SEC Charges E*Trade Subs: When Is the Due Diligence Sufficient?

Having the correct compliance procedures in place can often be critical. The SEC and the DOJ have repeatedly emphasized this in FCPA cases. Conducting due diligence can be equally critical. For gatekeepers such as lawyers, accountants and brokers, conducting appropriate due diligence can mean the difference between preventing a violation and becoming entangled in it. That was the result for two E*Trade subsidiaries who sold millions of shares of microcap stocks that were not registered despite representations to the contrary from their clients. In the Matter of E*Trade Securities, LLC, Adm. Proc. File No. 3-16192 (October 9, 2014).

From March 2007 through April 2011 the two E*Trade subsidiaries named at Respondents at various times facilitated the sale of millions of unregistered microcap shares for three Customers, according to the Order. Customer A opened an account with E*Trade in early 2007; Customer B opened an account later that year; and Customer C opened an account in March 2010. The Customers are institutional clients.

During the period the three Customers routinely acquired large quantities of newly issued penny stocks in private offerings. The Customers represented to E*Trade that the stocks were acquired in PIPE offerings. The size of the deposits varied from several thousand shares to a billion. The shares were issued by 247 companies. Generally the shares were resold within a short period. There were no registration statements on file with the Commission for the shares.

Respondents did not ask Customers A and B to identify the specific exemption from registration relied on. Likewise, the two Customers were not asked for documentation regarding any exemption. Rather, the two subsidiaries made the following inquiries:

  • What was the intended trading activity;
  • Customer A was asked for written representations that the shares were freely tradable;
  • Customer A furnished written representations that it would comply with the applicable law;
  • Respondents visited the offices of both customers several times to determine that they were reputable;
  • Beginning in March 2009 Respondents reviewed pending deposits to determine if they had financial risk; and
  • In November 2009 the trading history of both Customers was reviewed.

From March 2010 through April 2011 “Enhanced Due Diligence” was conducted regarding share deposits for Customers A and C. Under this process written representations were obtained from the Customer and issuer that the shares were freely tradable. Opinions from attorneys were also obtained that were based largely on representations from the reseller and issuer. Respondents also researched the attorneys.

These procedures were inadequate, according to the Order. While Securities Act Section 4(a)(4) exempts from registration brokers’ transactions, it is unavailable when the broker knows, or has reasonable grounds to know, that the shares are not exempt. To rely on the exemption a reasonable inquiry must be conducted. The scope of that inquiry depends on the surrounding facts and circumstances.

Here Customers A, B and C were continually faced with a series of red flags which should have raised a question as to whether they were engaged in an illegal distribution: 1) each acquired substantial amounts of newly issued penny stocks; 2) those shares were acquired from little known, non-reporting issuers; 3) they were acquired through private unregistered transactions; 4) the shares were immediately resold; and 5) the funds were wired out. Nevertheless, Respondents failed to conduct the kind of searching inquiry that was required under the circumstances. Accordingly, Respondents willfully violated Securities Act Sections 5(a) and 5(c).

To resolve the proceeding each Respondent consented to the entry of a cease and desist order based on the Sections cited and to a censure. On a joint and several basis Respondents will pay disgorgement of $1,402,850, prejudgment interest and a penalty of $1 million.

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