Between November 2017 and November 2021, three individuals actively solicited investments in securities, including providing marketing materials and advising on the merits of the investment, and received commissions for their sales. The SEC halted the activities of the individual defendants involved in May 2022, for operating a vast network of sales agents in connection with a $410 million fraud. Because such unauthorized activity is hard to contain, now in 2023, the SEC has followed up on its previous action by charging these three sales agents of the unregistered broker-dealer with fraud and unregistered broker activity.

As highlighted by the SEC’s recent complaint, sales agents must obtain licenses and broker-dealer registrations, pursuant to Section 15(a) of the Exchange Act, to engage in the business of facilitating securities transactions. While broker-dealer registration requirements are based on a facts and circumstances analysis, when an individual is advising on the merits, passing along marketing materials, and receiving compensation tied to those activities, there is likely to be a presumption that registration is required.

Broker Registration Requirements

The Exchange Act requires securities brokers to register with the SEC or, if they are individuals, to be associated with a brokerage firm registered with the SEC. The types of activities that may require broker-dealer registration based on the full set of facts and circumstances include:

  • Participating in important parts of a securities transaction, including solicitation, negotiation, or execution of the transaction.
  • Receiving compensation for participation in the transaction dependent upon, or related to, the outcome or size of the transaction or deal.
  • Handling the securities or funds of others in connection with securities transactions.

Risks Relating to Unregistered Activities

While the recent allegations are a particularly egregious example that include fraudulent statements hiding transaction-based compensation, the SEC’s enforcement action serves as a reminder that flouting broker-dealer registration requirements can result in expensive enforcement actions for both individuals and firms. Regulators and courts will look to the economic reality of the transaction and seek to determine whether there is direct or indirect compensation based on hallmarks of broker-dealer conduct.

In the blitz of regulatory and financial developments that have made headlines throughout the first quarter of 2023, a recent FINRA enforcement action serves as a reminder to both broker-dealers and their representatives that Regulation Best Interest (Reg BI) remains an area of focus for FINRA. This action underscores how important it is for broker-dealers to ensure that their representatives fully understand the risks and other features of complex financial products, make only suitable recommendations, and otherwise comply with Reg BI.

The Relevant Regulatory Standards

Reg BI (Customer Best Interests)

Reg BI requires broker-dealers and their representatives to act in the best interest of retail customers when making a recommendation regarding any securities transaction or investment strategy. The care obligation, set forth at Section (a)(2)(ii) of the rule, requires broker-dealers and their representatives to exercise reasonable diligence, care, and skill to, among other things, understand the potential risks, rewards, and costs associated with a recommendation, and have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers. As noted in the Letter of Acceptance, Waiver, and Consent (AWC), the SEC’s adopting release for Reg BI states that whether reasonable diligence, care and skill exist

[depends] on, among other things, the complexity of, and risks associated with the recommended security . . . and the broker-dealer’s familiarity with the recommended security ….”

FINRA Rule 2111 (Suitability)

FINRA Rule 2111 requires broker-dealers and their representatives to have a reasonable basis for believing that a recommended transaction or investment strategy is suitable for the customer based on the customer’s investment profile.

FINRA Rule 2010 (Standards of Commercial Honor and Principles of Trade)

FINRA Rule 2010 requires broker-dealers to observe high standards of commercial honor and just and equitable principles of trade.

Recommendations without a Reasonable Basis

In the recent action, the representative settled the AWC with FINRA and was fined for recommending unsuitable leveraged and inverse ETFs to retail customers without having a sufficient understanding of the product risks and features. As stated in the AWC, the representative should have been particularly mindful in light of FINRA’s previous Regulatory Notice 09-31, which notified and alerted members that complex ETFs, such as those that offer leverage or are designed to perform inversely to an index, “typically are not suitable for retail investors who plan to hold them for more than one trading session, particularly in volatile markets.”
Considering the facts at issue in the AWC, FINRA determined that the representative did not have a reasonable basis for making the recommendations because, among other things, he

did not understand that losses in leveraged and inverse exchange-traded funds can be compounded because of the daily reset function.”

