Securities Act Release No. 4445

Securities Exchange Act Release No. 6721

February 2, 1962

Distribution by Broker-Dealers of Unregistered Securities.

Recent decision of the Courts and of the Securities and Exchange Commission have raised important questions concerning the standards of conduct expected of a registered broker-dealer in connection with the distribution to the public of substantial blocks of unregistered securities, particularly in situations where the securities are those of relatively obscure and unseasoned companies and where all of the circumstances surrounding the proposed distribution are not known to the broker-dealer. ¹  Particularly significant are the following:  What steps the broker-dealer should take to make sure that he is not participating in an illegal distribution in violation of Section 5 of the Securities Act of 1933?  What investigation he should make concerning the issuer in order to avoid violations of the anti-fraud provisions of the federal securities laws in the course of the distribution, and particularly Section 17 of the Securities Act and Section 10(b) of the Securities Exchange Act and Rule 10b-5 thereunder?

In view of certain apparent misconceptions with regard to the responsibilities of a broker-dealer under these circumstances, it seems appropriate to set forth for the guidance of the industry and the Bar certain standards that the Commission believes applicable.

With regard to the registration requirements of the Securities Act of 1933, certain basic principles should be borne in mind. In the first place, Section 5 of the Securities Act of 1933 broadly prohibits the use of the mails or facilities of interstate commerce to sell a security unless a registration statement is in effect. A dealer or other person claiming the benefit of an exemption from this requirement has the burden of proving entitlement to it. ²  Where unregistered securities are offered to a dealer for distribution, exemption is commonly claimed under the first and third clauses of Section 4(1) of the Securities Act which, speaking generally, exempt transactions not involving any distribution by, or for an issuer or for a person controlling, controlled by, or under common control with the issuer. Consequently, in order for this exemption to be available, a dealer must not be participating directly or indirectly in any such distribution. He may become such a participant even if he has no direct contractual relationship or privity with an issuer or person in a control relationship if he, in fact, engaged in steps necessary to such a distribution. ³  Section 4(1) exempts trading transactions between individual investors with respect to securities already issued. It does not exempt distributions by issuers or control persons or acts of other individuals who engage in steps necessary to such distributions. ⁴  Consequently, a dealer who offers to sell, or is asked to sell a substantial amount of securities must take whatever steps are necessary to be sure that this is a transaction not involving an issuer, person in a control relationship with an issuer or an underwriter. For this purpose, it is not sufficient for him merely to accept "self- serving statements of his sellers and their counsel without reasonably exploring the possibility of contrary facts". ⁵

The amount of inquiry called for necessarily varies with the circumstances of particular cases. A dealer who is offered a modest amount of a widely traded security by a responsible customer, whose lack of relationship to the issuer is well known to him, may ordinarily proceed with considerable confidence. On the other hand, when a dealer is offered a substantial block of a little-known security, either by persons who appear reluctant to disclose exactly where the securities came from, or whether the surrounding circumstances raise a question as to whether or not the ostensible sellers may be merely intermediaries for controlling persons or statutory underwriters, then searching inquiry is called for.

The problem becomes particularly acute where substantial amounts of a previously little known security appear in the trading markets within a fairly short period of time and without the benefit of registration under the Securities Act of 1933. In such situations, it must be assumed that these securities emanate from the issuer or from persons controlling the issuer, unless some other source is known and the fact that the certificates may be registered in the names of various individuals could merely indicate that those responsible for the distribution are attempting to cover their tracks.

Exemptions Based on Legal Opinion

In United States v. Crosby, ⁶ the court found persuasive the contention of defendant dealers that, in selling large blocks of unregistered stock of Texas-Adams Oil Co., Inc., in reliance on a legal opinion based upon incomplete facts, they were "doing business as usual" and, to their best knowledge, according to acceptable standards. The court perhaps found this argument persuasive in the context of that criminal conspiracy trial, since no evidence to the contrary was before it. The experience of the Commission, however, clearly demonstrates that the conduct of these dealers did not meet acceptable standards. Not only did the transactions in fact violate Section 5 of the Securities Act, as the court found, but the surrounding circumstances made such violations altogether likely. Shortly after the transfer of control of Texas-Adams to a small group of related persons, large blocks of unregistered stock commenced to appear in the market, accompanied by a drumfire of optimistic publicity from the management, obviously designed to keep the price of the stock up. In such situations, responsible dealers, aware that they have the burden of proving the availability of an exemption, ⁷--and confronted with both an absolute liability to buyers under Section 12(1) of the Securities Act, and with the possibility of civil, administrative, or criminal proceedings--proceed with far more caution than was displayed in the Texas-Adams case, and the Commission expects, and will continue to expect, all dealers to do so. It was up t these dealers to make an appropriate investigation as to who their seller was ⁸ and not simply to rely upon the opinion of the seller's attorney that no control relationship existed.

