United States: SEC Releases Risk Alert And FAQs On Customer Sales Of Securities

On October 9, 2014, the United States Securities and Exchange Commission (the "SEC") announced an enforcement action against certain brokerage subsidiaries of E*TRADE Financial Corporation for failing in their gatekeeper roles and improperly selling unregistered penny stocks on behalf of their customers. The SEC found that E*TRADE Securities and G1 Execution Services (formerly, E*TRADE Capital Markets) sold billions of penny stock shares on behalf of customers, ignoring red flags that the offerings did not satisfy an exemption from the registration requirements of United States federal securities laws. Those broker-dealers agreed to settle the SEC's charges by paying more than U.S. $1.5 million in disgorgement and prejudgment interest from commissions they had earned on the improper sales plus a combined penalty of U.S.$1 million. In a targeted sweep of 22 broker-dealers, the SEC has uncovered deficiencies, including the following:

  • insufficient policies and procedures for monitoring and identifying red flags in customer-initiated sales;
  • inadequate controls for evaluating how customers acquired the securities and whether the securities could be lawfully resold without registration; and
  • failure to file suspicious activity reports (as required by the United States Bank Secrecy Act) upon encountering suspicious or unusual activity in connection with customers' sales of penny stocks.

The SEC also published on October 9, 2014, a Risk Alert and FAQs reminding broker-dealers of their obligations when engaging in unregistered transactions on behalf of customers.

Requirement for Registration or Exemption

Sections 5(a) and 5(c) of the United States Securities Act of 1933, as amended (the "U.S. Securities Act"), generally require all offers and sales of securities to be registered with the SEC unless those offers and sales qualify for an exemption. Section 4(a)(4) of the U.S. Securities Act exempts broker-dealers' transactions on any exchange or in the over-the-counter market but not the solicitation of such orders (i.e., unsolicited orders of customers) ("Section 4(a)(4) Exemption"); however, the Section 4(a)(4) Exemption is not available if the broker-dealer "knows or has reasonable grounds to believe that the selling customer's part of the transaction is not exempt from Section 5" of the U.S. Securities Act.1 A broker-dealer may rely on the Section 4(a)(4) Exemption if, after reasonable inquiry, the broker-dealer is not aware of circumstances indicating that the offer or sale of securities on behalf of its customer would violate Section 5 of the U.S. Securities Act, such as when the customer is an underwriter with respect to the securities or the transaction would be part of a distribution of securities of the issuer.2

Reasonable Inquiry of the Customer and Transaction

As discussed above, before relying on the Section 4(a)(4) Exemption, a broker-dealer must conduct a "reasonable inquiry" into the facts relating to a proposed unregistered sale of securities to form reasonable grounds for believing that the customer's sale is exempt from registration. The Risk Alert and the FAQs indicate that a broker-dealer cannot presume the sale is exempt from registration simply because (i) the security is accepted by the Depository Trust Company or a clearing firm or transfer agent raises no objections to the sales, or (ii) the security is delivered into an account of a customer without a restrictive legend in electronic form.

The FAQs indicate that in order for a broker-dealer to rely on the Section 4(a)(4) Exemption, including circumstances where a customer claims to have received the securities in a transaction exempt from registration or pursuant to the safe harbor under Rule 144, the reasonable inquiry under Rule 144(g)(4) should include, without limitation, the following matters as set forth in Note (ii) to Rule 144(g)(4):

  • the length of time the securities have been held by the broker-dealer's customer (including physical inspection of the securities, if practicable);
  • the nature of the transaction in which the securities were acquired by the customer;
  • the amount of securities of the same class sold during the past three months by all persons whose sales are required to be taken into consideration in evaluating compliance with the volume limitations of Rule 144(e);
  • whether the customer intends to sell additional securities of the same class through any other means;
  • whether the customer has solicited or made any arrangement for the solicitation of buy orders in connection with the proposed sale of securities;
  • whether the customer has made any payment to any other person in connection with the proposed sale of the securities; and
  • the number of shares or other units of the class outstanding, or the relevant trading volume.

Depending on the facts uncovered by the broker-dealer (including, for example, circumstances indicative of a distribution or a resale going beyond a typical secondary market transaction), additional inquiries may be needed before the broker-dealer can rely on the Section 4(a)(4) Exemption.

Red Flags

The FAQs indicate that a broker-dealer may violate Section 5 of the U.S. Securities Act if it fails to inquire sufficiently into the facts and circumstances of a transaction, given warning signs that the transaction may involve an underwriter or an unregistered distribution.3 The FAQs identify certain red flags requiring additional inquiry, including, without limitation:

  • when a customer deposits a large block of recently issued shares of a little-known issuer into its account and then requests that the broker-dealer sell such shares without a registration statement in effect;
  • when a customer sells securities soon after depositing them into the account;
  • when a customer engages in repeat transactions in the shares of a little-known issuer;
  • when an issuer of stock is a newly formed company, with little trading, operating, or earnings history; or
  • when a customer is engaged in stock promotion activities on behalf of the issuer.

Broker-dealers should have adequate policies, procedures and controls in place to ensure that they're satisfying their obligations before engaging in unregistered sales of securities on behalf of customers.


1. In the Matter of John A. Carley, Exchange Act Release No. 57246, 8 (Jan. 31, 2008) (Commission opinion). See also In the Matter of Jacob Wonsover, Exchange Act Release No. 41123, 28 (Mar. 1, 1999) (Commission opinion), aff'd, 205 F.3d 408 (D.C. Cir. 2000).

2. 17 C.F.R. § 230.144(g). See, e.g., World Trade Financial Corporation v. SEC, 739 F.3d 1243, 1248 (9th Cir. 2014); In the Matter of Midas Securities, LLC and Jay S. Lee, Exchange Act Release No. 66200, 8 (Jan. 20, 2012) (Commission opinion); In the Matter of Robert G. Leigh, Exchange Act Release No. 27667, 4 (Feb. 1, 1990) (Commission opinion).

3. See Midas, supra note 2, at 16-17.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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