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Responses to Frequently Asked Questions about a Broker-Dealer's Duties When Relying on the Securities Act Section 4(a)(4) Exemption to Execute Customer Orders

October 9, 2014

In these Frequently Asked Questions, the Division of Trading and Markets is reminding broker-dealers of their obligation to conduct a reasonable inquiry when selling securities in an unregistered transaction in reliance on Section 4(a)(4) of the Securities Act of 1933 (Securities Act). These questions and answers were prepared by, and represent the views of, the Division of Trading and Markets. These questions and answers are not rules, regulations or statements of the Commission. The Commission has neither approved nor disapproved these questions and answers.

The staff may update these questions and answers periodically. In each update, the questions added after publication of the last version will be marked with “MODIFIED” or “NEW.”

For Further Information Contact: Any of the following at (202) 551-5550: Paula Jenson, Deputy Chief Counsel; Lourdes Gonzalez, Assistant Chief Counsel; Kevin Schopp, Special Counsel; or Carl Emigholz, Special Counsel, Division of Trading and Markets, Securities and Exchange Commission, 100 F Street, NE, Washington, DC 20549-7010.

Background

Section 5 of the Securities Act requires all offers and sales of securities in interstate commerce to be registered, unless an exemption from registration is available.  Specifically, Sections 5(a) and 5(c) of the Securities Act generally prohibit any person, including broker-dealers, from using the mails or interstate means to sell or offer to sell, either directly or indirectly, any security unless a registration statement is in effect or has been filed with the Commission as to the offer and sale of such security, or an exemption from the registration provisions applies.  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).[1]  Scienter is not required to establish a Section 5 violation.[2]  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.[3]

Responses to Frequently Asked Questions

Question 1.

What exemptions from Section 5 of the Securities Act are potentially available to broker-dealers when selling securities on behalf of customers in unregistered transactions?

Answer:

Broker-dealers often rely on Section 4(a)(4), which exempts “brokers’ transactions, executed upon customers’ orders on any exchange or in the over-the-counter market but not the solicitation of such orders.”[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,” with certain exceptions.[5]    

Reliance on Section 4(a)(4) is unavailable, 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.”[6]  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 offer or sale of securities on behalf of its customer would violate Section 5, such as when the customer is an underwriter[7] with respect to the securities or the transaction would be part of a distribution[8] of securities of the issuer.[9]

Question 2.

What steps should a broker-dealer take if it intends to rely on the Section 4(a)(4) exemption? 

Answer: 

In order to rely on the Section 4(a)(4) exemption, a broker-dealer must conduct a “reasonable inquiry” into the facts surrounding a proposed unregistered sale of securities before selling the securities to form reasonable grounds for believing that a selling customer’s part of the transaction is exempt from Section 5.  The Commission 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.’”[10]  Whether a broker-dealer has conducted a “reasonable inquiry” depends on the facts and circumstances surrounding the transaction. [11]  According to the Commission, when conducting a reasonable inquiry into whether the transaction would violate Section 5, “it is not sufficient for [the broker-dealer] merely to accept ‘self-serving statements of his sellers and their counsel without reasonably exploring the possibility of contrary facts.’”[12]  Nor, where there are indicia of an illegal distribution of securities, can a broker-dealer “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.”[13]

For a broker to rely on the Section 4(a)(4) exemption, including in the context of a transaction where a customer claims to have received securities in a transaction exempt from Section 5 registration or pursuant to the Rule 144 safe harbor, the Commission has stated that the reasonable inquiry under Rule 144(g)(4) should include, but not necessarily be limited to, the following matters each of which is set forth in Note (ii) to Rule 144(g)(4):

  • the length of time the securities have been held by the broker-dealer’s customer (including physical inspection of the securities if practicable);
  • the nature of the transaction in which the securities were acquired by the customer;
  • the amount of securities of the same class sold during the past 3 months by all persons whose sales are required to be taken into consideration in evaluating compliance with the volume limitations of Rule 144(e);
  • whether the customer intends to sell additional securities of the same class through any other means;
  • whether the customer has solicited or made any arrangement for the solicitation of buy orders in connection with the proposed sale of securities;
  • whether the customer has made any payment to any other person in connection with the proposed sale of the securities; and
  • the number of shares or other units of the class outstanding, or the relevant trading volume.[14]

When a broker-dealer uncovers facts that may be indicative of a distribution or resale that goes beyond a typical secondary market transaction, additional inquiries may be warranted in order for the broker-dealer to rely on the Section 4(a)(4) exemption.

