When a person violates the Uniform Securities Act (USA), a criminal or civil violation could occur. Criminal violations subject a person to court-imposed fines and potential jail time, while civil violations subject a person to liabilities and penalties imposed by the state administrator. The difference between the two is based on one thing: whether the violation was willful.

Criminal penalties

A willful violation occurs if the person committing the violation was aware of what they were doing prior to the action. If proven as willful, criminal penalties may come into play. Legal consequences are not handled by the administrator, but instead the US court system. As we’ve discussed previously, the administrator remains in close contact with the legal system and petitions the court if seeking to enforce legal actions. The state administrator usually works in tandem with the state attorney general to bring criminal charges.

There’s technically no set of USA provisions that must be broken in order to be subject to criminal penalties. If a violation is deemed willful, it makes the person subject to criminal charges and prosecution. In practice, more egregious violations tend to be pursued in court. According to the North American Securities Administrators Association’s (NASAA’s) 2019 report, over 8,000 complaints were lodged with state administrators, but only 218 criminal enforcements occurred.

If the action is deemed worthy of criminal prosecution, a person could be subject to:

$5,000 maximum fine*
3-year maximum jail sentence*

*These penalties are levied on a per-violation basis. For instance, a person found guilty of three violations could face a maximum fine of $15,000 and up to 9 years of imprisonment.

Criminal prosecutions are subject to a 5-year statute of limitations. Meaning, any violation occurring more than 5 years ago cannot result in any legal consequences. With that being said, many test takers remember the specifics of criminal penalties as the ”5-5-3 rule.” There’s a 5-year statute of limitations, subjecting a person to a maximum $5,000 fine, plus a maximum 3-year jail sentence.

If you’re curious, you can look up criminal enforcement actions your state administrator participated in. First use NASAA’s ‘contact your regulator’ page to look up your administrator. Once you find your administrator’s webpage, there should be a section dedicated to enforcement actions. It should include actions taken against a person’s registration, plus criminal and civil actions. For example, here’s a historical summary of all enforcement actions taken by Colorado’s state administrator.

Civil liabilities

Even if a violation of USA provisions isn’t willful, it could still result in civil liability. This typically comes into play when an investor is due restitution of some form. For example, what if an investment adviser representative (IAR) makes a recommendation to purchase a security, but the security was a non-exempt unregistered security? As we’ve already learned, the only way to sell a non-exempt unregistered security is through an exempt transaction. If one is not claimed, the security shouldn’t have been recommended to the client. In this scenario, IAR (and by extension the investment adviser) would be held liable for paying restitution to their client.

The USA declares three primary types of restitution for civil liabilities: securities sales, securities purchases, and investment advice. Keep in mind these are for transactions or advice related to a violation of the USA. All forms of restitution are similar, but let’s look at the specifics:

Restitution for securities purchases (client buys)

Original cost of the security*
Less any income received from security
Plus the legal rate of interest**
Plus any legal fees

*A common “trick” on the exam relates to whether the investor should be compensated for the original cost of the security or the current market value. It’s always the original cost. Think about it - assume an investor was sold a security illegally and its value declined dramatically. Would it be fair to only compensate them for the current value of the security? Obviously, no.

**The legal rate of interest is determined by each state administrator. Its purpose is to compensate the investor for the time their money was locked up in an investment they shouldn’t have been sold.

Restitution for securities sales (client sells)

Client may recover (buy back) the security
Less any income paid by the security
Less any legal fees

Restitution for investment advice

Cost of the investment advice
Plus actual damages due to investment advice
Less any income received from security
Plus the legal rate of interest
Plus any legal fees

You shouldn’t be too concerned with the differences between the different forms of restitution. Generally speaking, the investor should be “made whole,” plus recover any legal fees. In most circumstances, a legal rate of interest is paid to compensate the investor for the time their money was locked up in a security they shouldn’t have purchased. However, the legal rate of interest does not apply when an investor sells a security to a registered person (assuming a violation occurred). In this scenario, the investor should be given their security back, plus any income the security paid while it wasn’t in the client’s possession.

