[ by Howard Haykin ]

The SEC on Tuesday issued a scathing release detailing alleged regulatory failures by the Chicago Board Options Exchange (CBOE) and an affiliate, the C2 Options Exchange, along with the ensuing settlement involving significant monetary, personnel, procedural and systems changes. 

Simply stated, CBOE agreed to pay a $6 million penalty and implement major remedial measures.  The financial penalty is the first assessed against an exchange for violations related to its regulatory oversight.  Previous financial penalties against exchanges involved misconduct on the business side of their operations. 

Yet, an SEC investigation found that CBOE failed to adequately police and control this conflict for a member firm that later became the subject of an SEC enforcement action - the recent case in which the SEC sanctioned optionsXpress as well as 2 top level execs.  [To read C-I’s account, click on: SEC/optionsXpress Settlement.]  CBOE put the interests of the firm ahead of its regulatory obligations by failing to properly investigate the firm's compliance with Regulation SHO and then interfering with the SEC investigation of the firm.

Self-regulatory organizations (SROs) must enforce the federal securities laws as well as their own rules to regulate trading on their exchanges by their member firms. In doing so, they must sufficiently manage an inherent conflict that exists between self-regulatory obligations and the business interests of an SRO and its members.

According to the SEC's order instituting settled administrative proceedings, CBOE demonstrated an overall inability to enforce Reg. SHO with an ineffective surveillance program that failed to detect wrongdoing despite numerous red flags that its members were engaged in abusive short selling. CBOE also fell short in its regulatory and compliance responsibilities in several other areas during a 4-year period.

Respondents.    Chicago Board Options Exchange, Incorporated (“CBOE”) is a Delaware corporation with its principal place of business in Chicago, IL.  CBOE is registered with the Commission as a national securities exchange pursuant to Section 6 of the Exchange Act.  CBOE provides regulatory services to several other exchanges pursuant to Regulatory Services Agreements. CBOE is a wholly-owned subsidiary of CBOE Holdings, Inc., a publicly-traded company.  The Commission previously brought two actions against CBOE for failure to enforce its rules.

C2 Options Exchange, Incorporated (“C2”) is a Delaware corporation with its principal place of business in Chicago, IL. C2 is registered with the Commission as a national securities exchange pursuant to Section 6 of the Exchange Act. C2 is a wholly-owned subsidiary of CBOE Holdings, Inc.

SEC Findings and Allegations.   CBOE reportedly moved its surveillance and monitoring of Regulation SHO compliance from one department to another in 2008 - and, in the view of the SEC, the transfer of responsibilities adversely affected its Reg. SHO enforcement program.  After that transfer, CBOE allegedly did not take action against any firm for violations of Reg. SHO as a result of its surveillance or complaints from 3rd parties.

Yet, Reg. SHO requires the delivery of equity securities to a registered clearing agency when delivery is due, generally 3 days after the trade date (T+3).  If no delivery is made by that time, the firm must purchase or borrow the securities to close out that failure-to-deliver position by no later than the beginning of regular trading hours on the next day (T+4). 

However, the SEC charged the exchange with the following allegations:

• CBOE failed to adequately enforce Reg. SHO because its staff lacked a fundamental understanding of the rule.
• CBOE investigators responsible for Reg. SHO surveillance never received any formal training.
• CBOE never ensured that its investigators even read the rules.
• Therefore, they did not have a basic understanding of a failure to deliver.

CBOE reportedly received a complaint in February 2009 about possible short sale violations involving a customer account at a member firm.  CBOE began investigating whether the trading activity violated Rule 204T of Reg. SHO.  However, CBOE staff assigned to the case did not know how to determine if a fail existed and were confused about whether Reg. SHO applied to a retail customer. CBOE closed its Reg. SHO investigation later that year. 

Perhaps pertaining to that scenario, as well as others, the SEC charged CBOE with the the following alleged violations:

• CBOE allegedly fail to adequately detect violations and investigate and discipline one of its members, but it also took misguided and unprecedented steps to assist that same member firm when it became the subject of an SEC investigation in December 2009. 
• Further, CBOE failed to provide information to SEC staff when requested, and went so far as to assist the member firm by providing information for its Wells submission to the SEC. The CBOE actually edited the firm's draft submission, and some of the information and edits provided by CBOE were inaccurate and misleading.
• The SEC brought its enforcement action against the firm in April 2012, and an administrative law judge recently rendered an initial decision in that case.

The SEC notes that CBOE and affiliate, C2 Options Exchange, allegedly had other regulatory and compliance failures at various times between 2008 and 2012:

• CBOE failed to adequately enforce its firm quote and priority rules for certain orders and trades on its exchange as well as rules requiring the registration of persons associated with its proprietary trading members.
• CBOE provided unauthorized "customer accommodation" payments to some members and not others without applicable rules in place, resulting in unfair discrimination.
• CBOE and affiliate C2 Options Exchange failed to file proposed rule changes with the SEC when certain trading functions on their exchanges were implemented.

The SEC further finds the following alleged violations: 

• CBOE violated Section 19(b)(1) and Section 19(g)(1) of the Securities Exchange Act, and Section 17(a) and Rule 17a-1, by failing to promptly provide information requested by the SEC that the exchange kept in the course of its business, including information related to the member firm that was under SEC investigation for Reg. SHO violations.
• CBOE and C2 agreed to settle the charges without admitting or denying the SEC's findings. CBOE agreed to pay $6 million, accept a censure and cease-and-desist order, and implement significant undertakings. C2 also agreed to a censure and cease-and-desist order and significant undertakings.

Voluntary Remedial Efforts and Initiatives.   After the SEC began its investigation, CBOE and C2 responded by engaging in voluntary remedial efforts and initiatives.  In reaching the settlement, the SEC took into account these remediation efforts and initiatives.

• CBOE reorganized its Regulatory Services Division;
• CBOE hired a CCO (Chief Compliance Officer) and 2 deputy CROs (Chief Regulatory Officers);
• CBOE updated WSPs;
• CBOE increased the regulatory budget and the hiring of regulatory staff;
• CBOE implemented mandatory training for all staff and management;
• CBOE hired a 3rd-party consultant to review its Reg. SHO enforcement program;
• CBOE conducted a "bottom-up" review of its Regulatory Services Division's independence;
• CBOE began a "gap" analysis to determine whether CBOE or C2 needed to file any additional rules, and reviewed all of CBOE's regulatory surveillances and the exchange's enterprise risk management framework.

After the SEC expressed concern about an accommodation payment to a member, CBOE hired outside counsel to investigate and self-reported additional instances of financial accommodations to other members . After considering CBOE's remedial efforts, the SEC determined not to impose limitations upon the activities, functions or operations of CBOE pursuant to Section 19(h)(1) of the Exchange Act.

SEC Staff Credits.   Investigation by:  Market Abuse Unit members Paul Kim, Deborah Tarasevich, and Structured & New Products Unit member Jill Henderson;  assisted by market surveillance specialist Brian Shute, trading strategies specialist Ainsley Kerr.   Supervision by Market Abuse Unit Chief Daniel Hawke.

For further details, go to:   [ SEC PR 13-107, 6/11/13 ] and [ SEC '34Act Release 69726, 6/11/13 ].