On October 9, the Securities and Exchange Commission released a Risk Alert and Frequently Asked Questions (FAQs) regarding customers’ sales of unregistered securities. The National Examination Program staff (Staff) of the Office of Compliance Inspections and Examinations performed a sweep of 22 broker-dealers to assess compliance with the Securities Act of 1933 (Securities Act) and various anti-money laundering rules under the Bank Secrecy Act and the Securities Exchange Act of 1934. The Risk Alert and FAQs discussed the requirement for broker-dealers to conduct a “reasonable inquiry” regarding customers’ unregistered sales of securities, which is required to use the Section 4(a)(4) exemption from Securities Act registration requirements.
In the Risk Alert, the Staff detailed deficiencies in policies and procedures related to the reasonable inquiry, particularly if the broker-dealers failed to make additional inquiries into whether shares were restricted securities. The Staff noted that the broker-dealers failed to file Suspicious Activity Reports regarding red flags of suspicious activity (such as atypical trading patterns). The Staff also noted that certain types of accounts appeared to be associated frequently with dumping large amounts of illiquid microcap stocks, which should have raised red flags for the broker-dealers.
In the FAQs, the Division of Trading and Markets clarified the following items:
- Section 4(a)(4) provides an exemption for broker-dealers executing customers’ orders on any exchange or in the over-the-counter market but not soliciting such orders, unless a broker-dealer knows or has reasonable grounds to believe that the transaction is not exempt under Section 5 of the Securities Act.
- Broker-dealers may claim the Section 4(a)(4) exemption if they conduct a “reasonable inquiry” into the facts surrounding an unregistered sale of securities (including but not limited to multiple factors listed in the FAQs).
- In any situation that raises red flags (including but not limited to those listed in the FAQs), broker-dealers violate Section 5 of the Securities Act if they fail to inquire sufficiently into the circumstances of a transaction to ensure it is not unlawful.
- The mere acceptance by a depository trust company of a security does not eliminate the need for broker-dealers to make a reasonable inquiry.
- The delivery of a security without a restrictive legend does not eliminate the need to make a reasonable inquiry.