by Securities and Exchange Commission
The Securities and Exchange Commission today announced publication of a Risk Alert and FAQs to remind broker-dealers of their obligations when they engage in unregistered transactions on behalf of their customers. The publication of the staff guidance was accompanied by the announcement of an enforcement action against two subsidiaries of E*TRADE Financial Corporation for improperly selling billions of shares of penny stocks through such unregistered offerings.
The Risk Alert summarizes deficiencies that were discovered by the SEC’s Office of Compliance Inspections and Examinations (OCIE) during a targeted sweep of 22 broker-dealers frequently involved in the sale of microcap securities. The sweep uncovered widespread deficiencies including:
- 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.
Said Kevin Goodman, National Associate Director of OCIE’s broker-dealer examination program:
Broker-dealers are key gatekeepers in addressing potential violations of the securities laws by customers. We will continue to assess the controls that firms in this business have in place to monitor for and report any suspicious activities.
Section 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. The SEC’s Division of Trading and Markets published FAQs to remind broker-dealers of the requirements for complying with the exemption. Said Stephen Luparello, Director of the SEC's Division of Trading and Markets:
Broker-dealers must be vigilant when facilitating sales on behalf of customers in unregistered transactions and remember that reliance on the broker’s exemption requires a reasonable inquiry of the customer and transaction.
The FAQs were prepared by Paula Jenson, Lourdes Gonzalez, Kevin Schopp, and Carl Emigholz of the Division of Trading and Markets. The Risk Alert was prepared by Steven Vitulano and Ellen Hersh of the Office of Compliance Inspections and Examinations.
Charges against Subsidaries of E*TRADE Financial Corporation
The Securities and Exchange Commission today announced an enforcement action against current and former brokerage subsidiaries of E*TRADE Financial Corporation that failed in their gatekeeper roles and improperly engaged in unregistered sales of microcap stocks on behalf of their customers.
An SEC investigation found that E*TRADE Securities and E*TRADE Capital Markets sold billions of penny stock shares 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. E*TRADE Securities remains an E*TRADE subsidiary while E*TRADE Capital Markets was sold earlier this year and is now called G1 Execution Services.
E*TRADE Securities and G1 Execution Services 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. They also must pay a combined penalty of $1 million. Said Andrew J. Ceresney, Director of the SEC’s Division of Enforcement:
Broker-dealers serve an important gatekeeping function that helps prevent microcap fraud by taking measures to ensure that unregistered shares don’t reach the market if the registration rules aren’t being followed. Many billions of unregistered shares passed through gates that E*TRADE should have closed, and we will hold firms accountable when improper trading occurs on their watch.
According to the SEC’s order instituting a settled administrative proceeding, the failures by E*TRADE occurred periodically from March 2007 to April 2011. The securities laws generally require all offers and sales of securities to be registered with the SEC unless those offers and sales qualify for an exemption. When brokers facilitate an unregistered sales transaction on behalf of a customer, they must reasonably ensure that an exemption does indeed apply.
The SEC’s order finds that three customers of E*TRADE routinely deposited to their E*TRADE accounts large quantities of newly issued penny stocks they had acquired through private, unregistered transactions with little-known, non-reporting issuers. The customers claimed that these penny stocks were “freely tradable” and they placed orders for E*TRADE to sell the securities to the public through “resales” without any registration statements in effect. Following the resales, the customers immediately wired the sales proceeds out of their accounts.
According to the SEC’s order, E*TRADE encountered numerous red flags indicating potential improper sales of securities. Nevertheless, the firm relied on a registration exemption for broker-dealers that permits them to execute a customer’s unregistered sales of securities if, after a reasonable inquiry, the broker-dealer is not aware of circumstances indicating that the customer is violating registration requirements. E*TRADE initially failed to identify any exemptions potentially available to these customers. When it later identified the purported exemptions upon which the customers claimed to be relying, E*TRADE failed to perform a searching inquiry to be reasonably certain that such exemptions applied for each unregistered sale executed by the three customers. Said Stephen L. Cohen, Associate Director of the SEC’s Division of Enforcement:
E*TRADE failed to fulfill its obligation to determine whether any exemptions applied to the sale of billions of shares of securities thereby depriving investors of critical protections under the federal securities laws,. Firms must take their reasonable inquiry obligations seriously and do more than check the box, particularly when red flags are apparent.
The SEC’s order finds that E*TRADE Securities and G1 Execution Services violated Sections 5(a) and 5(c) of the Securities Act of 1933. In addition to the monetary sanctions and without admitting or denying the SEC’s findings, the two firms agreed to be censured and consented to the order requiring them to cease and desist from committing or causing any future violations of the registration provisions of the Securities Act.
The SEC’s investigation was conducted by Deborah R. Maisel and Richard E. Johnston with assistance from Kyle DeYoung. The case was supervised by Jennifer S. Leete.