Tuesday, September 30, 2014

Courts vs SEC: Why Do Some Courts Disagree with the SEC's Broad Rules About Who Has to Register as a Broker? (Article 3 in a series of 14 Articles about Deal-Makers)

By Jim Verdonik

I'm an attorney with Ward and Smith PA. I also write a column about business and law for American Business Journals , have authored multiple books and teach an eLearning course for entrepreneurs. You can reach me at JFV@WardandSmith.com.Or you can check out my eLearning course at www.YouTube.com/eLearnSuccess
or read my newspaper articles at

This article is one of 14 articles in a series of articles about Deal-Makers called:

In article (2) of this series of articles, we discuss that in recent decades the SEC has broadened its interpretation of three key phrases contained in Section 15 (a) (1) of the Securities Exchange Act of 1934 and in the definition of the term "broker" in Section 3 (a) (4) (A) of the Exchange Act. 

The SEC's interpretation of these three key phrases is so broad that it appears the SEC believes it has discretion to treat as a broker anyone who is paid for providing any service in connection with a securities transaction. 

The SEC doesn't prosecute everyone who is paid for services in securities transactions, but by reserving the right to do so, the SEC is limiting the Access small businesses and young growth companies have to reasonably priced services by limiting the number of providers.

 Naturally, courts sometimes question whether the SEC is overreaching beyond what the Exchange Act means.  Let's start by our analysis of what the courts think by reviewing he key provisions of the Exchange Act.

Section 15(a) (1) of the Securities Exchange Act says:

"It shall be unlawful for any broker or dealer . . . to make use of the mails or any means or instrumentality of interstate commerce to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security . . . unless such broker or dealer is registered in accordance with subsection (b) of this section."

 We'll discuss "brokers" here and we'll discuss "dealers" in article (11) of this series of articles when we talk about exemptions from registration as brokers for issuers and associated persons.

 Section 3 (a) (4) (A) of the Exchange Act defines the term "broker" to mean "any person engaged in the business of effecting transactions in securities for the account of others."

 Courts are mixed in how they interpret these key phrases:

·         "Effecting transactions" in securities.

·         Being "engaged in the business."

·         "Induce or attempt to induce the purchase or sale" of a security.

 Some courts accept the SEC's broad interpretation.  Other court cases have found that there are circumstances in which the SEC has stretched these phrases beyond the statute's language.

 Relying on a court to save you from an overzealous regulator may not be the most prudent course of action, because of both the expense and the uncertainty of the outcome.  But if you find yourself in need of a defense, a number of district court cases have treated these issues differently than the SEC's pronouncements.

Until the courts of appeals and the Supreme Court ratify these cases where courts have disagreed with the SEC's positions, it is too early to say that there is a bona fide finder's exemption from registration or to define the scope of that exemption. 

These court cases do reminder us, however, that the SEC does not have unlimited powers.  Congress enacts statutes like the Exchange Act.  The courts interpret the Exchange Act.  The SEC's role is limited to administering the Exchange Act, issuing rules and prosecuting violators in the courts.

 In court, the SEC is not judge, jury and prosecutor.  The SEC wins some court cases and loses other cases.  The reasons the SEC loses varies.  Sometimes the SEC fails to prove facts.  In other cases, judges disagree with how the SEC interprets the law. 

 Even where a statute gives the SEC the power to make rules to administer the law, the courts have invalidated SEC rules where the court determined the SEC rule conflicts with the statute.  We note that the SEC continually issues broad statements about who is required to register as a broker, but the SEC has not translated its positions into an actual rule that defines the three relevant terms of the Exchange Act (effecting transactions, engaged in the business and induce or attempt to induce the purchase or sale of a security) as broadly as the SEC's positions about what they mean.

For finders and others who become targets of SEC allegations about requirements to register as a broker, a number of cases show where the weaknesses are in the SEC's armor.

 In SEC v. Kramer No. 8:09 CV-455-T 23 TBM (M. D. Fla. April 1, 2011), the Florida District Court stated: the SEC's" proposed single-factor "transaction-based compensation" test for broker activity… is an inaccurate statement of the law."  

The Kramer court also reminded the SEC that the courts retain the power to interpret the Exchange Act's definition of broker and the registration provisions of the Exchange Act by reminding the SEC that SEC no-action letters "have no binding legal authority." 

