The Securities and Exchange Commission last week announced a $1 million penalty and other enforcement action against one current and one former brokerage subsidiaries of E*Trade Financial Corporation for not adhering to rules on the sale of penny stocks.

The SEC said in a press release that the two subsidiaries, E*Trade Securities and E*Trade Capital Markets, failed in their roles as gatekeepers, selling billions of penny stock shares for customers over a four-year stretch while ignoring red flags that the offerings did not have the applicable exemption from registration provisions under securities law. The law typically requires all offers and sales of securities to be registered with the SEC unless they qualify for an exemption. Brokers are obligated to reasonably ensure an exemption does apply when facilitating an unregistered sales transaction for a customer.

According to the SEC, three E*Trade customers routinely deposited to their accounts large amounts of newly issued penny stocks, acquired through private, unregistered transactions with “little-known, non-reporting issuers.” The customers said the penny stocks were freely tradable and placed orders for E*Trade to publicly resell the securities without any registration statements in effect, the SEC said. Upon the resales, the customers immediately wired the proceeds out of their accounts. The activity in question occurred between March 2007 and April 2011.

The SEC said E*Trade came across numerous red flags indicating potential problems, but instead used the broker-dealer exemption allowing them to execute unregistered sales of securities for a customer if, after a “reasonable inquiry,” the broker-dealer is unaware of indications of violations of registration requirements. The SEC said E*Trade initially failed to identify any potentially applicable exemptions, and then subsequently failed to take steps to ensure the exemptions claimed by the customers actually applied.

“E*Trade failed to fulfill its obligation to determine whether any exemptions applied to the sale of billions of shares of securities, thereby depriving investors of critical protections under the federal securities laws,” Stephen L. Cohen, associate director of the SEC’s Division of Enforcement, said in a statement. “Firms must take their reasonable inquiry obligations seriously and do more than check the box, particularly when red flags are apparent.”

E*Trade Securities is still a subsidiary of E*Trade. E*Trade Capital Markets was sold earlier this year and now operates under the name G1 Execution Services. Both companies agreed to the SEC settlement, which includes a combined penalty of $1 million and repayment of more than $1.5 million in disgorgement and prejudgment interest from commissions earned on improper sales.

“Broker-dealers serve an important gate-keeping 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,” Andrew J. Ceresney, director of the SEC’s Division of Enforcement, said in a statement. “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.”

A spokesman for E*Trade told the Wall Street Journal, “We are pleased to have resolved this matter with the Commission and from a financial standpoint, this matter was previously reserved for.”

 

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