Naked Short Selling Case Ensnares Ex-OptionsXpress CFO, Customer

The Securities and Exchange Commission Monday charged the former chief financial officer of optionsXpress and three other officials of the online options and futures brokerage of engaging in “an abusive naked short selling scheme’’ involving billions of dollars of sham trades.

Charged in the case were one-time CFO Thomas E. Stern of Chicago as well as head of trading and customer service Peter J. Bottini and compliance officers Phillip J. Hoeh and Kevin E. Strine.

Also charged in the case was customer Jonathan I. Feldman. In the SEC's order against Stern, Feldman and optionsXpress, the SEC cited violations of Regulation SHO, which prohibits naked short selling.

OptionsXpress and Feldman engaged in “reset transactions” that gave the illusion that the brokerage had purchased the securities that it needed to deliver in the trades involved, but which the federal regulator said it had not.

Attempts to locate Stern and Feldman or their lawyers were not successful.

Bottini, Hoeh and Strine settled the charges against them, in a separate administrative proceeding with the SEC.

OptionsXpress engaged in “continuous failures to deliver,’’ during a period that lasted from October 2008 to March 2010, according to the SEC.

That pre-dated the acquisition of optionsXpress by The Charles Schwab Corporation by roughly a year and a half. Charles Schwab completed its $1.0 billion acquisition of the options and futures brokerage in September 2011.

"We believe the evidence at trial will demonstrate that, 1, optionsXpress covered all assignments consistent with Reg SHO; 2, there was no downward pressure on prices; 3, no one was defrauded; and, 4, the trades were not shams,’’ said Stephen Senderowitz, a partner at the Chicago law firm of Winston & Strawn, on behalf of optionsXpress, now a Schwab subsidiary

All the traded were arm’s length market transactions. “They had economic risk, they had economic purposes. They were not novel or exotic,’’ Senderowitz said.

The SEC’s Enforcement Division alleged that the sham transactions impacted the market for issuers of securities.

For instance, the regulator said, optionsXpress customers including Feldman accounted for an average of 47.9 percent of the daily trading volume in one security, from Jan. 1, 2010 to Jan. 31, 2010.

In 2009, optionsXpress customer accounts engaging in the activity purchased approximately $5.7 billion worth of securities and sold short approximately $4 billion of options.

Feldman in that year purchased at least $2.9 billion of securities and sold short at least $1.7 billion of options through his account at optionsXpress.

Failure to deliver securities when due is a violation of Regulation SHO. Regulation SHO requires the delivery of equity securities to a registered clearing agency when delivery is due, generally three days after the trade date

"Feldman and optionsXpress used sham reset transactions to avoid, sometimes for months, compliance with Reg. SHO's stock delivery requirements," said Robert Khuzami, Director of the SEC's Division of Enforcement. "In effect, they 'kited' shares of stock, thus depriving buyers of the benefit of their bargain - prompt delivery of their shares."

In a short sale, a seller makes a trade at a given price on the expectation that it can buy the shares on the open market at a lower price, before delivering the shares to the buyer at the agreed-upon price.

In a “reset” transaction, parties may appear to comply with their obligations to purchase a security when in fact they have not.

According to the SEC’s order involving Stern and Feldman, the customers involved simultaneously entered into the sale of a put and purchase of call with identical strike prices and expiration dates creating a “synthetic” long position.

The customers would also create a short position to hedge that long position. They generally did this by selling calls that were deeply “in the money.”

If, for instance, the current price of a stock is $10, a call option with a strike price of $5 would be considered deep in the money.

According to the SEC order, however, neither optionsXpress nor the customers delivered the shares within three days of the trades involved, creating a failure-to-deliver position.

Such a pairing can be considered a sham transaction, according to the SEC.

The ‘kiting’ occurs when a firm fails to deliver securities in a timely fashion.

According to the SEC, optionsXpress violated Rules 204 and 204T of Regulation SHO; Feldman willfully violated Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934 and Rules 10b-5 and 10b-21; optionsXpress and Stern caused and willfully aided and abetted Feldman’s violations of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rules 10b-5 and 10b-21 thereunder; and Stern “caused and willfully aided and abetted” optionsXpress’s violations of Rules 204 and 204T.

The SEC is pursuing public administrative and cease-and-desist proceedings against Stern, Feldman and optionsXpress. What kind of penalties might be involved remains to be determined, according to a reading of the SEC order against the three parties.

In settling, Bottini, Hoeh, and Strine neither admitted nor denied the SEC’s findings. Bottini, Hoeh, and Strine agreed, however, to “cooperate fully with the Commission in any and all investigations, litigations or other proceedings’’ coming out of the case.

"This is a situation in which there was no client harm, no client losses and no wrong-doing,'' said Sarah Bulgatz, director of Corporate Public Relations for Schwab. "optionsXpress cleared and covered its customers' short positions as it was required to do, and Reg SHO was never violated. Having consulted with numerous experts, consultants and law firms, we respectfully disagree with the SEC's interpretation."

Schwab has cooperated with the investigation and "looks forward to its being resolved,'' Bulgatz said.

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