 In rejecting the "transaction-based compensation" test the SEC applies, the Kramer court determined that it would rely on the Exchange Act's language: "In the absence of a statutory definition and enunciating otherwise, the test for broker activity must remain cogent, multifaceted, and controlled by the Exchange Act."

 The Kramer court put the SEC's rightful role into useful perspective in rejecting the SEC's arguments that the mere existence of "transaction based compensation" determines that someone is required to register as a "broker" under Section 15 (a) (1) of the Exchange Act. 

 Other courts have added insights into the tests they think are appropriate taking into account the Exchange Act's primary principles as expressed in the language of the statute.  These courts ask relevant questions without jumping to the conclusion that Section 15 (a) (1) of the Exchange Act requires everyone who is paid in connection with securities transactions to register as a broker.  The relevant questions we should all be asking are:

  • What does "being in the business" mean?
  • What does "effecting transactions" in securities mean? 
In SEC vs. Hansen 83 Civ. 3692, 1984  WL 2413 (SDNY 1984) and SEC vs. Kramer, 778 F. Supp. 1320 (MD Fla 2011) and Landegger Cohen No. 11-CV-01760-WJM-CBS, 2013 WL 5444052, 6-8 (D. Col. September 30, 2013), courts applied a multi-part test to determine whether the alleged broker was really "engaged in the business" of "effecting transactions" in securities.  The test includes:

  • Whether the alleged broker is an employee of the issuer.
  • Whether the alleged broker receives commissions as opposed to a salary.
  • Whether the alleged broker is selling (or previously sold) securities of other issuers.
  • Whether the alleged broker is involved in negotiations between the issuer and the investor.
  • Whether the alleged broker makes valuations about the merits of the investment or gives advice.
  • Whether the alleged broker is an active rather than a passive finder of investors.

In Landegger, the Colorado District Court indicated that the two primary factors for determining whether someone is "in the business" of "effecting securities transactions" are:

·         How often the alleged broker participated in similar transactions.
·         Whether the alleged broker received transaction-based compensation tied to the success of the transaction.

In SEC V. Bravata, 2009 WL 2245649 (E. D. Mich. 2009), a Michigan District Court indicated: "The most important factor in whether an individual entity is a broker is whether there is a regularity of participation in securities transactions at key points in the chain of distribution."  This focus on regularity evidences that the court believes that occasional transactions do not cause someone to be "in the business" any more than someone who holds an annual yard sale is in the retail business. 

The Bravata court also considered other factors, including how aggressively the finder pursues investors, participation in negotiating investment terms and offering advice or valuation information.  Hard selling may move you over the line from introducing people to "effecting transactions."

Courts in the Southern District of New York have focused on a more basic distinction between finders and brokers: 

 "A finder locates potential buyers and sellers, stimulates their interest and brings the parties together, while a broker brings the parties to an agreement on specific terms."  Jones v. Whalen (S. D. N. Y. March 29, 2002) and Antares Management v Galt Global Capital 12-CV-6076 S. D. N. Y. March 22, 2013). 

 This distinction seems to place greater weight on whether the alleged broker helped to negotiate an investment on specific investment terms than on how many transactions the finder did or how the finder is compensated.  In this scenario, it is not important that the finder:

  • Is "in the business" of introducing people, because introducing people is not the same as "effecting transactions" in securities any more than introducing two people who later decide to marry one another is the same as performing a marriage.
  • Is compensated with a success fee, because if you are not "effecting transactions" the success fee is irrelevant.
These New York decisions focus on what the finder did to help close the deal.  By doing this, the courts are implicitly saying that the Exchange Act's use of the term "effecting transactions" in securities requires greater involvement in the specific deal than simply introducing people.  If the finder does not actually "effect transactions," it does not matter that the finder is "in the business," or the nature of the compensation or the number of introduced transactions. 

This standard makes sense, because an issuer usually does not know how many other transactions a finder does.  Using an unregistered broker in an offering can cause an issuer to lose the offering's exemption from registration under the Securities Act.  Therefore, it does not make sense to punish an issuer for things a finder might do in other offerings of which the issuer is not aware.

