1

By the Office of Compliance Inspections and Examinations (“OCIE”)1

Volume IV, Issue 3 October 9, 2014

 

BROKER-DEALER CONTROLS REGARDING 

CUSTOMER SALES OF MICROCAP SECURITIES

I. Introduction

OCIE’s National Examination Program staff (the “Staff”), examined

22 broker-dealers (the “broker-dealers” or “firms”) that the Staff had 

identified as being frequently involved in the sale of the securities of 

microcap companies. The examinations assessed these firms’ 

compliance with certain provisions of the Securities Act of 1933 

(“Securities Act”) and the rules thereunder, as well as anti-money 

laundering (“AML”) requirements under the Bank Secrecy Act2 and 

the Securities Exchange Act of 1934 (“Exchange Act”). 

Specifically, the Staff evaluated compliance with the firms’ 

obligations to (1) perform a “reasonable inquiry” in connection with 

customers’ unregistered sales of securities when the firms are 

relying on the exemption set forth in Section 4(a)(4) of the 

Securities Act, and (2) file suspicious activity reports, as required under the Bank Secrecy Act 

and the Exchange Act, in response to “red flags” related to such sales.

Of the 22 firms examined, more than 80% were issued letters of deficiency for material control 

weaknesses and/or potential violations of law. The overwhelming majority of the firms 

examined were also referred to the Division of Enforcement or another regulatory agency for 

further consideration of whether violations of law occurred.

3

 1

 The views expressed herein are those of the staff of OCIE, in coordination with other staff of the Securities 

and Exchange Commission (“SEC” or “Commission”), including the Division of Trading and Markets. 

The Commission has expressed no view on the contents of this Risk Alert. This document was prepared by 

the SEC staff and is not legal advice.

2 The Bank Secrecy Act is the name commonly used for the Currency and Financial Transactions Reporting 

Act of 1970, 12 USC §1829b, 12 USC §§1951-1959, and 31 USC §§5311-5330.

3

 Today, the Commission issued an order in another matter involving violations of Section 5 of the Securities 

Act. See In the Matter of E*Trade Securities, LLC, and G1 Execution Services, LLC, Securities Act 

Release No. 9662, available at: http://www.sec.gov/litigation/admin/2014/33-9662.pdf.

This Risk Alert summarizes

deficiencies that OCIE staff observed 

in the controls that certain brokerdealers put in place to comply with 

obligations related to sales of the 

securities of microcap companies, 

including to (1) perform a 

“reasonable inquiry” in connection 

with unregistered sales of securities

in reliance on Section 4(a)(4) of the 

Securities Act, and (2) respond to 

suspicious activity in connection 

with such sales. A discussion of 

certain types of accounts that OCIE 

staff observed as being frequently 

associated with “dumping” of 

microcap securities is also included.
2

II. Overview of Broker-Dealer Obligations Regarding Proposed Customer Sales

A. Reasonable Inquiry under Securities Act Section 4(a)(4)

Sections 5(a) and 5(c) of the Securities Act generally provide that it is unlawful for any person, 

either directly or indirectly, to use the mails or interstate means to sell any security unless a 

registration statement is in effect or to offer to sell any security unless a registration statement 

has been filed with the Commission, unless an exemption from the registration provisions 

applies. Section 4(a)(4) of the Securities Act provides such an exemption for “brokers’ 

transactions executed upon customers’ orders on any exchange or in the over-the-counter market

but not the solicitation of such orders.”4 Reliance on Section 4(a)(4) is unavailable, however, for 

example, when a broker-dealer knows or has reasonable grounds to believe that the selling 

customer’s part of the transaction is not exempt from Section 5 of the Securities Act.

5

 The 

Commission and the courts have held that a broker-dealer may claim the Section 4(a)(4) 

exemption if, after reasonable inquiry, the broker-dealer is not aware of circumstances indicating 

that the customer would be violating Section 5, such as when the customer is an underwriter with 

respect to the securities or that the transaction is a part of a distribution of securities of the 

issuer.

6

 In conducting the reasonable inquiry under Section 4(a)(4), broker-dealers may consider 

the matters set forth in Note (ii) to Rule 144(g)(4).

7 Simultaneously with the issuance of this 

Risk Alert, the Division of Trading and Markets is issuing Frequently Asked Questions regarding 

the obligations of a broker-dealer to conduct a reasonable inquiry when engaging in unregistered

resales of securities in reliance on Section 4(a)(4).

