The staff of the SEC recently addressed broker-dealers’ obligations when engaging in transactions in unregistered securities by issuing FAQs and a Risk Alert that reported the results of examinations of a number of broker-dealers’ practices in handling unregistered securities. The SEC’s core focus in these areas is curbing and preventing activities that undermine, or threaten to undermine, well-functioning markets, including fraud, manipulation, and money laundering.
As background, Section 5 of the Securities Act of 1933 (“Securities Act”) requires all offers and sales of securities in interstate commerce to be registered, unless an exemption from registration is available. Section 4(a) of the Securities Act contains certain exemptions, including an exemption commonly relied upon by broker-dealers for “brokers’ transactions executed upon customers’ orders on any exchange or in the over-the-counter market but not the solicitation of such orders.”
The FAQs clarify the obligations of broker-dealers seeking to rely on the exemption in Section 4(a)(4) to conduct a “reasonable inquiry” into the facts surrounding a proposed unregistered sale of securities before selling the securities, in order to form reasonable grounds for believing that a selling customer’s part of the transaction is exempt from Section 5. The FAQs provide non-exhaustive factors that the SEC may consider to be part of this inquiry, and address a broker-dealer’s obligations in specific situations.
The accompanying Risk Alert summarizes the SEC staff’s examinations of 22 broker-dealers identified as being frequently involved in the sale of the securities of microcap companies. Specifically, the examinations assessed the firms’ compliance with obligations to (1) perform a “reasonable inquiry” in connection with customers’ unregistered sales of securities when the firms relied on Section 4(a)(4)’s exemption, and (2) file suspicious activity reports (SARs), as required under the Bank Secrecy Act and the Securities Exchange Act of 1934, in response to “red flags” related to such sales.
As evidenced by the FAQs and Risk Alert, the SEC and FINRA are highly focused on Section 5 compliance and related issues of anti-money laundering compliance and microcap manipulation.