FINRA Fines Broker-Dealer $5.5 Million For Violations Of Regulation SHO
On August 20, 2018, the Financial Industry Regulatory Authority (“FINRA”) announced that it fined a FINRA-regulated broker-dealer $5.5 million over allegations that it violated Regulation SHO under the Securities Exchange Act of 1934, see 17 CFR 242.200-204, by, among other things, failing to properly close out short sale positions when securities were not timely delivered, accepting short sales in restricted securities and at restricted prices, and maintaining a deficient supervisory system. Press Release, FINRA Fines Interactive Brokers $5.5 Million for Regulation SHO Violations and Supervisory Failures (Aug. 20, 2018); FINRA AWC No. 2014043143401 (Aug. 16, 2018).
Regulation SHO came into effect on January 3, 2005, and was designed to address concerns regarding so-called “short sales” of securities. Under Regulation SHO, a broker-dealer cannot affect a short sale unless it has reasonable grounds to believe that a security can be borrowed and delivered on the date that delivery is due. See 17 CFR § 242.203. In the event that a borrowed security is not delivered when delivery is due (a “failure-to-deliver” or “FTD”), a broker-dealer must close out the FTD by purchasing or borrowing securities of like kind by the beginning of regular trading hours on the next day. If the FTD position is not closed out, the broker-dealer cannot affect any further short sales without entering into an agreement to borrow that security. 17 CFR § 242.204. Additionally, broker-dealers must maintain supervisory systems that ensure compliance with the above regulations and are reasonably designed to prevent executing or displaying short sales in any security that has experienced at least a ten percent drop in price in a single day, except at prices above the current national best bid. 17 CFR § 242.201.
According to FINRA, from July 2012 through June 2015, the broker-dealer in question violated Regulation SHO and other related rules and regulations by failing to properly close out FTD positions on at least 2,329 occasions, and by routinely engaging in short sales in securities in which it had open FTDs without first arranging to borrow those securities. The broker-dealer’s systems allegedly permitted this conduct in part because they did not continue to restrict short sales until close-out transactions were ultimately cleared and settled, and because they registered credits for invalid close-out actions, such as borrows that were never delivered. Further, FINRA contended that the automated systems permitted the display of short sale orders at improperly low prices for securities that experienced at least ten percent drops in prices on single trading days.
FINRA found that the broker-dealer’s personnel had noted that the firm’s systems had been unreliable since at least 2011, when employees reported that the systems took credit for borrowing arrangements regardless of whether they were ultimately completed, and did not monitor whether shares were actually delivered. On multiple occasions between 2011 and 2014, the broker-dealer’s Director of Compliance Technology reported that the firm had no supervision for ensuring that short sales were not displayed at restricted prices, and that the firm’s automated system did not detect actual close-out problems or certain continuing FTDs. Indeed, the firm conducted analyses each year from 2012 to 2015 that identified gaps between the firm’s systems and the requirements of Regulation SHO, but FINRA contended that the firm nevertheless did not revise its systems until mid-2015.
In imposing a high fine, FINRA noted that it considered the lengthy period of the broker-dealer’s alleged misconduct and its failure to address red flags raised by its own personnel. Indeed, the Executive Vice President of FINRA’s Department of Enforcement, Susan Schroeder, commented that the broker-dealer “internally identified the problems, yet did not revise its supervisory systems for more than three years, creating the potential for negative impact to the markets and investor harm.” FINRA also appears to have been influenced by the firm’s disciplinary history with FINRA, which apparently included five separate instances of similar violations of Regulation SHO related to short sales generally, including failing to close out failure-to-deliver positions and maintain adequate supervisory systems.