October 28, 2020

SEC Enforcement Turns Attention to Reg. SHO Aggregation Unit

On September 30, 2020, the U.S. Securities and trading unit aggregation. Independent trading Exchange Commission (“SEC”) issued a settlement unit aggregation is available to a broker-dealer order imposing a $5 million civil monetary only if: penalty in connection with violations of Rule (1) The broker-dealer has a written plan of 200(g) under Regulation SHO,1 which requires a organization that identifies each broker-dealer to mark sales of securities as “long” aggregation unit, specifies its trading only if it is deemed to own the security being objective(s), and supports its sold, among other requirements.2 The SEC’s independent identity; findings were predicated upon the failure to maintain independence between two trading (2) Each aggregation unit within the firm units in connection with the firm’s synthetic prime determines, at the time of each sale, its brokerage swaps business. Because these trading net position for every security that it units could not be considered independent, their trades; net securities positions would be required to be aggregated, leading to the order marking failures (3) All traders in an aggregation unit pursue at issue in the SEC order. only the particular trading objective(s) or strategy(s) of that aggregation unit and Regulation SHO and Aggregation Units do not coordinate that strategy with any other aggregation unit; and Regulation SHO was first adopted in 2004 to address concerns regarding persistent failures to (4) Individual traders are assigned to only deliver and potentially manipulative or abusive one aggregation unit at any time.4 “naked” short selling.3 Regulation SHO formalized previously existing SEC relief from the Broker-dealers are further required to mark sell requirement that a seller’s position as “long” or orders as “long,” “short” or “short exempt,” and “short” be determined on an enterprise-wide may only mark an order as “long” where (i) the basis by permitting certain broker-dealers to security to be delivered is in the physical determine whether they are selling “long” or possession or control of the broker-dealer, or (ii) “short” on a profit-center or unit-by-unit basis. it is reasonably expected that the security will be Rule 200(f) under Regulation SHO requires a in the physical possession or control of the broker-dealer to aggregate all of its positions in a broker-dealer no later than the settlement of the 5 security to determine whether it is net “long” or transaction. “Short” sales are subject to a net “short” unless it qualifies for independent number of conditions that do not impact “long”

sales; this designation also allows “long” sellers to positions of both units together or netted the take priority over “short” sellers when a security “long” and “short” positions of both units across experiences a significant intra-day price decline.6 the entire broker-dealer.

***** Recent SEC Enforcement In the press release accompanying the SEC’s The findings in the SEC order indicate that the settlement order, Daniel Michael, Chief of the trading units in question, which were structured Complex Financial Instruments Unit of the SEC’s as part of the firm’s synthetic prime brokerage Division of Enforcement, cautioned firms who are swaps business, were not independent trading not fully complying with their obligations under units and were therefore not eligible for Regulation SHO, noting that: “Market participants independent trading unit aggregation. Because cannot disregard the rules of the road established of this incorrect designation, the firm had been by Reg SHO for all short sales.” As a result of this incorrectly marking “short” sale orders as “long” enforcement activity, we encourage firms to sales for a number of years in violation of review the structure of their trading units and Regulation SHO. their order marking practices to ensure that they The findings identified in the SEC order indicated are operating in compliance with Regulation SHO. that the two trading units had identical If you or your firm have questions about this Legal management structures, with the same front-line Update or about compliance with your regulatory supervisor overseeing both units, and traders obligations under Regulation SHO, please contact from both units sat side-by-side, with traders the authors or any member of our Broker-Dealer from one unit routinely substituting for traders in Regulation & Compliance practice. the other unit during absences.

Furthermore, the units had the same business purpose of hedging the firm’s synthetic exposure Author contacts: to equity securities created by swaps transactions, Marlon Paz differentiated only in that the one unit held long +1 202 263 3044 / +1 212 506 2307 hedges while the other unit held short hedges. In [email protected] the “long” unit, the firm marked all sell orders of equity securities executed upon unwind or Kyle Swan expiration of the related swap as “long” sales. In +1 202 263 3072 the “short” unit, the firm marked all sell orders of [email protected] equity securities executed to establish its hedge to its newly-created synthetic exposure as “short” sales. Endnotes As such, the units had the same trading strategy 1 or objective: to hedge synthetic exposure 17 C.F.R. § 242.200(g). established through the swap business. The 2 https://www.sec.gov/news/press-release/2020-238; bifurcation of hedging activity into separate units https://www.sec.gov/litigation/admin/2020/34-90046.pdf. allowed the equity sales of one unit to be 3 U.S. Sec. & Exch. Comm’n, Final Rule and Interpretation, uniformly marked “short” and those of the other Short Sales, 69 Fed. Reg. 48007, Exch. Act Rel. No. 34-50103 (Aug. 6, 2004), https://www.sec.gov/rules/final/34-50103.htm. unit to be uniformly marked “long.” This practice was found to be in contravention of Regulation 4 17 C.F.R. § 242.200(f). SHO because the units were not sufficiently 517 C.F.R. § 242.200(g)(1). independent. 6 See 17 C.F.R. §§ 242.201 (circuit breaker treatment); 203 The SEC order affirmed that the firm should have, (locate requirement); 204 (close-out requirement). at a minimum, netted the “long” and “short”

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