FINRA cited the representative for violating Reg BI’s care obligation and FINRA Rules 2111 and 2010.The representative was fined $2,500, required to make restitution to the customers that lost money based on his recommendations, and suspended for three-months.

Key Takeaways

  • Reg BI continues to be a regulatory priority for FINRA.
  • Broker-dealers must train, test and monitor their representatives to ensure they understand complex financial products and are capable of assessing for whom such products are appropriate.
  • Broker-dealers should also ensure that along with the customer’s age, income, investment objectives, investment horizon, and other information, that data regarding the customer’s indebtedness is also collected and factored into the analysis.

Given this week’s headlines, many emerging companies may be asking themselves: “Why am I holding so much cash?
The Investment Company Act of 1940 (the 1940 Act) may be to blame.

“Inadvertent” Investment Companies

But I don’t have any intent of being an investment company. Aren’t those mutual funds or hedge funds? I’m an operating company that produces goods or provides services.”

The 1940 Act can apply to all companies, not just those with investment-related businesses. The term “investment company” under the 1940 Act has two primary meanings:

  1. A company that is or holds itself out as primarily engaged in the business of investing or trading in securities, which describes many investment funds; or
  2. A company whose total assets (exclusive of government securities and cash items) are comprised of at least 40% “investment securities” (which is more broadly defined under the 1940 Act than “securities” are defined under the Securities Act of 1933).

In other words, even if it doesn’t hold itself out as an investment-related business, an operating company that has 40% or more of its assets invested in stocks, bonds or other securities (even conservative corporate bonds held for cash preservation purposes) is an “investment company.” As such, the company will be subject to the registration and other requirements of the 1940 Act unless it meets a conditional exemption under Section 3 of the 1940 Act or another relevant provision or rule under the 1940 Act. Intent is not an element of the second primary meaning of “investment company,” and even a company that produces goods and services could inadvertently meet the definition simply by having a balance sheet comprised of too high a percentage of “investment securities” in relation to its total assets.

Generally, Government Securities and Cash Items are Out of the Equation

Importantly, along with government securities, “cash items,” such as cash, bank demand deposits and federally-regulated money market funds, are typically (but not always) removed from both the “investment securities” numerator and the total assets denominator when calculating the 40% test described above or similar tests under exemptive provisions. Holding corporate assets in cash as opposed to “investment securities” helps a company avoid investment company status if an exemption is not available. Even holding cash can complicate things, though, since excluding a large cash position from the 40% test can cause a company’s “investment security” holdings to disproportionately affect the results of that calculation.
Many start-up companies find themselves in the position of holding proceeds from fund raising but with relatively few other offsetting assets. Seeking to avoid becoming an inadvertent investment company, they may choose to hold the proceeds in cash items or government securities. Rule 3a-8 excludes certain research and development companies (and some other start-up companies) from the definition of an investment company if certain conditions are met, but many companies are not able to meet the conditions. This means that start-ups may be at particular risk from instability in the banking system as they may be limited in the choices they have to invest their fundraising proceeds.

Avoiding Inadvertence

What should I do if I am worried about holding cash but want to avoid an investment company status issue?”

Even if a regulator does not approach a company, many significant deals require a representation or even an outside legal opinion as to the company’s status under the 1940 Act. Significant securities holdings could delay a deal or even require restructuring the business. So, while it may be tempting to move your liquid holdings from bank accounts to securities or other assets in light of recent bank developments, careful planning can help prevent inadvertently jumping from the frying pan into the fire.
Contact a securities lawyer knowledgeable on investment company status issues should you have any questions.

On March 10, 2023, volatility resulting from concerns regarding runs on certain banks triggered trading halts in those banks’ stocks on the New York Stock Exchange (NYSE) and Nasdaq. March 13, 2023, saw additional trading halts on bank stocks. This post provides a brief explanation of the Limit Up Limit Down (LULD) rules that pause and prevent trading in a single security from taking place outside a specific range, either up or down, from the average trading price during the previous five minutes.


