SEC Sanctions Broker-Dealer, Clearing Firm and Chief Compliance Officer for AML Violations

by Ballard Spahr LLP
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On May 16, 2018, the Securities Exchange Commission (“SEC”) announced it had settled charges against a registered broker-dealer, its clearing firm, and its chief compliance and anti-money laundering (“AML”) officer brought over the firm’s failure to file Suspicious Activity Reports (“SARs”) related to customers’ liquidation of billions of penny stocks over an eight month period.  In a companion action, the Financial Industry Regulatory Authority (“FINRA”) imposed a monetary penalty against the clearing firm for various AML compliance failures.

Chardan Capital Markets, LLC (“Chardan”) was a registered broker-dealer primarily engaged in underwriting private investment in public equity (“PIPEs”), private placements and initial public offerings (“IPOs”). In 2013, Chardan allegedly began actively engaging in the liquidation of thinly-traded penny stocks of microcap issuers.  Industrial and Commercial Bank of China Financial Services, LLC (“ICBCFS”) is a registered broker-dealer that, in late 2012, began clearing equity securities and, from October 2013 through June 2014, cleared Chardan’s customers’ penny-stock transactions.

We previously have blogged about the SEC and FINRA stepping up their AML-related enforcement, as well as the issue of AML-related individual liability for compliance officers and executives (see here, here, here, here and here).  Aside from reaffirming the dubious nature of penny stock trading, this case once again reflects the need to actually act on identified red flags and file related SARs.

The Compliance Program

31 C.F.R. § 1023.320(a)(2) implements the reporting obligations of covered financial institutions under the Bank Secrecy Act (“BSA”) and requires that broker-dealers report a transaction or pattern of transactions conducted through it involving or aggregating to at least $5,000 that the broker dealer suspects or has reason to suspect: (1) involves funds derived from illegal activity or is conducted to disguise funds derived from illegal activities; (2) is designed to evade any requirement of the BSA; (3) has no business or apparent lawful purpose and the broker-dealer knows of no reasonable explanation for the transaction after examining the available facts; or (4) involves the use of the broker-dealer to facilitate criminal activity. Exchange Act Rule 17a-8 requires broker-dealers to comply with the BSA’s reporting, record-keeping and record retention requirements and mandates that the broker-dealer file a SAR when required under Section 1023.320(a)(2).

During the relevant time period, Chardan maintained an AML compliance program and policy (the “Policy”) concerning knowing its customers, monitoring large-volume trading and adhering to Section 1032.320(a)(2) and Exchange Act Rule 17a-8. The Policy required the firm to file a SAR for transactions that “may be indicative of money laundering activity” and defined “suspicious activity” as including “trading that constitutes a substantial portion of all trading for the day in a particular security [and] heavy trading in low-priced securities[.]”  The Policy went on to identify red flags that may suggest potential money laundering, requiring the employee identifying any such red flag to elevate the concern to Chardan’s CCO and AML Officer, Jerard Basmagy (“Basmagy”) who, in turn, was required to “investigat[e] suspected money laundering activities and tak[e] corrective action when necessary.”  Those red flag included:

  • The customer’s background indicates possible criminal, civil or regulatory violations;
  • Customer’s transaction “lacks business sense”;
  • Customer “has opened multiple accounts with the same beneficial owner or controlling parties for no apparent business reason”;
  • Law enforcement subpoenas; and
  • Customer makes a “request to liquidate [penny stock] shares” or otherwise engages in activities indicating the sale of unregistered securities.

The Policy also set forth red flags particular to transactions in penny stocks, including that issuers:

  • Have no business, revenues or products;
  • Have frequently changed business structure;
  • Have officers who are associated with multiple penny stock issuers;
  • Have frequently changed business strategy or line of business; and
  • Have been subject of prior trading suspensions.

However, the SEC found that “Chardan’s actual practices did not comport with its documented procedures.”

The Suspicious Activity

According to the SEC releases, in late 2013, Chardan on-boarded seven new customers who routinely deposited and then immediately liquidated billions of shares of thinly-traded penny stocks. In the typical transaction, these customers obtained their holdings by converting debentures into shares of microcap issuers.  These shares were deposited with a custodian and then sold through the customers’ delivery versus payment/received versus payment (“DVP/RVP”) accounts at Chardan.

Sales numbered in the billions and regularly accounted for a substantial percentage of the daily volume in the individual stocks. This continued until the customers’ positions were entirely liquidated. For instance, each of the seven customers engaged in at least one transaction where their sales of a particular stock accounted for over 50% of the sales volume in that stock during a single trading day.  Four of the seven customers engaged in at least one transaction when their sales of a particular stock exceeded 70% of the sales volume in that stock during a single trading day.  In total, between October 2013 and June 2014, the seven customers sold over 12.5 billion shares of penny stocks.

Moreover, these liquidations bore other indicia that should have raised concerns under Chardan’s Policy. For instance, the seven customers were trading in penny stocks where the issuers had ongoing promotional campaigns and large accumulated deficits.  In some cases, post-trade, Chardan received regulatory inquiries concerning the penny stocks the relevant seven customers had traded in.  In other cases, Chardan discovered past criminal and regulatory issues with an entity associated with the seven customers. Further, the SEC had suspended trading in three securities after the securities had been liquidated by Chardan’s customers.

In addition, on at least six occasions between January and June 2014, ICBCFS identified suspicious activity and alerted Chardan to incidents and circumstances it determined indicated potential illegal activity associated with Chardan’s customers’ trading. Among those alerts:

  • On January 27, 2014, ICBCFS requested Chardan stop a customer’s trading “all these sub penny stocks today,” yet, subsequently, the customer sold multiple sub-penny stocks;
  • On March 18, 2014, ICBCFS closed a customer’s account after failing to receive a description of the customer’s sales transactions from Chardan;
  • On June 23, 2014, ICBCFS sought specific information on two transactions by Chardan customers trading penny stocks;
  • On June 25, 2014, ICBCFS sought information on ten specific transactions in penny stocks;
  • On June 26, 2014, ICBCFS sought information on eight specific transactions in penny stocks; and
  • On June 27, 2014, ICBCFS informed Chardan it had closed its customers’ accounts at another broker-dealer specializing in penny stocks.

Despite observing repeated instances of suspicious, high-volume trading and receiving specific alerts from ICBCFS, Chardan and Basmagy, whose duties required that he investigate suspicious activity and take corrective action, including filing SARs, never filed a SAR regarding these transactions and customers. Moreover, despite raising alarms to Chardan about suspicious trading, ICBCFS itself never filed a SAR related to these transactions and customers or produced any written analysis supporting its decision to not do so.

The Penalties

Although Chardan, ICBCFS and Basmagy have not admitted or denied the SEC’s factual findings, they each have each consented to the imposition of sanctions against them. Chardan will pay a $1 million penalty, ICBCFS will pay a $860,000 penalty and Basmagy will pay a $15,000 penalty.  Moreover, Basmagy has been barred from participating in any penny stock trading activities for a minimum of three years.  Finally, FINRA has separately sanctioned ICBCFS for failing to maintain an adequate AML policy, including failing to file SARs, and has fined ICBCFS $5.3 million.

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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