEC Investigation

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.

OptionsXpress and its chief financial officer, Thomas E. Stern, helped a client 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 a June 7 ruling by Brenda P. Murray, the chief administrative judge for the SEC.

Murray found that OptionsXpress allowed the trades knowing the shares would never be delivered and that the practice was illegal. After the judgment, OptionsXpress lawyer Stephen Senderowitz maintained the firm did nothing wrong and said it was considering an appeal. The actions occurred prior to the firm’s purchase by Schwab.

During the investigation, the SEC found that employees of the CBOE didn’t know enough about the short-sale law to 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.

Adequate Training

Staff members didn’t have adequate 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.

“The Chicago Board Options Exchange failed to fulfill its fundamental responsibilities as an SRO and exchange,” according to the SEC order. “CBOE’s failures were not mere oversights or technical violations, but a systemic breakdown in several of its regulatory and compliance responsibilities.”

The first monetary penalty secured by the SEC against an exchange was announced on Sept. 14, when NYSE Euronext agreed to pay $5 million to settle charges of compliance failures that gave certain customers a head start on trading information.

Educating Venues

“It’s a significant event whenever the SEC fines an exchange,” said Neal Wolkoff, former CEO of the American Stock Exchange, in an interview. “This is intended to allay concerns the investing public may have that exchanges aren’t separating their SRO functions from their commercial interests.”

The CBOE penalty and accompanying details of the investigation provided an opportunity to “thoroughly educate” the exchanges about what is expected from them, said Huey-Burns.

That’s highlighted by a passage in which the SEC notes that exchange staffers tried to assist OptionsXpress by helping it write a so-called Wells submission, a formal reply to regulatory concerns raised by the agency. The edited document contained inaccurate and misleading information, the SEC wrote.

“There’s no question in my mind that by putting that in the complaint the SEC is sending a message to the exchanges that, you may have to accommodate your members, but we want your focus to be on your regulatory role,” said Huey-Burns, a partner at Shulman Rogers Gandal Pordy & Ecker PA in Potomac, Maryland.

Judith Burns, an SEC spokesperson, said commission staff members don’t comment on cases beyond published statements. The SEC noted in its order that the CBOE has acted to address the issues, including changing its regulatory, compliance and corporate governance structure.

Equity Trading

The spread of equity trading across dozens of private venues and advances in technology have spurred the SEC to a broader role in exchange oversight. In April, the agency passed a rule, Regulation Systems Compliance and Integrity, directing exchanges to strengthen their technology and instructing member firms to participate in tests to show they can sustain operations after a large disruption.

Daniel Hawke, head of the SEC’s market-abuse unit, said in a speech on Feb. 25, 2012, that the agency had begun a broad examination of practices that gained dominance in the past decade amid the shift to automation. The SEC is looking into techniques such as co-location, in which exchanges let traders place computers close to the market’s systems to shave time off executions, rebates venues pay users, direct market access where brokers let investors send orders to venues themselves, and whether the types of orders that exchanges offer are being misused.

SRO Duties

The levying of fines against exchanges reflects an increased level accountability, said Bruce Weber, dean of the Alfred Lerner College of Business and Economics at the University of Delaware.

“Exchanges really need to think through their compliance enforcement and make their SRO duties something that’s taken very seriously,” said Weber by telephone. “In recent years, new product development, marketing, customer relations, investor relations and new listings have been getting high priority. If anything, their SRO duties have slipped backwards in terms of management priority.”