Wednesday, January 20, 2016
Author: David Schwartz J.D. CPA
On January 14, 2016, the SEC announced that a large U.S. broker dealer had agreed to settle charges that its securities lending practices violated federal securities regulations. According to the SEC’s order, the dealer violated Regulation SHO by providing "locates" to customers without an adequate review as to whether the securities could be borrowed reasonably at settlement. As a result, some customer short sales may have been executed improperly.
Investors wishing to engage in short sales often engage broker-dealers to locate stock for short selling. When a broker-dealer grants a “locate,” it represents that it has borrowed, arranged to borrow, or reasonably believes it could borrow the security to settle the short sale. The SEC found that the dealer granted locates in instances when it had not performed an adequate contemporaneous review of the securities to be located. According to the SEC, the dealer's employees "routinely processed customer locate requests by relying on a function of the order management system known as 'fill from autolocate,' which was accessed via the 'F3' key. This function enabled employees to cause the system to grant locate requests based on the amount of reliable start-of-day inventory," as reported by lending agent banks, even when the system had already allocated those securities to other customers earlier in the day.
In this situation, the dealer's employees may have placed too much reliance on their automated system. The SEC’s order found that when employees used the "F3" autoloate function to approve requests to borrow, they relied on their general belief that the automated model was conservative and that the approval of additional requests would not result in failures to deliver when the short sales became due for settlement. By placing so much faith in their computer controls, the employees did not think it was necessary to check alternative sources of inventory or perform additional review of the securities to be located.
 The SEC’s order finds that the dealer violated Rule 203(b)(1) of Regulation SHO and Section 17(a) of the Securities Exchange Act. Without admitting or denying the findings, the firm consented to the order and agreed to pay the $15 million penalty. The order censures and requires the firm to cease and desist from committing or causing any violations and any future violations of Rule 203(b)(1) of Regulation SHO and Section 17(a) of the Exchange Act relating to short sale locate records.