There are two general ways a civil liability can be settled:

Right of rescission
Legal actions

Right of rescission
If a registered person discovers they’ve violated the USA during a securities transaction and/or while providing investment advice, they can attempt to rectify the situation. The USA provides the right of rescission, which allows the registered person to proactively reach out to the client and offer restitution. This must be put in writing and is known in the industry as a rescission letter.

The rescission letter offers the same restitution discussed above, depending on the situation. For purposes of an example, let’s assume an agent mistakenly sells a non-exempt unregistered security to a client with no exempt transaction to claim. To avoid legal issues in the future, the agent sends a written rescission letter to the client, offering to buy back the security at its initial cost, minus income received from the security, plus the legal rate of interest and legal fees (if they exist).

When the client receives the letter, they have a few choices. They can accept the rescission letter and give back the security to the agent in return for restitution. They may also deny the offer, but this would release the agent from any future liability related to the transaction. The same result occurs if the client doesn’t respond to the letter within 30 days.

Legal actions
If the registered person isn’t willing to offer a rescission letter, the client can pursue legal action. In most cases, this would result in arbitration or a lawsuit depending on the client’s relationship with the firm. Virtually all financial firms require their clients and customers to sign arbitration agreements, which prevents the client from suing in court. In this scenario, the client would take the registered person to arbitration. If an arbitration agreement didn’t exist, a lawsuit could be filed.

Whether arbitration or a lawsuit unfolds, the client would be pursuing the same restitution discussed above. In these scenarios, legal fees would likely be at their peak given the costs of pursuing arbitration or lawsuits.

Civil liabilities are subject to a 3-year statute of limitations, but no later than 2 years after the discovery of the violation. Additionally, civil liabilities survive the death of all parties. If a client dies prior to pursuing arbitration or a lawsuit, their estate may move forward on their behalf. While the 2002 version of the Uniform Securities Act uses a different limitations period, the earlier of 2 years from discovery or 5 years from the violation, NASAA continues to test the 1956 version because most states still operate under statutes based on the 1956 Act.

Sidenote

Consequences related to offers with no transaction

What happens if a registered person makes an unethical or fraudulent securities-related offer, but no transaction occurs? For example, an agent offers a customer an unregistered, non-exempt security, but the customer doesn’t accept the offer. In such scenarios, customers and clients cannot bring civil action (e.g., file a lawsuit). As discussed above, all forms of civil restitution involve repayment for costs or losses related to trading a security or accepting investment advice. If a customer or client rejects an offer or recommendation, they have no legal recourse.

Regardless, the state administrator may still bring action against a person for unethical or fraudulent offers, even if a transaction or advice-related charges are not assessed.

Civil penalties

In addition to civil liabilities being awarded to clients, the administrator may impose a civil penalty for (non-willful) violations of the USA. These are basically fines levied against registered persons, and are typically reserved for persons with repeat offenses. Each state sets its own penalty structures.

Key points

Criminal penalties

Must involve a willful violation of the law
5-year statute of limitations
Potential penalties:
- $5,000 maximum fine
- 3-year maximum jail sentence

Civil liabilities

May result from a non-willful violation of the law
Can involve a lawsuit or arbitration
Can be avoided through the right of rescission

Restitution for securities purchases (client buys)

Original cost of the security
Less any income received from security
Plus the legal rate of interest
Plus any legal fees

Restitution for securities sales (client sells)

Client may recover (buy back) the security
Less any income paid by the security
Less any legal fees

Restitution for investment advice

Cost of the investment advice
Plus actual damages due to investment advice
Less any income received from security
Plus the legal rate of interest
Plus any legal fees

Right of rescission letter

Proactive offer to make an investor “whole”
- Offers the restitution listed above
Client has 30 days to accept the offer
No legal action may be taken by an investor if the offer is rejected

Civil penalties

Fines levied by state administrators for violations of the law