On October 9, the SEC’s Office of Compliance Inspections and Examinations (OCIE) issued a risk alert resulting from its examinations of broker-dealer controls involving customer sales of unregistered securities. Of the 22 firms examined, more than 80 percent were given deficiency letters, and the overwhelming majority were referred to the Division of Enforcement.

The offer and sale of securities must be registered pursuant to Section 5 of the Securities Act of 1933 (the “Securities Act”) unless a specific exemption exists. Section 4 (a) (4) provides an exemption for broker’s transactions executed upon customers’ orders, but not the solicitation of such orders. Reliance on this exemption is inappropriate if the broker-dealer has reasonable grounds to believe that the transaction is not exempt, including, for example, where the customer may be considered to be an underwriter or is otherwise involved in an unlawful distribution.

OCIE also draws attention to the possible requirement for a broker-dealer to file a Suspicious Activity Report (SAR) under the Bank Secrecy Act with the Financial Crimes Enforcement Network (FinCEN) in connection with the improper sale of unregistered securities if it “knows, suspects, or has reason to suspect” that the transaction:

  1. involves funds derived from illegal activity or is conducted to disguise funds derived from illegal activities;
  2. is designed to evade any requirement of the bank Secrecy Act;
  3. has no business purpose or apparent lawful purpose and the broker-dealer knows of no reasonable explanation for the transaction after examining the available facts;
  4. or involves the use of the broker-dealer to facilitate criminal activity.

Broker-dealers will need to carefully assess the need to file a SAR in the case of possible unlawful distributions.  Merely turning away the customer’s business is not sufficient if a SAR is required. A failure to file a SAR when required is a violation of Section 17(a) of the Securities Exchange Act of 1934, and Rule 17a-8.

The Risk Alert also identifies common deficiencies in the design of procedures requiring a reasonable investigation as to the availability of securities exemptions, including:

  • Insufficient detail, including an absence of a discussion concerning ‘red flags’ or reviews to be conducted
  • Reliance on the absence of restrictive legends on stock certificates – such reliance is not adequate
  • Reliance on the acceptance of the securities into a participant account at the Depository Trust Company or the absence of transfer agent objections to a transfer – such reliance is inadequate
  • Some firms did not collect adequate information concerning how the customer acquired the securities

The Risk Alert also discusses common patters suggesting illegal activity that point to the need for a SAR to be filed, many of which involve penny stock issuers in circumstances designed to disguise the identity of beneficial owners or those directing the trading activities.

Read OCIE’s Risk Alert.

At the same time, the SEC staff issued an FAQ about broker-dealers’ duties when relying on the broker’s exemption in Section 4 (a) (4) of the Securities Act. Read the Section 4 (a) (4) FAQ.

The SEC also announced the commencement of an enforcement action against two firms for improperly selling very large amounts of penny stocks through unregistered offerings. Read the SEC’s announcement.