Regulators Investigating Firms Sub-Account Use in Shorting Stocks

Government regulators are investigating investment firms that set up sub-accounts with their broker dealers to mask illegal short selling schemes. I reported for Growth Capitalist this week that FINRA and the SEC are currently doing a sweep of hedge funds and their brokers dealers for the use of sub-account under the hedge funds master account to essentially naked short a stock.

The regulatory investigation is on top of the short selling fines the SEC imposed on 22 firms last month. The government is focused on how firms short a stock within a five day rule before a new issue for the stock – which is basically naked shorting.

The use of sub-accounts, sometimes set up in names of people who are not actually the investor in the funds, is similar to the ‘rathole’ game Jordan Belfort used in the mid-90’s at his illustrious Long Island firm Stratton Oakmont. You might remember Belfort from his tell-all novel ‘The Wolf of Wall Street’ – which is now going to be a lucid and greedy portrayal of what can happen behind the scenes with stock trading in a major motion picture this year.

But regulators aren’t just looking at bucket shops trying to use straw buyers. Even if a real investor’s money is being used to short a stock in the subaccount, while the Master account is long the stock, say five days before a new issue (illegal practice Rule 105), FINRA or the SEC is likely to come after the firm. And they’ll fine the broker-dealers for not inspecting what the hedge funds are doing via compliance violations even if the broker-dealer had little or no intent on allowing the hedgie to do illegal trading.

Last year the poster child for this kind of scheme, William Yeh of Genesis Securities, was banned from nearly every stock exchange for what he did with master and subaccounts. You can read all about Yeh’s scheme in the FINRA lawsuit here.

I am now seeing Wall Street securities lawyers warning their clients to be on guard for this kind of thing:

Master/sub-account relationships raise a host of regulatory issues for firms and carry the risk that the firm does not know the identity of its “customer” as required by federal securities laws, including the Customer Identification Program (CIP) provisions of the Bank Secrecy Act, and FINRA Rule 3310. In some situations, despite the fact that there is an intermediary master account, a firm may be required to recognize a sub-account as a separate customer of the firm. FINRA examiners closely review firms’ procedures for determining the beneficial ownership of each account within a master/sub-account structure in accordance with the guidance published in Regulatory Notice 10-18. FINRA examiners will review firms’ systems for monitoring, detecting and reporting suspicious activity in master/sub-account structures, whether or not the sub-account should be considered the firm’s customer for CIP purposes.

And FINRA says it’s using 16 examiners to figure out if a hedgie/traders master account is basically being allowed to operate as an unregistered broker-dealer:

FINRA examiners also will focus on whether the firm is properly monitoring transactions in master/sub-account structures for potentially manipulative activity and reporting that activity, as appropriate, on a Suspicious Activity Report (SAR). In a recent enforcement action, FINRA sanctioned a firm for failing to adopt risk-based procedures to verify the identity of sub-account holders, even though these customers lived overseas in high-risk jurisdictions and could freely execute trades for their own profit, and also for failing to adopt effective procedures for detecting suspicious activity.

The problem with these regulator inspections is master/sub-account relationships have now also raised issues under other FINRA and SEC rules, such as margin rules and books and records requirements. Meaning firms could get hit with a ‘net-capital charge’ if the regulator thinks there is prop trading in the sub account and the real owner who reaps the dollars is different than the master account.

This is seen as a ‘Johnny Come Lately’ action by the SEC and FINRA by some small cap stock CEO’s who have been made to look like lunatics for complaining about naked shorting over the last decade and our Chris Cox/ Mary Shapiro style of leadership at the SEC did nothing about it. Others think it’s a witch hunt by the SEC because Main Street is frustrated at their total lack of getting BIG fines out of traders who break securities laws and keep making millions of dollars.

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Comments

  1. FINRA and the SEC are a joke.

    None of these alleged “probes” should be taken seriously by any of the “big shots.”

    The only people that have to worry are the working stiffs, frontline brokers, analysts and advisors. J.P. Morgan’s deal with the Justice Department to pay $13 billion in settlements for all their fraud is proof of this. Those mortgage-backed securities were collateralized so many times that they might as well have not existed at all. The Collateralized Debt Obligations weren’t worth their face value to begin with!

    Jamie Dimon and his freak show colleagues are already breaking open the champagne.

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