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OptionsXpress Inc., a unit of U.S. brokerage Charles Schwab Corp., and its former chief financial officer helped to facilitate sham transactions that violated U.S. securities laws, an administrative court ruled.
OptionsXpress and Thomas E. Stern helped a client, Jonathan I. Feldman, conduct trades designed to fake compliance with laws prohibiting so-called naked short sales, where investors sell a stock they don’t possess in hope of profiting from declines, according to the ruling by Brenda P. Murray, the chief administrative judge for the Securities and Exchange Commission. The judge said OptionsXpress should pay $3,574,599 and Feldman $4,656,377. Stern, who was fired in 2012, was ordered to pay $75,000 and banned from the securities industry.
Feldman’s use of so-called buy-write transactions, where a share purchase is immediately offset by selling an in-the-money call option, to cover short positions broke rules requiring all short sales to be backed by deliverable shares, the judge said in a 105-page initial decision issued June 7. OptionsXpress and Stern allowed the trades knowing the shares would never be delivered and knowing other rulings indicated the practice was illegal, the judge said.
“To put it bluntly, no one had any skin in the game,” Judge Murray wrote. “By not performing its responsibility and closing out fail-to-deliver positions, OptionsXpress allowed Feldman and others to continue what, in effect, was naked short selling.”
Stephen Senderowitz, a lawyer representing OptionsXpress, disputed Judge Murray’s interpretation of the events, and said OptionsXpress is reviewing the decision for the purposes of an appeal.
“We believe the evidence at trial demonstrated that OptionsXpress at all times acted consistent with all regulations and bought in the shorts and delivered securities as required,” said Senderowitz in an e-mailed statement. “The firm was in touch with regulators regarding the transactions, no one was harmed, and the transactions were neither novel nor exotic.”
Gregory Lawrence and Daniel McCartin, lawyers for Feldman, did not return calls seeking comment.
The action was initiated by the SEC. In a short sale, an investor borrows a stock and sells it, with the goal of profiting from a price decline. The SEC’s Regulation SHO requires investors and their brokers to deliver shares within three days of making a short sale and bars firms from executing further bets until previous ones are settled.
“OptionsXpress believes that Reg SHO did not prohibit the transactions at issue here, and that the evidence showed there was no naked short selling as OptionsXpress timely bought in all shorts and delivered securities as required by regulations,” added Senderowitz, a lawyer at Winston & Strawn LLP.
The SEC settled related claims against three OptionsXpress employees: Peter Bottini, Phillip Hoeh and Kevin Strine, according to a separate administrative order.
Feldman used OptionsXpress to target companies where demand to sell short was so high that it was difficult or expensive to borrow shares. To get around that, synthetic short bets were created by selling bullish options priced far below the level of the stock, known as deep-in-the-money calls.
“Whenever the deep-in-the-money call options that Feldman wrote were assigned to him, Feldman ended up in a short position,” Murray said in the judgment. “This would have been true for any trader. What was different for Feldman and certain other customers was that it was not an infrequent or unplanned occurrence, rather it was their deliberate and consistent trading practice.”
Five customers including Feldman used the strategy between October 2008 and March 2010 on about 25 stocks, including Sears Holdings Corp. (SHLD:US) and American International Group Inc., the SEC said. In 2009, they bought about $5.7 billion of securities and sold about $4 billion of options, the regulator alleged.
Feldman’s trades, involving at least $2.9 billion of purchases and $1.7 billion of options, occurred between July 2009 and March 2010, the SEC alleged. Feldman estimated he made $3 million to $4 million on the trades he did through OptionsXpress, according to the judgment.
At one point, according to the judgment, Feldman messaged Dean Kolocouris, a friend who was also alleged to have engaged in the practice: “read the latest thread on the [Sears] ‘volume spikes.’ Very entertaining. (Until someone notifies the SEC, and they shut down the strategy!! Then we’ll need a real job.”
OptionsXpress didn’t levy extra fees on hard-to-borrow stock and was alone at the time in allowing the use of buy-writes to cover short positions, according to Judge Murray’s ruling.
“Feldman’s actions constitute fraud because by writing calls he represented to the market as a whole and to purchasers of his deep-in-the-money calls that he was going to make delivery if his calls were exercised and assigned when he had no intention of doing so, and, in fact, by entering buy-writes, he did not cover his short position,” Judge Murray said.
Charles Schwab, the San Francisco-based brokerage, agreed to buy OptionsXpress for about $1 billion of stock in 2011, adding the retail options brokerage founded in 2000 to its equity and mutual fund offerings. The acquisition was completed in September 2011.
OptionsXpress claimed to have 320,000 customers in 2010, according to the judgment.
The company knew the stocks purporting to cover the short positions were committed to call options that “would be exercised and assigned so that no shares were delivered,” the judge wrote. Stern knew, or was reckless in not knowing, that the transactions violated securities statutes, Murray said.
Feldman was senior vice president and chief lending officer at a regional bank until resigning in April 2012 and was one of OptionsXpress’s biggest customers, according to the judgment. He maintained that he relied on OptionsXpress to know the rules and follow them, the judgment said. That argument was inapplicable, the judge said.
“Sophisticated traders cannot do transactions that they knew, or were reckless in not knowing, were illegal and then blame their broker who they knew had a substantial financial interest in continuing the transactions,” Murray said.
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