8

 This guidance should be consulted for more 

detail on the availability of the Section 4(a)(4) exemption. FINRA has also issued its Notice to 

Members 09-05 addressing these obligations and providing guidance.9 

 

4 Broker-dealers may also potentially rely on the exemption provided by Section 4(a)(3) of the Securities 

Act, which generally exempts “transactions by a dealer,” but that exemption is unavailable for certain 

transactions, including those involving an underwriter. See In the Matter of Owen V. Kane, Exchange Act 

Release No. 23827 (Nov. 20, 1986) (Commission opinion), aff’d, 842 F.2d 194 (8th Cir. 1988).

5 In the Matter of John A. Carley, Exchange Act Release No. 57246, 2008 WL 268598, *8 (Jan. 31, 2008) 

(Commission opinion). See also In the Matter of Jacob Wonsover, Exchange Act Release No. 41123 (Mar. 

1, 1999) (Commission opinion), aff'd, 205 F.3d 408 (D.C. Cir. 2000); In the Matter of Quinn and Co., Inc., 

Exchange Act Release No. 9062 (Jan. 25, 1971) (Commission Opinion).

6

 17 C.F.R. § 230.144(g). See, e.g., World Trade Financial Corp. v. S.E.C., 739 F.3d 1243, 1248 (9th Cir.

2014) (agreeing with the D.C. Circuit’s decision in Wonsover v. S.E.C. and the Commission “that a broker 

is not merely an ‘order taker,’ and must conduct a reasonable inquiry into the circumstances surrounding 

the transaction before the broker may claim the protection of the Section 4(4) brokers’ exemption.”)

(citation omitted); In the Matter of Midas Securities, LLC and Jay S. Lee, Exchange Act Release No. 

66200, at 19 (Jan. 20, 2012).

7

 See “Frequently Asked Questions about a Broker-dealer’s Duties When Relying on the Securities Act 

Section 4(a)(4) Exemption to Execute Customer Orders,” SEC’s Division of Trading and Markets (Oct. 9, 

2014), available at: http://www.sec.gov/divisions/marketreg/mrfaq.htm (herein “TM FAQ”), at Question 

No. 2.

8

 See TM FAQ, supra note 7.

9

 FINRA Notice to Members 09-05, “Unregistered Resales of Restricted Securities,” (Jan. 2009), available 

at: http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p117716.pdf. (“Firms 
3

B. Obligations under the Bank Secrecy Act and Exchange Act

Exchange Act Section 17(a) and Rule 17a-8 thereunder require broker-dealers to comply with 

the recordkeeping, record retention, and reporting obligations of the Bank Secrecy Act and the 

regulations thereunder.10 These regulations mandate, among other things, that broker-dealers file

a Suspicious Activity Report (“SAR”) with the Financial Crimes Enforcement Network 

(“FinCEN”) to report any transaction (or a pattern of transactions of which the transaction is a 

part) by, at, or through the broker-dealer involving or aggregating funds or other assets of at least 

$5,000 that it “knows, suspects, or has reason to suspect”: (1) involves funds derived from illegal 

activity or is conducted to disguise funds derived from illegal activities; (2) is designed to evade 

any requirements of the Bank Secrecy Act; (3) has no business or apparent lawful purpose and 

the broker-dealer knows of no reasonable explanation for the transaction after examining the 

available facts; or (4) involves use of the broker-dealer to facilitate criminal activity.11 The 

failure of a broker-dealer to file a SAR, as required by these regulations, is a violation of 

Exchange Act Section 17(a) and Rule 17a-8.

III. Examination Observations

A. Examinations

In conducting the 22 examinations, the Staff assessed: (1) the controls the broker-dealers had

implemented regarding the unregistered sale of securities when relying on the Section 4(a)(4) 

 

that do not adequately supervise or manage their role in such distributions run the risk of participating in an 

illegal, unregistered distribution.”) This Notice to Members, which includes a discussion of the 

requirement that broker-dealers establish a supervisory system and corresponding written supervisory 

procedures to avoid becoming participants in potential unregistered distributions of securities, offers the 

following examples of red flags that firms could consider:

• a customer opens a new account and delivers physical certificates representing a large block of thinly 

traded or low-priced securities;

• a customer has a pattern of depositing physical share certificates, immediately selling the shares and 

then wiring out the proceeds of the resale;

