SEC Risk Alert: Options Trading That Evades Short-Sale Rule Requirements

risk managementShort sale activity continues to be a significant focus of the SEC, particularly when it involves short sales without delivery, or “failures to deliver.”

The SEC’s Office of Compliance Inspections and Examinations (OCIE) has now  issued a new Risk Alert raised by its examination staff’s observation that some options trading strategies are being used to evade the short-sale rule, Rule 10b-21.  The alert addresses the need for customers, broker-dealers and clearing firms to be aware of options trading activity that could be used to avoid complying with the close-out requirements of Reg SHO.

Under the rule,  it is fraudulent to sell an equity security if it deceives a person participating in the transaction about the seller’s  intention or ability to deliver the security by settlement date.  Rule 10b-21 covers such situations where a seller deceives a broker-dealer, participant of a registered clearing agency, or a purchaser about its intention to deliver securities by settlement date, and the seller then fails to deliver securities by settlement date.  The violative activity would include broker-dealers (including market makers) acting for their own accounts.  Broker-dealers could also be held liable for aiding and abetting a customer’s fraud under Rule 10b-21.

In addition to addressing, with examples, trading strategies that could be used to circumvent Reg SHO requirements, and other helpful ways that OCIE has observed that some firms have used to effectively detect and prevent violation of the rule, the alert provides summary guidance covering (a) Reg SHO Close-out Requirement; (b) Reg SHO Locate Requirement; (c) Rule 10b-21; (d) Key Trading Terms and Concepts; and (d) Option Activity Related to Hard to Borrow and/or Threshold Securities.

Author: Dexter Johnson

The author is a an attorney who for the past 14 years has concentrated his practice in representing, successfully, investment advisers, broker-dealers, corporations and individuals who are subject to SEC, FINRA, State or other regulations and who may be the subject of regulatory examination, review or investigation. He formerly worked at the SEC. His regulatory and litigation experience has encompassed virtually every type of securities issue in the industry. He has also negotiated favorable outcomes in many of these matters for his clients.