When there is single-stock, industry specific, or market wide volatility, trading halts are a way to create speed bumps to allow markets to absorb information and calm volatility. The Securities and Exchange Commission (SEC) took emergency action to halt trading in response to the 2008 financial crisis. More recently, as detailed in our 2020 post summarizing the overarching framework in which exchanges may halt trading, exchanges imposed trading halts in response to extreme market volatility with unprecedented magnitude and velocity triggered by the coronavirus pandemic. Our prior post explained that exchanges may utilize different types of regulatory halts during periods of market turmoil, particularly when individual stocks endure large fluctuations over short periods. Last week the securities markets experienced turmoil in one sector, regional banks, when shares in three banks experienced sharp declines following the announcement that another bank had been place in receivership with the Federal Deposit Insurance Corporation (FDIC).

Types of Trading Halts

Exchanges such as NYSE and Nasdaq may initiate different types of trading halts, such as market-wide circuit breaker halts (MWCB), which temporarily halt trading in all National Market System (NMS) securities in the event a MWCB is breached, but not all trading halts are the same. In the case of the March 10 trading halts, it was the LULD rules that triggered NYSE and Nasdaq single-stock circuit breaker halts.

LULD Rules

Part of the SEC’s mission is to maintain fair, orderly, and efficient markets. To address extraordinary market volatility, in April 2019 the SEC adopted the LULD rules. The LULD rules prevent trades in NMS securities from occurring outside of specified price bands, which are set at a percentage level above and below the average reference price of a security over the preceding five-minute period. The previous day’s closing prices on the security’s primary listing exchange is used to set the bands for a given day. The price band percentage itself does not change intraday. The LULD rules apply during regular trading hours of 9:30 am ET – 4:00 pm ET.

The percentage levels for the price bands of a security’s circuit breakers are dependent on whether the security is a Tier 1 or Tier 2 security.

  • Tier 1: All securities in the S&P 500, the Russell 1000 and select exchange traded products.
  • Tier 2: With limited exceptions, all other NMS securities.

Per the LULD Operating Committee, the current price bands themselves are as follows:

Under LULD rules, there is a five-minute trading pause on an NMS security if trading is unable to occur within the specified price band after fifteen seconds. The trading pause may be extended for another five minutes and, thereafter, all markets may resume trading. If a security is in a trading pause during the last ten minutes of the exchange’s regular trading hours, the exchange will not reopen trading and will attempt to execute a closing transaction using its established closing procedures. Reg NMS Rule 611 provides certain exceptions to LULD price bands (i.e., Self Help, Not Regular Way, Open/Close, Crossed Markets, Intermarket Sweep, Benchmark, Flickering Quotes, and Stopped Orders) as well as other exemptions.


Reg SHO also imposes a single-stock circuit breaker. Instead of halting or suspending trading, it places heightened restrictions on certain types of trades. Rule 201 of Reg SHO prohibits short-selling at or below the national best bid in a security that declines 10% or more from its prior day’s closing price. Once triggered, the circuit breaker remains in effect for the remainder of the trading day and the following day. The circuit breaker can be retriggered on the following day. One of the primary policy goals of the Rule 201 circuit breaker is to allow long sellers a chance to sell without short sellers placing additional downward pressure on the price.


As the markets navigate the second-biggest bank failure in U.S. history, trading halts may continue in certain banking stocks and could have collateral consequences in other sectors.

On March 1, 2023, the U.S. Department of Justice (“DOJ”) unsealed an indictment against the CEO of a publicly traded health care company (the “Executive”) relating to charges of an insider trading scheme. The indictment represents the first time that DOJ has brought criminal insider trading charges stemming from an executive’s use of a Rule 10b5-1 trading plan. The investigation is part of a data-driven initiative led by DOJ’s Fraud Section to identify executive abuses of 10b5-1 trading plans.

