It’s easy to think of an orchestra as only the artistic staff - instrumental musicians and a conductor or artistic director. Although the conductor or artistic director determines the repertoire and (along with the musicians) the musical interpretation, many additional people contribute to a successful performance.

Like a high school, orchestras may have a robust library that must be organized. That task falls on the orchestra's librarian. If the orchestra's library doesn't include the required music, the librarian must arrange to purchase, rent, or borrow it. An orchestra’s librarian also ensures that individual musicians have the parts to pieces the orchestra is performing and collects the parts and refiles them when they are no longer needed.

The stage crew sets chairs and music stands on the stage in the formation requested by artistic staff. Most orchestras have box office staff who manage ticket distributions and collect ticket sales money, with orchestra management determining how the concert will be advertised, how many tickets will be available, and how much they will cost. And most concert halls have ushers who collect tickets and help concertgoers find their seats in the concert hall.

Selling a real estate fund can be similar to an orchestra performance. A few people – either licensed securities professionals or a select group of sponsor management – may directly sell securities. Behind them may be a larger group of individuals who perform the ministerial, clerical, and administrative staff necessary to complete the sales.

When companies sell their own securities, their executives and employees must be careful not to run afoul of the Securities Exchange Act of 1934 (Exchange Act) and broker-dealer licensing requirements. These challenges are common with real estate securities and startups, where corporate executives may be involved in the securities sale process.

This article discusses potential pitfalls companies face under broker-dealer rules when selling their securities and what companies should do to qualify for the safe harbor in Rule 3a4-1.

Who is a Broker-Dealer?

The Exchange Act defines “broker” as “any person engaged in the business of effecting transactions in securities for the account of others.” Under the Exchange Act, a “dealer” is “any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise.”

Not everyone who buys and sells their own securities is a dealer. For example, someone who doesn’t sell their own securities as part of a regular business is a “trader,” not a dealer. Although the issuer of securities may technically sell securities for their own account, the SEC has long stated that an issuer is generally not a broker or a dealer.

More relevant in the real estate fund context, the SEC has claimed that the general partner of a limited partnership (LP) is not a broker or dealer when selling the LP’s securities. It follows that the manager of a limited liability company (LLC) isn’t a broker or dealer when it sells the LLC’s securities.

However, individual officers and employees of the issuer, general partner, or LLC manager can sometimes be brokers. So, real estate fund sponsors need to monitor their officers’ and employees’ activities to ensure they aren’t functioning as unlicensed brokers.

How to Tell if Someone is a Broker-Dealer Under Securities Laws

Someone might be a broker if they

• Participate in the solicitation of investors, negotiation of terms, or execution of a securities transaction.

• Receive "transaction-based compensation" that is contingent on the successful sale of securities or is based on a percentage of securities sold.

• Handle other people’s money in connection with a securities transaction

Receipt of “transaction-based compensation” is a critical factor in determining if someone is a broker. So, issuers need to take care that employees don’t receive bonuses or other compensation based on the amount of securities sold – even if the bonus isn’t a motivating factor in the employee’s activities.

Generally, sponsor personnel won’t handle investor funds – those should go to the issuer’s bank account. However, sponsor personnel need to be aware that if they are actively selling real estate securities or meeting with or soliciting investors, they may be acting as brokers. On the other hand, Exchange Act rules provide that someone whose functions are “solely clerical or ministerial” isn’t a broker.

Rule 3a4-1 “Issuer Exemption” – General Requirements

The words “clerical” and “ministerial” aren’t well-defined in securities law, so it's difficult to be sure what activities are permitted and what activities will cause someone to be considered a broker. Using the orchestra analogy, it’s easy to conclude that the librarian performs a clerical or ministerial duty since they only acquire and organize the music selected by the conductor or artistic director. But since the stage crew goes on stage, it may not be as apparent that their activities are ministerial. The stage crew goes on stage in front of the audience, and the setup affects the performance. Yet, the stage crew doesn’t decide the stage setup; they do as they are instructed by a decisionmaker, such as the conductor or orchestra manager.

To make the analysis easier for issuer personnel, the SEC adopted Rule 3a4-1, which is frequently called the "issuer exemption." I believe it's more accurately called the "issuer agent exemption" since it describes a safe harbor where “associated persons of an issuer” aren’t considered brokers.

The Rule 3a4-a safe harbor is non-exclusive, so not meeting the rule does not necessarily mean an individual is a broker. However, real estate fund sponsors and issuers best serve their personnel by ensuring their duties fall under the safe harbor.

