Is the individual a broker?
The Securities Exchange Act of 1934 (the “Act”) defines a broker as any person engaged in the business of “effecting transactions in securities” for the account of others. “Effecting transactions” is broadly construed as soliciting, structuring, negotiating and/or executing securities transactions, identifying potential purchasers, handling money for someone else, or receiving transaction-based compensation.
Some examples of activity that may require registration as a broker-dealer include, but are not limited to:
- Effecting securities transactions for the account of others for a fee or purchasing or selling securities at a regular place of business for the entity’s own account;
- Operation of an electronic or other platform to trade securities;
- Acting as a placement agent for the private placement of securities;
- Acting as a finder of investors for issuers or the sale of securities;
- Finding investors (even if in a “consultant” capacity) or customers for, making referrals to, or splitting commissions with registered broker-dealers;
- Participating in a selling group or underwriting of securities, finding investment banking clients for registered broker-dealers;
- Providing support services (such as clearing and settlement) to registered broker-dealers;
- Finding investors for venture capital financings, including private placements;
- Finding buyers and sellers of businesses where securities are involved; or
- Advertising as a market maker or providing continuous quotes in securities.
Similarly, in a June 2007 no-action letter to Hallmark Capital Corp. (“HallCap”), the SEC stated that it appeared that HallCap would be required to register with the SEC as a broker-dealer. HallCap assisted small businesses with revenues under $25 million with their debt and equity capital needs. HallCap would prepare a confidential information summary describing the business, identifying broker-dealer firms that might be interested in working with the company, and arranging meetings leading to an engagement of the broker-dealer by the client company to raise capital. Once the broker-dealer was engaged, it had control of and oversight over all significant aspects of any securities transaction, including investor solicitation and execution of the transaction. HallCap was compensated with a modest upfront retainer and a fee based on the outcome of the transaction. (Hallmark Capital Corporation No-Action Letter (June 11, 2007).
There is a very very narrow exception from registration for individuals who merely act in the capacity of a “finder.” In deciding whether the person acted as a broker or a finder, the SEC typically looks at the totality of circumstances. The following questions typically get analyzed:
- Does the individual receive transaction-based compensation, such as commissions or referral fees?
- Does the individual engage in solicitation of potential investors?
- Does the individual participate in the various aspects of a securities transaction, including solicitation, structuring advice, and negotiation?
- Is he or she an active rather than passive finder of investors?
- Is the individual otherwise engaged in the business of effecting securities transactions or was previously disciplined for such activity? and
- Does the individual handle securities or funds in connection with the transaction.
1. The finder should only be involved with making introductions to suitable, accredited investors.
2. The individual should not solicit or pre-screen any investors on behalf of the company.
3. The finder should also be sure to avoid any substantive discussions with any potential investors of your company.
4. The finder should not participate in any negotiations, discuss the value of the investment, handle any funds or securities involved with completing a transaction, or hold themselves out as providing any securities-related services.
5. The finder should also not assist an issuer or potential investor with the completion of any transaction.
6. The individual should avoid transaction-based compensation. Non-contingent fixed fee compensation may be acceptable but it should not be based on the success of the deal. The fee should be paid regardless of how the deal turns out.
7. The finder may perform ministerial function of facilitating the exchange of documents or information.
8. As an independent contractor, the finder should not have authority to speak on behalf of the company in any way.
Bad Things That Can Happen to the Company
There are many risks the company may face when engaging an unregistered finder.
1. Rescission. Under Section 29(b) of the Act, contracts entered into in violation of the Act may be rendered void. Additionally, the company may also be violating state securities laws, and investors may again get rescission rights (i.e., they can demand their money back).
2. Loss of Exemption from Registrations. The use of unregistered broker-dealer may cause the company to lose its exemption from the registration requirements of the Securities Act of 1933, and from applicable state laws. The SEC may issue a cease-and-desist order, seek civil money penalties, and even refer the matter to the attorney general for prosecution. In accordance with the bad actor disqualification provisions of Rule 506 of Regulation D adopted by the SEC in July 2013, an offering by an issuer would be disqualified if there was an SEC disciplinary order or a cease-and-desist order. This would be very damaging to the company’s reputation and ability to raise capital in the future.
3. Risks relating to disclosure obligations. There is risk that a finder’s failure to disclose the fact that it is not registered as a broker-dealer could itself be characterized in regulatory enforcement proceedings or private litigation as the issuer's misleading omission that amounts to fraud on the issuer under Section 10b-5 of the Securities Act. This could prevent future investors from wanting to invest in the company and may prevent any legal counsel working on behalf of the company from issuing legal opinions in connection with a subsequent finding.
4. Aiding and Abetting Liability. The issuer may be subject to civil and criminal penalties, including pursuant to Section 20(e) of the Act on the theory that the company aided and abetted an unregistered broker-dealer.
5. Private Actions. There could be a private action brought by investors for damages suffered.
The SEC appears to be strictly enforcing regulations requiring broker-dealer registration. Although tempting, a company should strongly consider all potential risks prior to engaging a finder and not just evaluate an individual based on the size of their Rolodex.
This article is not a legal advice, and was written for general informational purposes only. If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga. Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate, securities, and intellectual property law.