Larry Bergmann Addresses Regulation SHO and Bona-Fide Market Making

Larry Bergmann Addresses Regulation SHO and Bona-Fide Market Making

December 21, 2016
by Larry E. Bergmann

Trading and Markets Update:

Regulation SHO and Bona-Fide Market Making

The SEC has instituted administrative proceedings against Wilson-Davis & Company (WDCO), a Utah broker-dealer, and certain associated persons for, among other things, improperly claiming the “bona- fide market making” exception to the requirement in Rule 203 of Regulation SHO to obtain a “locate” of stock before effecting short sales. https://www.sec.gov/litigation/admin/2016/34-79580.pdf

Of note, the firm has not settled with the SEC, while the CEO, Head of proprietary trading, and the trader that caused the violations have settled. https://www.sec.gov/news/pressrelease/2016-266.html

The Order Instituting Proceedings (OIP) pulls together many of the SEC’s extant statements on what constitutes “bona-fide market making” in the context of Rule 203(b)(2)(iii) of Regulation SHO which is “a limited exception to the locate requirement for short sales effected by a market maker in connection with bona-fide market making activities in the securities for which the exemption is claimed.” [OIP at 2] As the SEC explains, this “narrow” exception is available only to:

  1. A U.S.-registered broker-dealer;
  2. That qualifies as a “market maker” under Exchange Act Section 3(a)(38);
  3. Is a market maker in the security being sold; and
  4. Is engaged in bona-fide market making in that security at the time of the short sale. [OIP at 3]

The OIP quotes the SEC’s statement in 2008 that “a market maker engaged in bona-fide market making is a ‘broker-dealer that deals on a regular basis with other broker-dealers, actively buying and selling the subject security as well as regularly and continuously placing quotations in a quotation medium on both the bid and ask side of the market.’” [OIP at 3] More specifically, indicia of bona-fide market making include:

  1. the market maker incurs economic or market risk with respect to the securities (e.g., by putting its own capital at risk to provide continuous two-sided quotes in markets);
  2. engages in a pattern of trading that includes both purchases and sales in roughly comparable amounts to provide liquidity to customers or other broker-dealers; and
  3. posts continuous quotations that are at or near the market on both sides and that are communicated and represented in a way that makes them widely accessible to investors and other broker-dealers. [OIP at 3]

The order also references the SEC’s previous examples of situations that do and do not indicate bona-fide market making activity, and notes that it is the obligation of the person claiming the exception to demonstrate eligibility. [OIP at 3-4]

The proceeding focusses on WDCO’s proprietary trading group. The firm took the position, which was reflected in its written supervisory procedures (WSPs), that all of its proprietary trading was bona-fide market making activity, and therefore it did not require traders to obtain, nor did it have processes or procedures to require, locates for short sales. [OIP at 4-5] The OIP charges that the firm improperly claimed the exception because:

  1. It made no distinction between (a) assuming the “purported status of a market maker” and continuously posting “superficially two-sided quotations” for a security, and (b) taking steps to ensure its actual activity constituted bona-fide market making activity.
  2. Its quoting and trading did not comport with the indicia of bona-fide market making.
  3. Rather, its conduct exhibited the characteristics that the SEC has described as not qualifying as bona-fide market making. [OIP at 5]

The OIP provides examples that were typical of WDCO’s activity:

  1. WDCO posted bids that were at or near the best bid and updated the bid throughout the day (apparently mostly in OTC stocks);
  2. However, it posted offer quotations that were not at or near the best offer and did not update the offers for several hours or days at a time; and
  3. It executed short sales that were substantially away from its posted offer quotations. [OIP at 6-9]

As a result of this activity, WDCO allegedly reaped millions of dollars in “illicit trading profits.”

Observations:

  1. Despite WDCO’s extensive short selling and failure to obtain locates, there is no indication in the OIP that WDCO failed to make delivery on its short sales. This once again shows the importance that the SEC places on obtaining locates even in the absence of delivery failures.
  2. In the OIP examples of WDCO’s quoting and trading, it appears that it claimed market maker status but regularly quoted away from the inside market on both sides of the market, and its offers were very far away from the inside market and infrequently updated.
  3. This case reinforces the notion that satisfying the requirements for market maker status is necessary but not sufficient to claim the bona-fide market making activity exception, and that, while “market maker” may be a status, “bona-fide market making activity” is assessed at the time of each short sale by a market maker. See also, SEC Division of Market Regulation, “Frequently Asked Questions Concerning Regulation SHO” (updated March 18, 2015), footnote 3, available at https://www.sec.gov/divisions/marketreg/mrfaqregsho1204.htm.
  4. WDCO’s deficient WSPs also are alleged to have resulted in violations of Exchange Act Rule 15c3-5(c)(2)(i), which “requires that a broker or dealer’s risk management controls and supervisory procedures be reasonably designed to prevent the entry of orders unless there has been compliance with all regulatory requirements that must be satisfied on a pre-order entry basis.” WDCO allegedly did not have controls or procedures to prevent the entry of proprietary short sales that did not comply with Regulation SHO, namely it allowed its traders to rely on the locate exception without having controls in place to ensure that they were actually engaged in bona-fide market making at the time of their short sales. [OIP at 11]

Larry E. Bergmann (202) 661-7032 lbergmann@mmlawus.com.

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