A Look Inside the Regulatory Kitchen

The SEC’s Order and the NYSE Decision against Goldman find that for more than two years, beginning in March 2000, the customers’ pattern of trading and Goldman’s own records reflected that they were selling the securities short in violation of Rule 105 and Rule 10a-1(a). The customers did not deliver to Goldman in time for settlement the securities they purported to sell long, but rather, had to borrow the securities from Goldman to settle all of their sales. Goldman’s records also reflected that its customers covered their short positions with securities purchased in follow-on and secondary offerings after executing their sales. Had Goldman instituted and maintained procedures reasonably designed to detect these significant trading disparities, it could have discovered the pattern of unlawful trades by its customers.

via Press Release: SEC and NYSE Settle Enforcement Actions Against Goldman Sachs Unit for Role in Customers’ Illegal Trading Scheme; 2007-41; Mar. 14, 2007.

This is a before and after story, designed to show how the financial regulatory environment works.

The background: back in March, 2007, Goldman Sachs was fined $2 million by the SEC and the New York Stock Exchange together for a series of violations having to do with the improper oversight of their customers’ behavior. (See the above press release by the SEC). Exactly what this violation was is a complicated matter to describe, but it boils down to this: Goldman had customers who represented that they had properly borrowed stock for short sales, when in fact they had not.

Under the rules at the time, Goldman as a prime broker had a responsibility to make sure that their customers really had located shares in a stock before they sold them. This sounds like a simple concept, but in practice the brokers usually weren’t too curious about where their customers (hedge funds, in many cases) were finding their stock for short sales. Whether the short sales were proper shorts or naked shorts, the brokers were making a lot of money, and asking a bunch of questions or instituting stringent review procedures would only slow trading down.

So Goldman got caught, and it wasn’t an insignificant fine. “Of course $2 million is a parking ticket to Goldman, but relatively speaking, it’s a lot of money for an SEC fine,” is how one economist characterized the action.

Naturally, the industry was pissed. How can they do business, if they have to actually ask where the money is coming from?

We can see this frustration at a conference of the Securities Industry and Financial Markets Association (SIFMA), the trade group representing the financial services industry, held at the Marriott Marquis in New York on May 23, 2007. In researching the upcoming story I was given transcripts of several of these conferences, most of which involve compliance officers from the major banks talking about their (sometimes diffident) efforts to abide by the rules.

At this particular meeting in New York, Goldman Sachs Associate General Counsel Jon Breckenridge, Morgan Stanley Managing Director and Counsel Robert O’Connor, and Bank of America Associate General Counsel Michael Rogers are consulting with James Brigagliano, who at the time is the Associate Director for Trading Practices of the SEC, and has shown up at the conference to confer with the banks.

Hilariously, the men all call Brigagliano “Jamie.” Maybe it’s appropriate for the compliance officers for major financial companies to call their regulator by his first name, but in these conversations, the way they call him “Jamie” sounds like they’re talking to a towel boy for an SEC football team.

At one point, for instance, O’Connor asks if there’s been any progress in amending a 1994 no-action letter that defined what Prime Brokerage is. The industry had suggestions for refining that SEC action and here, the banks via these men are asking for a status report on these changes. “Jamie, where do we stand on revisions to the letter?” asks O’Connor.

Brigagliano answers cheerfully: “Well, Rob, I think there’s agreement or consensus on the substance of the letter…hopefully we’ll resolve the vehicle shortly and move on to other substance.”

(A note here, since I’ve already received letters suggesting that this might not be a big deal. It might not be. But you have to understand the context. If you’re some ordinary small company and, say, you receive a Wells Notice from the SEC informing you that you’re the target of an investigation, you might spend the next two years praying to God every night to get a “no-action” letter from the Commission. If you do get it, it’s a stroke of luck, like deliverance from hell. In the case of these companies, they ask for and they get movement on no-action letters as a matter of routine. Whereas a smaller company can’t hope to have this kind of dialogue, with these banks the regulatory process is clearly collegial as a matter of course. Not to overdramatize it, but this scene is a little like a DEA agent going to a Hemp Growers convention, and having the editor of High Times call out, “Hey, Jamie, how’s that legalization plan going?” And having him be like, “It’s coming, fellas, it’s coming!”)

Anyway, at this meeting, which takes place just a couple of months after the Goldman fine, the men are bitching to Brigagliano about what a terrible pain in the ass life is now, after that regulatory blow. Life, it seems, is no longer worth living, now that this pall has been cast over their collective existence.

“Now, when you read this settlement…” says Rogers. “Not that long ago, you could ask outside counsel, ‘Do I as a prime broker need to worry about Reg M violations by my clients?,’ the answer would be ‘No. It’s the client, the hedge fund that has to worry about breaking them, not you.’ It’s evolved to where prime brokers are thinking, OK, I’ve now got to worry about trades that are executed through my execution side.”

Translation: once upon a time, you didn’t have to worry about where the money was coming from. That was the customer’s problem. Now we actually have to look into the deals we’re doing.

“And it goes back,” Rogers continues, “to this creeping effect of the monitoring burden on the prime broker.

Brigagliano’s answer here is hilarious. In essence, what he says is, “You guys were so fucking shameless and did this so often that we had no choice but to fine one of you, even though we might not have wanted to.” Here is his actual response:

“I think,” he says, “that in G Sac [i.e. Goldman] the Commission believed that the firm had so much information and so many red flags and it continued for so long that it simply was not permitted to turn a blind eye to the trader’s activities.”

Now here’s where it gets funny. After he says this, Brigagliano’s tone quickly changes and he immediately shifts gears, promising to listen to the banks in the future on this issue.

“Certainly, going forward,” he says, “if market participants have questions as to the application of those principles in other circumstances, we’d certainly be willing to have a dialogue on that.”

And guess what? They did end up having a “dialogue.” And a very productive one at that!

A year and a half or so after this meeting, after the collapse of Bear Stearns and Lehman Brothers, the SEC instituted a new rule called “10b21.” The new rule made it clear that “those who lie about their intention or ability to deliver securities are violating the law.”

To put that in English, it was now officially a crime to lie to your poor broker about where you located your stock, and whether or not you intended to deliver that stock.

This was, of course, already against the law. It was covered under the broad fraud statute in the SEC code, rule 10b5. All this new rule did was formally put the blame for bad locates on the customer, not the broker who took his business. “The new rule didn’t do anything,” says an attendee of those SIFMA meetings. “It just exempted the prime brokers from responsibility. It’s a joke.”

To be fair, 10b21 came out simultaneously with a new amendment to Reg SHO, the rule governing naked short-selling. This new amendment, 204t, made broker-dealers ultimately responsible for the failed trades of their customers. But the act of accepting bad locates, or allowing customers to continually push through dodgy or mis-marked trades (often through an automated or “sponsored access” system) — and this incidentally is exactly what Goldman was fined for back in 2007, when a Goldman customer used an automated system to systematically mis-mark short trades as long trades — that seems to have been defined in 10b21 as a crime belonging to the customer only.

One former securities regulator described 10b21 as a “nothing burger,” not needed because it was already covered by an existing law (10b5), whose only significance is that it shifted blame to the customer.

Anyway, this is how the regulatory world works. When the big players get stung even a little bit, the rules eventually get clawed back, or tweaked.

By the way, “Jamie” Brigagliano is still around. In fact he got a nice promotion after Obama got elected. In April of this year he was named co-Acting Director of the SEC’s Division of Trading and Markets, overseeing the options and securities exchanges, as well as brokers, dealers, transfer agents, and credit rating agencies. Just last week he was out there pimping the round table on naked short-selling that began today.

More on all of this later…