Morgan Stanley got a $5 million penalty and a cease-and-desist order for breaching short selling rules.

They played the half long half short game, the Securities and Exchanges Commission (SEC) just said, and then reported the closed longs as only longs. They say:

“According to the SEC’s order, the structure of Morgan Stanley’s prime brokerage swaps business resulted in violations of Reg SHO.

As set forth in the order, Morgan Stanley hedged synthetic exposure to swaps by purchasing or selling the securities referenced in the swaps, and it separated its hedges into two aggregation units – one holding only long positions, and the other holding only short positions.

According to the order, Morgan Stanley was able to sell its hedges on the long swaps and mark them as “long” sales without concern for Reg SHO’s short sale requirements.”

They specifically say Morgan Stanley violated Rule 200(g) of Reg SHO with Regulation SHO being new rules passed in 2005 that governs short sell trading strategies.

They aim to prevent unethical practices with the specified rule stating an order can only be marked long when the seller owns the security and either it is within the possession of the broker-dealer or it’s expected it will be by the time of settlement.

Morgan Stanley relied on an aggregate units exception, but SEC says that doesn’t apply because “the units had identical management structures, locations, and business purposes as well as the same strategy or objective.”

It’s not clear how long SEC has known about this and did nothing until the FinCEN files recently exposed dirty money banking practices, but Daniel Michael, Chief of the Complex Financial Instruments Unit at SEC, says:

“For many years, Morgan Stanley has improperly relied on Reg SHO’s aggregation unit exception, resulting in orders being mismarked for countless transactions… Market participants cannot disregard the rules of the road established by Reg SHO for all short sales.”

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