“What has been will be again / what has been done will be done again; there is nothing new under the sun.” Ecclesiastes 1:9.
On October 9th the SEC brought a settled administrative action against E*Trade Securities and G1 Execution Services (formerly E*Trade Capital Markets) for their part in the unregistered sales of billions of shares of penny stocks between 2007 and 2011. Suffice it to say that they weren’t the only ones. On the same day the Commission also (1) released FAQs on a broker-dealer’s duties on when trying to rely on the reasonable inquiry exemption when executing customer orders; and (2) issued a Risk Alert on broker-dealer controls regarding customer sales of penny stocks. The gist is, broker-dealers cannot turn a blind eye when executing its customers’ sales of securities of dubious or uncertain origin. These documents are all part of the SEC’s larger effort to focus on financial system gatekeepers and thereby save staff resources that would otherwise be spent chasing individual bad actors. What’s most interesting to me about the case and accompanying educational materials is how old the underlying principles are. The SEC has been preaching about broker-dealer oversight of little-known securities for literally half a century. And yet here we are.
Here’s the law in this area (roughly): Section 5 of the Securities Act prohibits the offer and sale of securities unless a registration statement is in effect or the offer and sale are subject to an exemption. Section 2(a)(11) defines a securities underwriter partially as “any person who has purchased from an issuer, with a view to, or offers or sells for an issuer in connection with, the distribution of any security.” There’s nothing especially wrong with being an underwriter, but if you are, that status will affect your (and, as we’ll see, your broker’s) ability to dump securities on the open market willy-nilly.
Also, many securities are properly sold under exemptions every day, but some people still like to make sales that are neither registered nor exempt. Broker-dealers don’t relish the idea of being liable for these sales, so Securities Act Section 4(a)(4) includes an exemption just for them. To rely on that exemption, though, a broker must, among other things, engage in a “reasonable inquiry” into the facts surrounding the proposed unregistered sale, and after such inquiry it must not be “aware of circumstances indicating that the person for whose account the securities are sold is an underwriter with respect to the securities or that the transaction is part of a distribution of the securities of the issuer.” See Section 4(a)(4); Rule 144(g)(4). The idea is, the broker needs to be sure it’s not just acting as a link in the chain of distribution from the issuer to the market; if it is, and the sales are not registered, it could be liable under Section 5.
But what counts as a “reasonable inquiry”? The SEC explained the general principles over 50 years ago in an interpretive release: Distribution by Broker-Dealers of Unregistered Securities, Securities Act Release No. 4445 (Feb. 2, 1962):
A dealer who is offered a modest amount of a widely traded security by a responsible customer, whose lack of relationship to the issuer is well known to him, may ordinarily proceed with considerable confidence. On the other hand, when a dealer is offered a substantial block of a little-known security, either by persons who appear reluctant to disclose exactly where the securities came from, or where the surrounding circumstances raise a question as to whether or not the ostensible sellers may be merely intermediaries for controlling persons or statutory underwriters, then searching inquiry is called for.
The E*Trade Case
So what did the E*Trade subsidiaries do? Basically, they had three institutional customers, known for purposes of the SEC’s administrative order as A, B, and C. From the time that those customers began trading penny stocks, the order says E*Trade was presented with the following recurring red flags: (1) the three customers acquired substantial amounts of newly issued penny stocks; (2) directly from little known, non-reporting issuers; (3) through private, unregistered transactions; (4) then immediately resold those shares; and (5) wired out the sales proceeds. Hmmm, does that sound familiar? The SEC thought these facts should have raised a question as to whether these customers were engaged in an unlawful distribution by, for example, acting as statutory underwriters.
So, in the face of these red flags, what did the E*Trade subsidiaries allegedly do (or not do)? For three years, they did not ascertain whether an exemption from registration was available. They didn’t ask A and B to identify the specific exemptions they were relying on. Later, the subsidiaries conducted an Enhanced Due Diligence review and allegedly relied on conclusory representations by A and C that the claimed exemptions were available. According to the order, they also relied on attorney opinion letters that claimed to identify an applicable exemption and why it was properly available. These letters, though, indicated that their conclusions were primarily based on unverified representations by the customers and issuers and did not describe all of the elements of the claimed exemptions.
The SEC held that the E*Trade subsidiaries were aware of facts showing that their customers were engaging in improper distributions of securities, and found them liable for direct violations of Section 5. They are jointly and severally liable for disgorgement of $1.4 million and a penalty of $1 million. Given that G1Execution is no longer part of E*Trade, they’ll have to sort out who pays what.
What to Do
What should a broker in the same position do here? The FAQs explain what we’ve known all along. The factors a reasonable inquiry should cover are included 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 3 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.
For smaller shops without an online presence – increasingly rare – staying on top of problematic trades may be relatively simple. Outliers selling large blocks of microcap securities will stand out. For broker-dealers allowing online trading, their compliance software should be written to automate exception reports based on these factors if it doesn’t incorporate them already. And take them seriously when electronic triggers are pulled, without relying on a customer’s or issuer’s own representations.
Other Aspects of the Risk Alert
The Risk Alert also noted that broker-dealers should keep a careful watch out for particular kinds of accounts and account structures, including accounts of purported stock loan companies, accounts using a master/sub-structure, and held in the names of corporate entities or foreign financial institutions. All could have the effect of disguising trading activity and facilitating unregistered sales. Finally, if appropriate, broker-dealers should be prepared to file Suspicious Activity Reports notifying FinCEN of bad actors in their midst. The exam sweep leading to the Risk Alert found a number of firms that were not filing SARs when necessary.