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Introductory Look Into Compliance Today

Organizations aspire to ensure compliance with relevant laws and regulations. One way they do this is by administering a strong and robust compliance program. These programs are generally led by a Chief Compliance Officer (“CCO”). The CCO is responsible to constantly look for ways to improve, review, structure and/or maintain the organization’s oversight program. Many times, when things go wrong—the company will point to the CCO for accountability. We’ve all heard of some of the more recent compliance cases in the news. There was Chipotle …and …Chipotle … and did I mention, Chipotle? Compliance programs from companies such as Volkswagon have also been called into question. Despite these glooming reports, some firms have become proactive in their efforts to take compliance seriously. While others have been ordered to revamp their program. Either way, financial compliance is being taken much more seriously than ever before.


A Recent Case Against Goldman Sachs

Recently, Goldman Sachs (“GS”) was forced to pay $15 million to settle SEC charges that its securities lending practices violated federal regulations. GS violated Regulation SHO (17 CFR 242.200); a regulation which the SEC adopted to address concerns regarding persistent “fails to deliver” and potentially abusive short sales. GS has been ordered to cease and desist from committing any further violations of the short sale statute.


Regulation SHO requires brokerages to enter an agreement to borrow securities on behalf of customers or to have reasonable grounds for believing that it can borrow the security. According to the SEC’s order, broker-dealers such as GS are regularly asked by customers to locate stock for short selling. Granting a “locate” means that there is a bona fide arrangement for a firm to borrow—or reasonably believe it could borrow the security to execute a customer’s short sale. This is known as a broker-dealer locate requirement.


Between 2008 and 2013, GS employees relied on an automated system to fill customers’ stock requests. However, a problem with the system allowed employees to grant customers’ “locate” requests based on the inventory reported to GS early in the day by other large financial institutions—even after the inventory had been depleted as the team processed requests during the day. According to the Commission, the team did not check other possible sources for securities or perform a “meaningful further review.”


Thus, the SEC found that GS violated the regulation by improperly providing locates to customers where it had not performed an adequate review of the securities to be located. Such locates were inaccurately recorded in the firm’s locate log. These logs must reflect the basis upon which GS had given out locates. Essentially, GS agreed to transactions without determining if the stocks were available.


The SEC also alleged that when its Office of Compliance Inspections and Examinations reviewed GS’s lending practices in 2013, the firm “created the incorrect impression that the Demand Team conducted an individualized review for all locate requests” when it did not. The SEC acknowledged GS’s effort to replace its deficient automated system beginning in at least mid-2013.


Additional Lawsuits Could Follow

While the firm was improperly advising customers that it had located shares for their transactions, some of those customers were likely paying for a service the firm wasn’t providing. Costs to borrow shares can be considerable under normal circumstances, but they spike when there is more demand by investors to short a company’s stock than there is stock to borrow. Clients may have to pay substantially more of the trade’s value to secure the shares. If GS charged borrowing fees when it had not actually located the shares, its customers might well try to recover those costs. Moreover, customers could file civil actions for damages for these actions

Could a more robust compliance program prevented this?

From the outside looking in—this seems like an issue that the firm could have prevented had they implemented a more robust oversight program. Although, the SEC acknowledged that GS had taken steps to improve its deficient automated system, it certainly was not enough. The problem with GS was that they were borrowing based on an autolocate function key instead of individually processing locates. The failure to do so clashed with the “reasonable grounds to believe” requirement of the short sale regulation. The principle purpose of the requirement for a seller locate a source from which to borrow the security is to prevent the failure of trades that would occur if the short seller was unable to deliver the security at the settlement of the trade. Ultimately, this was what ended up happening with GS. Thus, it could be said that GS should have instituted a better oversight program, that documented compliance with the locate requirement before allowing broker-dealers to accept the short sale order. Yet on the other hand, GS had taken steps to improve the deficient automated system. In addition, it was reported that no customers were foiled as a result of this practice. Furthermore, the settlement sum was a reasonably small amount of money. Therefore, this may be something that was a relatively minor infraction and perhaps unassumingly a lesson to learn going forward.


Nebyu Retta is a graduate of The University of South Carolina. He is third year evening student at Suffolk University Law School and a staff member of the Journal of High Technology Law. He works for the Office of the Attorney General.

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