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Potential Pitfall While Raising Capital: Are You Making Payments to an Unregistered Broker?

By Patrick A. Traber | Categories: Articles, Corporate and Securities Law | Share June 2017

For startups and emerging businesses, raising money is not an easy task. Entrepreneurial founders look high and low to locate investors willing to contribute capital to the business in exchange for ownership, debt or other types of securities.  Often intermediaries may be engaged by companies to locate investors for a “commission” or “success fee” contingent upon the size or outcome of the transaction or deal – the Securities and Exchange Commission (SEC) refers to this type of an arrangement as “transaction-based compensation.”   If you are making such payments to an unregistered broker, you could be violating both Federal and state securities law and putting yourself and your company at considerable risk.  

The issues related to payments to unregistered brokers are complex, but neither new nor limited to small and emerging companies.  Last month, in a letter dated May 17, 2017, the SEC Advisory Committee on Small and Emerging Companies aptly and pointedly summed up the issue: “There is significant uncertainty in the marketplace about what activities require broker-dealer registration …. [c]ompanies that want to play by the rules struggle to know in what circumstances they can engage a ‘finder’ or platform that is not registered as a broker-dealer.”  Broker-dealers, funds and others entities involved in securities transactions frequently ask our Corporate and Securities Law Group about what type of fee can be paid for what type of activities related to securities transactions.  

Below is a brief summary of the current state of the law and possible consequences of violating it.  The summaries are intended to be merely an illustrative primer on the issues and not an exhaustive dissertation.

What is the law?

With limited exceptions, Section 15 of Securities Exchange Act of 1934 (Act) makes it unlawful for any broker or dealer to use any means of interstate commerce (mail, telephone, or internet) to “effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security,” unless that broker or dealer is registered with the SEC.  Section 3 of the Act generally defines the term “broker” as any person engaged in the business of effecting transactions in securities for the account of others.  Although state laws have different language, many of them are designed for the same purpose – to make it unlawful for unregistered brokers to raise money.

The SEC’s Guide to Broker-Dealer Registration lists each of the following individuals or businesses as potentially needing to register as a broker, depending on a number of additional factors:

  • “finders,” “business brokers,” and other individuals or entities that engage in the following activities:
    • finding investors or customers for, making referrals to, or splitting commissions with registered broker-dealers, investment companies (or mutual funds, including hedge funds) or other securities intermediaries;
    • finding investment banking clients for registered broker-dealers;
    • finding investors for “issuers” (entities issuing securities), even in a “consultant” capacity;
    • engaging in, or finding investors for, venture capital or “angel” financings, including private placements;
    • finding buyers and sellers of businesses (i.e., activities relating to mergers and acquisitions where securities are involved);
  • investment advisers and financial consultants;
  • certain foreign broker-dealers;
  • persons that operate or control electronic or other platforms to trade securities;
  • persons that market real-estate investment interests, such as tenancy-in-common interests, that are securities;
  • persons that act as “placement agents” for private placements of securities;
  • persons that market or effect transactions in insurance products that are securities, such as variable annuities, or other investment products that are securities;
  • persons that effect securities transactions for the account of others for a fee, even when those other people are friends or family members;
  • persons that provide support services to registered broker-dealers; and
  • persons that act as “independent contractors,” but are not “associated persons” of a broker-dealer.

That list ticks through many of the same people and groups that entrepreneurs and emerging businesses contact to raise money or who approach emerging businesses and offer to raise money for them. The primary source of determining what additional factors matter are the SEC’s no-action letters, which provide insight to the SEC’s approach to enforcement.  The no-action letters represent the views of the SEC staff but are restricted to the specific requester based on the detailed facts and circumstances set forth in the request.  So the no-action letters are not legally binding on the SEC and the SEC reserves the right to change the positions reflected in prior no-action letters.  

