Fundraising Startups and their Associated Persons - Can They Be Broker-Dealers?

Continuing with the theme of broker-dealer registration, I now switch to the issuer safe harbor.  As you know, a broker is "any person engaged in the business of effecting transactions in securities for the account of others."  The key phrase here is "for the account of others".  Since many startup companies cannot attract the attention of broker-dealers to help them secure funding, the companies do it themselves.  Raising funds on the company's own behalf is not considered to be a broker-dealer activity.  However, even if the issuer itself is not a broker, anyone working for it may be because they would be selling securities of the issuer for the account of the issuer, not their own.  This brings into question the fundraising activities of issuer associated persons: its partners, officers, directors or employees. Note that Rule 3a4-1(c)(1) definition of "associated persons of the issuer" does not include independent contractors.

Whether such persons have to register as broker-dealers depends on facts and circumstances of each case.  In 1985, the SEC adopted Rule 3a4-1 that acts as a narrow nonexclusive safe harbor for associated persons.  Complying with the requirements of this Rule means that such associated person will not be required to register as a broker-dealer while engaging in fundraising activities.  First, the person needs to meet all three general requirements:

1. Not be subject to a statutory disqualification at the time of his participation; AND
2. Not be "compensated in connection with his participation by the payment of commissions or other remuneration based either directly or indirectly on transactions in securities"; AND
3. not at the time of his participation be an associated person of a broker or dealer (ie, its partner, officer, director or employee).

With respect to the second requirement, the SEC noted in the Proposing Release that "This prohibition is intended to preclude compensation arrangements which vary with or depend upon the success of the sale efforts by associated persons."  This does not seem to prohibit compensating the associated person for the participation in the capital raise but precludes varying the amount of compensation based on the amount raised.  One needs to be very careful with structuring the compensation of persons engaged in fundraising for the company.

If the three general conditions are satisfied, the associated person then needs to meet one of the following three criteria:

1. Participate only in transactions involving offers and sales of securities to institutional investors, including broker-dealers, banks, investment companies or in connection with mergers, asset sales or certain other transactions (not really applicable to startups) - Rule 3a4-1(a)(4)(i)(A, B, C, D); OR
2. Limit activities to (i) preparing written offering materials subject to approval by a partner, officer or director of the issuer, while not engaging in oral solicitation, (ii) responding to investor inquiries, provided that responses are limited to information in the offering document, or (iii) ministerial and clerical work in effecting the transaction; - Rule 3a4-1(a)(4)(iii); OR
3. Perform (throughout the offering or starting at the end of the offering) substantial duties on behalf of the issuer other than marketing the securities, provided that this person is not a broker-dealer or its associated person within the prior 12 months and does not participate in the sale of securities of the issuer more than once every 12 months - Rule 3a4-1(a)(4)(ii). 

The issuer's founders, directors, officers, and employees would most likely rely on the third criterion when raising capital for their company.  However, it is important to remember that such fundraising efforts cannot happen more than once every 12 month period and that their compensation cannot depend on the success of their fundraising activities.

As I previously mentioned, this Rule is a nonexclusive safe harbor.  However, it is difficult to judge what activities would be permissible if you step outside of the strict confines of the Rule.  The SEC has repeatedly brought actions against associated persons of the issuers for failure to register (although often in connection with other charges such as fraud).

In conclusion, all startup founders should carefully structure their fundraising efforts so that their team is not deemed to be unregistered broker-dealers.

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  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.