• a customer deposits share certificates that are recently issued or represent a large percentage of the 

float for the security;

• share certificates reference a company or customer name that has been changed or that does not match 

the name on the account;

• the lack of a restrictive legend on deposited shares seems inconsistent with the date the customer 

acquired the securities or the nature of the transaction in which the securities were acquired;

• there is a sudden spike in investor demand for, coupled with a rising price in, a thinly traded or lowpriced security;

• the company was a shell company when it issued the shares;

• a customer with limited or no other assets under management at the firm receives an electronic transfer 

or journal transactions of large amounts of low-priced, unlisted securities;

• the issuer has been through several recent name changes, business combinations or recapitalizations, or 

the company’s officers are also officers of numerous similar companies; and

• the issuer’s SEC filings are not current, are incomplete, or nonexistent.

10 Self-regulatory organizations’ rules also contain AML requirements. See, e.g., FINRA Rule 3310.

11 See 31 CFR §1023.320.
4

exemption and the filing of SARs in response to “red flags” associated with unregistered sales; 

and (2) whether those controls operated effectively such that each broker-dealer’s activity 

complied with existing legal requirements. 

In particular, the Staff scrutinized the broker-dealers’ liquidations of large blocks of shares of 

microcap issuers that were also the subject of significant promotional efforts. 

B. Observations

1. Reasonable Inquiry under Securities Act Section 4(a)(4)

While the majority of the examined broker-dealers had adopted supervisory policies and 

procedures regarding conducting a reasonable inquiry when relying on the Section 4(a)(4) 

exemption, the Staff observed deficiencies in their design or implementation, including:

• Some firms’ policies and procedures did not contain sufficient detail to assist the 

firms’ employees in their efforts to effectively monitor and identify situations 

where facts and circumstances suggest the customer may not have had a claimed 

exemption. For example, some firms’ policies and procedures merely stated that 

a reasonable inquiry should be conducted, without providing any additional 

discussion of potential red flags that could indicate a possible Section 5 violation, 

protocols that the staff should follow when encountering red flags, or supervisory 

reviews that should be conducted to determine whether the securities were resold 

in compliance with an available exemption;

12

• Some firms relied, without further inquiry, on the absence of restrictive legends 

on stock certificates to conclude that the securities could be resold in unregistered 

transactions.

13

 12 The SEC has found similar written supervisory policies and procedures to be deficient. See, e.g., Midas 

Securities, LLC, supra note 6, at 12 (“The minimal written procedures the Firm had lacked meaningful 

guidance setting forth “reasonable inquiry” procedures for registered representatives to follow when 

customers sought to sell large amounts of an unknown stock to the public without registration. As 

Applicants admitted, the written procedures included no specific risk factors alerting registered 

representatives to the possibility that a proposed transaction might be part of an unlawful distribution—

such as the classic warning signs of an obscure issuer, a thinly traded security, and the deposit of stock 

certificates in a large volume of shares. The procedures also lacked any guidance to registered 

representatives about how to determine whether a proposed sale was exempt from registration, including 

asking their customer how, when, and under what circumstances the customer acquired the stock. Because 

of these deficiencies, the written procedures also failed to provide the supervisors with a reliable 

mechanism for identifying securities sales that should be investigated or halted for violating the Securities 

Act.”)

13 The certificates of securities acquired in a nonpublic transaction usually bear a restrictive legend, which 

indicates that the securities cannot be resold without registration or compliance with an exemption. 

However, the Staff has observed a number of instances at several broker-dealers in which the firms relied 

on the absence of a restrictive legend as a basis for believing that the deposited shares were unrestricted,

without conducting a further inquiry. The SEC has found such reliance to be inadequate. See, e.g., Quinn 

and Co., supra note 5 (stating that the failure of an issuer to place a restrictive legend on the stock cannot 

relieve a broker-dealer from its duty as a professional in the securities business to make a reasonable 

inquiry into facts known to it indicating that it is participating in an illegal unregistered sale of securities).
5

• Some firms relied, without further inquiry, on the delivery of the shares into a 

customer’s account in electronic form through a transfer from the Depository 

Trust and Clearing Corporation (“DTCC”) or the issuer’s transfer agent as a basis 

for believing either that the shares were not restricted securities or that no further 

inquiry regarding the customer was necessary;

14 and

• Some firms did not collect information from the customer about how large blocks 

of shares, deposited into the customer’s account that the customer requested the 

broker-dealer to sell, had been acquired, despite the fact that the firms did not 

know how the customer had acquired the shares.

