Risk Keeping the Wolves from Wall Street: Understand Broker-Dealer "Gatekeeper" Obligations and Recent Regulatory Actions NY Institute of Finance

Keeping the Wolves from Wall Street

Understand Broker-Dealer 'Gatekeeper' Obligations


  • The Securities and Exchange Commission (“SEC”) is taking a tough stance on broker-dealers that facilitate sales of unregistered securities by customers.
  • Two large cases brought in 2014 are instructive. One of the cases, brought by FINRA against Brown Brothers Harriman, resulted in a fine of $8 million against the firm
  • Reliance on customer representations or attorney opinion letters is not enough to satisfy the “reasonable inquiry” requirement; firms must instead conduct a “searching inquiry.”
  • Firms must be alert to “red flags” that could be indicative of microcap fraud through an unregistered distribution, such as a “pump and dump” scheme or insider trading, as well as that the microcap trading is being used to engage in money-laundering.
  • A strong control environment with comprehensive policies and procedures is critical.

The SEC is increasingly demonstrating, through its public statements and enforcement actions that broker-dealers are subject to significant “gatekeeper” obligations to prevent microcap fraud through the sale of unregistered securities.

In October 2014, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) issued a risk alert warning firms regarding the sale of unregistered securities. The risk alert came about after a sweep examination of 22 firms that actively facilitate trading in so-called penny stocks.1

1 The term penny stock generally refers to a security issued by a very small company that trades at less than $5 per share. Penny stocks generally are quoted over-the-counter, but may also trade on securities exchanges, including foreign securities exchanges. In addition, the definition of penny stock can include the securities of certain private companies with no active trading market. The penny stock rules and regulations are contained in Exchange Act Section 15(h) and Exchange Act Rules 3a51-1 and 15g-1 through 15g-100)

The results of the sweep were compelling: the SEC found that at least 18 of the 22 firms had deficient controls or procedures to prevent violations of the laws on selling unregistered securities.

The conduct at issue (verifying that a valid exemption exists under Section 4(a)(4) of the Securities Act before a broker executes sales of unregistered securities on behalf of customers 2 is neither new nor obscure; the SEC first issued guidance on the subject more than 50 years ago, in 1962, and FINRA most recently issued guidance on the subject in 2009. What’s more, the majority of the firms surveyed in the sweep did have policies and procedures on the subject.

2 Section 5 of the Securities Act of 1933 prohibits the sale of unregistered securities without an exemption. Section 4(a)(4) provides an exemption to brokers transacting in unregistered securities on behalf of customers.

The problem, as OCIE noted, was that most of those procedures were deficient in either their design or their implementation. Among other things, for example, although a firm’s procedures may have recited the requirement to verify an exemption, in many cases the procedures did not provide meaningful guidance to supervisors or compliance staff on how to verify the exemption, what red flags to look for, what to do if red flags popped up, or how to do a supervisory review to ensure that the firm was not violating Section 5 of the Securities Act. As a result, firms either failed to collect necessary information from customers, or simply assumed that an exemption existed if the shares were electronically deposited into the firms’ accounts via DTCC or a transfer agent, or relied (erroneously) on the fact that share certificates did not contain a restrictive legend - even though not all restricted share certificates are required to contain such a legend - to indicate if they could be transferred in conformity with Section 5 of the Securities Act. 3

3 Although restricted shares almost always contain a legend to that effect on the share certificate, control shares (shares obtained from a controlling shareholder) may not have the legend, because they may not have been restricted in the hands of the control person. A purchaser of control securities takes them subject to a restriction irrespective of their status when they were owned by the control person. See SEC Investor Rule 144.

Despite seemingly well-established standards of conduct, there have been several prominent failures by firms, and according to the OCIE Risk Alert, most of the firms in the sweep were referred to the Division of Enforcement or another regulatory agency for further investigation, so it is likely that there will be more cases in the near future.

Two large cases brought in 2014 are instructive. One of the cases, brought by FINRA against Brown Brothers Harriman, resulted in a fine of $8 million against the firm

Additionally, a $25,000 fine and one-month suspension was levied on its former Global Anti-Money Laundering (“AML”) Compliance Officer.4 The other case, announced by the SEC at the same time that OCIE issued its risk alert, involved two subsidiaries of online broker E*Trade Securities.5

4 See FINRA’s press release and Letter of Acceptance, Waiver and Consent (“AWC”)

5 See SEC’s press release and order instituting public administrative and cease-and-desist proceedings

In that case, E*Trade was subject to fines and disgorgement of $2.5 million. 6

6 FINRA (and its predecessor NASD) has brought a number of cases in recent years involving deficiencies in connection with the sale of unregistered securities. See, e.g., Oppenheimer & Co., Inc. FINRA Disciplinary Proceeding No. 2009018668801, August 5, 2013; Network 1 Financial Securities, Inc. NASD AWC No. EAF0400940001, July 11, 2007; NevWest Securities Corporation, NASD AWC E0220040112-01, March 21, 2007, and related case SEC v. CMKM Diamonds, Inc., et. al, U.S. Dist. Court for the District of Nevada, Civil Action No. 08- CV 0437 (Lit. Rel. No. 20519 / April 7, 2008); and Cardinal Capital Management, Inc. NASD AWC E072003004201, July 22, 2005;

