The U.S. Securities and Exchange Commission (the “SEC”) recently proposed a new, conditional exemption from registration as a broker for individuals who are “finders” that connect accredited investors with issuers looking to raise capital.[1] If adopted, the exemption will change the longstanding tenet that accepting any transaction-based compensation in the sale of securities makes one a broker that, absent an exception, will need to register as a broker.
In 1991, Paul Anka received a no-action letter from the SEC that legitimized the finder concept – essentially that one could sell their rolodex for use in the sale of securities without registering as a broker-dealer.[2] In his 2013 autobiography, entertainer and member of Frank Sinatra’s Rat Pack, Mr. Anka discussed his association with the mafia.[3] Many securities lawyers have viewed the fact Mr. Anka had supposed mob ties yet was able to get the no-action letter with a degree of humor. Although the Paul Anka letter is part of the SEC staff’s guidance, in a number of public speeches, the SEC staff has indicated that it would not provide no-action relief under a comparable fact pattern regarding compensation arrangements today.[4] The SEC’s proposed finders exemption is an effort to address – and expand –the no-action letter granted to the crooner that has outlived the Rat Pack.
SEC Chairman Jay Clayton noted that the proposed exemption would “bring clarity to finders’ regulatory status in a tailored manner that addresses the capital formation needs of certain smaller issuers while preserving investor protections.” The proposal will expand the activities that finders can conduct without fear of being required to register as a broker. To understand the proposed finders exemption it is necessary to understand what is a broker.
I. What is a Broker?
Section 3(a)(4)(A) of the Securities Exchange Act of 1934 (the “Exchange Act”) defines “broker” broadly as “any person engaged in the business of effecting transactions in securities for the account of others.” The courts and the SEC have taken an expansive view of the scope of these terms. Often, courts apply a “facts and circumstances” analysis in evaluating whether a person has acted as a broker, with no single element being dispositive. Courts and the SEC have determined that a person “effects transactions in securities” if the person participates in such transactions “at key points in the chain of distribution.”[5] According to the SEC, such participation may include, helping an issuer to identify potential purchasers of securities.[6]
A. Engaged in the Business
Courts have read, “engaged in the business” as connoting a certain regularity of participation in purchasing and selling activities rather than a few isolated transactions.[7] Two factors are important in determining whether there is “regularity of business”: (i) the number of transactions and clients,[8] and (ii) the dollar amount of securities sold, as well as the extent to which advertisement and investor solicitation were used.[9] However, neither of these factors is determinative.
While a single isolated advertisement by a person seeking to purchase or sell securities may not in all cases cause a person to be a “broker,” transactions by a person as the first step in a larger enterprise could still be found to meet the regularity threshold.[10] The dollar amount of the transactions can indicate regularity, although courts have held that there is no requirement that such activity be a person’s principal business or principal source of income.[11]
The SEC has stated:
[N]othing . . . would warrant a conclusion that a person is not “engaged in the business” merely because his securities activities are only a small part of his total business activities, or merely because his income from such activities is only a small portion of his total income. On the contrary, if the securities activities are engaged in for commissions or other compensation with sufficient recurrence to justify the inference that the activities are part of the person’s business, he will be deemed to be “engaged in the business.”[12]
Besides “regularity of business,” courts and the SEC have identified several other factors that indicate that a person is “engaged in the business.” These factors include: (1) receiving transaction-related compensation;[13] (2) holding oneself out as a broker, as executing trades or as assisting others in settling securities transactions;[14] and (3) soliciting securities transactions.[15]
B. For the Account of Others
In order to be considered a “broker,” a person must be effecting transactions in securities for others. As a result, a firm effecting transactions solely on its own behalf is generally not considered to be acting as a “broker.” The SEC has taken the position that a firm may be acting as a broker where it effects transactions in securities nominally on its own behalf, but where those transactions are at the direction of individual traders that hold membership interests in the firm, effectively acting as the firm’s customers.
C. Transaction-based Compensation
In the SEC’s no-action guidance and enforcement actions, receiving commissions or other transaction-related compensation is one of the determinative factors in deciding whether a person is a “broker” subject to the registration requirements under the Exchange Act.[16] Transaction-related compensation refers to compensation based, directly or indirectly, on the size, value or completion of any securities transactions.[17] The SEC typically looks behind the terms of a compensation arrangement to determine its economic substance, that is, to determine whether it is transaction-related. Thus, a fee arrangement designed to compensate a person for what that person would have received if the person directly received transaction-related compensation (for example, a flat fee that is recalculated periodically to reflect an increase or decrease in the number of transactions) could be the equivalent of transaction-related compensation. In this regard, a flat fee representing a percentage of expected future commissions could be considered transaction-related. The receipt of transaction-based compensation often indicates that a person is engaged in the business of effecting transactions in securities.[18] Absent an exemption, a person that receives commissions or other transaction-related compensation in connection with securities-based activities generally would be viewed as a broker-dealer.[19]
Whether a person receives transaction-related compensation is often an important factor – if not the most important factor – in the SEC’s decision to grant or deny no-action relief to, or bring enforcement actions against, persons providing services to broker-dealers. For example, the SEC staff has denied no-action relief to personal services companies that are established by registered representatives of a broker-dealer and receive commissions earned by the registered representatives from the broker-dealer.[20] Although the SEC has granted no-action relief under limited circumstances in which a celebrity acting as finder “sold his rolodex,” and would receive a success-based fee, it has since publicly distanced itself from that precedent.[21]
D. Finders
The SEC staff has historically recognized a very narrow exception to the broker-dealer registration requirements for finders. A “finder” is a person who places potential buyers and sellers of securities in contact with one another for a fee. There is no “finder exception” in the Exchange Act or SEC rules; instead, the finder analysis is based on SEC no-action letters. The SEC’s decision to grant no-action treatment in some cases to permit finders to engage in limited activities without registration as broker-dealers is presumably based on the idea that certain limited activities in relation to securities transactions do not create risks sufficient to warrant registration.
The SEC’s guidance on “Who is a ‘Broker’” currently includes “finders,” “business brokers,” and individuals who ‘[find] investors for "issuers" (entities issuing securities), even in a "consultant" capacity; or [engage] in, or [find] investors for, venture capital or "angel" financings, including private placements.”[22] In an industry where a well-stocked rolodex can often lead to comfortable financial support and handshake investment deals are struck over drinks at happy hours or conferences, the identity of a “broker” is becoming less and less defined.
E. Consequences of Failure to Register as a Broker
The potentially severe consequences of acting as an unregistered broker include potential bars from the industry or civil or criminal penalties. The potential consequences of using an unregistered broker in offering include rescission of the offering.
II. Proposed Finders Exemption
The proposed exemption will create two classes of finders - Tier I Finders and Tier II Finders (each a “Finder” and, collectively, the “Finders”) - that will not be required to register as brokers...
