$2 Mill Fine for Weak Compliance

FINRA today hit broker-dealer firm Cantor Fitzgerald with a $2 million fine for sloppy compliance practices that lasted at least five years, in an enforcement action sure to warm a compliance officer’s heart.

The offenses related to naked short selling, where an investor first borrows stock to sell at a high price, then buys it back at a lower price to return to the original owner — except the investor doesn’t first obtain the borrowed stock before selling it. (That’s the “naked” part.)

Naked short selling is carefully restricted under Regulation SHO, which requires broker-dealers to be reasonably certain that those borrowed shares will be available for delivery within a limited time period. So broker-dealers need policies and procedures to govern short-selling, and must designate a specific individual to supervise compliance with Regulation SHO.

In practical terms, for broker-dealer firms that might handle billions of shares annually, that means building a whole compliance department to meet Regulation SHO’s requirements. That’s where Cantor Fitzgerald got into trouble.

Specifically, FINRA’s consent order said, Cantor Fitzgerald…

• Continued to rely on manual procedures to identify its compliance obligations from 2013 to 2018, even as the volume of shares Cantor traded for clients more than doubled from 35 billion shares in 2013 to 79 billion in 2014.
• Ignored numerous warnings from compliance staff in 2013, 2014, and 2015 that the firm had systemic compliance trouble with Regulation SHO and that the firm’s supervisory systems weren’t up to the challenge at hand.
• Had insufficient written supervisory procedures, including failure to designate a specific person in charge of compliance with Regulation SHO.
• Failed to implement any improvements to its compliance program, including the hiring of more compliance staff, until 2016, despite those numerous red flags raised by staff in earlier years.

We should also note that Cantor Fitzgerald had run afoul of FINRA rules over Regulation SHO twice before, in 2011 ($250,000 fine) and 2012 ($150,000 fine).

All those failures in the compliance system then led to multiple instances of abusive naked short selling, which is forbidden under SEC rules. Thus Cantor Fitzgerald agreed to pay a $2 million penalty for these most recent shortcomings, plus hiring an independent consultant to review of the firm’s policies, systems, procedures and training related to Reg SHO.

“Firms need to ensure that their supervisory systems are reasonably tailored to their business and once they become aware of deficiencies in their supervisory systems, they must promptly remediate them,” Susan Schroeder, FINRA’s enforcement chief, said in a statement.

Beyond Paper Compliance Programs

The message in this settlement, which compliance officers should print out and staple to the CFO’s forehead, is that compliance programs must be adequately designed and resourced for the workload involved. That’s not a new message, but this latest version of it does drive home the point in a detailed manner.

For example, Cantor’s capital markets supervision (CMS) group was responsible for reviewing suspicious trades. In 2013 and 2014, this group had four or five members to review the trading activity of roughly 700 sales executives — and since Cantor’s share volume more than doubled in that period, the supervision employees “routinely worked twelve-hour days,” FINRA said.

CMS staffing levels were not reasonable, given the amount of supervisory oversight delegated to CMS, the number of trades CMS reviewed, and the highly manual nature of CMS’s responsibilities. Because its members routinely worked twelve-hour days, the head of CMS made several requests for additional personnel. However, Cantor did not increase the number of people assigned to CMS until 2016…

Another issue: Cantor failed to address several examples of misconduct or weaknesses in compliance even after the firm’s compliance department recommended changes, apparently because those changes would involve, ya know, doing things people wouldn’t like.

In one instance, the compliance department identified a certain trading desk that conducted too many “late close-outs,” a warning sign for suspicious short selling. The compliance team recommended new controls to confirm the authenticity of those late trades and designating a specific person with responsibility to oversee the activity. Managers never implemented those recommendations.

In another instance, the compliance department flagged another trading desk that was violating short-selling rules too often, and recommended formal discipline. Managers never followed through on that recommendation, either.

The message here is that real commitment to a compliance program matters. That commitment includes giving compliance and supervisory teams adequate resources to do their jobs; and executive will to follow through with remedial action when the compliance department flags a problem.

Like I said, a message to warm the compliance officer’s heart.