STOCKGATE TODAY- Canada Responds with Enforcement An online newspaper reporting the issues of Securities Fraud
Regulation SHO; Canada Responds with Enforcement Trumping SEC once again - April 24, 2006
David Patch
How does it look when the Canadian Investment Dealers Association (IDA) has imposed the first regulatory action pertaining to Regulation SHO which is a US based law introduced by the SEC in January 2005?
On April 18, 2006 the IDA announced a $1 Million fine against Canadian Brokerage Union Securities and bared John P Thomson for failure to develop and implement compliance systems to the required standards of the IDA. While these violations may appear benign, the details are far from it.
According to the complaint the IDA Compliance staff identified a number of securities at Union Securities that were not properly located by Union Securities and consequently the firm was not able to deliver after a short sale was executed [naked short]. In certain stocks, the failures by Union Securities to document the "locate" were continuous. These trades were executed into the US Markets as short sales and violated the rules of locate pertaining to Regulation SHO which the complaint specifically addressed.
The complaint further detailing that during the Short Selling Period, Union Securities executed short sales for certain OTCBB companies without proper "locate" procedures being done. In each instance, Union Securities relied on the US market maker to perform the "locate" and relied on the US market maker to document the "locate.” By relying on the US market maker, Union Securities failed to properly perform and document the "locate.” In certain instances, Union Securities continued to short threshold securities with fails outstanding for a period of 13 or more consecutive settlement days without pre-borrowing. Union Securities was executing under a process called naked shorting.
In April 2004, the NASD introduced a rule change that required all US member firms to take on the responsibilities for locates on all non-member firms trading into the US markets. This Rule change (Rule 3370) was to directly address the failure of firms trading outside the US from failing trade deliveries on short sales. When regulation SHO was introduced in January 2005 the NASD rescinded Rule 3370 citing Regulation SHO as duplication of the rule.
So by the settlement enforced in Canada, the US member firms accepting the trades from Union Securities, illegal trades, were out of compliance with Regulation SHO. The market maker executing these trades without proper locates was doing so illegally. So where is the SEC action? How is it that the Canadians have identified and settled a case involving US firms as co-conspirators and yet the US regulators have done nothing?
According to media publications, including publications by the Depository Trust Clearing Corporation (DTCC), the SEC is on record claiming that Regulation SHO is a success. “There has been little or no evidence of extensive naked short selling to date.” That statement now must be put into context as clearly the SEC is not auditing to the same quality level as the Canadian IDA.
When I contacted SEC spokesman John Heine over the IDA’s allegations that US member firms were involved in the fraud perpetrated by Union Securities and why the SEC has not taken any similar actions, Mr. Heine only responded that the SEC had no comment on the matter. That was not surprising as the SEC never has any comments about when they are made fools of.
To understand the magnitude of the situation, let’s consider the securities violations that potentially transpired between Union Securities and US member firms.
Rule 203(b): Specifically, the rule “prohibits a broker-dealer from accepting a short sale order in any equity security from another person, or effecting a short sale order for the broker-dealer’s own account unless the broker-dealer has (1) borrowed the security, or entered into an arrangement to borrow the security, or (2) has reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due. The locate must be made and documented prior to effecting a short sale, regardless of whether the seller’s short position may be closed out by purchasing securities the same day.”
In the case closed by the IDA, US member firms were accepting trades in violation of Rule 203(b).
Rule 203(b)(3) “requires a participant of a clearing agency registered with the Commission to take action to close out the fail to deliver that has remained for thirteen consecutive settlement days by purchasing securities of like kind and quantity. In addition, Rule 203(b)(3)(iii) states that the participant, and any broker-dealer for which it clears transactions, including any market maker that would otherwise be entitled to rely on the bona-fide market making exception, is prohibited from effecting further short sales in the particular threshold security without borrowing, or entering into a bona-fide arrangement to borrow, the security until the fail to deliver position is closed out.”
