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Faulty Broker Dealer Gatekeeping Leads To SEC Enforcement Action

Faulty Broker Dealer Gatekeeping Leads To SEC Enforcement Action

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October 17, 2014

The Securities and Exchange Commission (“SEC”) recently announced an enforcement action against two broker-dealers that apparently failed in their “gatekeeper roles” and improperly engaged in unregistered sales of microcap stocks on behalf of their customers.

This action, along with issuance of the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) National Exam Program Risk Alert (“Risk Alert”) and the Division of Trading and Markets’ “Responses to Frequently Asked Questions about a Broker-Dealer's Duties When Relying on the Securities Act Section 4(a)(4) Exemption to Execute Customer Orders” (“FAQ”) will certainly have impact to broker-dealers policies and procedures, as well as other controls related to suspicious activity reports and related areas.

Red Flags Ignored
The SEC investigation found that the firms sold billions of shares in microcap companies for customers during a four-year period while ignoring “red flags” that the offerings were being conducted without an applicable exemption from the registration provisions of the federal securities laws. Red Flags ignored included:

  • a customer opens a new account and delivers physical certificates representing a large block of thinly traded or low-priced securities;
  • a customer has a pattern of depositing physical share certificates, immediately selling the shares and then wiring out the proceeds of the resale;
  • a customer deposits share certificates that are recently issued or represent a large percentage of the float for the security;
  • share certificates reference a company or customer name that has been changed or that does not match the name on the account;
  • the lack of a restrictive legend on deposited shares seems inconsistent with the date the customer acquired the securities or the nature of the transaction in which the securities were acquired;
  • there is a sudden spike in investor demand for, coupled with a rising prince in, a thinly traded or low-priced security;
  • the company was a shell company when it issued the shares;
  • a customer with limited or no other assets under management at the firm receives an electronic transfer or journal transactions of large amounts of low-priced, unlisted securities;
  • the issuer has been thought several recent name changes business combinations or recapitalizations, or the company’s officers are also officers of numerous similar companies; and
  • the issuer’s SEC filings are not current, are incomplete, or non-existent.

Finding successSection 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.

In addition to a combined penalty of $1 million, the two firms agreed to settle the SEC’s charges by paying back more than $1.5 million in disgorgement and prejudgment interest from commissions they earned on the improper sales. See SEC Press Release 2014-225.

The Risk Alert and the FAQ
OCIE staff, during their targeted sweep of 22 broker-dealers, identified the following concerns in the Risk Alert:

  • 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.

Risk AlertAs per the Risk Alert, of the 22 firms examined, 80% were issued letters of deficiency for material control weaknesses and/or potential violations of law, with the majority of the firms examined were also referred to the Division of Enforcement or another regulatory agency for further consideration of whether violations of law occurred.

OCIE concluded “most of the examined broker-dealers have policies and procedures requiring the firm to conduct a reasonable inquiry into the facts surrounding a proposed unregistered sale to determine if the customer is an underwriter.” However, the OCIE examinations “illuminated control weaknesses in the design or implementation of those policies and procedures.” The Risk Alert presented examples of certain situations where these control weaknesses have resulted in the broker-dealers failing to conduct a reasonable inquiry and/or failing to file SARs regarding suspicious sales activity. Control weaknesses identified included:

  • Some firms’ policies and procedures did not contain sufficient detail to assist the firms’ employees in their efforts to effectively monitor and identify situations where facts and circumstances suggest the customer may not have had a claimed exemption. For example, some firms’ policies and procedures merely stated that a reasonable inquiry should be conducted, without providing any additional discussion of potential red flags that could indicate a possible Section 5 violation, protocols that the staff should follow when encountering red flags, or supervisory reviews that should be conducted to determine whether the securities were resold in compliance with an available exemption;
  • Some firms relied, without further inquiry, on the absence of restrictive legends on stock certificates to conclude that the securities could be resold in unregistered transactions.
  • Some firms relied, without further inquiry, on the delivery of the shares into a customer’s account in electronic form through a transfer from the Depository Trust and Clearing Corporation (“DTCC”) or the issuer’s transfer agent as a basis for believing either that the shares were not restricted securities or that no further inquiry regarding the customer was necessary; and
  • Some firms did not collect information from the customer about how large blocks of shares, deposited into the customer’s account that the customer requested the broker-dealer to sell, had been acquired, despite the fact that the firms did not know how the customer had acquired the shares.

In addition, OCIE discussed in the Risk Alert their observations that certain types of accounts as being frequently associated with “dumping” of microcap securities.

The Division of Trading and Markets issued an FAQ in effort to remind broker-dealers of their obligation to conduct a reasonable inquiry when selling securities in an unregistered transaction in reliance on Section 4(a)(4) of the Securities Act of 1933.



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