By Amanda Maine, J.D.
By a unanimous vote, the Securities and Exchange Commission imposed penalties, disgorgement, and a cease and desist order on a broker-dealer for its role in a complex short-selling scheme. However, the commissioners disagreed with the initial decision of the administrative law judge regarding alleged violations by a retail customer of the broker-dealer, finding that the Enforcement Division had not presented sufficient evidence that the customer had committed securities fraud. The Commission also again rejected constitutional challenges to its in-house administrative court system (In the Matter of optionsXpress, Inc., Release No. 33-10125, August 18, 2016).
Regulation SHO and fraud charges. In April 2012, the SEC charged optionsXpress, Inc., an online brokerage and clearing agency, with violating Rules 204 and 204T under Regulation SHO. The SEC had alleged that optionsXpress failed to satisfy its close-out obligations by engaging in a series of sham transactions designed to give the appearance of having purchased shares to close out an open failure-to-deliver position without actually doing so. The firm allegedly relied on buy-writes (paired stock and options transactions) to address its fail to deliver positions, and the buy-writes did not timely close out optionsXpress’s fails.
An optionsXpress customer, Jonathan I. Feldman, was also charged with fraud for executing 390 buy-writes while knowing that he had no intention of fulfilling his obligations under the options contracts, according to the SEC. An administrative law judge agreed with the Enforcement Division’s allegations and imposed penalties, disgorgement, and cease-and-desist orders on both respondents. The respondents petitioned the Commission for review of the ALJ’s initial decision.
optionsXpress. The Commission agreed with the ALJ that optionsXpress’s reliance on the buy-writes to satisfy its delivery and close-out obligations under Regulation SHO was improper. The firm argued that the Division could not present evidence of harm to any specific investors by its conduct, but the Commission pointed out that persistent fails to deliver undermine market integrity, even without identifying a particular individual or entity harmed.
The Commission noted that while it is not by itself unlawful for a broker-dealer to have a fail to deliver, the broker-dealer is required to close out its fail to deliver position by borrowing or purchasing securities of like kind and quantity. Shares of the securities at issue were not being delivered in sufficient quantities to close out optionsXpress’s failures to deliver, the Commission advised. By relying on its customers’ buy-write transactions, optionsXpress perpetuated and maintained its original fail position. The Commission also cited pre-Rule 204 guidance on fails and close-outs, settled enforcement actions, and guidance accompanying the adoption of Rules 204 and 204T in support of the argument that participants cannot employ combined purchase-and-sale transactions to circumvent those rules.
The Commission also upheld the ALJ’s sanctions on optionsXpress. A cease-and-desist order was proper due to the repeated and serious nature of the violations, the risk that the firm could commit future violations, and its failure to accept responsibility for its conduct. Disgorgement in the amount of $1.5 million was reasonable as the approximate commissions earned by optionsXpress in executing the buy-writes. Finally, third-tier civil penalties were appropriate due to optionsXpress’s “deliberate and reckless disregard of regulatory obligations over a prolonged period.” Finding that optionsXpress violated Rules 204 and 204T approximately 1,200 times, the Commission imposed a civil monetary penalty of $2 million.
Feldman. The commissioners disagreed with the ALJ’s findings holding Feldman liable for fraud. The Division’s contract-based fraud theory was that Feldman sold call options with no intention of fulfilling the resultant delivery obligations when the options were exercised. The Commission pointed out, however, that Feldman did not have any obligation to do so. Broker-dealers like optionsXpress have the obligation and ability to deliver shares, not retail customers like Feldman. There was also no evidence that Feldman secretly intended not to deliver the shares, and in fact was very open about his trading strategy.
The Division also alleged that Feldman’s repeated use of buy-writes deceived market participants about the timely delivery of their shares, effectively amounting to market manipulation. The Commission disagreed, finding fault with the Division’s evidence of scienter, which was primarily Feldman’s statements that he did not want to settle his position. This argument, according to the Commission, “conflates the concept of ‘delivery’ applicable to broker-dealers and that applicable to customers.” The Commission also pointed out that Feldman’s profits were not affected by whether optionsXpress actually delivered the shares. In addition, the Commission noted that Feldman was given assurances from optionsXpress that his use of buy-writes was not inappropriate under SEC regulations.
Constitutional arguments. Finally, the Commission rejected the respondents’ arguments that its ALJ regime is unconstitutional, which is a position it has taken in the recent past (see, e.g., Raymond J. Lucia, John J. Aesoph), as well as a position bolstered by a recent D.C. Circuit opinion. The respondents challenged the appointments of the SEC’s ALJs as unconstitutional under the Appointments Clause, arguing that they are “inferior officers” like the special trial judges of the Tax Court in Freytag v. Commissioner. The Commission reiterated its opinion that SEC ALJs have fewer powers than special trial judges, and instead are employees similar to the FDIC’s ALJ’s under Landry v. FDIC.
The Commission also disagreed with the respondents’ contention that dual for-cause removal restrictions on its ALJs are unconstitutional under Free Enterprise Fund v. PCAOB. The Commission pointed out that Free Enterprise specifically did not address ALJs. It also observed that the nature of the duties of ALJs is dramatically different from the PCAOB in that ALJs perform adjudicative rather than enforcement or policymaking functions. In addition, ALJs have less independence than the PCAOB, the Commission stated; ALJs merely take the cases assigned to them rather than possessing the independence of the PCAOB, which determines its own priorities and can interfere in the affairs of regulated firms without Commission preapproval. Finally, the Commission noted that the ALJ system, unlike the PCAOB, is not novel and has worked effectively for over 70 years.
The release is No. 33-10125.