Expects SEC Fine Over Regulatory Failings Related to this Case.

[ by Howard Haykin ]

An SEC Judge on Friday ruled that optionsXpress, its former CFO, and a customer had violated Regulation SHO from late 2008 to March 2010, in the naking short selling of options on 25 companies, including AIG, Sears, and Under Armour.   When it brought the charges against the broker and its customer more than a year ago, the SEC said 3 other optionsXpress officials had settled in separate administrative proceedings without admitting or denying its findings.

SEC Chief Administrative Law Judge, who presided over the case, announced sanctions against the defendants, including:  $8.3 million in combined fines and disgorgements, prejudgment interest, and a ban from the industry.

Profile of Defendants.   optionsXpress is the broker-dealer subsidiary of optionsXpress Holdings, Inc. a public parent company that was acquired by The Charles Schwab Corporation on 9/1/11.  Formed in late 2000, optionsXpress began taking customers in early 2001, and has been a self-directed, self-clearing options broker for retail customers since September 2006. Tje firm is not a market maker and does not trade in its own account.  optionsXpress is one of the largest options brokerage firms - unsworn estimates are that it had approximately 250,000 customers in 2008 and 320,000 customers in 2010.  optionsXpress’s policy is not to provide retail customers with investment advice.

Thomas Edward Stern joined optionsXpress in 2000-2001, and was the CFO, FinOp, primary regulatory liaison beginning in 2009, and member of the board of directors of optionsXpress from 2007 through mid-2009.  He has been active in the options industry for a very long time - he was a CBOE member in 1973, worked as a floor trader for about 17 years.  At optionsXpress, Stern reported to the CEO.  Stern was an Options Clearing Corporation (OCC) Board member from September 2009 until optionsXpress terminated his employment on 1/11/12.  Stern disputes the statement on his Form U-5 that he failed to assure that the information submitted to a regulator was accurate and that he violated the employee code of conduct.

Stern testified he was never in operations, and while he became optionsXpress’s primary regulatory liaison when the firm's Chief Compliance Officer (CCO) left in 2009, he was not responsible for compliance with Reg. SHO.  Stern describes his position as similar to a baseball utility infielder in that he was called on for an opinion, but had no responsibilities. Stern monitored optionsXpress’s liquidity status and,on a daily basis, monitored the sites where it had settlements – futures, CBOE, money markets, and the Nat'l Securities Clearing Corp. (NSCC) – to make sure sufficient cash was on hand.

Jonathan I. Feldman, 56, was a customer of optionsXpress.  At the time, he was an SVP at Eastern Savings Bank in Maryland - having worked there from 1993 until he resigned in late April 2012.  Currently, he's self-employed.  Feldman was a self-directed customer of optionsXpress from 12/12/08 through 4/1/10.  He initiated trade strategies and placed his own orders. In fact, Feldman was one of optionsXpress’s biggest retail clients, and he entered sales orders every day.  One expert considered Feldman to be a professional in the sense that he was a sophisticated, highly educated trader.

Arguments. 

The SEC argues that optionsXpress violated Reg. SHO Rule 204 by failing to deliver securities by market open on T+4.   

According to the Division, CNS records demonstrate that optionsXpress had failures to deliver for at least 25 securities for significant periods of time between October 2008 and March 2010, and these failures to deliver “dwarfed”  other  firms’ failures  to  deliver.   

• The buy-write transactions executed by optionsXpress, which consisted of purchasing securities on the close-out date and simultaneously selling deep-in-the-money calls, did not satisfy its delivery obligation. 
• There was no economic purpose for the buy-write transactions;
• The customer’s economic purpose was to make a profit by extending its short position without delivering shares and optionsXpress knew that these rolling fails to deliver meant that shares were not being delivered to CNS.

