Microcap Securities: OCIE Issues Risk Alert Related to Broker-Dealer Controls Regarding Customer Sales

October 17, 2014

On October 9, 2014, the Securities and Exchange Commission’s (“Commission”) Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert reporting on significant deficiencies it found in its sweep of 22 broker-dealers that regularly sell microcap securities (“Risk Alert”).1 OCIE’s examinations focused on whether the firms (1) “perform[ed] a ‘reasonable inquiry’ in connection with customers’ [sales of unregistered securities] when the firms are relying on the exemption set forth in Section 4(a)(4) of the Securities Act [of 1933 (“Securities Act”) that exempts from the requirement to be registered securities transactions by brokers in unsolicited transactions], and (2) file[d] suspicious activity reports, as required under the Bank Secrecy Act and the [Securities] Exchange Act of 1934 (“Exchange Act”)], in response to ‘red flags’ related to such sales.”2 OCIE issued deficiency letters to a large number of the broker-dealers it examined, and stated in the Risk Alert that it had referred many of the firms to the Division of Enforcement (“Enforcement”) and other agencies. The Risk Alert reminds firms of their obligations in connection with sales of microcap securities and summarizes common deficiencies noted in OCIE’s examinations, and Frequently Asked Questions issued at the same time by the Division of Trading and Markets (“Trading and Markets”) (the “Trading and Markets FAQs” or “FAQs”) gives guidance on the proper use of the Securities Act Section 4(a)(4) exemption (“Section 4(a)(4) Exemption”).3 With the publication of the Risk Alert, the Commission also announced a settled enforcement action against E*TRADE Securities and G1 Execution Securities regarding sales of microcap securities.4

Broker-Dealer Obligations in Connection With Sales of Microcap Securities

The Risk Alert reminds firms that the Section 4(a)(4) Exemption is unavailable if “a broker-dealer knows or has reasonable grounds to believe that the selling customer’s part of the transaction is not exempt from Section 5 of the Securities Act.”5 The Risk Alert also notes that “a broker-dealer may claim the Section 4(a)(4) [E]xemption if, after reasonable inquiry, the broker-dealer is not aware of circumstances indicating that the customer would be violating Section 5, such as when the customer is an underwriter with respect to the securities or that the transaction is a part of a distribution of securities of the issuer.”6 Although whether an inquiry is “reasonable” depends on the facts and circumstances, the Risk Alert advises firms to consider the factors listed in Note (ii) to Rule 144(g)(4) (that are repeated in Trading and Markets’ FAQs) and in Financial Industry Regulatory Authority (“FINRA”) Notice to Members 09-05.7

The Risk Alert also reminds firms of their obligations under the Exchange Act to comply with “the recordkeeping, record retention, and reporting obligations of the Bank Secrecy Act and the regulations thereunder,” which include the obligation to file Suspicious Activity Reports (“SARs”) in certain circumstances.

Common Broker-Dealer Deficiencies

The OCIE staff focused its examinations on the effectiveness of broker-dealer controls associated with the unregistered sale of securities in general and in the context of “liquidations of large blocks of shares of microcap issuers that were also the subject of significant promotional efforts.”8 The examinations found that, while most of the broker-dealers had adopted policies and procedures incorporating the obligation to conduct a “reasonable inquiry” for purposes of the Section 4(a)(4) Exemption, the polices provided little guidance on the appropriate scope of that inquiry and lacked guidance on:

  • Common indicia used to determine whether shares were restricted securities, and 
  • Requirements to collect information that would inform the firm as to how shares had been acquired.9

The OCIE staff also noted that, although firms were aware of the reasonable inquiry requirement, many failed to enforce their policies and procedures and did not file SARs when they encountered “unusual or suspicious activity in connection with customers’ sales of microcap securities.”10

The OCIE staff also expressed concerns regarding the use of certain corporate and omnibus accounts, as well as accounts controlled by stock loan companies and foreign financial institutions to engage in this trading. OCIE noted that these accounts “can be used to disguise the trading activity of the accounts’ beneficial owners by commingling securities and funds from several beneficial owners.”11 According to OCIE, these accounts “appeared to be frequently associated with the unregistered sale of large quantities of the illiquid shares of microcap issuers, including sales of restricted securities on behalf of corporate insiders” and that certain firms “holding [such] accounts often failed to conduct reviews of the activity occurring in the accounts after encountering red flags.”12

