JP Morgan Securities LLC agreed to pay a fine of US $350,000 to the Financial Industry Regulatory Authority as a result of multiple violations of Securities and Exchange Commission Regulation SHO, principally between October 19, 2011, and January 27, 2012, caused by alleged “systems issues.” According to FINRA, the firm’s problem derived from a coding error in a change to the firm’s automatic market tool it used to assist traders make two-sided markets in securities. The coding error, said FINRA, caused the firm to execute over 21,200 short sales during the relevant time period without a “locate.” (Under Reg SHO, a broker-dealer accepting a short sale of an equity security from a customer (or engaging in a short sale in its own proprietary account) must first borrow the security, enter into a bona fide arrangement to borrow the security, or have reasonable grounds to believe the security can be borrowed before the delivery date, thus satisfying its so-called “locate requirement.”) After the problem was detected, JP Morgan “immediately” suspended use of the automated tool and a few months afterwards self-reported the problem to FINRA, acknowledged the regulator. FINRA said that US $250,000 of JP Morgan’s fine was attributable to “supervisory violations,” namely the failure of the firm’s supervisory procedures to “provide for a statement of supervisory step(s) to be taken by the person(s) responsible for supervision with respect to [the relevant provision of Reg SHO].” FINRA claimed the firm’s sanctions “significantly take into consideration the firm’s self-reporting … and the remedial measures taken by the firm … ”
My View: Implicit in the odd wording used by FINRA to describe JP Morgan’s supervisory violation is that the firm had a procedure to oversee compliance with Reg SHO. It appears, however, the procedure may not have itemized the specific steps to be taken by supervisors in carrying out their supervision. Retrospectively, many procedure manuals are not likely to provide for every step necessary to preclude a potential violation. First, drafters of procedures manuals are likely not sufficiently clairvoyant enough to consider all potential breakdowns. And second, a procedures manual that is too comprehensive and detailed will likely be unread. Indeed, FINRA seems to recognize this as it explicitly requires members solely to have written compliance policies and written supervisory procedures reasonably designed to achieve compliance with applicable FINRA rules (click here to access FINRA Rule 3130) – not perfectly designed! Too often regulators charge failure to supervise as an adjunct to other charged substantive violations. However, not every problem is a result of improper supervision. Sometimes mistakes just happen because humans are flawed. If there is any doubt about this, click here to access the article “Court Chastises SEC for Causing Unwarranted Collapse of Foreign Bank” elsewhere in this edition of Bridging the Week.