Rule 10b5-1 Plans

Rule 10b5-1 trading plans offer an affirmative defense from insider trading liability on the basis of material non-public information (“MNPI”) under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5. It is an affirmative defense whereby insiders can set up future trades pursuant to a binding contract adopted in compliance with the rule. However, the defense is unavailable if the insider is in possession of MNPI at the time the insider adopts the trading plan. Additionally, a plan does not protect an insider who does not enter into a plan in good faith or uses a plan as part of an effort or scheme to evade the prohibitions of Rule 10b5-1.

DOJ’s Criminal Indictment for the Insider Trading Scheme

DOJ alleges that the Executive allegedly avoided more than $12.5 million in losses by entering into two Rule 10b5-1 trading plans while in possession of MNPI concerning the likelihood that the health care company’s then-largest customer would terminate its contract. In May 2021, the Executive allegedly entered into his first 10b5-1 plan shortly after learning that the relationship between the health care company and the customer was deteriorating. Then, in August 2021, the Executive allegedly entered into his second 10b5-1 trading plan approximately one hour after the health care company’s chief negotiator for the contract confirmed to the Executive that termination was likely.

In establishing the 10b5-1 plans, the Executive allegedly refused to engage in any “cooling-off” period – the time between entering into the plan and selling the stock – despite warnings from the Executive’s brokers. Instead, the Executive allegedly began selling shares of the health care company on the next trading day after establishing each plan. On August 19, 2021, just six days after the Executive adopted his August 10b5-1 plan, the health care company announced that the customer had terminated its contract and the health care company’s stock price declined by more than 44%. The Executive is charged with one count of engaging in a securities fraud scheme and two counts of securities fraud for insider trading.

Renewed Focus on Rule 10b5-1 Plans by SEC and DOJ

This first criminal indictment comes immediately on the heels of recent amendments to Rule 10b5-1 by the U.S. Securities and Exchange Commission (“SEC”) which went into effect on February 27, 2023. The amendments made a number of key changes to Rule 10b5-1 summarized in more depth here by our sister blog, Public Chatter. Key elements of the newly amended Rule 10b5-1 include:

  • Mandatory cooling off periods for directors and non-directors.
  • Restrictions on Overlapping and Single-Trade Plans.
  • Written Certifications when entering into Rule 10b5-1 Plans.
  • Annual Reporting of Insider Trading Policies and Procedures and Quarterly Reporting on Use of Trading Plans.
  • Narrative and Tabular Disclosure About Timing of Option Grants.

Implications for the Digital Asset Industry

DOJ’s indictment relating to insider trading should interest digital asset issuers, trading platforms, and other digital asset intermediaries. As the SEC continues to take the stance that “a vast majority” of digital assets are securities, DOJ’s case demonstrates that the relevant risks relating to securities offerings and subsequent transactions may involve criminal as well as civil charges. Digital asset industry participants should give serious consideration to the value of implementing insider trading policies including the use of 10b5-1 plans.

What’s Next

DOJ’s criminal case against the Executive is now proceeding in federal court in California. If convicted, the Executive faces a maximum penalty of 25 years in prison on the securities fraud scheme charge and 20 years in prison on each of the insider trading charges. Meanwhile, the indictment is an indication of the Fraud Section’s and federal law enforcement’s focus on executive abuses of Rule 10b5-1 plans. To rely on its affirmative defense, strict adherence to the rule is necessary.

In February 2023, FINRA provided an update on its review of member broker-dealer firms’ practices for their social media practices and related privacy protection. In it, FINRA summarized practices it has observed to date to help firms evaluate whether their practices and supervisory systems are reasonably designed to address risks related to social media influencer and referral programs as well as to address compliance with privacy requirements.

The update followed FINRA’s targeted sweep of such practices announced in September 2021 in which FINRA shared that it would review firms’ practices related to their acquisition of customers through social media channels, as well as firms’ sharing of customers’ usage information with affiliates and non-affiliated third parties.

