## Facts

- Howard J. Shultz was a registered market maker on the Chicago Board Options Exchange (CBOE), trading options for his own account.
- The CBOE’s Business Conduct Committee began disciplinary proceedings against Shultz and three other market makers based on trading in Eastman Kodak option series.
- The Committee charged that Shultz’s conduct violated multiple Exchange rules, including provisions requiring conduct consistent with just and equitable principles of trade and requiring market makers to avoid dealings inconsistent with a fair and orderly market (including CBOE Rule 8.7(a)).
- On three separate trading days, Shultz and the other market makers executed a sequence of “circular” trades: each participant bought from and sold to another participant the exact same option within minutes, at the same price, leaving each trader in the same net position as before the sequence began.
- On each of those days, the circular trades occurred at prices about $1 lower than the prior sale price in the series.
- After the circular trades, there was an offer to sell at an even lower price that remained unfilled and became the final offer at the close of the day, contributing to a lower close in the series.
- Shultz held short positions in the options involved and stood to gain from a decline in the option price.
- At the Exchange hearing, the CBOE’s director of investigations presented evidence about the timing, pricing, and pattern of the transactions and their market effect.
- Shultz denied wrongdoing but could not give a satisfactory explanation for entering perfectly offsetting trades at the same price and then declining to buy when the option was offered for sale at an even lower price.
- Shultz’s own witnesses conceded the trading pattern was unusual.
- The Committee found rule violations and imposed a three-week suspension and a $2,500 fine; the CBOE Board of Directors affirmed on internal review.
- Shultz petitioned the Securities and Exchange Commission (SEC) for review. The SEC conducted a hearing, made a de novo determination of facts and law, found the misconduct established by clear and convincing evidence, and affirmed the sanctions.
- Shultz petitioned the Seventh Circuit for review of the SEC’s final order.

## Issues

1. Whether claimed unfairness or bias in the CBOE disciplinary process required setting aside the SEC’s order affirming the Exchange’s sanctions.
2. Whether the SEC’s findings that Shultz participated in improper circular trading and violated CBOE rules were supported by substantial evidence.
3. Whether CBOE Rule 8.7(a), requiring conduct consistent with a fair and orderly market (and related broad conduct standards), was unconstitutionally vague as applied to Shultz’s trading.

## Decision

- The Seventh Circuit affirmed the SEC’s order sustaining the CBOE’s three-week suspension and $2,500 fine.
- Alleged defects or bias at the Exchange level did not justify reversal where the SEC conducted its own de novo review and the court found no basis to conclude the Commission’s decision was tainted.
- Substantial evidence supported the SEC’s conclusion that the circular trades were improper: the rapid, offsetting transactions at identical prices, their downward effect on the series, the lack of a credible legitimate explanation, and Shultz’s short position permitted the inference that the activity was inconsistent with Exchange standards for market integrity.
- The court rejected Shultz’s vagueness challenge, holding that Rule 8.7(a) and comparable broad Exchange conduct rules provided adequate notice when applied to a professional market maker and to the specific trading pattern at issue.

## Legal Principles

- On review of SEC action affirming self-regulatory organization discipline, the court reviews the SEC’s final order, not the Exchange’s decision in isolation.
- Where the SEC conducts de novo review and independently determines the facts and law, claimed Exchange-level procedural flaws warrant relief only if they resulted in Commission error affecting the final order.
- The SEC’s factual findings are sustained if supported by substantial evidence on the record as a whole.
- Patterns of circular, economically meaningless trades that move quoted prices can support discipline as conduct inconsistent with just and equitable principles of trade and with a fair and orderly market.
- Broad exchange rules such as “just and equitable principles of trade” and “fair and orderly market” are not void for vagueness when applied to regulated professionals and to conduct that plainly threatens market integrity.

## Conclusion

The Seventh Circuit upheld the SEC’s affirmance of CBOE sanctions against market maker Howard Shultz for circular Eastman Kodak options trades that pushed prices downward without changing the traders’ net positions, finding the SEC’s determination supported by substantial evidence, rejecting claims of unfairness in the Exchange process given the SEC’s de novo review, and holding that Rule 8.7(a) and related broad conduct standards were not unconstitutionally vague as applied.


Shultz v. Securities and Exchange Commission, 614 F.2d 561 (1980)