Absence Of Stock Legend Does Not Relieve Broker Of Duty Of Inquiry

by Allen Matkins

Section 5(c) of the Securities Act of 1933 generally declares it unlawful to offer a security unless a registration statement has been filed.  Section 5(a) of the same act generally makes it unlawful to sell a security unless a registration statement is effective.  Brokers would have a difficult time effecting offers and sales of securities if a registration statement had to be filed before every offer and a registration statement had to be declared effective before every sale. This is where Section 4(4) comes into play.  That statute provides that Section 5 does not apply “to brokers’ transactions executed upon customers’ orders on any exchange or in the over-the-counter market but not the solicitation of such orders.”  The term “brokers’ transactions” is not defined by the Act and the Act certainly doesn’t say anything about “reasonable inquiry” being a condition to brokers’ transaction.

Despite the obvious absence of any statutory basis, the Securities and Exchange Commission takes the position that a broker must conduct a “reasonable inquiry” to claim the Section 4(4) exemption for trades that violate Section 5.  In an opinion issued yesterday, the Ninth Circuit Court of Appeals agreed. World Trade Fin. Corp. v. United States SEC, 2014 U.S. App. LEXIS 866 (9th Cir. 2014).  That case involved a broker that executed trades in shares of a reverse merger company.  While the broker had procedures for trading “Rule 144? stock, those procedures were triggered only when the shares carried a restrictive legend.  It so happens that in this case, the transfer agent had removed the legends based on a legal opinion deemed by the court to have been incorrect.  In concluding that reasonable inquiry is required under Section 4(4), the Ninth Circuit agreed with an earlier opinion by the D.C. Circuit, Wonsover v. SEC, 205 F.3d 408 (D.C. Cir. 2000).

I, however, don’t agree.  The statute doesn’t mention a reasonable inquiry and Congress certainly could have imposed such a condition had it so desired.  There’s no question that Congress knew how to impose a reasonable inquiry requirement.  Indeed, Congress employed the term “reasonable investigation” in Section 11 of the very same act.

While it is true that the SEC has included the concept of “reasonable inquiry” in defining “brokers’ transaction” in Rule 144(g), that definition is completely irrelevant to Section 4(4).  Rule 144 begins with the following: “The term brokers’ transactions in section 4(4) of the Act shall for the purposes of this rule be deemed to include transactions by a broker in which such broker . . .”.  This leads to several important points.  First, Rule 144 is a non-exclusive safe harbor under Section 4(1), not Section 4(4), of the Securities Act.  It is an odd twist of logic to pick a provision of a non-exclusive rule and convert it into a mandatory condition of a statute.  Moreover, Rule 144 was not intended to define terms for the purposes of Section 4(4).  In adopting the definition the SEC plainly and explicitly did so “for purposes of this rule [Rule 144]“.  Even more tellingly, the definition in Rule 144(g) by its terms establishes a subset of transactions within the potentially larger category of Section 4(4) brokers’ transactions.

The Ninth Circuit mentioned the importance of registration as an element of investor protection, but this is not a reason to write words into a statute.  By “fixing” or “improving” legislation, judges run the risk of becoming legislators.  Not only does this infringe on the separation of powers, it relieves legislators of the responsibility for careful drafting and fixing what they have drafted.  When a court, rather than the legislature, adds to a statute, the effect is retroactive and the people are deprived of both input and notice.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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