Social Media Influencer and Referral Programs

FINRA highlighted the importance for broker-dealers using social media of maintaining appropriate written supervisory procedures (“WSPs”) for their social media influencer and referral programs. Per FINRA, possible considerations for such WSPs include:

  • Differentiating between social media influencer and referral programs, including additional controls for social media influencers with a relatively large social media presence, as well as any additional requirements for programs managed by member firms, affiliates, or marketing agencies;
  • Updating WSPs on a regular basis and in response to program developments, regulatory changes, or industry trends; and
  • Addressing program participants’ compensation.

Among other important findings, FINRA highlighted broker-dealers’ practices for maintaining adequate records of social media influencer and referral program communications with the public and providing training and defining permitted and prohibited conduct for social media influencers.


In its update, FINRA also noted broker-dealer firms’ obligations for compliance with Regulation S-P and other applicable laws, rules, and regulations for protecting customer nonpublic information (“NPI”) and noted that broker-dealers are limited in disclosing customer NPI with non-affiliated third parties. From its sweep, FINRA highlighted various relevant firm practices including again maintaining WSPs addressing a broker-dealer’s obligations under Regulation S-P by including in the firm’s WSPs if relevant:

  • The general obligation to deliver privacy notices to customers no later than when members establish a customer relationship, and annually thereafter;
  • Protecting usage information for customers who opt out of information sharing; and
  • Collecting and sharing of customer usage information, including information collected using “cookies,” and sharing that information with third parties.

FINRA also highlighted other practices such as permitting customers to opt out of information sharing with third parties and not sharing this information. If the firm shares non-anonymized NPI with third parties, broker-dealers should consider maintaining written agreements with those third parties limiting their use of that information consistent with Regulation S-P.

Final Thoughts

While FINRA released this update, its sweep is still ongoing and FINRA will likely provide additional information about its findings and observations post-sweep. Of note, the SEC continues to focus on social media practices. In February 2023, the SEC entered into an enforcement order with NBA Hall of Famer and Boston Celtics legend Paul Pierce relating to, among other charges, his touting of crypto asset securities on social media without disclosing the payment he received for the promotion. Similarly, privacy continues to be a priority of the SEC in 2023. Its Division of Examinations listed broker-dealers’ information security and operational resiliency as a priority in its 2023 Priorities. Broker-dealer firms can expect more on these topics from FINRA and the SEC in the months to come.

On November 2, 2022, the SEC proposed wide-ranging changes to how open-end investment companies (other than exchange traded funds and money market funds, “Funds”) process and price shareholder transactions and manage their corresponding liquidity risks (the “Proposal”). This post attempts to summarize key elements of the Proposal as a precursor to our analysis of its merits. “Attempts” is the apt term, as the Proposal would involve substantial revisions to multiple rules and disclosure forms, which makes organizing our summary a challenge. Continue Reading Sorting Out the Universal Swing Pricing Proposal

While working out the possible impact of the SEC’s proposal to require central clearing of triparty repurchase agreements, we realized that we short-changed the analysis of multilateral netting in our last post. Our explanation of the SEC’s example focused on just the cash side of the trades, which is to say the amounts to be paid. To appreciate multilateral netting fully, we need to consider the security side of the trades, what is to be delivered, as well. This post seeks to rectify our oversight. Continue Reading Treasury Clearing Proposal: More on Multilateral Netting

Our previous post explained the SEC’s proposal (the Proposal) to require central clearing of all “eligible secondary market transactions” with a participant in the Fixed Income Clearing Corporation (FICC). In this post we review the benefits of central clearing cited by the SEC to justify its Proposal. We also discuss “hybrid clearing” and “multilateral netting.” Continue Reading Central Clearing of Treasury Trades—What the SEC Hopes to Accomplish

On October 7, 2022, the SEC reopened the comment period for a dozen proposed rules “[d]ue to a technological error.” As a result of this error, “a number of public comments submitted through the Commission’s internet form for the submission of comment letters were not received by the Commission and therefore were not posted in the relevant comment file.” Comments can be filed from October 7 until two weeks after the SEC’s order is published in the Federal Register—a date that has yet to be established. Continue Reading SEC Reopens Comment Periods Due to Technical Glitch