White Collar

SEC's Expansive Broker-Dealer Enforcement Under Fire: An In-Depth Examination

By: Lucosky Brookman
SEC's Expansive Broker-Dealer Enforcement Under Fire: An In-Depth Examination

A high-profile Freedom of Information Act (FOIA) lawsuit brought by law firm Gibson, Dunn & Crutcher against the Securities and Exchange Commission (SEC) has thrown an intense spotlight on concerns about the scope of the agency’s aggressive pursuit of enforcement actions against individuals accused of acting as unregistered broker-dealers.

While the SEC possesses inherent advantages in the underlying contested cases that directly motivated Gibson Dunn’s FOIA challenge, the broader legal principles involved in interpreting the statutory broker-dealer definition extend far beyond the narrow facts of those singular enforcement actions. As such, the ongoing Gibson Dunn lawsuit warrants close monitoring by attorneys in the securities law space given the SEC’s expansive legal interpretations at issue could sweep in potentially thousands of market participants not previously viewed as subject to broker registration requirements.

Recent Spike in Unregistered Broker-Dealer Charges

In recent years, the SEC Division of Enforcement has notably ramped up filing charges against individuals and entities alleged to have been illegally acting as unregistered broker-dealers in violation of Section 15(a) of the Securities Exchange Act of 1934 (“Exchange Act”).

Many of these enforcement actions have focused on frequent trading activities in large volumes of low-priced OTC and penny stocks that the SEC maintains should have legally necessitated broker-dealer registration, along with associated diligence, disclosure and compliance obligations.

Critics have accused the SEC of essentially bypassing the Administrative Procedures Act’s formal rule-making procedures by adopting significant new expansions of the statutory broker-dealer definition through simply pursuing a flurry of litigation wins premised on novel legal theories deviating from longstanding market understandings.

The concerns culminated in Gibson Dunn filing a FOIA lawsuit against the SEC in June 2022 after it failed to respond to requested disclosure of internal agency communications relating to this seismic shift in enforcement policy and interpretation of decades old statutes.

SEC Maintains Favorable Fact Pattern in Contested Broker Cases

In evaluating the likelihood of success of Gibson Dunn’s legal challenge, the specific facts underlying the contested SEC enforcement actions that directly spurred the FOIA litigation must be acknowledged as posing challenges.

The SEC enforcement matters involve defendants trading truly massive share volumes in the multiple billions over short time periods. These astronomical trading levels make arguments against functionally serving as unregistered dealers in securities significantly more difficult.

For example, one action targeted defendant Ibrahim Almagarby and his entity Microcap Equity Group (MEG) for the rapid sale of over 7.4 billion(!) shares of low-cost OTC stocks over a three year span following debt conversions. Given the vast trading quantities, the SEC persuasively argued this reached dealer levels necessitating registration.

In granting the SEC summary judgment, U.S. District Judge Marcia Cooke found the entire MEG business model hinged on quickly flipping huge volumes of shares, further cementing the dealer allegations.

The SEC has continued prevailing in similar cases under this framework, winning a June 2022 case against defendants accused of selling 2.5 billion unregistered penny stock shares while relying on the dealer registration exemption, for instance.

While Almagarby has appealed his loss with separate counsel, the staggering trading volume makes rebutting his functionally operating as an unregistered dealer extremely difficult under the Exchange Act’s textual dealer definition covering those “engaged in the business of buying and selling securities.”

Broader Ramifications for Interpretation of the Broker-Dealer Standard

However, as Gibson Dunn aptly highlights, the principles involved in the SEC’s ongoing campaign extend far beyond the narrow facts of these individual enforcement actions to implicate “what it means to be a ‘dealer’ under the Exchange Act—of critical importance to our nation’s financial industry and securities markets.”

In its FOIA litigation against the SEC, Gibson Dunn warns that under the agency’s “extraordinarily broad legal theory in these cases, any business that regularly buys and sells securities must register as a ‘dealer.’”

This interpretation would hypothetically capture “virtually every hedge fund, investment company, and family office in the United States” that has been operating for years on the understanding they fall outside the broker-dealer registration requirement, according to Gibson Dunn’s urgent warnings.

Other securities attorneys concur that while the SEC has a compelling argument on the facts of the initial cases it chose to pursue applying its expansive broker-dealer interpretation, significant issues remain regarding impacts on the financial industry at large.

Former SEC enforcement attorney Jeremiah Williams noted the number of shares traded in the underlying disputed matters raises legitimate registration questions given the goals of investor protection. But he simultaneously called broker-dealer qualification “a big issue” warranting the legal challenge Gibson Dunn is mounting even if the particular cases at issue leave them disadvantaged.

Georgia State University law professor Anne Tucker echoed these concerns about the SEC’s “idiosyncratic enforcement” potentially bypassing public notice and comment that formal rule-making would provide. She suggested individual judges presented with the huge trading volumes may naturally gravitate toward the SEC’s ad hoc interpretation without considering broader market impacts and reliance interests.

High Likelihood of Eventual Appellate Rulings on SEC’s Contested Broker Authority

Former SEC officials have defended the SEC’s discretion to update its interpretations of decades-old statutes through incremental litigation victories. But Gibson Dunn remains undeterred, apparently willing to invest the time and resources needed to wage a multi-year challenge to the SEC’s expansive broker-dealer enforcement all the way up through federal appellate courts if necessary.

Gibson Dunn lawyers contend evolving technological changes surrounding high frequency trading strategies and investor risk management techniques may necessitate some broker-dealer clarifications. But they argue the SEC must do this through formal rule making with public notice and comment rather than de facto amendments via litigation positions.

Notably, the SEC did announce in late 2021 the start of a formal rule making process to update its broker-dealer guidance. But no final rule changes have yet been published. This leaves ample legal uncertainty the SEC is filling through aggressive filing of contested enforcement actions against defendants like Mr. Almagarby.

The sheer magnitude of the share volumes traded by defendants like MEG make appellate success an uphill climb based on the Exchange Act’s operative language and investor protection goals. But Gibson Dunn’s willingness to mount a vigorous, sustained challenge targeting the bounds of the SEC’s ability to effectively set policy through enforcement actions rather than formal rule-making is understandable.

Given the statutory interpretation stakes involved, the issues seem destined for resolution by federal appellate courts, if not ultimately the Supreme Court’s intervention should Gibson Dunn stay the course as signaled. We will continue to follow and report on developments in this impactful case as it progresses through procedural stages. Please contact experienced counsel at Lucosky Brookman to discuss the implications of this evolving issue.