SEC Charges Adviser and its Principal in Illegal Short Selling Scheme

Who may be interested: Investment advisers, broker-dealers.

Quick Take: The SEC recently filed a lawsuit charging an investment adviser and its managing partner (collectively, the Adviser) with allegedly engaging in a fraudulent short selling and order marking scheme involving the stock of at least ten public companies. By initiating this action, the SEC clearly intends to enforce the order marking requirements of Regulation SHO and the naked shorting prohibitions of Rule 203(b)(1) on investment advisers in an effort to protect the integrity of the securities markets.

The SEC complaint alleges that the Adviser generated over $2 million in illicit profits from its fraudulent trading scheme involving the mismarking of orders and naked short sales occurring from at least March 2017 to May 2019.

Short selling is the legal practice of selling borrowed securities with the goal of repurchasing the same securities at a lower price before they must be returned to the lender. Under Rule 200(g) of Regulation SHO, broker-dealers are required to mark all orders for transactions in publicly traded securities as “long”, “short” or “short exempt.” In a naked short sale, the selling party does not borrow, or make arrangements to borrow, the securities the party is short selling to make timely delivery within the transaction’s settlement period. Rule 203(b)(1) prohibits naked short selling by requiring broker-dealers to “locate” securities being sold before accepting a short sale order. “Locate” means the broker must borrow the securities, enter into a bona fide arrangement to borrow the securities, or have reasonable grounds to believe that the securities can be borrowed so that they can be delivered on the date delivery is due.

The SEC complaint alleges that the Adviser engaged in fraudulent and deceptive practices by intentionally mismarking its orders as “long” when the Adviser was aware, or should have been aware, that the orders were “short”. The SEC complaint further alleges that the Adviser used naked short sales in some instances to artificially deflate the price of securities, allowing the Adviser to purchase more shares at a lower price. The complaint states that the Adviser made false and misleading statements to at least one executing broker-dealer to conceal the fact that the Adviser had not located shares prior to placing short sales, in violation of Regulation SHO.

The SEC complaint charges the Adviser with violations of Section 10(b) of the Exchange Act and Rules 10b-5 and 10b-21 thereunder, as well as Sections 204 and 206(4) of the Advisers Act and Rules 204-2 and 206(4)-7 thereunder. The SEC complaint seeks permanent injunctions, disgorgement and civil monetary penalties.

The SEC’s complaint can be found here.

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