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Harry Frischer

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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.

Section 546(e) of the bankruptcy code prohibits a bankruptcy trustee from avoiding “settlement payment[s]”, or payments “made in connection with a securities contract,” that are “made by or to (or for the benefit of)” qualifying financial entities, including financial institutions, stockbrokers, commodities brokers and others.   In a ruling that conflicts with precedent from the Second, Third, Sixth, Eighth, and Tenth Circuits, a decision last week by a Seventh Circuit panel held that the safe harbor provision of section 546(e) does not preclude a trustee from recovering a transfer to a party that was not a qualifying financial entity, where a qualifying financial institution was merely the conduit for the transaction.  See FTI Consulting v. Merit Management Group, LP.

Will a broker-dealer be liable when a financial advisor employed by the firm solicits investments as part of a fraudulent scheme, where the firm specifically prohibited the advisor from soliciting the investment, the fraudulent investment was made away from the firm, and the investors never became customers of the firm?  The Eleventh Circuit recently answered that question with a resounding “maybe,” and clarified that the employer could be liable in negligence if it knew or should have known that its employee posed a risk of defrauding others.

The U.S. Supreme Court’s decision yesterday in Merrill Lynch v. Manning clarified the scope of federal jurisdiction under the Exchange Act in certain important respects, but also left open critical issues that may arise in future cases.  Although the Court rejected federal jurisdiction in resolving the sole issue that was before it, the Court also stated that federal courts might well have jurisdiction over state law claims that “necessarily raise” substantial issues under federal law.

The decision, however, provides little guidance as to how that standard may be applied. Future cases involving securities trading, and the extensive body of federal regulation governing that activity, may well require future courts to determine that issue.

Last week, FINRA sought approval from the SEC for a proposed change to the FINRA arbitration rules, under which monetary awards requiring the parties to pay each other damages would be offset, so the party owing the larger award would be required to pay only the net difference.  If the arbitrators do not intend monetary awards to be offset, they must specifically say so in the award.

In Jinnaras v. Alfant, decided on May 5, 2016, the New York Court of Appeals rejected a proposed settlement of a shareholder class action, where the proposed settlement would have deprived out-of-state class members of a “cognizable property interest” by failing to provide a mechanism for class members residing outside of New York to opt out of the settlement.

The Delaware Supreme Court ruled yesterday that out-of-state corporations no longer would be subject to general personal jurisdiction in Delaware merely because they had registered to do business in Delaware. In making that ruling, the Court overruled prior state precedent, under which foreign corporations were deemed to have consented to jurisdiction in Delaware when they registered to do business within the state.

In an April 15, 2016 speech to the Brookings Institution, FINRA CEO Richard G. Ketchum addressed the fundamental question of whether the equity markets are sufficiently fair, flexible, and efficient to encourage the participation of retail investors.   Ketchum described the substantial concerns of some investors regarding these issues and outlined recent action by FINRA to alleviate these concerns, including the steps FINRA will take to assess a firm’s culture of compliance.

As we reported here, in its 2016 Regulatory and Examination Priorities Letter, FINRA recently announced a new initiative to formalize FINRA’s assessments of firm culture.  The need to review broker-dealers’ cultural values with respect to compliance arose in the wake of repeated compliance breakdowns that have harmed investors.  Ketchum’s speech to the Brookings Institution provides additional insight into these examinations.