SEC Charges Trading Firm’s Education Program Violates Broker Registration Section
Commission enforcement actions have focused on Exchange Act Section 15(a) and its prohibition on acting as a broker without registering with the agency in recent months. The Exchange Act defines a broker as any person “engaged in the business of effecting transactions in securities for the accounts of others.” Certain banking, trust and sock purchase plan activities are among those specifically exempted from the definition. The line between what is permitted without registration and what is prohibited has long been the subject of discussion. Recent enforcement actions seem to be fueling that debate. Consider, for example, the Commission’s most recent settled action in this area, In the Matter of CYGS, LLC, Adm. Proc. File No. 3-17896 (March 31, 2017).
CYGS is a proprietary trading firm established in 2009. The firm trades for its own account through ETC Brokerage Services. The firm places about $1.9 billion in trades annually. Proprietary trading is a major source of firm income.
The trading firm also earns income from its membership program. That program focused primarily on educating members about trading. It permitted members to practice the lessens learned with the firm’s capital under limited circumstances by placing trades through its brokerage account at ETC.
Specifically, CYGS sold memberships to persons for a flat fee of $5,000. Membership had the following benefits: 1) Access to CYGS’s chat room which provided real time commentary on securities; 2) proprietary software; 3) educational materials; 4) video tutorials; 5) training; 6) the opportunity to apply lessons learned by trading with CYGS capital within certain limits; 7) greater leverage when trading since members used the firm’s capital; and 8) profits from the trades but not necessarily the losses since the firm them within limits as well as the expenses.
Limits were imposed on member trading to minimize loss. First, trades were executed through the firm’s ETC brokerage account. Second, members were only permitted to have up to $50,000 of buying power based on several factors analyzed by the firm. Third, the average amount traded each month by members was monitored and limited. Fourth, CYGS closed out positions when the losses reached a specified threshold. Finally, CYGS reviewed trades in advance and cancelled those deemed inappropriate or too risky with assistance from proprietary software.
The Order charged violations of Exchange Act Section 15(a) “because it [CYGS] was engaged in the business of effecting securities transactions for its member-traders without being registered . . .” according to the Order. No additional analysis or explanation is offered.
To resolve the proceeding, the firm consented to the entry of a cease and desist order based on Exchange Act Section 15(a) and to a censure. CYGS also agreed to pay disgorgement of $35,000, prejudgment interest of $879 and a penalty of $25,000.
Traditionally in bringing Section 15(a) charges the SEC has focused on “transaction based compensation” as the hallmark of an unregistered broker charge, although other factors were considered. See, e.g., In the Matter of Ronald D. Morley, Adm. Proc. File No. 3-17658 (Nov. 1, 2016)(retirement services firm paid transaction based compensation to solicit investors settled unregistered broker charges); In the Matter of American Life, Inc., Adm. Proc. File No. 3-17285 (June 13, 2016)(EB-5 immigration regional center that received transaction based compensation from investors as part of immigration program charged with acting as unregistered broker); In the Matter of Linda Yoo, Adm. Proc. File No. 3-17182 (March 28, 2016)(Immigration attorney who received transaction based compensation in connection with the investments by foreign nationals in the EB 5 immigration program charged with acting as an unregistered broker); but see In the Matter of Barry B. Clarke, Adm. Proc. File No. 3-17172 (August 15, 2016)(vice president of foreign airline charged with 15(a) violation for selling firm’s shares to raise money for the company).
At the same time some recent cases also seem to be focusing on conduct beyond just transaction based compensation. See, e.g., In the Matter of Angel Oak Capital Partners, LLC, Adm. Proc. File No. 3-17849 (Feb. 16, 2017) (firm assisting registered broker and trading through its account charged with 15(a) violations); see also In the Matter of 3C Advisors & Associates, Inc., Adm. Proc. File No. 3-17070 (Sept. 19, 2016)(capital advisory firm that facilitated private places and aided with capital raise charged with 15(a) violation where compensation was transaction based).
CYGS was not paid transaction based compensation. To the contrary, the firm was paid a flat membership fee for those who sought the benefits of membership (although its broker apparently gave it some consideration for the volume of trades which in part came from members). Likewise, the firm did not solicit persons to purchase securities or seek to sell securities in a specific project as in some of the cases cited above. While the sale of the membership provides clear financial benefits to the firm, the primary benefit to members appears to be educational – the members learn how to trade with little risk. Educating investors is supposed to be a focus for the SEC. That point is not, however, referenced in the Order here.
Perhaps more importantly, the specific conduct that violated Section 15(a) in the Commission’s view is not specified or identified in the Order. Yet SEC enforcement actions are supposed to provide notice to the market place of what constitutes wrongful conduct to prevent its repetition in the future. If the Commission is going to redefine or expand the edges of the statutes and rules it administers in enforcement actions – a questionable practice at best – it would do well to at least specifically identify the conduct that is supposedly wrongful to provide adequate notice in accord with its Constitutional obligations.