Brokers Selling Unregistered Securities

In connection with an enforcement action, the SEC provided answers to frequently asked questions about the broker’s exemption in the resale of unregistered securities and warnings of common deficiencies in this compliance area among 22 recently examined broker-dealers. This is the first direct guidance on the resale of unregistered securities (often colloquially called penny stocks) from any regulator since FINRA’s Regulatory Notice 09-05 in January 2009. The SEC is working aggressively to root out microcap fraud, and this follows a growing number of high-dollar settlements and enforcement actions against brokers and brokerage firms alleging illegal sales of unregistered securities in violation of Section 5 of the Securities Act of 1933. In the most recent action, announced concurrently with the SEC press release, 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. The SEC’s guidance and the E*TRADE settlement should remind all brokers and brokerage firms engaged in the resale of unregistered securities about the importance of establishing procedures to ensure compliance with the securities laws.

In the E*TRADE press release, Andrew J. Ceresney, Director of the SEC’s Division of Enforcement, stated that, “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 SEC guidance focused on two main points.  First, the reasonable inquiry requirement, the legal standard that brokerage firms must meet in order to take customers’ orders to sell unregistered securities, should be a fact-based analysis in which the firms identify any red flags and follow up accordingly; and second, the anti-money laundering (AML) component is the provisions from the Bank Secrecy Act that require broker-dealers to file suspicious activity reports (SARs) any time they identify potentially suspicious activity. “Broker-dealers must be vigilant when facilitating sales on behalf of customers in unregistered transactions and remember that reliance on the broker’s exemption requires a reasonable inquiry of the customer and transaction,” said Stephen Luparello, Director of the SEC’s Division of Trading and Markets.

While this enforcement action targeted broker-dealers, small public companies should understand the limitations on unregistered securities so that they can work with their legal counsel and transfer agents to avoid any claim that they have participated in an unregistered offering.

Although the SEC release captures, in large part, policies and procedures that many brokerage firms have previously adopted, every brokerage firm should review its policies and procedures to ensure that they are compliant with this new guidance regarding the sale of unregistered securities.

The securities lawyers at Kruse Landa Maycock and Ricks have been assisting small public companies and brokerage firms for more than 40 years. Please contact us if you have questions about compliance procedures or other securities-related matters.

Kevin Timken is a member of Kruse Landa Maycock and Ricks specializing in public company and broker-dealer compliance. Please call him at 801-531-7090 or him at