SEC’s Complaint Against OptionsXpress Alleges Complex Trading Scheme Based Upon Some Simple Proofs

Posted on April 18th, 2012 at 9:55 AM

The SEC (Securities and Exchange Commission) has instituted cease-and-desist proceedings against Chicago-based optionsXpress, a retail, online brokerage firm specializing in options and futures, as well as its chief financial officer and one of its retail customers.  The allegations of the complaint sweep broadly and allege a “complex short selling scheme.”  As complex as the scheme, the SEC seeks to simply prove many of its factual allegations based upon admissions found in internal email communications at optionsXpress.  Let’s examine the complaint.

            Preliminarily, securities regulations such as Regulation SHO of the Exchange Act, require brokerage firms to meet certain delivery requirements when they engage in short selling for customers.  The SEC alleges that optionsXpress, a wholly-owned subsidiary of The Charles Schwab Corporation, violated securities regulations when it “failed to satisfy its close-out obligations…by repeatedly engaging in a series of sham transactions, known as ‘resets’, designed to give the appearance of having purchased shares to close-out an open failure-to-deliver position while in fact not doing so.”  Confusing?  Here is the allegation against the customer: Jonathan Feldman violated securities regulations “when he sold options knowing that he had no intention of fulfilling his obligations under those contracts.”   More specifically, according to the SEC, sellers sometimes engage in “naked” short selling and failures to deliver as part of a scheme to manipulate the price of the security, or possibly to avoid borrowing costs associated with short sales.

            How did optionsXpress and its CFO aid and abet Feldman?  According to the SEC, “The sham resets were accomplished by optionsXpress facilitating its customers buying shares and simultaneously selling deep in-the-money call options that essentially were the economic equivalent of selling shares short.”  Huh?  The SEC rephrases it this way: “The purchase of shares created the illusion that the firm had satisfied the close-out obligations; however, the shares that were ostensibly purchased in the reset transactions were never actually delivered to the purchasers because on the same day the shares were ‘purchased’, the deep in-the-money calls were exercised, thereby effectively reselling the shares.”

            Right about now, heads are spinning just trying to understand that “scheme” and, perhaps more importantly, asking the question, “So what?”  The SEC answers that question this way.  First, the “sham reset transactions” impacted the market for the issuers.  One company included Sears.  The SEC alleges that in January, 2010 alone, Feldman and 5 other customers accounted for on average 47.9% of the daily trading volume of Sears.  Now, this is getting interesting!  And, in 2009 alone, the six optionsXpress customer accounts in total purchased approximately $5.7 billion (not million, but billion) worth of securities and sold short approximately $4 billion of options.  Indeed, in 2009, Feldman himself purchased at least $2.9 billion of securities and sold at least $1.7 billion of options through his account at optionsXpress.  In doing so and in failing to deliver, according to the SEC, their actions negatively affected purchasers of stocks by depriving them of the benefits of share ownership, such as voting and lending, and also created a misleading impression of the market for the issuers’ stocks.

            According to the SEC, the law was clear; reset transactions violated Regulation SHO.  The SEC details in the complaint how it issued guidance in 2003, and describes the regulatory actions that have been brought against firms and individuals since 2007.

            All of the above takes up about 11 pages of the SEC’s complaint.  As complex as that is, the next 13 pages of the complaint reads more like an historical “Gotcha”!

            The SEC begins its “Red Flag” allegations – really more of an amazing collection of smoking gun email communications – with the following, “optionsXpress knew early on that the trading was problematic.”  From there, the complaint details emails among traders, emails to and from the compliance department, emails to and from the clearing department, and so forth. 

The SEC appears particularly disturbed in reviewing communications to FINRA (the Financial Industry Regulatory Authority) as part of its investigation.  Following a series of internal email communications describing why certain customers were trading the way that they were trading, optionsXpress took the position officially with FINRA that it did not know and could not speculate as to why certain customers were trading the way they were trading.  Likewise, the SEC was not pleased to learn that optionsXpress began charging customers higher commissions.  One optionsXpress trader justified the increased commissions by saying that the trades were so large the regulators might start to notice!  And the SEC could not resist quoting customer Feldman complaining about those increased commissions:

            “Millions of $$ inc[sic] commissions [sic],,,,yet treat me/us like criminals….But, in the big’s still quite the gig..where can you get such mkt-bating [sic] retuens [sic] consistently?  So, as disgusting as [optionsXpress] are [sic], have to bend over and get raped, and take the punishment,,,,”

The next stage of the process will be a public hearing, with the right of the firm, its CFO and customer Feldman to file an answer to the complaint.  While the scheme is complicated in nature, the story will be most interesting as it unfolds!


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