On 1 June 2015 the U.S. Securities and Exchange Commission (SEC) issued a ‘cease-and-desist’ order in administrative proceedings instituted by the SEC under the Securities Exchange Act of 1934 against two broker-dealers: Merrill Lynch, Pierce, Fenner & Smith Incorporated and Merrill Lynch Professional Clearing Corporation (together: Merrill). The order concerns short selling. Short selling is a transaction to sell securities (on an exchange), e.g. shares, that the seller does not own. In that case, the seller may overcome this by borrowing the shares he has to deliver at the last possible moment to meet his obligations. This is what an investor might do who expects to make a profit from share prices dropping: the investor concludes the transaction to sell the shares he does not own for say 1 dollar or euro per share. He then borrows the shares he has to deliver from someone else, sells those shares (via a broker-dealer) to the counterparty, and later buys corresponding shares on the market for perhaps 0.95 dollar or euro to give back to the borrower (making a profit of 0.05 per share). This is risky because share prices at a later moment could actually have gone up to perhaps1.05 dollar or euro per share.
To counter the risks of short selling, U.S. law (Regulation SHO) requires a broker-dealer inter alia not to accept a short sale order from a client unless he has ‘Reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due’. This is the so-called ‘locate requirement’: the broker-dealer must be able to ‘locate’ shares that are available for borrowing. As interpreted by the SEC a broker-dealer is in compliance with this requirement when, ‘easy to borrow (“ETB”) lists may provide reasonable grounds to believe that the security sold short is available for borrowing’, and: ‘While broker-dealers […] use their own criteria to determine whether or not a security should be included on its ETB list, the information used to generate the ETB list must be less than 24 hours old’.
In the case of Merrill the SEC found inter alia that in some cases Merrill had used older data, ‘leading to Merrill accepting and executing short sale orders based on inappropriate reliance on defective ETB lists, such that Merrill did not have reasonable grounds to believe the security could be borrowed for delivery’. The SEC ordered Merrill inter alia to ‘cease and desist from committing or causing any violations and any future violations’ and pay a sum of money representing the profits earned as a result of its non-compliance (without interest $ 1,566,245.67) as well as ‘a civil money penalty’ ($ 9 million). The ‘cease-and-desist’ order can be found at www.sec.gov, enforcement, administrative proceedings, 2015 release no. 34-75083 - June 1 2015 - Merrill Lynch, et al.