15

Additionally, in interviews with the Staff, compliance staff and senior management at some of 

the examined firms appeared to be unaware of their firms’ obligation to conduct a reasonable 

inquiry, when relying on the Section 4(a)(4) exemption, particularly before executing large sales 

orders involving shares of thinly traded issuers.16 Also, the Staff observed that some firms failed 

to enforce their policies and procedures related to conducting a reasonable inquiry in connection 

with handling unsolicited customer orders.

2. Failure to Respond to Suspicious Activity

The Staff observed that some firms failed to file SARs, as required by the Bank Secrecy Act and 

the firms’ policies and procedures, when encountering unusual or suspicious activity in 

connection with customers’ sales of microcap securities. Some indications of this activity were

actually known by the examined broker-dealers, including the following examples:17

• Atypical trading patterns in the issuers’ securities, including trading involving

sudden spikes in price and volume;

• Certain patterns of trading activity being common to several customers, including, 

but not limited to the sales of large quantities of the shares of multiple issuers by 

the customers;

• Notifications received from the broker-dealers’ clearing firms that the clearing 

firms had identified potentially suspicious activity in the securities of certain 

 14 The SEC has found such reliance to be inadequate. See, e.g., In the Matter of the Application of ACAP 

Financial, Inc. and Gary Hume, Exchange Act Release No. 70046 (July 26, 2013) (Commission Opinion) 

(“[W]e have repeatedly explained that where ... there are indicia of an illegal distribution, a broker cannot 

claim that its sales of a security were exempt from registration simply because the stock certificates lack a 

restrictive legend or a clearing firm or transfer agent raises no objections to the sales.”), available at

http://www.sec.gov/litigation/opinions/2013/34-70046.pdf. 

15 See TM FAQ, supra note 7, at Question No. 2 (“the Commission has stated that the reasonable inquiry 

under Rule 144(g)(4) should include... the nature of the transaction in which the securities were acquired by 

the customer[.]”)

16 Id.

17 The Staff does not contend that the existence of any of these examples, which may indicate suspicious 

activity, necessarily triggers the broker-dealer’s obligation to file a SAR. Whether the broker-dealer has 

such an obligation depends on the totality of facts and circumstances in a particular situation. 
6

issuers or certain of the broker-dealers’ customer accounts. Such notifications 

took the form of alerts, expressions of concern, or actions taken by the clearing 

firms to restrict trading in certain issuers’ securities and/or certain customer 

accounts; 

• The involvement of certain types of accounts, including those that provide 

anonymity to the beneficial owners (such as the accounts described in Section 

III.B.3 herein), in the liquidation of the shares of the microcap issuers; and

• Requests received from FINRA for information relating to certain issuers and the 

broker-dealers’ customer accounts.

Other indications of suspicious activity were readily discoverable by the broker-dealer staff, 

including:18

• Certain types of issuer information, such as nominal assets and low operating 

revenue, and frequent changes to the type of activity in which the business was 

engaged, the name of the corporate entity, directors, and/or management; and

• Sales through the broker-dealer by individuals known throughout the industry to 

be stock promoters.

19

3. Types of Accounts Used to Dump Microcap Stock

As part of the examination initiative, the Staff identified certain types of accounts that appeared 

to be frequently associated with the unregistered sale of large quantities of the illiquid shares of 

microcap issuers, including sales of restricted securities on behalf of corporate insiders. They 

included certain omnibus accounts, which can be used to disguise the trading activity of the 

accounts’ beneficial owners by commingling securities and funds from several beneficial 

owners.20 Examples of such omnibus accounts included, but were not limited to:

• Accounts of purported stock loan companies, which may hold the restricted 

securities of corporate insiders who have pledged the securities as collateral for, 

and then defaulted on, purported loans, after which the securities are sold on an 

unregistered basis;

21

• Accounts held in the name of a corporate entity (or LLC), either for the 

company’s own use or as a third-party custodian on behalf of other beneficial 

shareholders or customers, which disguise the unregistered sales of securities

 18 See note 17 supra. 

19 See TM FAQ, supra note 7, at Question No. 3.

20 Generally, omnibus accounts are those in which money or securities for more than one beneficial owner are 

commingled by a custodian or a sub-custodian.

