While insider trading typically garners all the headlines, the Commission has also brought a series of cases focused on another type of trading which also can have pernicious market effects – naked short selling. Recently, the Commission has brought a number of actions centered on claimed violations of Reg. SHO, which deals which short selling
Reg. SHO does not ban short selling. Rather, the regulation was adopted to curb short selling which can have a negative market impact. In adopting Reg. SHO the Commission concluded that naked short selling can have a negative impact on the market, particularly where there are persistent failures to deliver the security not just within the usual three day settlement period but for an extended period. In some instances the amount of “fails to deliver” may be greater than the total public float for the security. This can adversely impact the rights of the buyer of a security, according to the Commission.
To avoid this result Reg. SHO has a “locate requirement” which specifies generally that that market participants seeking to effect a short sale borrow, arrange to borrow, or at least have reasonable grounds to believe that a security can be borrowed within the delivery time. There is a market maker exemption. A second facet of the rule has a “close out” provision which generally requires that a clearing broker who has a failure to deliver for thirteen consecutive days close the position by purchasing the securities in a bona fide transaction.
The action brought against Jeffery Wolfson, his brother Robert, and the firm where they were employed, Anchor Trading II, LLC, alleges repeated violations of both of these provisions of Reg. SHO. In the Matter of Jeffrey A. Wolfson, Adm. Proc. File No. 3-14726 (Jan. 31, 2012). According to the Order, over a one year period beginning in July 2006, the Respondents earned at least $17,375,000 in illicit trading profits in violation of Reg. SHO and specifically Rules 203(b)(1) and 203(b)(3). The profits were made by employing three key schemes to evade the requirements of the Regulation:
Reverse conversions: This transaction ties a short stock sale to a synthetic long position with the same trader and hedges the short position. The synthetic long is created by selling a put option and buying a call option with the same expiration date and strike price. In executing this type of transaction, typically for hard to borrow threshold securities, the Respondents did not comply with the locate or close out requirements. The transaction did however permit them to attract business from prime brokerage firms seeking to create inventory for stock loans on hard to borrow securities.
Reset transactions: In this type of a transaction Respondents appeared to comply with their obligation to purchase the security sold short but in reality did not. Here the security was actually purchased while simultaneously buying from the same counterparty a short term, deep in the money put option (or the reverse). In reality the pairing of the transactions was simply a mechanism to borrow the stock for a day. Stated differently, it was a sham transaction, according to the Order.
Assist transactions: This is essentially the opposite side of the reset transaction. Here Respondents would assist their reset transactions as well as those of others.
This is not the first Commission case in which traders have utilized these types of tactics to try and circumvent the requirements of Reg. SHO (here). It may however be one of the largest.