In simple terms, the US member is responsible for taking necessary actions to close out this fail to deliver after a fail to deliver has exceeded 13 consecutive days on a threshold security. Until this action has taken place, the member firm and/or the executing broker-dealer (Union Securities) would be placed on restrictions from shorting the threshold security. The IDA complaint identifies that this did not in fact take place but that the US member firms continued to allow Union Securities to short threshold securities into failures.
Apparently none of the US member firms representing US clients affected a buy-in notice to Union Securities to close out the failed trades.
Ironically, the SEC trusted the “honor system” of the member firms compliance operations and took out proposed language in Regulation SHO that would have made it a requirement for the registered clearing agency that processed the transaction to refer the party failing to deliver to the NASD and the designated examining authority for such broker-dealer for appropriate action. Clearly this was a mistake.
The IDA complaint also identifies that the securities involved in the illegal short sales were issuers listed on the OTCBB quotation system. These are small, typically illiquid micro cap securities that the SEC has identified as easily manipulated. In the past, these have been the issuers that have been used to launder money for criminal elements and a place where SEC Commissioner Paul Atkins identifies that abusive “Bear Raids” take place.
Most OTCBB securities are non-hypothecatable (non-lendable) which is why US member firms will not accept short selling into these securities. This again raises the question as to how member firms could be accepting short sales into securities that are designated as hard to borrow.
With the enforcement action taken by the IDA US investors can only question what happened on this side of the border. Where was the breakdown? Who is responsible? But more specifically, what ever happened in those SEC audits they claim were taking place? How is it that the Canadian authorities can so quickly identify abuses and respond and yet the Securities and Exchange Commission, the top cops of all trading markets, can’t seem to pull the trigger?
I asked these and more question to SEC spokesman john Heine and received the typical arrogant answer – “No Comment”
Apparently the investing public has no right to challenge the SEC on yet another failure in responding to market fraud.
The questions to be considered are clear.
Did the SEC turn a blind eye on enforcement based on the Commission staffs clear prejudice against micro cap securities?
Has the SEC once again given the US member firms a free pass on securities violations relating to violations of Rules 15c3-3, 15c6-1 and Regulation SHO where member firms represent the buy-side of the market and show no interest in forcing delivery of purchased and fully paid for securities?
My disdain for members of the Commission staff is clear. They have failed to protect the investing public and thus deserve little by way of respect from us. Commissioner Annette Nazareth trimmed back Regulation SHO when acting as Director of Market Regulation in spite of the concerns identified by the investing public. Nazareth publicly belittled those voicing concern labeling the concerned as whiners. Nazareth has never stepped up and taken responsibility for her failures instead protecting them through denial.
Now, barely one year into the rule change, we are faced with the realities of our past concerns. Where does the SEC stand on the US market makers and broker-dealers that were the co-conspirators in this fraud? Without their participation, the illegal trades would never have been executed.
SEC Spokesman John Heine had no comment on any such actions being taken. It’s a secret!
The SEC can’t get the job done and instead of making hard fast rules that would be easy to enforce – Settle all Trades – the SEC created loopholes and a reliance on the ‘Honor System” of Wall Street. In this case the SEC was trumped by an outside authority [IDA] on fraud taking place on the SEC’s home turf and they appear content with that. Fraud that aided a Canadian seller and injured US investors is accepted by the SEC.
So yes John Heine, Annette Nazareth, Chairman Cox, and the rest of the SEC executive team, Regulation SHO is working – If you are the criminal conducting securities fraud. Be proud of that.
If the Commission is looking for positive spin, I suggest you pass your “SHO is a success” speech back on to Stuart Goldstein at the DTCC. I am sure Stu would put out another misleading press release to insure the investing public that all is well in the clearance and settlement of trades. After all, accuracy of information disseminated to the public does not apply to securities regulators. It is only fellow American’s you are misleading.
In closing remember these words:
“Naked short sellers enjoy greater leverage than if they were required to borrow securities and deliver within a reasonable time period, and they may use this additional leverage to engage in trading activities that deliberately depress the price of a security.” [Market Manipulation]
The source of this comment is none other than the SEC’s Division of Market Regulation under the proposed rule change to Regulation SHO.
For more on this issue please visit the Host site at www.investigatethesec.com .
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