Your good client, Avery Phillips, Chairman of the Board, calls you because he is considering engaging a friend, Tepper, to identify potential investors for his company. Phillips explains that Tepper has extensive business contacts and that he we would be willing to pay Tepper a fee equal to 1% of the total investments introduced through Tepper. Phillips then goes on to say that he also has a few friends who may want to invest, and that he would like to be paid 1% of the amounts his friends invest.

Neither Tepper nor Phillips is registered with the SEC as a broker-dealer, so Phillips wants to understand the potential regulatory implications of the proposed arrangement. What do you tell him?

Regulatory Framework

Let’s start with the basics. Section 15(a) of the Exchange Act requires that persons engaged in “broker” or “dealer” activity must register with the SEC unless an exemption is available. In general, a “broker” is any person “engaged in the business of effecting transactions in securities for the account of others” and a “dealer” is any person “engaged in the business of buying and selling securities for such person’s own account.” Based on no-action guidance from the SEC Staff, activities that may be deemed (alone or in combination) to confer “broker” status include:

  • soliciting investors to enter into securities transactions (including private transactions);
  • assisting issuers in structuring prospective securities transactions or helping issuers to identify potential purchasers of securities;
  • participating in the negotiating process or otherwise bringing buyers and sellers of securities together (including in the M&A context); and
  • receiving compensation contingent on the success of a securities transaction or based on the amount or value of a securities transaction.

Activities that have been identified (alone or in combination) by the SEC Staff as indicators of “dealer” status include:

  • participating in a selling group, underwriting securities or purchasing or selling securities as principal from or to customers rather than from or to only brokers or dealers;
  • carrying a dealer inventory (positions intended to be used directly or indirectly to trade with customers) or holding oneself out as a dealer or market-maker or as otherwise willing to buy or sell particular securities on a continuous basis;
  • obtaining a regular clientele of customers, issuing or originating securities or rendering incidental investment advice to others; and
  • engaging in trading transactions for the benefit of others (including for an affiliate or for an affiliate’s customers), rather than consistently based on one’s own judgment and investment and liquidity objectives.

Finders as Brokers: Proceed with Caution

In a 2013 speech, David Blass, the Chief Counsel for the SEC’s Division of Trading and Markets reiterated that the SEC has consistently viewed transaction-based compensation as the “hallmark” of broker dealer activity. Essentially, the SEC view is that a person who receives a success fee in a securities transaction must be registered as a broker-dealer. Thus, Tepper must be a registered broker-dealer (that is, licensed with a brokerage firm) to lawfully be paid a fee in connection with investments in Avery’s company. He may do so either by registering his own broker-dealer or by associating with an existing brokerage firm.

Do Any Exemptions Apply?

The existence of a “finder’s exemption” from the broker-dealer registration requirements has always been more fiction than fact. Decades ago, the SEC Staff issued a no-action letter to singer-songwriter Paul Anka (noted for having penned and performed a No. 1 hit often voted one of the worst songs of all time — “(You're) Having My Baby”) enabling him to receive transaction-based compensation without broker-dealer registration. However, not only was the no-action position narrowly tailored to allow Anka only to provide a list of names and telephone numbers of possible investors and to have no further contact or involvement in the transaction, but the Staff has since changed its tune, indicating that they would not issue the letter today. And, although some courts have been more liberal in allowing the payment of finder’s fees, the SEC’s position on the matter now makes paying such fees to unregistered persons entirely impractical given the risks discussed below.

Rule 3a4-1under the Exchange Act (the so-called “issuer’s exemption”) provides that an associated person of an issuer (such as employees and directors of the issuer or its affiliates) may be exempt from the requirement to register as a broker or dealer under the Exchange Act to the extent he or she complies with the conditions outlined in the Rule. Among these conditions, however, is the requirement that the individual not receive transaction-based compensation. For that reason, employees, such as investor relations personnel, may not qualify for the exemption to the extent they receive commissions or bonuses based on the amounts raised (Blass, in the speech referenced above, specifically noted that private fund managers who pay employees transaction-based compensation for selling interests in a fund would not be able to avail themselves of the Rule 3a4-1 safe harbor). It should also be noted that the exemption is only available to persons who have other substantive duties for the issuer and participate in an offering of securities no more than once every 12 months (which limits the exemption’s utility for many private funds). Accordingly, while our good client Avery may be able to sell securities in his company to his friends, he may not be paid a success fee for his efforts.

Risks of Engaging an Unregistered Broker-Dealer

Using unregistered broker-dealers to help raise capital may expose companies, private fund managers and their principals to enforcement actions, as demonstrated in two recent SEC enforcement actions, even where there are no allegations of fraud or other misconduct.

More significantly, Section 29(b)of the Exchange Act provides that contracts made in violation of the Exchange Act shall be void in respect of the “rights of any person who, in violation of any such provision, rule, or regulation, shall have made or engaged in the performance of any such contract.” Thus, if a sale of securities is effected through an unregistered broker-dealer, investors may have the right to rescind their purchases, providing a potential “put” right to investors. This had disastrous consequences in 2012 for Neogenix, a public biotech company, when the SEC discovered Neogenix had used unregistered finders in its late stage financings. The SEC insisted Neogenix disclose its potential liability to investors with rescission rights, and the resulting impact on its financial statements led Neogenix into bankruptcy.

To make a long story short, company executives and fund managers should be careful in their arrangements surrounding capital raising activities, and be particularly wary of compensation agreements that may be construed as providing transaction-based compensation to persons not properly registered as broker-dealers under the Exchange Act and applicable state securities laws.