SEC Warns Broker-Dealers of Risks Associated with Offshore Omnibus Accounts Transacting in “Penny Stocks”
Last week, the SEC Division of Trading and Markets published a staff bulletin highlighting various risks for broker-dealers arising from certain transactions in “penny stocks” and other low-priced securities. The Commission emphasized that these risks are heightened when the identities of a foreign financial institution’s underlying customer and/or the ultimate beneficial owner of the funds and securities are unknown to a broker-dealer because of the omnibus account structure.
In particular, the Division has found that:
- Low-priced securities transactions in omnibus accounts maintained for foreign financial institutions can pose a particularly high risk of illicit activities, including fraud, money laundering, and unregistered securities offerings.
- Nominee accounts and multiple foreign financial intermediaries can be used to obscure the identities of persons engaging in illicit activities.
- Layers of anonymity and concealment can facilitate violations of the federal securities laws, such as non-exempt unregistered securities offerings, fraudulent stock promotion, and manipulative trading, as well as other illicit activities.
The Division noted that, in the past few years, the Commission has brought a number of enforcement actions centered on allegations of unregistered securities offerings and/or schemes to defraud investors that have involved individuals and entities that allegedly concealed their control of publicly traded companies and increasingly used omnibus accounts to purchase and/or liquidate low-priced securities. These scenarios often involve allegations that omnibus accounts opened at a U.S. broker-dealer by a foreign financial institution can act to shield the nature of the illicit activities by, among other things, concealing a wrongdoer’s identity. These charges collectively also involve allegations of hundreds of millions of dollars in illegal sales proceeds at the expense of U.S. retail investors. These proceeds often were quickly transferred to overseas accounts.
The Staff is concerned that this type of illicit activity, including fraud or unlawful distributions of securities, is being facilitated by U.S. broker-dealers who are not sufficiently discharging their AML and other obligations.
The Division noted that:
- it is concerned that broker-dealers are conducting insufficient due diligence on omnibus accounts held for foreign financial institutions;
- a U.S. broker-dealer’s reliance upon another financial institution, including an affiliate, to conduct due diligence on a foreign omnibus account may be unreasonable; and
- U.S. broker-dealers may be ignoring red flags that FINRA has published.
The bulletin reminds broker-dealers of their existing obligations under the Bank Secrecy Act (“BSA”), Rule 17a-8 under the Exchange Act, Section 5 of the Securities Act of 1933 (“Securities Act”) and FINRA rules, and considerations relating to the application of these obligations in the context of effecting low-priced securities transactions through omnibus accounts maintained for foreign financial institutions.
Among other things, the BSA requires broker-dealers to establish a risk-based AML program, including policies and procedures reasonably designed to detect and report suspicious activities (“AML Program”). In addition, as part of their AML Program, broker-dealers are required to establish a written risk-based due diligence program for any “correspondent accounts” established, maintained, administered or managed for foreign financial institutions (“Special Due Diligence Program”), which include omnibus accounts held for a foreign financial institution introducing transactions in low-priced securities.
Specifically, the Special Due Diligence Program must include appropriate, specific risk-based policies, procedures, and controls reasonably designed to enable a broker-dealer to detect and report, on an ongoing basis, any known or suspected money laundering conducted through or involving any foreign correspondent account. At a minimum, the due diligence program must include, among other things, the following:
- An assessment of the money laundering risk posed by such correspondent account, based on a consideration of relevant risk factors, including, as appropriate:
- The nature of the foreign financial institution’s business and the markets it serves;
- The type, purpose, and anticipated activity of such correspondent account;
- The nature and duration of the broker-dealer’s relationship with the foreign financial institution (and any of its affiliates);
- The AML and supervisory regime of the jurisdiction that issued the charter or license to the foreign financial institution, and its owners if applicable, to the extent that such information is reasonably available;
- Information known or reasonably available to the broker-dealer about the foreign financial institution’s AML record; and
- The application of risk-based procedures and controls to each such correspondent account reasonably designed to detect and report known or suspected money laundering activity, including a periodic review of the correspondent account activity sufficient to determine consistency with information obtained about the type, purpose, and anticipated activity of the account.
Where the broker-dealer determines that the risks cannot be appropriately managed, particularly in the context of low-priced securities transactions, the Staff believes that a broker-dealer should consider (1) refusing to open or closing the account, (2) restricting or rejecting transactions effected on behalf of the customers of the foreign financial institution (e.g., restricting transactions to those effected on behalf of ultimate beneficial owners where the relevant characteristics of those owners are known by the foreign financial institution and communicated to the U.S. broker-dealer to a sufficient extent for the U.S. broker-dealer to conclude that there is not a heightened risk of illicit activity), and (3) filing a SAR as appropriate.
The Division also reminded broker-dealers that nothing under the federal securities laws or FINRA rules obligates them to accept an order where they believe that the associated compliance or legal risks are unacceptable. In light of this fact, broker-dealers should consider the consequences of facilitating transactions, regardless of whether or not they fulfill their AML obligations. For example, under certain circumstances, a broker-dealer may fulfill its AML obligations by detecting and reporting suspicious activity, but in facilitating the transactions, the broker-dealer could expose itself to liability for aiding and abetting and/or causing misconduct, including by participating in an unregistered securities offering.
In SEC Chairman Jay Clayton‘s letter regarding the Staff Bulletin, he reinforced the Commission’s continued commitment to identifying and eradicating fraud targeting Main Street investors, including fraud in the “penny stock” market.
For further information about this securities law blog post, please contact Brenda Hamilton, Securities Attorney at 101 Plaza Real S, Suite 202 N, Boca Raton, Florida, (561) 416-8956, by email at [email protected] or visit www.securitieslawyer101.com. This securities law blog post is provided as a general informational service to clients and friends of Hamilton & Associates Law Group and should not be construed as, and does not constitute legal advice on any specific matter, nor does this message create an attorney-client relationship. Please note that the prior results discussed herein do not guarantee similar outcomes.
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Brenda Hamilton, Securities Attorney
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