SEC Cracks Down on Non-Registered Broker Dealers

As the economy begins to recover from a two-year recession, companies are exploring options to "grow the business" to take advantage of opportunities.  To do so, many companies turn to outside sources to identify financing.  If history is any guide, many companies will use "finders" - a match-maker of sorts for the cash needy and the financially flush.  A finder's role can be varied, from assisting companies in identifying potential investors to providing consulting services to promoting the sale of a new issuance of securities.  Essentially a "finder" is a person who assists a securities issuer in locating investors but is not registered as a broker-dealer under the Securities Exchange Act of 1934.  The problem lies in the status of finders as unregistered broker-dealers.  Persons acting as unregistered broker-dealers are generally prohibited from effecting securities transactions by both federal and state securities law (subject to limited exception).

Risky Business
The risks can be great to companies who choose the finder route for capital raising.  First, registered broker-dealers are allowed to engage in certain activities that finders are not---effecting transactions in securities for the account of others, for example.  A finder may run afoul of this restricted activity and not even know it.  How?  A registered broker-dealer is required to have met certain educational and testing requirements that presumptively should make him aware of the laws and regulations governing his activities.  As such, an unaware finder may be more likely than a registered broker-dealer to engage in wrongful conduct under either Federal or State law in connection with an offering.  While this may spell bad news for the finder, it can be more problematic for the company attempting to raise capital.  The purchasers of the securities sold with the assistance of the unregistered broker-dealer may be able to rescind their entire investment in the company.  Furthermore, the botched placement could taint the company's reputation, thereby limiting capital raising and alerting regulators that the company has a troubled history.

The following four factors weigh heavily in the SEC's analysis of whether a finder is acting as an unregistered broker dealer:

Commissions / Transaction-based compensation (most important factor)
Making buy/sell recommendations & providing investment details
History of selling securities (regular activity)
Active in negotiations between the investor and the issuer
No single factor appears to be dispositive.  However, the SEC has stated in several no-action letters that transaction-based compensation (commissions) represents one of the hallmarks of being a broker-dealer.  In the past the SEC has taken the position in limited circumstances that percentage-based compensation (as opposed to a flat rate) would not require a finder to register as a broker-dealer if the other factors set forth above were not present.  Therefore, depending on the nature of the finder's services, percentage-based compensation could be permitted.  However, if percentage-based compensation is based on the outcome of the transaction, the SEC has usually taken the position that registration as a broker-dealer is required except in limited circumstances.  Given the risks involved, companies should typically not engage finders on a percentage-based compensation basis.

The issue is not just one of federal domain----the states have their own rules regarding broker-dealers.  On January 14, 2004, a unit of John Hancock Financial Services Inc. was hit with a $175,000 fine by the Massachusetts Securities Division due to two of its former employees operating as unregistered broker-dealers via an unregistered venture capital operation---golf tournaments for matching venture capitalists with potential investors.  The employees intended to collect a finder's fee for venture investments that resulted from the events and apparently were attempting to solicit and place investment funds---an action requiring broker-dealer registration.  Note that state securities law issues must be addressed on a state-by-state basis based upon the state of residence of each investor or prospective investor.  Some states take the position that certain exemptions from registration of securities offered in the state, such as exemptions comparable to Regulation D, are unavailable if a finder's fee is paid in connection with the transaction.  Further, states may have their own requirements for registration of the finder as a broker-dealer even if the finder's exception from registration is available at the federal level. The only state that provides a licensed designation for finders acting as such is Michigan.  In some states, sales through an unregistered agent are voidable.

Because no law or rule clearly sets out the parameters of permissible conduct for a finder, the current practice is varied.  While some attempt to comply with what they believe the law is (e.g., introductions to potential investors only), the majority ignore the warnings and engage in unregistered broker-dealer activity.  The SEC and NASD are aware that the rule is the exception in the finder community and have turned their attention to reforming current practice.
 
On the Radar
Now that the SEC has addressed a majority of the Sarbanes-Oxley reforms, the finder issue has become a priority.  In fact, at the 22nd Annual SEC Government-Business Forum on Small Business Capital Formation, hosted by the SEC on September 22 and 23, 2003, a new approach to the finder issue was made "the highest priority recommendation of the Forum."  The recommendations, while not official SEC positions, are very influential in SEC decision-making.  The Forum's finder recommendation is as follows:

The SEC should work with NASAA and the NASD to undertake the following:

a. address the regulatory status of finders;
 
b. facilitate an appropriate role for finders in the capital-raising process; and 
c. clarify the circumstances under which issuers and others can legally compensate finders and other capital formation specialists who meet minimum standards.

In undertaking this effort, the SEC staff should focus specifically on whether to create an exemption from broker-dealer and/or investment adviser registration requirements for certain finders or instead issue a new regulation enabling these finders to register under a simplified regime aimed at regulating finders engaging in a defined category of activities. Factors that should be considered in crafting such an exemption or regulation should include:

a. whether NASD membership should be required;
 
b. the form of the application (such as the one proposed by the ABA Task Force Draft Form 1010EZ dated July 9, 2002, referred to as "Form 1010-EZ - Private Placement Broker-Dealer"); 
c. lower fees for application and (annual) renewal;
d. appropriate testing requirements;
e. certification as to no "bad boy" disqualifications;
f. no custody of client funds or securities permitted;
g. no minimum net capital requirements;
h. appropriate bonding requirements;
i. explicit recognition that transaction-based remuneration is permitted;
j. no discretionary authority permitted for investments;
k. appropriate record-keeping requirements; and
l. applicable sales practice rules.

Further to this initiative, the SEC staff should:

a. consider the findings and recommendations in the upcoming final report on the subject of finders of the Subcommittee on Small Business Issuers of the Federal Regulation of Securities Committee of the ABA Section of Business Law; and
 
b. within the next 12 months issue a concept release addressing the adoption of a finder exemption and soliciting comment from the small business community and other interested parties.
 

Proceed with Caution
If a company plans to use a finder to meet potential investors for capital raising, it should do so with caution.  Keep in mind that:

agreements between the company and the finder should carefully detail the finder's role;
agreements should prohibit finder involvement in presentations to investors, negotiation and structuring of the investment terms, analysis of the investor's portfolio, or any other action that would likely fall within the broker-dealer scope; and
finder compensation should be documented in detailed terms, avoiding the use of performance-based or transaction-based commissions, instead opting for a flat fee approach not based on performance.
We're keeping our eyes on this area, so stay tuned for further developments---and if you want to engage someone who is raising money and does not clearly fit in a safe-harbor from registering as a broker-dealer, talk to us first.

If you have any questions, please contact one of the following attorneys from our Growth Companies & Private Equities Practice Team:

 Phone  E-mail
Sherman A. Cohen
 404.873.8630
 sherman.cohen@agg.com
 
Robert F. Dow 404.873.8706 robert.dow@agg.com
David E. Howard 404.873.8594 david.howard@agg.com
Stuart C. Johnson 404.873.8712 stuart.johnson@agg.com
M. Nan King 404.873.8774 nan.king@agg.com
Clinton D. Richardson 404.873.8664 clinton.richardson@agg.com

This bulletin was prepared by the law firm of Arnall Golden Gregory LLP. It presents information on legal matters of general interest in summary form. This document should not be construed as legal advice or opinion on specific matters. Please direct inquires to Arnall Golden Gregory 1201 West Peachtree Street Suite 2800, Atlanta, GA 30309 or info@agg.com.