Unregistered Broker-Dealer Penalties: SEC Charges

Unregistered broker-dealer risk generally arises when a company raises capital in a private securities offering via persons or entities not registered as broker-dealers. These individuals often claim they act as consultants, advisers, investment bankers, or finders.

When such individuals or entities seek investors on a regular basis or receive compensation based on transactions, they must be registered with relevant regulatory authorities – the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA).

Transgressions could lead to steep penalties. The SEC has issued many similar fines over the past several years. While the SEC focuses primarily on regulated entities and publicly traded securities, the dealings of unregistered broker-dealers draw scrutiny too.

Usually, inspections arise when a transaction has already attracted attention rather than on a stand-alone basis But recently, the SEC’s Division of Enforcement has shown greater interest in pursuing punitive action against unregistered broker-dealers.

SEC Investigations and Charges

In 2005, the American Bar Association’s Business Law Section commissioned a “Report and recommendations of the task force on private placement broker-dealers“. The report found that there is an “informal and unstructured confluence of practices that put investors together with companies in need of capital,” which was described as the “vast gray market of securities brokerage.”

In all likelihood, the SEC does not have the requisite resources to thoroughly monitor compliance levels of each and every one of the thousands of private security offerings that take place every year. As a result, unregistered broker-dealer activity is typically discovered as part of another inquiry – for example, because of fraud.

For example, in 2021, SEC issued a $2.75 million penalty to Neovest Inc., a provider of an order and execution management system, for its failure to register as a broker-dealer. In this case, the SEC Neovest’s failure to properly register “deprived its customers of protections associated with registration, including inspections and examinations by the SEC and the requirement to establish policies and procedures to safeguard customer information.”

Additionally, M&A Brokers ought to be careful as well. A First Circuit Court’s decision in EdgePoint Capital Holdings, LLC v. Apothecare Pharmacy, LLC held that a mergers and acquisitions broker’s contract may be voided due to a failure to register as a broker-dealer.

Digital Markets

In September of 2019, the SEC filed its first civil lawsuit seeking to prove violations in the digital asset markets sphere. In a case filed before the US District Court for the Central District of California, the SEC indicted ICOBox and its founder, Nikolay Evdokimov, for offering unregistered public securities in an initial coin offering (ICO).

The SEC has, before, filed civil suits and initiated enforcement actions against many ICO token issuers for not registering properly. The case of ICOBox provided one of the first opportunities for the courts to clarify the application of broker-dealer regulations on the digital asset industry.

In the case of ICOBox, the SEC argued that the defendants offered and sold digital tokens to 2,000 investors publicly, without filing a registration statement or meeting exemption requirements. The offering was marketed via social media channels, the ICOBox website, and a white paper.

ICOBox represented that the offering was exempt from registration because these tokens did not represent securities. The SEC, however, claimed and argued that ICOBox’s offering failed the Howey test. Also, the SEC alleged that ICOBox used the capital from the token offering to develop and operate an unregistered digital asset securities brokerage service. According to the SEC, ICOBox facilitated 35 token offerings of other issuers, raising almost $650 million of investor money.

ICOBox offered marketing services for those seeking to launch their tokens via the company. Furthermore, ICOBox performed this in exchange for a flat fee along with transaction-based compensation as a “success fee.”

Exemptions from Registration

The Securities Exchange Act of 1934 stipulates that any person operating as a broker in the US securities markets must register before the SEC and obtain a membership with FINRA. Additionally, FINRA has sought to clarify requirements for registered broker-dealers who deal with finders.

FINRA Rule 2040, effective since 2015, has been enacted to help align broker-dealer activity with the Securities Exchange Act and to provide additional guidelines related to transaction-based compensation payments to unregistered persons.

Of course, there are exemptions from broker-dealer registration requirements. For example, companies that sell securities for their own account are, generally, not brokers.

Likewise, they are not dealers because the sale of securities is not a part of their regular business. SEC Rule 3a4-1 creates a safe harbor for individuals associated with an issuer who participate in the sale of the issuer’s securities.

Expert Help is Vital

Given the existing similarities between finders and broker-dealers, seeking regulatory clarifications from either the SEC or FINRA is paramount. Determining whether an intermediary is acting in the capacity of a finder or an unregistered broker-dealer is a fact-based analysis that can often be quite complex.

To successfully navigate the ever-changing landscape of financial markets regulation, hiring an experienced expert is a mindful choice. Online broker-dealers face distinct regulatory challenges compared to traditional brick-and-mortar players.  Expertise in registration and compliance plays an important part.

As such, InnReg is uniquely positioned to support innovation in the brokerage and online trading space while remaining compliant with registration requirements. Since 2013, InnReg has supported the launch of more than ten digital broker-dealers and possesses the experience needed to add immense value to your corporate operations.