Despite sometimes seemingly inconsistent analysis in the no-action letters, it is clear that one question emerges at the forefront in the SEC’s analysis in determining if a person is acting as a “broker” – is the compensation for the person’s participation in the transaction dependent upon, or related to, the outcome, or size of the transaction or deal?  If the answer is yes, the SEC has taken the position that any person receiving transaction-based compensation in connection with another person’s purchase or sale of securities typically “must register as a broker-dealer or be an associated person of a registered broker-dealer.” According to the SEC, a person’s receipt of transaction-based compensation in connection with a securities transaction is the “hallmark of broker-dealer activity” because it represents a salesman’s stake in the venture which triggers public policy concerns to protect investors.  The economic substance of the compensation will be evaluated by the SEC to determine if the compensation is directly or indirectly related to the size, value or completion of any transaction, so simply trying to disguise transaction-based compensation (e.g. “consulting fees”) will not work.

The SEC has found resistance to its position that transaction-based compensation is determinative from United States District Courts1 and it is true that other factors and circumstances will interplay.  However, if there is transaction-based compensation flowing to an unregistered broker in your transaction, you need to ensure that knowledgeable securities counsel has reviewed the arrangement.

What are the consequences?

Consequences for paying an unregistered broker exist at both the Federal and state level.  Two of the most drastic problems include rescission and aiding and abetting liability.

First and foremost, the entire transaction may be subject to rescission.  Under Section 29 of the Act, contracts entered into in violation of the Act may be rendered void. This remedy could be disastrous to your business.  As a result of potential rescission liability, the investor essentially has the equivalent of an option on the transaction if an unregistered broker was involved.  If the deal goes well, the investor can proceed quietly to appreciate the gain.  If the deal goes poorly, then the investor can seek to rescind the entire transaction such that the company must return the investment.  

Second, the unregistered broker and the issuing company may be rendered jointly and severally liable. Section 20 of the Act allows the SEC to impose aiding-and-abetting liability on any person that knowingly or recklessly provides substantial assistance in a violation of the Act.  This could extend liability to the company, its officers, directors and agents. The unlicensed broker and company could be the subject of enforcement actions by the SEC and the appropriate state regulatory authority, including civil monetary penalties or criminal sanctions.   Everything the company and its team have worked to accomplish can quickly fall apart due to SEC enforcement actions or investor lawsuits over payments to unregistered brokers.   

What can you do?

If you are uncertain as to how payment of unregistered brokers may impact you and your business, or how to address the issues going forward, the SEC recommends reviewing its interpretations, consulting with private counsel, or asking for advice from the SEC’s Division of Trading and Markets. The law, however, is dynamic and keeping apprised of it is crucial.  For example, last week, on June 8, 2017, the House of Representatives passed the Financial CHOICE Act of 2017 (FCA).  Within the FCA is a provision that creates an exemption from SEC broker-dealer registration requirements for merger and acquisition brokers (FCA § 401).  If the FCA is passed by the Senate, it would provide certain mergers and acquisitions brokers greater comfort than a January 31, 2014 SEC no-action letter currently relied upon by many firms. The Johnson Pope Corporate and Securities Law Group fields multiple inquiries related to these and other capital raising issues each week.  The analysis required to answer these questions is necessarily fact intensive, but the depth of our collective experience in these areas lets us confidently guide our clients through these intricate issues.

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1 For example, several decisions have rejected the premise that the transaction-based compensation itself is enough to require registration under the Act. S.E.C. v. Kramer, 778 F. Supp. 2d 1320, 1339 (M.D. Fla. 2011) (receiving transaction-based compensation for introducing investor cannot, without additional evidence, qualify person as a broker under Section 15); Sec. & Exch. Comm’n v. Mapp, No. 4:16-CV-246, 2017 WL 823559, at *1 (E.D. Tex. Mar. 2, 2017) (promoting the company and soliciting investors for an undisclosed transaction-based compensation in the form of shares of common stock was not a determinative factor).


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