SEC Releases Risk Alert And FAQs On Customer Sales Of Securities

On October 9, 2014, the United States Securities and Exchange Commission (the "SEC") announced an enforcement action against certain brokerage subsidiaries of E*TRADE Financial Corporation for failing in their gatekeeper roles and improperly selling unregistered penny stocks on behalf of their customers. The SEC found that E*TRADE Securities and G1 Execution Services (formerly, E*TRADE Capital Markets) sold billions of penny stock shares on behalf of customers, ignoring red flags that the offerings did not satisfy an exemption from the registration requirements of United States federal securities laws. Those broker-dealers agreed to settle the SEC's charges by paying more than U.S. $1.5 million in disgorgement and prejudgment interest from commissions they had earned on the improper sales plus a combined penalty of U.S.$1 million. In a targeted sweep of 22 broker-dealers, the SEC has uncovered deficiencies, including the following:

insufficient policies and procedures for monitoring and identifying red flags in customer-initiated sales; inadequate controls for evaluating how customers acquired the securities and whether the securities could be lawfully resold without registration; and failure to file suspicious activity reports (as required by the United States Bank Secrecy Act) upon encountering suspicious or unusual activity in connection with customers' sales of penny stocks. The SEC also published on October 9, 2014, a Risk Alert and FAQs reminding broker-dealers of their obligations when engaging in unregistered transactions on behalf of customers.

Requirement for Registration or Exemption

Sections 5(a) and 5(c) of the United States Securities Act of 1933, as amended (the "U.S. Securities Act"), generally require all offers and sales of securities to be registered with the SEC unless those offers and sales qualify for an exemption. Section 4(a)(4) of the U.S. Securities Act exempts broker-dealers' transactions on any exchange or in the over-the-counter market but not the solicitation of such orders (i.e., unsolicited orders of customers) ("Section 4(a)(4) Exemption"); however, the Section 4(a)(4) Exemption is not available if the 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 U.S. Securities Act.1 A broker-dealer may rely on the Section 4(a)(4) Exemption if, after reasonable inquiry, the broker-dealer is not aware of circumstances...