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.