Question 3.

What if a situation raises red flags?  What additional steps should a broker-dealer take in response to red flags?

Answer:

If a situation raises “red flags,” additional inquiry is necessary for a broker-dealer to rely on the Section 4(a)(4) exemption.[15]  A number of situations may raise “red flags” that require additional inquiry, including, but not limited to:

  • When a customer deposits a large block of recently issued shares of a little-known issuer into its account and then requests that the broker-dealer sell such shares without a registration statement in effect;
  • When a customer sells securities soon after depositing them into the account;
  • When a customer engages in repeat transactions in the shares of a little-known issuer;
  • When an issuer of stock is a newly formed company, with little trading, operating, or earnings history; or
  • When a customer is engaged in stock promotion activities on behalf of the issuer.[16]

In any of these or similar situations, a broker-dealer is “required to conduct a searching inquiry to assure itself that [its customer’s] proposed sales [are] exempt from the registration requirements and not part of an unlawful distribution.”[17]  Thus, a broker-dealer may violate Section 5 if it fails to inquire sufficiently into the circumstances of a transaction, given classic warning signs that the transaction may involve an unregistered distribution or an underwriter.[18]  As the Commission has stated, a broker-dealer relying on Section 4(a)(4) cannot act as a mere order taker; rather, a broker-dealer must make “whatever inquiries are necessary under the circumstances to determine that the transaction is a normal ‘brokers’ transaction’ and not part of an unlawful distribution.”[19]

Question 4.

If a security is accepted by Depository Trust Company (“DTC”), does this eliminate the need for a broker-dealer to conduct a reasonable inquiry when relying on the Section 4(a)(4) exemption for the offer and sale of such security?

Answer:

No.  A broker-dealer relying on Section 4(a)(4) is not relieved of the need to make a reasonable inquiry because a security is accepted by DTC.  Further, offers and sales of a security that is accepted by DTC continue to be subject to the registration requirements of Section 5, unless an exemption from registration is available. 

Question 5.

If a security is delivered into an account of a customer without a restrictive legend in electronic form, does this eliminate the need for a broker-dealer to conduct a reasonable inquiry when relying on the Section 4(a)(4) exemption for the offer and sale of such security?

Answer:

No.  A broker-dealer relying on Section 4(a)(4) is not relieved of the need to make a reasonable inquiry because a security is delivered into an account of a customer without a restrictive legend in electronic form.  Offers and sales of securities continue to be subject to the registration requirements of Section 5, unless an exemption from registration is available.[20]



[1] See SEC v. Cavanagh, 445 F.3d 105, 111 n.13 (2d. Cir. 2006).

[2] See  SEC v. Calvo, 378 F.3d 1211, 1215 (11th Cir. 2004).

[3] See SEC v. Ralston Purina Co., 346 U.S. 119, 126 (1953).

[4] The Commission has taken the position that the Section 4(a)(4) exemption only applies to the broker-dealer’s part of a transaction and does not extend to the customer, who must find a separate exemption.  See Rule 154, Securities Act Release No. 4818, 2 (Jan. 21, 1966).  In these transactions, customers often rely on Section 4(a)(1) of the Securities Act, which exempts “transactions by any person other than an issuer, underwriter, or dealer.”

[5] See In the Matter of Owen V. Kane, Exchange Act Release No. 23827, 2 (Nov. 20, 1986) (Commission opinion), aff’d, 842 F.2d 194 (8th Cir. 1988).

[6] In the Matter of John A. Carley, Exchange Act Release No. 57246, 8 (Jan. 31, 2008) (Commission opinion).  See also In the Matter of Jacob Wonsover, Exchange Act Release No. 41123, 28 (Mar. 1, 1999) (Commission opinion), aff'd, 205 F.3d 408 (D.C. Cir. 2000).    

[7] 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 – i.e., persons directly or indirectly controlling or controlled by the issuer, or under direct or indirect common control with the issuer. 