There have been a number of cases in which dealers have unsuccessfully sought to justify a claim to exemption under Section 4(1) of the Securities Act simply by securing from the sellers, actual or ostensible, representations that such persons are neither officers, directors, nor large stockholders of the issuer, and submitting such representations to an attorney who then gives an opinion to the effect that, assuming the correctness of such representations, exemption under Section 4(1) is available. Obviously, an attorney's opinion based upon hypothetical facts is worthless if the facts are not as specified, or if unspecified but vital facts are not considered. Because of this, it is the practice of responsible counsel not to furnish an opinion concerning the availability of an exemption from registration under the Securities Act for a contemplated distribution unless such counsel have themselves carefully examined all of the relevant circumstances and satisfied themselves, to the extent possible, that the contemplated transaction is, in fact, not a part of an unlawful distribution. Indeed, if an attorney furnishes an opinion based solely upon hypothetical facts which he has made no effort to verify, and if he knows that his opinion will be relied upon as the basis for a substantial distribution of unregistered securities, a serious question arises as to the propriety of his professional conduct. ⁹

Anti-Fraud Provisions

A broker-dealer undertaking the sale of a block of securities under the circumstances referred to herein has the further problem of avoiding conduct which will violate the anti-fraud provisions of the federal securities laws. In making such a distribution, he will probably find it necessary, or at least desirable, to recommend purchase of the security by his customers. The Commission has, however, repeatedly held that it is a violation of the anti-fraud provisions for a broker-dealer to recommend a security unless there is an adequate and reasonable basis for the recommendations ¹⁰ and, further, that such recommendations should not be made without disclosure of facts known or reasonably ascertainable, bearing upon the justification for the recommendation. ¹¹  As indicated, the making of recommendations for the purchase of a security implies that the dealer has a reasonable basis for such recommendations which, in turn, requires that, as a pre-requisite, he shall have made a reasonable investigation. In addition, if such a dealer lacks essential information about the issuer, such as knowledge of its financial condition, he must disclose this lack of knowledge and caution customers as to the risk involved in purchasing the securities without it. ¹²

In view of the foregoing principles, it would appear that if a dealer undertakes the retail distribution of a block of securities without obtaining reliable information concerning the issuer, there is a substantial risk that he will violate the anti-fraud provisions of the securities laws, either by making recommendations without an adequate basis or by failing to disclose the absence of available information. Indeed, a serious question arises as to whether a dealer who undertakes an aggressive retail distribution to individuals of an obscure, unregistered security, with regard to which reliable information is not readily available, can meet his obligation to treat customers fairly and in accordance with the standards of the profession. ¹³  The mere fact that a security may allegedly be exempt from the registration requirements of the Securities Act of 1933 does not relieve a dealer of these obligations. On the contrary, it may increase his responsibilities, since neither he nor his customers receive the protection which registration under the Securities Act is designed to provide.

¹  United States v. Francis Peter Crosby, 294 F. 2d 928 (C. A. 2, 1961); SEC v. Culpepper, 270 F. 2d 241 (C. A. 2, 1959);
Gilligan, Will & Co. v. SEC, 257 F. 2d 461 (C. A. 2, 1959); SEC v. Mono-Kearsarge, et al., 167 F. Supp. 248 (D. Utah, 1958); Barnett & Co., SEA Rel. 6310; Best Securities, SEC Rel. 6282.

²  SEC v. Ralston Purina, 346 U. S. 119 (1953); Gilligan, Will & Co. v. SEC, supra Note 1; SEC v. Culpepper, supra Note 1; and Edwards v. United States, 312 U. S. 473 (1941).

³  SEC v. Culpepper, supra note 1.

⁴  SEC v. Chinese Consolidated Benevolent Association, 120 F. 2d 738 (1941), cert. denied, 314 U. S. 618; SEC v. Culpepper, supra Note 1.

⁵  SEC v. Culpepper, supra Note 1. See also SEC v. Mono-Kearsarge Consolidated Mining Company, supra Note 1.

⁶  Supra note 1.

⁷  Ralston-Purina supra note 2. Gilligan, Will, supra note 1; SEC v. Culpepper, supra note 1.

⁸  The seller turned out to be a nominee for the controlling group and the brother-in-law of one of them.

⁹  In United States v. Crosby, supra note 1, the court appears to have regarded the giving of such opinions as significant evidence supporting a jury finding that an attorney was guilty as a co-conspirator.

¹⁰  Leonard Burton, SEA Rel. 5798; Barnett & Co., supra note 1. MacRobbins & Co., SEA Rel. 6462; Midland Securities Inc., SEA Rel. 6524.

¹¹  Leonard Burton, supra note 10; Best Securities, supra note 1.

¹²  MacRobbins & Co., Inc., supra note 10.

¹³  Best Securities, supra note 1.