What do the Chicago Board Options Exchange and I have in common? According to the SEC, through at least 2009, neither of us had a fundamental understanding of Regulation SHO! (Note--I still do not have a fundamental understanding of Regulation SHO. I assume CBOE now does).

In an administrative proceeding brought today, the SEC charged the CBOE and an affiliate called C2 with systemic breakdowns in their regulatory and compliance functions as SROs, including a failure to "enforce or even fully comprehend rules to prevent abusive short selling."

According to the the SEC's order, CBOE demonstrated an overall inability to enforce Reg. SHO. The SEC said that despite the presence of numerous red flags that its members were engaged in abusive short selling, CBOE failed to detect such wrongdoing. Specifically, the SEC stated, CBOE moved its surveillance and monitoring of Reg. SHO compliance from one department to another in 2008. Following this transfer of responsibilities, however, 

CBOE failed to adequately enforce Reg. SHO because its staff lacked a fundamental understanding of the rule. CBOE investigators responsible for Reg. SHO surveillance never received any formal training. CBOE never ensured that its investigators even read the rules. Therefore, they did not have a basic understanding of a failure to deliver.

In one 2009 case cited by the SEC, for example, CBOE began investigating whether certain trading activity violated Rule 204T of Reg. SHO. The CBOE staff assigned to the case, however, allegedly "did not know how to determine if a fail existed and were confused about whether Reg. SHO applied to a retail customer." The CBOE later closed the investigation.

To settle the SEC's charges, CBOE agreed to pay a $6 million penalty, accept a censure and cease-and-desist order, and implement significant undertakings. According to the SEC, the $6 million penalty is the first assessed against an exchange for violations related to its regulatory oversight.  These remedial measures include, among other things:

CBOE hired a chief compliance officer and two deputy chief regulatory officers;

CBOE's increased its regulatory budget by 52.8% over 2011 for 2012 and an additional 46.6% over 2012 for 2013 and increased the headcount of the Regulatory Services Division from 99 approved positions in October 2011 to 169 approved positions by April 2013; 

CBOE updated written policies and procedures, implemented mandatory training for all staff and management, and hired a third-party consultant to review its Reg. SHO enforcement program; and

CBOE also conducted a "bottom-up" review of its Regulatory Services Division's independence and reviewed all of CBOE's regulatory surveillances and the exchange's enterprise risk management framework. 

The SEC noted in its administrative proceeding that based on the CBOE's remedial efforts, the SEC determined not to impose limitations upon the activities, functions or operations of CBOE pursuant to Section 19(h)(1) of the Exchange Act.

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