• Even if the Court accepts optionsXpress’s argument that the buy-write transactions satisfied optionsXpress’s delivery obligation, optionsXpress still violated Reg. SHO by failing to close out its failure to deliver positions at market open. 
• For the 1,205 buy-writes executed before 8/20/09, a time when optionsXpress only required its customers to be bought in on T+4, 97% of the buy-writes were executed after 10:00 a.m. ET. 
• The Division contends that optionsXpress knew that Rule 204 required the transactions to be entered into at market open and knew that this was not being done.
• Feldman's offer and sale of options contracts with no intention of delivering securities when assigned was fraudulent and manipulative conduct because market participants were deceived about the volume of trading in the securities at issue and about whether they would receive their shares in a timely fashion. 
• Feldman’s use of buy-writes allowed him to avoid delivery and Feldman knew that his trades were not settling and were deceiving market participants.
• There was contemporaneous communications by Feldman to brokers and his friends as evidence that he understood the call options he sold would be exercised and assigned on a daily basis and stock would not be delivered in settlement.
• At a minimum, Feldman negligently relied on optionsXpress to ensure compliance with the law by failing to do due diligence on the legality of his trading in the face of numerous red flags that should have tipped him off to the violations.
• Feldman further violated Exchange Act Rule 10b-21 by selling call options on hard-to-borrow securities knowing that they would be promptly exercised and assigned when Feldman did not intend to make delivery but would instead execute buy-writes, which Feldman knew would not result in actual delivery.
• optionsXpress caused and willfully aided and abetted Feldman’s violations by allowing Feldman’s trading to continue when it knew from discussions with regulators that its customer’s transactions may be a sham.

• Stern caused and willfully aided and abetted optionsXpress’s violations of Rule 204 and caused and willfully aided and abetted Feldman’s fraud.
• Stern was optionsXpress’s primary regulatory liaison, was intimately familiar with Feldman’s trading, and participated in the calls with the regulators during which concerns were raised about the trading.
• Stern was closely involved in optionsXpress’s ‘perpetual fail’ policy, which the Division asserts “institutionalized optionsXpress’s Reg. SHO-circumventing conduct.”

[NOTE TO READERS:    Refer to pages 71 - 74 for Arguments put forth by optionsXpress, Feldman and Stern.]

Issues Identified by SEC Judge.     The issues presented are whether a clearing broker can meet its obligation to deliver securities by executing buy-writes -  i.e., does a purchase of securities offset by a simultaneous sale of a deep-in-the-money call option count as delivery.  If the answer is no, ...

• did the clearing broker’s customer commit fraud by engaging in buy-writes,
• did the clearing broker’s Chief Financial Officer (CFO) cause and aid and abet all the violations, and,
• did the clearing broker cause and aid and abet its customer’s violations.

The OIP alleges that from at least October 2008 to 3/18/10 (relevant period):

• (1) optionsXpress, Inc. willfully violated Rules 204 and 204T of Regulation SHO – Regulation of Short Sales (Reg. SHO);
• (2) Jonathan I. Feldman willfully violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and Exchange Act Rules 10b-5 and 10b-21;
• (3) Stern caused and willfully aided and abetted optionsXpress’s and Feldman’s violations; and,
• (4) optionsXpress caused and willfully aided and abetted Feldman’s violations. OIP at 2, 24-25.

The OIP alleges that 5 optionsXpress customers engaged in similar illegal conduct in 6 accounts during the relevant period:  Feldman, Mark Zelezney (Zelezney), Blake Gentry (Gentry), a friend of Zelezney, Dean Kolocouris (Kolocouris), a friend of Feldman’s, and Bradley Nielson (Nielson).  Feldman was the largest trader among these customers.

SEC Judge's Order.    SEC Chief Administrative Law Judge issued the following orders with regard to the 3 defendants:

Monetary Sanctions:

• optionsXpress, Inc., shall disgorge $1.6 million plus prejudgment interest from 10/7/08;  and
• Jonathan Feldman shall disgorge $2.6 plus prejudgment interest from 6/1/09.

• optionsXpress, Inc., shall pay a $2 million civil monetary penalty;
• Jonathan Feldman shall pay a $2 million civil monetary penalty; and
• Thomas Stern shall pay a $75K civil monetary penalty.

Other Sanctions.

• Thomas Stern is barred from being associated with a broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization or from participating in an offering of penny stock; and
• prohibited permanently from serving or acting as an employee, officer, director, member of an advisory board, investment adviser, or depositor of, or principal underwriter for, a registered investment company or affiliated person of such investment adviser, depositor, or principal underwriter.

For further details, go to:   [ SEC Initial Decision Release #490, 6/7/13 ] and  [ Reuters, 6/10/13 ].