Bates Research | 03-04-21
Are Low-Priced Securities a Backdoor to Fraud? FINRA Says Watch Out
On February 15, 2021, FINRA issued an alert warning firms to pay attention to risks associated with low-priced securities activities. The Notice highlights the basic compliance tools that should be reviewed to address current concerns. These include a review of red flag indicators of suspicious activity, adequacy of monitoring systems, and systems for consistent and accurate reporting. In light of their concern that bad actors, looking to take advantage of market urgencies like the COVID pandemic, will continue to perpetrate “pump and dump” and other schemes that exploit those attributes, FINRA underscores the risks of low-priced security transactions as a compliance priority. (See Bates article on FINRA’s 2021 Exam Priorities).
Low-Priced Securities
Low-priced securities are securities issued by companies with a low market capitalization (less than $250-300 million) and which sell at low prices (less than $5 per share). Also known as “microcap” or “penny stocks,” a surge in these transactions has been observed in promotions and sales for COVID-related products including vaccines, test kits and personal protective equipment. They have also been prominent in new products and services related to the expanding cannabis market. Both examples gave rise to the FINRA warning about the immediate potential for fraud and market manipulation.
To strengthen compliance controls, FINRA recommended that firms review and strengthen their detection, monitoring, suspicious activity reporting, and fraud reporting compliance processes. In addition, FINRA reminded firms of a November 20, 2021 modified SEC Bulletin that identified the risks associated with transactions of low-priced securities held in omnibus accounts. That Bulletin noted that the risks of transacting in low-priced securities are heightened when held by foreign financial institutions and “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.” Concerned with the anti-money laundering (“AML”) implications, SEC staff recommended that brokers consider “obtain[ing] information regarding the relevant characteristics of ultimate beneficial owners of the funds and securities.”
Detection
FINRA provided a long list of red flags to be incorporated into compliance detection frameworks that would alert firms to potential misbehavior involving low-priced securities. The list draws compliance officers’ attention to the specific activities of issuers, third party promoters and customers in the marketplace.
Specifically, among other indicators, FINRA warns firms to be alert to issuers who:
- change names or business models frequently to accommodate emergent and potentially lucrative market trends;
- engage in reorganizations that concentrate stock ownership in the hands of a small number of shareholders;
- do not provide current or adequate public financial information;
- offer unsupported scale and revenue projections; and
- push social and other media outreach with information not confirmed in financial statements or SEC disclosures.
As to third-party promoters, FINRA alerts firms to beware of activities that:
- hype products or services where claims cannot be confirmed;
- are tied to trends or unverifiable independent news or research;
- offer unsupported projects for investment returns; and
- lead to spikes in online activity, or that use text or unsolicited phone calls to tout specific microcap or penny stocks.
As to a firm’s customers, FINRA recommends that compliance officers monitor for low-priced stock activity that might be suspicious. This might include:
- customers depositing significant blocks of low-priced stock;
- any transactions that suggest an intention to affect the stock price;
- attempts to “mark the close;”
- unsuitable transactions in low priced stock, particularly for vulnerable adults;
- customers who route high volume sell orders (with no buys) to the firm for execution; and
- multiple account openings through electronic means (reflecting the deposit of shares from the same issuer).
FINRA advises firms to note the “overlap” between these red flags and previous guidance on suspicious AML activity.
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Monitoring, Suspicious Activity and Fraud Reporting
In its observations of firms’ supervisory systems, FINRA identified certain effective methods to mitigate the risks associated with the described red flags. These include monitoring customer investments in low-priced securities and enhancing the supervision over representatives that trade in these securities. Account monitoring is a high priority—FINRA suggests an initial focus on establishing revised risk-based criteria (particularly for specified adults and seniors) that can serve to identify unusual purchases of low-priced securities and trigger outreach to customers “to determine if these decisions were the result of solicitation or influence by a third party.”
FINRA also suggests additional controls on “account and share acceptance,” to determine the characteristics of securities that investors would be allowed to hold and transact from their accounts, for example. These may include “risk-based acceptance policies” on low-priced security deposits (i.e. whether the issuer is listed on an exchange), or requiring AML department approval for exceptions to firm policies on transacting in low priced securities.
Finally, FINRA reaffirmed the AML suspicious activity and fraud reporting rules required of its members and reiterated the Bank Secrecy Act (“BSA”) obligations to conduct ongoing customer due diligence, including ongoing monitoring to identify and report suspicious transactions to FinCEN.
Conclusion
Policies and practices on low-priced securities transactions touch on numerous compliance areas, including fraud, financial crime and AML. The consolidation of many previously highlighted red flags for detecting suspicious microcap or penny stock transaction activity is consistent with the prevailing concern across the regulatory enforcement landscape of an increase in bad actors looking for greater opportunities to defraud investors.
FINRA’s recommendations for tightening up the supervision, monitoring and reporting processes are intended to deal with evolving markets (e.g. COVID and cannabis products and services). The prescriptions are entirely consistent with broader trends in AML enforcement. In a recent Bates White Paper covering the passage of the Anti-Money Laundering Act of 2020 (AMLA), Edward Longridge, Managing Director of Bates Group’s AML & Financial Crimes Practice considered the abundant red flag guidance around fraud during COVID-19:
“When a regulator issues such guidance, firms have to incorporate it. AML officers know that firms will be examined on it. Against the backdrop of COVID, these alerts put increasing pressure on AML departments to keep up…AMLA requires making the SARs process more efficient, including automating types of SARs so the SARs review teams and the transaction monitoring investigation teams are focusing on the really critical SARs and having very good information fed back to FinCEN.”
While it remains to be seen if the urgency around the monitoring of low-priced securities transactions evolving will coalesce with a FinTech solution that would satisfy the AMLA, these conversations is part of an evolving framework for addressing the ongoing challenges.
How Bates Helps
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- Hank Sanchez, Managing Director, hsanchez@batesgroup.com | 504-450-9632
- Rory O'Connor, Director, roconnor@batesgroup.com | 860-671-7270
Bates AML and Financial Crimes helps its clients meet their AML/FC obligations through experience, resources and ongoing guidance. Our services are tailored to the specific needs and requirements of our clients and that regulators are seeking, including in the areas of AML tuning and optimization, implementation of new systems, trade finance, and AI-driven process automation solutions, AML and sanctions system model validations; governance and oversight processes; redesign and updates to AML policies and procedures; AML and sanctions risk and gap assessments; regulatory response support; and staffing support for AML backlogs and lookbacks. For more information, please contact:
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