Division of Trading and Markets FAQ

On the same day that OCIE issued the Risk Alert, Trading and Markets issued a five question FAQ regarding reliance on the Section 4(a)(4) Exemption.13 The FAQ summarizes the Section 4(a)(4) Exemption, describes the information a broker-dealer should review to conduct a reasonable inquiry (e.g., length of time customer has owned the shares, nature of transaction, volume of similar transactions, size of the transaction at issue, solicitations of buyers by the customer) and red flags to be aware of (e.g., deposits of large blocks of newly issued shares followed quickly by a sale, repeat transaction in little known issuers, customer’s stock promotion activities). Trading and Markets, however, limits its advice on reacting to these red flags, noting only that broker-dealers must “conduct a searching inquiry” to verify the transaction’s exempt status.14 Left unsaid, is that if the broker-dealer cannot satisfy itself that the transaction is exempt, it cannot legally execute the transaction, and that, as the Risk Alert notes, in some cases the firm may be required to file a SAR.

Recent Related Enforcement Actions

In conjunction with the publication of the Risk Alert, and as warned by the staff in the Risk Alert, the Commission announced a settled enforcement action against E*TRADE Securities (“E*Trade”) and G1 Execution Securities (“G1”) alleging violations of Section 5(a) and 5(c) of the Securities Act.15 The Commission alleged that E*Trade and G1 ignored red flags in connection with the execution of unregistered penny stocks and were not entitled to rely on the Section 4(a)(4) Exemption because they did not perform a “reasonable inquiry.” E*Trade and G1 were ordered to cease and desist from committing or causing any violations and any future violations of Sections 5(a) and 5(c) of the Securities Act, censured, ordered to pay disgorgement of approximately $1.4 million, ordered to pay prejudgment interest of $182,166 and ordered to pay a civil money penalty of $1,000,000.

What to Expect

The Risk Alert clearly suggests that the Commission (and maybe FINRA) plans to announce similar cases in the coming months. Similarly, this is likely to remain an area of OCIE focus. Moreover, it marks one more instance of regulators questioning the use (or misuse) of account types that may hide the identity of beneficial owners or others important facts related to the transaction, suggesting that firms should continue to consider how these accounts are supervised and what information firms should seek regarding these transactions.16 Broker-dealers should, therefore, be reviewing their related policies and procedures in light of the Risk Alert and FAQs to ensure that they are robust.


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1 National Exam Program Risk Alert: Broker-Dealer Controls Regarding Customer Sales of Microcap Securities, Volume IV, Issue 3 (Oct. 9, 2014) ("Risk Alert").

2 See Id. at 1.

3 Section 4(a)(4) of the Securities Act permits sales and offers to sell securities that do not have an effective registration statement for “brokers’ transactions executed upon customers’ orders on any exchange or in the over-the-counter market but not the solicitation of such orders.” Risk Alert at 2.

4 In the Matter of E*Trade Securities, LLC and G1 Execution Services, LLC, Administrative Proceeding File No. 3-16192 (Oct. 9, 2014).

5 See Risk Alert at 2.

6 See Id.

7 Risk Alert at 2; 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 (Oct. 9, 2014) ("FAQs"); FINRA Notice to Members 09-05: Unregistered Resales of Restricted Securities (Jan. 2009).

8 Risk Alert at 4.

9 Id. at 4-5.

10 Id. at 5.

11 Risk Alert at 7.

12 Id. at 6-7.

13 See FAQs.

14 See FAQs.

15 In the Matter of E*Trade Securities, LLC and G1 Execution Services, LLC, Administrative Proceeding File No. 3-16192 (Oct. 9, 2014).

16 See, e.g., FINRA Issues Guidance on Master and Sub-Account Arrangements, Regulatory Notice 10-18 (April 2010); Brown Brothers Harriman & Co. AWC No. 2013035821401 (Feb. 2014) (action arising from trading of penny stocks in omnibus accounts for foreign bank customers).

This article was originally published by Bingham McCutchen LLP.