The cases share some common features:

  • Both firms were found to have violated or failed to prevent violations of Section 5 of the Securities Act for extended periods of time – over approximately four years in each case, during which time they sold or delivered billions of shares of unregistered shares in microcap companies for customers.
  • There were significant red flags at each firm to suggest that the trades might not comply with the Section 4(a)(4) exemption, which should have resulted in heightened scrutiny of customers’ transactions.
  • Although each firm had policies and procedures that purported to address compliance with Section 5 of the Securities Act, the firms’ procedures were found to be materially deficient, in part because they failed to adequately instruct compliance staff on how to follow-up on red flags or suspicious activity.
  • The firms frequently relied on third parties (transfer agents and customer or issuer attorneys) to determine the status of securities rather than conducting their own inquiries.
  • The firms failed to file Suspicious Activity Reports (“SARs”), as required by the Bank Secrecy Act, for numerous transactions.

Applicable Requirements and the Gatekeeper’s Obligations

Sections 5(a) and 5(c) of the Securities Act generally prohibit the offer and sale of securities unless a registration statement is filed with the SEC and in effect or unless the sale is pursuant to valid exemption. Section 4(a)(4) of the Securities Act, the “brokers exemption” is one such exemption; it provides that a broker may facilitate an unsolicited customer order unless the broker knows or has reasonable grounds to believe that the selling customer’s part of the transaction is not exempt after reasonably inquiry.

Both FINRA’s AWC and the SEC’s Order focus on whether the broker should have known that there was not an applicable exemption. In particular, the cases describe the numerous red flags that the firms ignored. In E*TRADE’s case, the customers routinely deposited large quantities of newly issued penny stocks that had been acquired through private, unregistered transactions with little-known, non-reporting issuers. The customers asserted that the shares were freely tradable without a registration statement in effect pursuant to the “brokers” exemption, and E*TRADE permitted the customers to sell the shares into the market. Following the sales, the customers immediately wired the proceeds out of their accounts. Despite these obvious red flags, according to the SEC Order, E*TRADE initially failed to identify any registration exemption available to the customers, and when it later identified purported exemptions it failed to perform the requisite searching inquiry to be reasonably certain that the exemption was applicable to each unregistered sale.

In the Brown Brothers case, the firm provided execution and/or custodial services for penny stock transactions on behalf of certain bank customers in known bank secrecy havens through omnibus accounts for undisclosed underlying customers of foreign banks. The firm and its Global AML Compliance Officer were aware of numerous instances of suspicious activity relating to penny stocks, including that the transactions involved unregistered penny stocks; that the customers made deposits of large blocks of the securities; that many of the securities were deposited in certificate form and consisted of a large percentage of the outstanding shares; that multiple purportedly unrelated entities deposited shares of the same penny stock at the same time; that customers sold the securities immediately after depositing the shares; that the issuer’s public filings noted serious financial concerns; that suspicious press releases touted the securities; and that news sources indicated the securities were subject to “pump and dump schemes”. The FINRA AWC describes an inadequate monitoring and review system for red flags indicative of penny stock fraud, as well as a failure to file SARs for related suspicious activity. 7

7 The FINRA action also included findings and sanctions for significant AML deficiencies over an extended period of time.

Despite the existence of policies and procedures to monitor the trading activity in question, the SEC and FINRA found these efforts to have been inadequate. Significantly, in response to concerns, E*TRADE implemented a series of steps that it described as “enhanced due diligence.” These steps included: review of attorney opinion letter claiming that the brokers exemption was available; obtaining written customer and issuer representations (although unsubstantiated) to the effect that the securities were “freely tradable” and that the customer would comply with applicable laws and regulations; reviewing the trading history for securities previously sold by certain of the customers to assess whether the securities had been subject to market manipulations; visiting the customer offices; reviewing pending customer deposits to assess whether the customer would be assuming any financial risk associated with the resales; and researching the attorneys who authored the opinion letters to identify potentially negative information about them and to confirm that they were not on a list of banned attorneys maintained by the OTC “pink sheet” market.

Despite E*Trade’s efforts, the SEC concluded that the due diligence steps taken by E*TRADE were not strong enough and did not constitute the required “reasonable inquiry” that the brokers exemption was available given the continued presence of red flags.

