Penny Stock Rules That Govern Broker Dealers
LawCast- Penny Stock Rules That Govern Broker Dealers- On October 9, 2014, the Securities and Exchange Commission (“SEC”) filed an enforcement action against E*Trade Securities and E*Trade Capital Markets for selling billions of shares of unregistered and otherwise restricted penny stocks for their customers. The SEC found that the firms processed the sales on behalf of three customers while ignoring red flags that the offerings being conducted were in violation of the federal securities laws in that the shares were neither registered nor subject to an available exemption from registration. E*Trade Securities and E*Trade Capital Markets settled the enforcement proceeding by agreeing to pay a total of $2.5 million in disgorgement and penalties.
The SEC press release on the matter quoted Andrew J. Ceresney, Director of the SEC’s Division of Enforcement, as saying, “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.”
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. A prima facie case for a violation of Section 5 is established upon a showing that: (1) no registration statement was filed or in effect as to the offer and sale of the securities; (2) a person, directly or indirectly, sold or offered to sell the securities; and (3) the sale or offer to sell was made through the use of interstate facilities (including the mail). Scienter or intent is not required to establish a Section 5 violation. Once a prima facie violation of Section 5 is established, the burden shifts to the person claiming an exemption from registration to establish the availability of the claimed exemption.
Section 4(a)(4) of the Securities Act of 1933 (“Securities Act”) provides an 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. Also on October 9, the SEC issued a Risk Alert and FAQ to remind broker-dealers of their obligations related to unregistered transactions under Securities Act Section 4(a)(4) on behalf of their customers, and ensuring such transactions are being conducted in accordance with securities laws.
Section 4(a)(4) is not, in and of itself, an exemption from registration. Section 4(a)(4) allows brokers to process the sale of unregistered securities where there is a valid exemption from such registration. The SEC has stated that broker-dealers “have a responsibility to be aware of the requirements necessary to establish an exemption from the registration requirements of the Securities Act and should be reasonably certain such an exemption is available.”
Section 4(a)(4) generally works in conjunction with Section 4(a)(1), which is a registration exemption for “transactions by any person other than an issuer, underwriter, or dealer.” Accordingly, a prerequisite to relying on Section 4(a)(4) is that the seller is not acting as an “underwriter.” The term “underwriter” is defined in Section 2(a)(11) of the Securities Act to include “any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates or has a direct or indirect participation in any such undertaking.” For purposes of this definition, the term “issuer” includes the issuer’s affiliates, including persons directly or indirectly controlling or controlled by the issuer, or under direct or indirect common control with the issuer.
