SEC Charges Chicago Board Options Exchange for Regulatory Failures

June 13, 2013 by Thomas F. Burke, P.C.

The Securities and Exchange Commission charged the Chicago Board Options Exchange (CBOE) and an affiliate for various systemic breakdowns in their regulatory and compliance functions as a self-regulatory organization, including a failure to enforce or even fully comprehend rules to prevent abusive short selling.

CBOE agreed to pay a $6 million penalty and implement major remedial measures to settle the SEC's charges. The financial penalty is the first assessed against an exchange for violations related to its regulatory oversight. Previous financial penalties against exchanges involved misconduct on the business side of their operations.

Self-regulatory organizations (SROs) must enforce the federal securities laws as well as their own rules to regulate trading on their exchanges by their member firms. In doing so, they must sufficiently manage an inherent conflict that exists between self-regulatory obligations and the business interests of an SRO and its members. During the investigation, the SEC found that employees of the CBOE didn't know enough about the short-sale law to enforce it, according to the SEC statement. Not only did they fail to detect violations, they "took misguided and unprecedented steps" to assist the firm that later became the subject of an SEC enforcement action. CBOE put the interests of the firm ahead of its regulatory obligations by failing to properly investigate the firm's compliance with Regulation SHO and then interfering with the SEC investigation of the firm.

According to the SEC's order instituting settled administrative proceedings, CBOE demonstrated an overall inability to enforce regulations with an ineffective surveillance program that failed to detect wrongdoing despite numerous red flags that its members were engaged in abusive short selling. CBOE also fell short in its regulatory and compliance responsibilities in several other areas during a four-year period.

Exchange executives, long shielded from legal scrutiny in the U.S., have been put on notice that may be changing after the $6 million fine for unprecedented lapses in supervision. The settlement with the biggest American options venue, marks the third time in nine months the Securities and Exchange Commission has announced financial sanctions against a market operator. Before collecting $5 million from NYSE Euronet (NYX) in September for data dissemination violations, the commission had never imposed a monetary penalty on an exchange.

More than a decade of evolution in the way stocks, options, futures and derivatives trade in the U.S. has raised scrutiny of exchanges, which compete against each other for profits while supervising members as self-regulatory organizations. The role, dating from a period when markets were owned by the firms that used them, has been questioned following lapses in technology and oversight. Clearly the SEC is sending a message that SROs will be more closely scrutinized and have a an increased level of accountability for their oversight responsibilities.