Just as the Securities and Exchange Commission announced an enforcement action on Thursday against subsidiaries of E*Trade for engaging in unregistered sales of micro-cap stocks, the agency released a Risk Alert reminding broker-dealers of their obligations when they engage in unregistered transactions on behalf of their customers.
The SEC enforcement action was against current and former brokerage subsidiaries of E*TRADE Financial Corp., which the agency said 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.
“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,” said Andrew Ceresney, director of the SEC’s Division of Enforcement, in a statement. “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.”
The Risk Alert summarizes deficiencies that the SEC’s Office of Compliance Inspections and Examinations observed in the controls that certain broker-dealers put in place to comply with obligations related to sales of the securities of microcap companies, including to perform a “reasonable inquiry” in connection with unregistered sales of securities in reliance on Section 4(a)(4) of the Securities Act, and respond to suspicious activity in connection with such sales.
The alert also discusses certain types of accounts that OCIE staff observed as being frequently associated with “dumping” of microcap securities.
According to the SEC’s order instituting a settled administrative proceeding, the failures by E*Trade occurred periodically from March 2007 to April 2011.
As the SEC explains, 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 agency states.
“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 SEC says. “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,” the SEC said. “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.”