The SEC Order identifies several key areas where E*TRADE should have handled the situation differently. First, when faced with a customer that engaged in a pattern of depositing large quantities of thinly trade securities acquired directly from little known non-reporting issuers in private transactions, the firm should have relied on an attorney’s opinion only if (a) it described the relevant facts in sufficient detail to provide an explicit basis for its legal conclusion that an exemption from registration was available and (b) the broker-dealer’s reasonable investigation did not uncover contrary facts. In E*TRADE’s case, the SEC noted that the attorney opinion letters did not generally meet that test and moreover, in some cases stated that the customer had investment intent whereas the customer immediately sold the shares following deposit. And of course the sales were improper, a fact that E*TRADE did not identify.

As noted above, simultaneous with the announcement of the E*TRADE enforcement action, OCIE issued a Risk Alert on deficiencies observed in the controls in place at certain broker dealers to comply with obligations related to sales of microcap companies. In addition, the SEC’s Division of Trading and Markets issued Responses to Frequently Asked Questions (“FAQs”) providing guidance on broker-dealer obligations with respect to the brokers exemption.

In addition to the deficiencies described above, OCIE also observed that some firms failed to file SARs, as required by the Bank Secrecy Act and the firms’ policies and procedures, when encountering unusual or suspicious activity in connection with customer sales of microcap securities. Some examples of activity that should have raised red flags included:

  • Atypical trading patterns, including trading involving sudden spikes in price and volume;
  • Certain patterns of trading activity being common to several customers – for example, sales of large quantities of the shares of multiple issuers by the customers;
  • Notifications from the broker-dealer’s clearing firm that the clearing firm had identified potentially suspicious activity in certain issuers of customers trading through the broker-dealer;
  • Certain types of accounts that provide anonymity to the beneficial owners in the liquidation of shares of microcap issuers (for example, accounts of purported stock loan companies seeming to hold restricted securities of corporate insiders who have pledged the securities as loan collateral and then defaulted on purported loans, accounts in the name of a corporate entity which could disguise unregistered sales by corporate insiders, accounts in the name of foreign financial institutions who may have sold shares on behalf of stock promoters, accounts using a master/sub structure which enables trading anonymity with respect to the sub-account activity);
  • Issuers with nominal assets and low operating revenue, frequent changes in the type of business the issuer is engaged in, the name of the corporate entity, directors and/or management; and
  • Sale by individuals known to be stock promoters.

The Trading and Markets FAQs provides additional guidance to broker-dealers regarding what constitutes a reasonable inquiry when relying on the brokers exemption in Section 4(a)(4) of the Securities Act. FAQ 2 makes clear that whether a broker-dealer has conducted a reasonable inquiry depends on the facts and circumstances surrounding the transactions. The broker-dealer “must be aware of the requirements necessary to establish an exemption from the registration requirements of the Securities Act and should be reasonably certain such an exemption is available”.

Importantly, it is not sufficient to merely accept self-serving statements by the seller and their counsel without reasonably exploring the possibility of contrary facts. Moverover, the lack of a restrictive legend, acceptance by DTC or lack of objection from a clearing firm or transfer agent are not determinative. The answer to FAQ 2 states that a reasonable inquiry should include, but not be limited to, the following matters:

  • The length of time the securities have been held by the customer and 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 3 months by all persons whose sales must be taken into consideration in evaluation 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 arrangements for the solicitation of buy orders in connection with the proposed sale;
  • Whether the customer has made any payment to any other person in connection with the proposed sale; and
  • The number of shares of the securities outstanding, or relevant trading volume.

If a broker-dealer uncovers facts that suggest a distribution or resale that goes beyond a typical secondary transaction, additional inquiries are warranted before it can rely on the brokers exemption.

FAQ 3 lays out some red flags that are “classic warning signs” that warrant additional inquiry. These include:

  • When a customer deposits a large block of recently issued shares of a little-known issuer into its account and then requests the sale of such shares without a registration statement in effect;
  • When a customer sells securities soon after depositing them;
  • When a customer engages in repeat transactions in the shares of a little-known issuer;
  • When the issuer 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.

If red flags are present, the broker-dealer must make whatever inquiries are necessary under the circumstances to determine that the transaction is not part of an illegal distribution.

A fundamental tenet of the U.S. securities laws is that registration of securities is a key component of investor protection, and that in the absence of vigilant controls, ordinary investors are at risk of exploitation by stock promoters and other unscrupulous market participants. Accordingly, the SEC relies on a coalition of entities to protect investors, including, significantly, broker-dealers who function as the so-called gatekeepers for securities transactions undertaken on behalf of their clients.

The size and scale of the FINRA case against Brown Brothers, and the SEC case against E*Trade, as well as the scope of the deficiencies identified by OCIE in its sweep, strongly suggest that regulators have prioritized actions against brokers who fail to perform their gatekeeper obligations with respect to the sale of unregistered securities. Therefore, firms and their compliance personnel will continue to come under tight scrutiny in this area, and would be well served to reinvigorate their compliance efforts in this area. In the meantime, expect to see increased attention to this issue, possibly including enforcement actions and referrals to the SROs or other regulators for follow-up investigation.

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