On October 9, 2014, the Securities and Exchange Commission (the "SEC") published a Risk Alert and FAQs to remind broker-dealers of their obligations when they engage in unregistered sales of securities on behalf of their customers. The SEC also announced an enforcement action against current and former brokerage subsidiaries of E*TRADE Financial Corporation that failed in their gatekeeper roles and improperly engaged in unregistered sales of microcap stocks on behalf of their customers.
Section 4(a)(4) of the Securities Act of 1933 provides a registration exemption for broker-dealers when executing customers' unregistered sales of securities if, after reasonable inquiry, the broker-dealer is not aware of circumstances indicating that the customer would be violating the registration requirements of Section 5 of the Securities Act of 1933.
The Risk Alert summarizes deficiencies that were discovered by the SEC's Office of Compliance Inspections and Examinations ("OCIE") during a targeted examination of 22 broker-dealers frequently involved in the sale of the securities of microcap companies. Specifically, the OCIE staff evaluated compliance with the firms' obligations to (1) perform a "reasonable inquiry" in connection with customers' unregistered sales of securities when the firms are relying on the exemption set forth in Section 4(a)(4) of the Securities Act of 1933, and (2) file suspicious activity reports, as required under the Bank Secrecy Act and the Securities Exchange Act of 1934, in response to "red flags" related to such sales.
The examination uncovered widespread deficiencies including:
- Insufficient policies and procedures to monitor for and identify potential red flags in customer-initiated sales.
- Inadequate controls to evaluate how customers acquired the securities and whether they could be lawfully resold without registration.
- Failure to file suspicious activity reports, as required by the Bank Secrecy Act, when encountering unusual or suspicious activity in connection with customers' sales of microcap securities.
The Risk Alert can be found here.
The SEC stated that broker-dealers "are key gatekeepers in addressing potential violations of the securities laws by customers," and the SEC "will continue to assess the controls that firms in this business have in place to monitor for and report any suspicious activities."
The SEC's Division of Trading and Markets also published FAQs to remind broker-dealers of the requirements for complying with the Section 4(a)(4) exemption. The FAQs can be found here.
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