In a rare reversal of its own administrative law judge in the Matter of optionsXpress, the full Securities and Exchange Commission unanimously held that the SEC’s Enforcement Division had not met its burden of proof that the customer of a broker-dealer had committed securities fraud in connection with his clearing broker-dealer’s failure to deliver stock as required by Regulation SHO.

The customer in this case implemented an option trading strategy which exploited the price difference between certain options and their underlying securities.  The trading strategy focused on “hard to borrow” securities, which were more expensive to borrow due to high short-seller demand.  As a result of the trading strategy, the customer held substantial short positions in the underlying hard to borrow securities over a sustained period of time.

Under Regulation SHO, a broker-dealer is required to deliver securities to its clearing house in connection with a sale within three days of settlement.  If it does not do so, it must close out the fail to deliver on the next settlement day by purchasing or borrowing similar securities in the market. Here, the broker-dealer repeatedly failed to deliver the securities in which the customer held short positions.

In an attempt to cure these failures to deliver, the broker-dealer repeatedly issued “buy-in” notices to the customer, directing him to cover the short positions in his account. In response to these notices, the customer’s strategy was to place orders for the underlying stock while simultaneously writing deep-in-the-money calls for an equivalent number of shares in that stock, known as “buy-writes.”  At the end of each trading day, the execution of these two transactions resulted in no securities being available for the broker-dealer to deliver to its clearing house, prohibiting it from curing its fail to deliver positions. A new buy-in would be issued to the customer the following day, and the customer would again respond to the notice by executing more buy-writes, and the broker-dealer was again unable to cure the failures to deliver.  In one instance, the broker-dealer held a fail to deliver position in one particular security for 238 consecutive settlement days.

In 2013, the ALJ found that the broker-dealer had violated Regulation SHO, and that the customer had violated certain antifraud provisions of the securities laws. In particular, the ALJ determined that the customer committed fraud and market manipulation by knowingly failing to make delivery of the underlying securities as required, and by using buy-writes to deceive market participants about the timely delivery of shares.  While the Commission largely upheld the ALJ’s findings against the broker-dealer, they found the record insufficient to support the ALJ’s findings that the customer failed to fulfill his own delivery obligations or that he otherwise engaged in actionable conduct.

Although a clearing broker-dealer has an obligation to deliver securities to its clearing house under Regulation SHO, the Commission held no such regulatory obligation exists for a customer. Any obligation that a customer may have to deliver securities arises only from contractual arrangements between a customer and its broker, or through representations made by the customer in respect of its trades. The Commission further found that broker-dealers could not transfer their regulatory responsibilities to a customer by relying on the customer’s buy-writes to fulfill their Regulation SHO delivery obligations.

The Commission also found that the customer had not misled the broker-dealer and was “notably transparent” about his strategy of continuously using buy-writes to cover buy-in notices.  Likewise, the Commission held that there was insufficient evidence to find that the customer acted with scienter to deceive or defraud.  The customer was never advised by any broker-dealer that his trades were causing violations of Regulation SHO or that investors were not receiving their shares. Accordingly, there was insufficient evidence to conclude that the customer was aware that his repeated use of buy-writes had a manipulative impact on the market or that the customer was familiar with the intricacies of Regulation SHO.

The Commission’s unanimous rejection of its own ALJ’s ruling and the position of SEC enforcement staff, although perhaps based on facts that may be unique to this case, demonstrates and that the Commission can be active, engaged and open-minded where the circumstances warrant.