Long and Short: SEC Expects Accurate Data from Advisers
Next time you report trades to brokers, make certain you correctly characterize them. One firm just settled with the SEC for $4.25 million and was forced to admit wrongdoing in regard to the agency’s allegations of mischaracterizing long and short sales.
New York City-based OZ Management on July 14 settled with the Commission after being charged with providing inaccurate data to four of its prime brokers from January 2008 through December 2013. The incorrect data caused inaccuracies in the brokers’ books and records, as well as in data they provided to the SEC during investigations, the agency said. OZ Management is indirectly owned by mega-giant Och-Ziff Management Group, an alternative asset manager with approximately $47.3 billion in assets under management.
According to the SEC, the bad data caused the brokers to "inaccurately list 552 million shares in their own books and data." Further, that same incorrect data was allegedly incorporated into the "blue sheets" that brokers sent to the Commission and other regulators. In this case, the errors resulted in the inaccurate reporting of approximately 14.4 million shares to the SEC, the agency said, adding that FINRA made several referrals to the SEC concerning possible violations of Rule 105 of Regulation M based on the incorrect data.
"The SEC relies on the accuracy of the books and records of financial institutions and blue-sheet data," said SEC Division of Enforcement director Andrew Ceresney. "OZ Management’s inaccurate data had a substantial ripple effect that the SEC staff discovered through diligent investigative work."
OZ Management issued a brief statement on the matter through a spokesperson: "This reporting issue has been resolved and we have taken steps to ensure that it does not re-occur." An attorney representing the adviser referred calls for comment to the spokesperson.
Dangers of garbage in, garbage out
"In an era where an increasing number of market participants and regulators are relying on data analytics for decision making, this case highlights the perils of ‘garbage in, garbage out,’" said Zaccaro Morgan partner Nicolas Morgan. "The SEC routinely relies on broker ‘blue sheet’ data to aid investigations of market manipulation, insider trading and reporting violations, and here the SEC alleges that the adviser’s failure to submit correct transaction information resulted in regulatory referrals concerning possible violations of Rule 105. While this type of case is unusual, regulators’ growing reliance on big data suggests that such actions may become more frequent — and troublesome for those caught up in regulatory investigations stemming from the reporting errors of others."
The SEC settlement did include one instance of OZ Management violating Rule 105, which involved the adviser allegedly engaging in short sales during the restricted period prior to the pricing of a secondary offering, and then purchasing shares in that offering. The Commission has an ongoing dragnet to catch violators of Rule 105, and has brought actions against numerous advisers in the past few years.
Rodgers & Hardin partner Stephen Councill noted that while SEC requirements for admissions of guilt are growing, they still do not occur in very many cases. "I think here it reflects the Commission’s frustration with having spent resources investigating certain trading activity, only to find out that the blue-sheet data it relied on to determine who traded was inaccurate."
An admission of guilt is "a pretty heavy sanction for a mistake, but in this case, the admission might not be a major concern if it has no collateral consequences," he said. "Usually, an admission to wrongdoing can be a significant problem if there is private litigation related to the same underlying issue."
Blue sheets, named for the color of the original paper forms, are electronic forms generated by market makers, brokers and clearing firms to provide information in response to requests from the SEC and self-regulatory organizations. They contain data relating to trading activity, including whether transactions were purchases, long sales or short sales.
If inaccurate data is provided, it not only means that the parties providing them – in this case, brokers – have inaccurate information on their books, it means that the SEC, FINRA and other regulators do not have accurate data when conducting investigations. The agency will come down hard when one of its basic tools is threatened, as the $4.25 million penalty and its insistence on an admission of guilt in this case indicate. The OZ Management action is the second recent SEC action involving blue sheets. In 2014, Scottrade (ACA Insight, 4/20/15), in another settlement involving allegedly inaccurate and incomplete blue sheet data, was forced to pay $2.5 million to the agency and, like OZ Management, had to admit wrongdoing.
"Blue sheet information is the lifeblood of many SEC investigations and examinations," said Ceresney after that case was settled. "When firms fail to provide us with accurate or complete trade data, it risks compromising our ability to detect and investigate securities law violations."
The SEC conducted an investigation of OZ Management in 2013, and it was during that investigation that it found that "the firm’s own files identified certain trades differently than the blue sheets," the agency said. Specifically, the discrepancy occurred with trades that OZ Management did not characterize as either long or short based on how they were marked when they were sent to the market. Instead, they were filtered based on other factors, such as the relevant fund’s position in the stock at the prime broker, the agency said.
"As a result, the way trades were identified sometimes changed, causing some long sales to be erroneously shown as short sales when OZ Management provided the data to its prime brokers," the SEC said.
How was this alleged misidentification allowed to happen? According to the administrative order instituting the settlement, each day OZ Management would export the trading data on its order management system to its custom-built, in-house accounting software platform, the Financial Controls and Information System (FCIS). At the close of trading each day, FCIS would create an electronic trade file and transmit it to the prime brokers, where the funds maintained accounts and where the trades would settle.
The trade files identified the security, executing broker, trade date, settlement date, price, quantity and whether the trade was a long sale, short sale or a purchase, the SEC said.
Two views don’t work
Unfortunately, when FCIS was launched in January 2008, OZ Management also "implemented a functionality that enabled FCIS to produce trade files to prime brokers in two different versions, or ‘views,’" the agency said. FCIS also used a "strategy filter," which the SEC said also "impacted certain trade files."
"As a result of these configurations, in a number of circumstances, OZ Management provided fund prime brokers with trade files that inaccurately listed the trade type (long or short) of sales," the agency said.
Under the "fund view," for instance, OZ Management sent to some of its prime brokers a version of the trade file that displayed long or short sales "based on the relevant fund’s position in the security firm-wide," the SEC said. This view correctly reflected how the adviser marked the sales (long or short) for its brokers.
But under the "prime broker view," the agency said, prime brokers received data that "identified a sale as long or short based on the relevant fund’s position in the stock at the prime broker where the trade was sent for settlement [emphasis SEC] and not based on whether the sale in question had actually been marked long or short when OZ Management sent the sale to the market through its executing brokers."
"Because this logic was focused on listing the trade in the trade file in a manner consistent with the fund’s position at the prime broker [emphasis SEC], it sometimes switched the identification of the trade type from the way it was identified when OZ Management sent the sale to the market through its executing brokers," the SEC said.
Why were two different views allowed? According to the SEC’s administrative order, OZ Management developed the prime broker view so that the adviser and its prime brokers would not need to manually reconcile, on a trade-by-trade basis, sales that were executed as long based on the fund’s global net position, but where the fund did not hold sufficient shares to settle that trade at the prime broker, where settlement took place.
"OZ Management did not consider the possible effects of the ‘prime broker view’ on the accuracy of the prime brokers’ required books and records, or inform the prime brokers that the trade files they received from OZ Management did not represent how OZ Management marked sales when OZ Management sent the trades to the market," the agency said.
Since discovery of the violations in late 2013, OZ Management ceased providing trade files with the prime broker view, and has provided corrected historical information to the affected brokers, the SEC said. The prime brokers themselves are working with the agency to resubmit corrected blue sheets and address inaccurate information in their systems.
OZ Management was charged with causing its four prime brokers to violate Section 17(a) of the Exchange Act, as well as its Rule 17a-3(a)(3), both of which require broker-dealers to make and keep records and provide them to the Commission. In addition, the firm was charged with causing their prime brokers to violate Rule 17a-25, which requires broker-dealers to electronically submit securities transaction information, known as the blue-sheet data, to the Commission upon request. Finally, the adviser was charged with violating Rule 105 of Regulation M.