Enforcement News: In A First of Its Kind, The SEC Charges a Provider that Facilitates Electronic Trading for Operating as an Unregistered Broker-Dealer

• Posted on: Jun 30 2021

The Securities Exchange Act of 1934 (“Exchange Act”) governs the way in which the nation’s securities markets and its brokers and dealers operate. Under the Exchange Act, most “brokers” and “dealers” must register with the Securities and Exchange Commission (“SEC” or the “Commission”) and join a “self-regulatory organization,” or SRO. Section 15(a)(1) of the Exchange Act, 15 U.S.C. §78o(a).

Under Section 3(a)(4)(A) of the Exchange Act, 15 U.S.C. §78c(a)(4)(A), a broker is defined as a person or entity that regularly: (i) participates in the solicitation, negotiation, or execution of securities transactions, (ii) receives transaction-based compensation contingent on the value or success of securities transactions or (iii) handles investor funds or securities. 

Apart from the foregoing, individuals and businesses need to register as a broker when, among other things, they act as “finders” – e.g., they find investors or customers for, making referrals to, or splitting commissions with registered broker-dealers, investment companies (or mutual funds, including hedge funds) or other securities intermediaries; they find investment banking clients for registered broker-dealers; they act as “placement agents” for private placements of securities; they provide support services to registered broker-dealers; they act as “independent contractors,” but are not “associated persons” of a broker-dealer; and they are otherwise engaged in the business of effecting or facilitating securities transactions.

Unlike a broker, who acts as agent, a dealer acts as principal. Section 3(a)(5)(A) of the Exchange Act defines a “dealer” as a person or entity that (i) holds himself/herself out as being willing to buy and sell securities on a continuous basis or (ii) originates securities that they buy and sell. Individuals who buy and sell securities for themselves generally are considered traders and not dealers.

The SEC considers the regulatory regime applicable to broker-dealers to be a cornerstone of the U.S. federal securities laws because it provides important safeguards to investors and market participants. Among other things, registered broker-dealers must (a) satisfy comprehensive recordkeeping, reporting, and supervisory obligations, and (b) pass inspection and examination by the SEC and SRO. In addition, broker-dealers must address conflicts of interest and implement policies and procedures that are reasonably designed to achieve compliance with applicable securities laws and regulations, and with applicable FINRA rules, including, without limitation, safeguarding customer information and preventing identity theft. 

On June 29, 2021, the SEC announced (here) that Neovest Inc. (“Neovest”), a provider of an order and execution management system (“OEMS”) that facilitates electronic trading, had agreed to pay a $2.75 million penalty for its failure to register as a broker-dealer in violation of the federal securities laws.  This is the SEC’s first case charging an OEMS provider for operating as an unregistered broker-dealer.

According to the SEC’s order (here), Neovest, a subsidiary of JPMorgan Chase & Co., operates an OEMS that allows customers to route orders for stocks and options to more than 360 customer-selected destination brokers for execution.  The OEMS had been Neovest’s primary product. The SEC found that prior to being acquired by JPMorgan Chase, Neovest engaged in this activity through its registered broker-dealer, Neovest Trading Inc. The SEC also found that although Neovest withdrew its broker-dealer registration after it was acquired, it continued to operate the OEMS as an unregistered broker-dealer by, among other things, participating in the order-taking and order-routing process and soliciting customers and destination brokers through the firm’s website and direct outreach at industry conferences and trade shows.  Neovest played a role in determining the routing options that were available to its customers by entering into agreements with the destination brokers.  According to the SEC, in exchange for its OEMS services, Neovest also continued to receive transaction-based compensation by having payments from destination brokers redirected to J.P. Morgan Securities LLC, a registered broker-dealer, which then transferred the proceeds to Neovest.

The SEC further found that Neovest’s failure to register as a broker-dealer deprived its customers of protections associated with registration, including inspections and examinations by the SEC and the requirement to establish policies and procedures to safeguard customer information.  As detailed in the SEC’s order, during the period that Neovest failed to register, the firm replicated a database containing customer authentication information, including user names and passwords, to one of its most active customers and failed to exercise any supervision over the customer’s use of the database. 

“According to the SEC’s order, Neovest circumvented the regulatory regime that grants broker-dealers the privilege of operating in our markets,” said Joseph Sansone, Chief of the SEC Enforcement Division’s Market Abuse Unit.  “Today’s charges underscore the SEC’s commitment to securing the important investor protections that flow from broker-dealer registration.”

By its order, the SEC censured Neovest and found that it willfully violated Section 15(a) of the Exchange Act.  Without admitting or denying the SEC’s findings, Neovest consented to the order and agreed to cease and desist from committing or causing any violations and any future violations of Section 15(a) of the Exchange Act, and to pay a $2.75 million penalty.