Toronto investment dealer Cormark Securities Inc. has agreed to pay US$800,000 to settle U.S. Securities and Exchange Commission claims that it repeatedly mislabelled trades on behalf of a hedge-fund client.
Between August, 2016, and October, 2017, Cormark facilitated US$660-million worth of share sales in the United States for an unnamed hedge fund using trade orders that were incorrectly labelled as “long” sales when they were in fact “short” sales.
A trade is marked “long” when the seller actually owns the stock they are selling. A trade should be marked “short” if the seller is borrowing stock to sell. Investors short-sell borrowed shares when they expect the share price to drop, allowing them to rebuy the shares at a lower price and pocket the difference.
Cormark mislabelled more than 200 short sales over a 14-month period, the SEC said in a settlement agreement with Cormark, published Monday. Cormark agreed to the US$800,000 penalty and a “cease and desist” order “without admitting or denying the findings” contained in the settlement.
On more than 80 occasions, the SEC settlement says, the hedge fund failed to settle the trades on schedule. This suggests that the trades were not only mislabelled, but that the hedge fund was also “naked shorting” – the practice of selling stock short without first securing shares to borrow.
Naked short-selling is illegal in the United States. The SEC settlement does not explicitly say the hedge fund was naked shorting. But it does note that the SEC trade-labelling system was designed, in part, to prevent naked shorting.
“Although Cormark made efforts to settle the hedge fund’s trades on time, the hedge fund repeatedly failed to deliver the securities it sold “long” by the scheduled settlement date during the relevant period,” the SEC settlement noted.
“In just the first month that Cormark placed “long” sale orders of [an unnamed issuer’s] stock for the hedge fund, the hedge fund failed to deliver shares to settle its trades by settlement date nine times.”
Cormark was routing the orders through a trade execution system run by ITG Canada Corp., which is now called Virtu ITG Canada Corp. According to the SEC settlement, ITG notified Cormark on a number of occasions that the hedge fund had failed to deliver the shares on time.
“Despite this, Cormark took no steps to confirm whether the hedge fund’s subsequent sale orders should be marked “long,” and simply continued to submit “long” sales on behalf of the hedge fund to ITG Canada,” the SEC settlement said.
In response to questions about the settlement, Cormark chief operating officer Susan Streeter said: “the SEC alleged the trades were mismarked in error, but did not allege it was done willfully.”
The settlement does say that Cormark “should have known” that its actions would lead to a violation of SEC rules.
“Cormark co-operated fully with the SEC in this investigation, and is pleased to put the matter behind it and move forward,” Ms. Streeter said. She declined to name the hedge fund in question.
ITG was also subject to a US$200,000 SEC penalty for continuing to accept mislabelled orders from Cormark.
“After repeated failures to deliver [shares], it was not reasonable for ITG Canada to continue to rely on Cormark’s order-marking information for orders to sell the securities of the Issuers absent further inquiry,” the SEC said in a separate settlement agreement published Sunday.
Short-selling is a legitimate part of capital markets, giving investors a way to bet on share prices falling. Naked shorting, on the other hand, can distort markets and lead to unfair trading.
As lawyers from the firm McMillan LLP wrote in a 2019 report: “Naked shorting carries with it particular risks – including an increase in failed trades, the distortion of share prices and the creation of phantom shares.”
Canadian securities regulators take a less strict line on naked shorting than the SEC. In Canada, the McMillan lawyers write, “naked shorting flies entirely under the regulatory radar unless the short fails to settle for a period of 10 trading days after the expected settlement date.”
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