An “underwriter” therefore includes any person who purchases from either the issuer or an affiliate of the issuer with a view to a distribution of securities; offers or sells for the issuer or an affiliate of the issuer in connection with a distribution of securities; or participates, directly or indirectly, in a distribution of securities from the issuer or an affiliate of the issuer to the investing public. 

[8] While the Securities Act does not define the term “distribution,” Securities Act Rule 144 provides a “safe harbor” to those security holders who wish to sell securities under the Section 4(a)(1) exemption, which exempts “transactions by any person other than an issuer, underwriter, or dealer.”  A person satisfying the applicable conditions of the Rule 144 safe harbor is deemed not to be engaged in a distribution of the securities and therefore not an underwriter for purposes of resale under the Section 4(a)(1) exemption.

[9] 17 C.F.R. § 230.144(g).  See, e.g., World Trade Financial Corporation v. SEC, 739 F.3d 1243, 1248 (9th Cir. 2014); In the Matter of Midas Securities, LLC and Jay S. Lee, Exchange Act Release No. 66200, 8 (Jan. 20, 2012) (Commission opinion); In the Matter of Robert G. Leigh, Exchange Act Release No. 27667, 4 (Feb. 1, 1990) (Commission opinion).

[10] In the Matter of World Trade Financial Corp., Exchange Act Release No. 66114, 13 (Jan. 6, 2012) (quoting Stone Summers & Co., Exchange Act Release No. 9839, 3 (Nov. 3, 1972)).

[11] Distribution by Broker-Dealers of Unregistered Securities, Securities Act Release No. 4445, 2 (Feb. 2, 1962) [hereinafter Distribution Release].

[12] Distribution Release, supra note 11, at 1 (quoting SEC v. Culpepper, 270 F.2d 241, 251 (2nd Cir. 1959)); see also World Trade Financial Corp. v. SEC, supra note 9, at 1249 (9th Cir. 2014) (“[B]rokers rely on third-parties at their own peril, and will not avoid liability through that reliance when the duty of reasonable inquiry rests with the brokers.”); In the Matter of ACAP Financial, Inc. and Gary Hume, Exchange Act Release No. 70046, 14 (July 26, 2013) (Commission opinion) (rejecting broker’s reliance on the absence of a restrictive legend and the lack of objection by its clearing firm and transfer agents); Wonsover v. SEC, 205 F.3d 408, 415 (D.C. Cir. 2000) (rejecting registered representative’s reliance on clearing firm, the transfer agent and counsel); Stead v. SEC, 444 F.2d 713, 716 (10th Cir. 1971) (holding that the act of calling the transfer agent is obviously not a sufficient inquiry); Sales of Unregistered Securities by Broker-Dealers, Securities Act Release No. 5168, 2 (July 7, 1971) (stating that information received from little-known companies or their officials, transfer agent or counsel must be treated with great caution as these are the very parties that may be seeking to deceive the firm).

[13] ACAP Financial, supra note 12, at 15.

[14] 17 C.F.R. § 230.144(g)(4), Note (ii).

[15] See World Trade Financial Corporation v. SEC, supra note 9, at 1248 (“[W]here . . . there are numerous red flags indicating suspicious circumstances, a more searching inquiry is required.”).  See also FINRA Notice to Members 09-05, “Unregistered Resales of Restricted Securities,” (Jan. 2009).

[16] See Midas, supra note 9, at 14-15; ACAP Financial, supra note 12, at 4; see also Wonsover, supra note 12, at 415. 

[17] See Midas, supra note 9, at 14.

[18] See Midas, supra note 9, at 16-17.

[19] See Midas, supra note 9, at 16 (quoting Leigh, supra note 9, at 4); see also In the Matter of Evans & Co. Inc., Exchange Act Release No. 21696, 5 (Jan. 30, 1985) (settled order) (“Since any broker-dealer claiming an exemption from the registration requirements has the burden of proving its availability, it is the broker-dealer that must establish the adequacy of the inquiry.”).

[20] See ACAP Financial, supra note 12, at 15 (“[W]e have repeatedly explained that where, as here, 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.”).

http://www.sec.gov/divisions/marketreg/faq-broker-dealer-duty-section4.htm

Modified: 10/09/2014