21 See, e.g., SEC v. SW Argyll Investments, LLC (d/b/a Argyll Investments, LLC), et al., Lit. Rel. No. 22296 

(March 16, 2012), available at: http://www.sec.gov/litigation/litreleases/2012/lr22296.htm; see also, e.g., 

SEC v. Manuel M. Bello, Ayuda Equity Funding, LLC, and AmeriFund Capital Holdings, LLC, Lit. Rel.

No. 22400 (June 25, 2012), available at: http://www.sec.gov/litigation/litreleases/2012/lr22400.htm.
7

owned by corporate insiders of the company and allow for those insiders to 

withdraw proceeds individually;

22

• Accounts held in the names of foreign financial institutions, such as offshore

banks and/or broker-dealers that sold shares of the stock on an unregistered basis

on behalf of customers, who may have been stock promoters;

23 and

• Accounts using a master/sub-structure, which allows for trading anonymity with 

respect to the sub-accounts’ activity.

24

The Staff observed that broker-dealers holding these types of accounts often failed to conduct 

reviews of the activity occurring in the accounts after encountering red flags,

25 as required by 

FINRA and/orCommission rules26 or by the broker-dealer’s own policies and procedures.

IV. Conclusion

In the examinations, the Staff observed that most of the examined broker-dealers have policies 

and procedures requiring the firm to conduct a reasonable inquiry into the facts surrounding a 

proposed unregistered sale to determine if the customer is an underwriter. The examinations, 

however, illuminated control weaknesses in the design or implementation of those policies and 

procedures. This Risk Alert has presented examples of certain situations where these control 

weaknesses have resulted in the broker-dealers failing to conduct a reasonable inquiry and/or 

failing to file SARs regarding suspicious sales activity. 

The Staff welcomes comments and suggestions about how the Commission’s examination 

program can better fulfill its mission to promote compliance, prevent fraud, monitor risk, and 

inform SEC policy. If you suspect or observe activity that may violate the federal securities laws 

or otherwise operates to harm investors, please notify us at 

http://www.sec.gov/complaint/info_tipscomplaint.shtml.

 22 See, e.g., FINRA Letter of Acceptance, Waiver and Consent No. 2013035821401, RE: Brown Brothers 

Harriman & Co., available at: 

https://www.finra.org/web/groups/industry/@ip/@enf/@ad/documents/industry/p443448.pdf.

23 See, e.g., SEC v. Gibraltar Global Securities, Inc. and Warren A. Davis, Civil Action No. 13 Civ 2575 

(S.D.N.Y.), available at: http://www.sec.gov/litigation/litreleases/2013/lr22683.htm; see also, e.g., FINRA

v. Oppenheimer & Co., Inc., Disciplinary. Proceeding No. 2009018668801 (Aug. 5, 2013), available at: 

http://www.finra.org/web/groups/industry/@ip/@enf/@ad/documents/industry/p315930.pdf.

24 Generally, in the master/sub-account trading model, a top-level customer opens an account with a 

registered broker-dealer (the “master account”) that permits the customer to have subordinate accounts for 

different trading activities (“sub-account”). OCIE previously issued a Risk Alert with respect to 

master/sub-accounts, which more fully describes regulatory concerns and risks regarding those accounts. 

See National Exam Risk Alert on Master/Subaccounts, available at:

http://www.sec.gov/about/offices/ocie/riskalert-mastersubaccounts.pdf.

25 See Section III.B.1-2 above for a discussion of red flags that the Staff noted during the examinations.

26 See Section II above.
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This Risk Alert is intended to highlight for firms risks and issues that the Staff has identified in the course of 

examinations regarding broker-dealer controls regarding customer sales of microcap securities. In addition, this 

Risk Alert describes factors that firms may consider to (i) assess their supervisory, compliance and/or other risk 

management systems related to these risks, and (ii) make any changes, as may be appropriate, to address or 

strengthen such systems. These factors are not exhaustive, nor will they constitute a safe harbor. Other factors 

besides those described in this Risk Alert may be appropriate to consider, and some of the factors may not be 

applicable to a particular firm’s business. While some of the factors discussed in this Risk Alert reflect existing 

regulatory requirements, they are not intended to alter such requirements. Moreover, future changes in laws or 

regulations may supersede some of the factors or issues raised here. The adequacy of supervisory, compliance 

and other risk management systems can be determined only with reference to the profile of each specific firm 

and other facts and circumstances.