To qualify for Rule 3a4-1, issuer and sponsor personnel first must satisfy three threshold requirements:

• Not be subject to statutory disqualification. A “statutory disqualification” generally means someone previously has been found to have violated securities laws.

• Not receive transaction-based compensation.

• Not be an associated person of a broker or dealer. Someone who is a licensed securities professional usually can't qualify for the safe harbor. But there can be exceptions when the individual's activities are solely ministerial and clerical. However, that analysis is beyond the scope of this article.

Rule 3a4-1 – Pathways to the Safe Harbor

Once an individual or legal entity meets the threshold requirements, there are three pathways to safe harbor in Section (a)(4).

The first pathway (in Section (a)(4)(i)) applies when the securities are sold to certain regulated buyers, such as broker-dealers, investment companies, banks, or insurance companies. Only occasionally will an entire offering by a real estate fund or startup qualify for Rule 3a4-1(a)(4)(i).

The second pathway (in Section (a)(4)(ii)) applies to issuer personnel to engage in selling securities provided they have substantial additional duties for the company and are involved in only one offering in any 12-month period. Since the SEC has indicated that an individual may work on an offering until it concludes, Section (a)(4)(ii) functionally requires a 12-month cooling-off period between selling activities for different offerings.

Section (a)(4)(ii) is commonly utilized by startups, where principals initially spend the bulk of their time actively selling the company's securities and only later move their focus to operations. However, this Section may not work well for real estate securities sponsors if they are engaged in serial offerings. At a minimum, the same individuals can be involved in selling only one such offering in any 12-month period.

The best path for real estate sponsors is to structure their sales practices so their personnel fall under the third pathway (in Section (a)(4)(iii)). Although some call section (a)(4)(iii) the ministerial and clerical exception, this pathway permits activities that go beyond strictly ministerial or clerical activities provided strict requirements are met.

Specifically, Section (a)(4)(iii) requires that issuer personnel restrict their “participation to any one or more of the following activities:”

A. ”Preparing any written communication or delivering such communication through the mails or other means that does not involve oral solicitation by the associated person of a potential purchaser; Provided, however, that the content of such communication is approved by a partner, officer or director of the issuer;

B. Responding to inquiries of a potential purchaser in a communication initiated by the potential purchaser; Provided, however, that the content of such responses is limited to information in a registration statement filed under the Securities Act of 1933 or a similar offering document;

C. Performing ministerial and clerical work involved in effecting any transaction.”

Section (a)(4)(iii)(A) permits written solicitation of potential purchasers under limited circumstances, and Section (a)(4)(iii)(B) allows oral communications with potential purchasers if the content of the discussions is limited to the offering materials.

Unlike Section (a)(4)(ii), Section (a)(4)(iii) does not limit the number of offerings an individual may be involved in during a 12-month period, probably because the activities in that Section are clerical and ministerial and do not constitute broker or dealer activities.

Best Practices for Issuers

The safest pathway under the Exchange Act for all issuers and particularly real estate funds is to limit all individual activities to clerical and ministerial duties. Some safeguards necessary to fall under the “clerical and ministerial” exception overlap best practices for securities disclosure:

• Ensure that all information in marketing materials is in the private placement memorandum or offering memorandum (PPM). Given that most subscription agreements state that investors may rely only on the PPM when purchasing securities, there shouldn’t be marketing materials that deviate from or add to the PPM anyway.

• Require at least one senior company executive or board member and the company’s legal counsel to approve the PPM and all marketing materials and advertisements for securities. Not only does this aid in compliance with Section (a)(4)(iii), but it also is a good business practice to ensure that corporate decisionmakers are directly involved in the approval of PPM content.

• Require company personnel to limit investor communications to the PPM approved by company senior management and legal counsel. Investors usually must certify that they are relying only on the PPM when purchasing securities, so issuer personnel should not confuse communications by attempting to add to or explain the PPM disclosures.

• Don’t engage in cold calling or orally solicit investors. Instead, consider utilizing Rule 506(c), Regulation A+, and Regulation CF offerings, which allow general advertising. In particular, cold calling is characteristic of boiler room activities. Reputable sponsors should avoid that practice.

• Ensure as many communications as possible are in writing. Again, it’s a good business practice to conduct business in writing to avoid misunderstandings and protect against failed memories.

• Inform employees they may only engage in clerical and ministerial activities and educate them about what they may and may not do.

• Create protocols for marketing areas, such as websites and newsletters. If they include information about an offering, they should communicate only information from the PPM, include appropriate disclaimers, and be approved by company senior management and legal counsel.

This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.