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.

Footnotes

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration
Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:
  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.
  • Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.
    If you do not want us to provide your name and email address you may opt out by clicking here
    If you do not wish to receive any future announcements of products and services offered by Mondaq you may opt out by clicking here

    Terms & Conditions and Privacy Statement

    Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

    Use of www.mondaq.com

    You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

    Disclaimer

    Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

    The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

    Registration

    Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

    • To allow you to personalize the Mondaq websites you are visiting.
    • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
    • To produce demographic feedback for our information providers who provide information free for your use.

    Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

    Information Collection and Use

    We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

    We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

    Mondaq News Alerts

    In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

    Cookies

    A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

    Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

    Log Files

    We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

    Links

    This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

    Surveys & Contests

    From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

    Mail-A-Friend

    If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

    Emails

    From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

    *** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .

    Security

    This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

    Correcting/Updating Personal Information

    If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

    Notification of Changes

    If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

    How to contact Mondaq

    You can contact us with comments or queries at enquiries@mondaq.com.

    If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.

    By clicking Register you state you have read and agree to our Terms and Conditions