SEC Division of Enforcement; The laws they won’t enforce – April 21, 2005
Lessons Learned. Each of us thrives to become better by learning from past mistakes. In the Corporate Boardrooms they call this “Lessons Learned”.
After the stock market crash of 1929 Congress created their rendition of lessons learned by creating what we now identify as the Securities Acts of 1933 and 1934. These are the guidelines that define the operations of our Securities Markets as handed down from Congress to the Securities and Exchange Commission. Rules are then promulgated out of the various Sections of the Securities acts themselves. These are a set of rules intended to be strictly enforced but rules the SEC has repeatedly become selective with. Such are the rules pertaining to Wall Street obligations to settle trades.
Rules 15c3-3 and Rules 15c6-1 are rules promulgated off the Securities Act of 1934 and are intended to address the needs for the prompt settlement of trades. During the market crash “Bear Raids” were executed whereby sellers would drive market valuations down on the sale of securities that were unavailable for settlement. The result of the “Bear Raids” was an intended fear instilled into investors who would in turn sell out of their holdings continuing to drive the security valuations even lower. This “raid strategy” created opportunity for those orchestrating the fraud to pick up shares cheap for large profitability and future settlement.
Rule 15c6-1 requires all executing broker/dealers to enter into a contract for trade with the intent of complying with a three-day normalized settlement window. Outside of unforeseen glitches (lost certificates, improperly tagged trades, etc…) all trades are expected to comply unless a pre-arranged written agreement for alternative settlement takes place. These alternate settlement terms are generally limited to bona-fide market making activities or arbitrage arrangements. The burden on settlement is not limited to sell-side only broker/dealers but instead insures intent on the buy-side to seek out settlement where settlement fails.
Rule 15c3-3 then places the requirements on the buy-side executing broker to seek prompt control and possession of traded securities that are fully paid for. This implies that when that buy-side executing broker debits your account of the cost, plus commission, for the trade executed they are then obligated to seek the prompt control and possession of the security paid for. Journal entry settlement [electronic IOU] of a delivery failure is not control or possession under the terms of securities law and thus, by journaling a share into your account the obligation is not satisfied.
With the spirit and understanding of these laws clearly drafted, why has the SEC not only failed to take enforcement actions on such violations but instead created laws that are in direct violation of these very “lessons learned”? The SEC, under compelling evidence of fraud in settlement has yet to take up any enforcement action against either of these two rules.
When Regulation SHO was approved in June of 2004 the SEC had in their possession undeniable data pertaining to large industry-wide settlement abuses. The SEC even referenced a report written by Economics Professor Leslie Boni, working for the SEC at the time, in which Professor Boni accuses the industry of strategically failing trades for financial gains at the risk of investor protection. Ironically, the SEC took this information they had obtained and elected to violate the securities laws when they created regulation SHO. They ignored the laws on the books and the data before them.
The time difference between June 23, 2004 and January 3, 2005 is slightly more than six months. June 23 was the release date for Regulation SHO and January 3 was the effective date in which the industry must initiate compliance. With a six-month window of opportunity to clean up any potential settlement failures [many representing Rule 15c6-1 and 15c3-3 violations] the SEC was not yet convinced that all could be effectively closed out in time. The problem was too pervasive. Therefore, the SEC “grandfathered” all pre-existing fails leading up to January 3, 2005 from compliance to the mandatory closeout provisions drafted into Regulation SHO. The SEC knew that Wall Street would not comply with settlement during this window of opportunity. The SEC, in a Q&A to investors on April 11, 2005 stated “The grandfathering provisions of Regulation SHO were adopted because the Commission was concerned about creating volatility where there were large pre-existing open positions.” Reality is, the SEC was protecting the fraud as they had no intent on taking enforcement for the violations.
Ironically, volatility was exactly why Rule 15c6-1 and 15c3-3 were created, Sell-Side volatility that instills fear and drives investors out in a “Bear Raid” trading strategy. Now the SEC is protecting those who benefited from this illegal act by grandfathering fails that are already in violation of pre-existing securities laws. Any fail that cannot be closed in a six-month window of opportunity is a fail that has no legal standing to exist. The SEC simply gave the fraud a free pass and they did so in violation of Congressional law.
This is not rocket science here folks; the SEC aided and abetted fraud that the SEC has in their possession the records to show exists. The SEC in failing to effectively enforce pre-existing securities laws now created new law to protect the criminals from future enforcements.
But to make sure that we all understood the importance to trade settlements, the Congress further emphasized the need for prompt settlement of trades in the draft of Section 17A of the Securities Act of 1934. This section mandates that the SEC create a national clearance and settlement system that will promptly and accurately settle trades for the protection of the markets and the investors. That national system is now owned by the NYSE and NASD and is called the Depository Trust Clearing Corporation (DTCC).
Section 17A argues that “The prompt and accurate clearance and settlement of securities transactions, including the transfer of record ownership and the safeguarding of securities and funds related thereto, are necessary for the protection of investors and persons facilitating transactions by and acting on behalf of investors”.
Why Congress imposed language that not only referenced the investor but the persons facilitating transactions [executing broker/dealers] is that to not settle the trades can create a financial burden that can bankrupt firms whose books contain significant fails. The volatility the SEC uses as an excuse for grandfathering in fraud is really upward volatility that the SEC fears would impair the functional operations of many smaller and possibly larger securities firms who for years have been rewarded for violating the laws of settlement.
The SEC intentionally allowed the violations of prompt settlements to protect the financial well being of the industry players who effectively robbed, stole, and cheated hundreds of millions of investors.
Recently the DTCC Chief Deputy General Counsel Larry Thompson, speaking on behalf of the DTCC, presented the evidence that illustrates the lack of intent of the DTCC to insure settlements of trade executions. Mr. Thompson admitted that the DTCC does not execute buy-ins, force trade settlements, or restrict abusive behavior by unscrupulous broker/dealers. Mr. Thompson claims the DTCC has no authority. If a share is made available for settlement they will use it but if not, they just record the fails as a natural event. The DTCC has logs of the duration of time a fail exists, has data that could be used to determine the abusive participants in settlement failures, but does little with the available data. So who then is responsible for trade settlement?
The national clearance and settlement system created for the protection of investors and the industry has become nothing more than a high cost operation of good old boys looking to insure the profitability of the members they support. The act of settling a trade has become less of an important factor in our securities markets in spite of what Congress identified as “lessons learned”.
So the key questions remain,
Why won’t the SEC enforce the pre-existing laws that are clearly written into the Securities Acts passed down from Congress?
Who does the SEC really protect when they allow fails to go uncontrolled?
Who becomes accountable within the SEC when the SEC passes a law that violates the rights of shareholders and violates the laws passed down by Congress?
Who ultimately has taken on the responsibility of insuring that trades are being settled as presented to investors when they enter the securities markets?
I keep asking myself how competent the SEC really is, and as hard as I try to be impartial, it becomes more and more difficult when I can read and understand these laws better than the attorneys retained to enforce them. Failing intent to settle trades is illegal.
SEC Enforcement Director Stephen Cutler should not be provided accolades for his “success” as he departs, Stephen Cutler should be admonished for his failure to instill a zero-tolerance stance on securities violations. Hundreds of millions of investors have suffered at the hands of regulatory negligence and it boils down to the SEC simply not knowing the laws.
For copies of these laws, please log on to http://www.law.uc.edu/CCL/xyz/sldtoc.html
For more on this issue please visit the Host site at www.investigatethesec.com .
ps. IMSO...all shorting must go.