In some statements about why the SEC is especially concerned about success fees, the SEC has indicated that success fees create temptation for finders to resort to hard sales tactics to pressure people into making investments.  It is difficult to equate giving advice to an issuer about deal terms with hard selling to investors.  This again illustrates the SEC overreaching.

 The SEC's position is strongest where a finder is continually interacting with investors about deal terms or the value of the securities.  Where the finder is advising only the issuer and does not interact with investors about deal terms, the SEC's position that the finder is selling the deal or "effecting the transaction" is weaker.  Issuers have many advisers who are not required to register as brokers.  It is difficult to justify treating an adviser to the issuer who also introduced an investor differently than other advisers to the issuer.

 Certainly, to the extent the SEC worries about success fees creating the temptation to engage in high pressure sales tactics with investors, that factor is not present where the finder communicates advice about deal terms solely to the issuer.

Finders have an economic incentive to have deals close, but they no real economic incentive to establish the deal terms, because they are paid the same amount regardless of the deal terms.  Finders are usually neutral on deal terms.  Consequently, we should not assume that finders always participate in establishing deal terms or always do anything else beyond introducing people and encouraging them to do a deal of some kind. 

 What is the primary value of finders?  Usually, the primary value a finder brings is to cause potential investors to spend the time to evaluate whether to invest in a particular issuer.  Investors are busy people.  They can't evaluate all deals in the market.  Usually, the finder is someone whose judgment the investor respects enough to spend time to read a business plan or talk to a management team.  In some cases, finders affect the decision to make an investment, but in most transactions they simply get the investor's attention and the investor makes its own decision.

 What finders actually do varies from one deal to the next.  That's why it is difficult to say that finders always have to register as brokers or never have to register as brokers.  Different finders simply do different things in different deals. 

Another factor to consider is what other issues does the case involve?  Many finders' cases are litigated together with allegations of fraud by issuers and/or the finders.  The New York cases described above did not involve allegations by investors that fraud was committed.  The issuers were arguing that the finders' unregistered status was a defense to paying the finders' fee.  Section 29(b) of the Exchange Act provided that any contract made in violation of any provision of the Exchange Act is void.  If an unregistered finder accepts a fee for activities that require the finder to register as a broker the fee contract is void.

Where there are allegations of fraud, a trial about complicated fraud issues may be avoided by determining that a finder was really an unregistered broker, which would give investors basically the same rescission rights they would have if the plaintiffs were able to prove that fraud occurred.  Often, its easier for plaintiffs to win damages by proving that fees were paid to people who should be registered as brokers than to prove that fraud occurred.  Consequently, the best defense any finder or broker (whether or not registered) would have is to avoid being involved in transactions where investors may believe fraud has occurred.

 Finders who want to rely on the difference between introducing investors to issuers and "effecting transactions" should not circulate a term sheet and should resist the temptation to help investors and issuers to compromise on specific terms, which is often important to getting a deal closed.  If you do participate in negotiations or help establish deal terms, it's probably safer to give advice to the issuer than to the investors.  The less you interact with investors after the introduction, the better your arguments are that you did not "effect the transaction" because you refrained from the process of selling the deal.

 Although there is no safe harbor, finders have the best defenses against being required to register as brokers under Section 15 (a) (1) of the Securities Exchange Act of 1934 in the following circumstances:

  • The finder is not doing more than introducing the issuer of securities to investors.  That means not advising the investor to invest and not participating in negotiations between the investor and the issuer, including not circulating or commenting on term sheets and not collecting investor signatures and checks.
  • If the finder participates in establishing deal terms, it is as a consultant to the issuer and communicates only with the issuer, not with investors.
  • The finder only infrequently accepting finder's fees.
  • The finder is not playing a part in any of the key points in the chain of distribution of securities.
  • The finder does not hold itself out to the public that it is in the business of raising capital.
  • The finder issues disclaimers to investors that the finder is not providing investment advice and is not making any recommendation to purchase securities.  These disclaimers should specifically indicate that the finder's role ended with the introduction to the business that is raising capital.
  • The finder does not hold money or securities of either investors or the issuer.
With respect to compensation, finders are in a better position if they charge for introductions without regard to whether the people being introduced actually make investments, but businesses that are trying to raise capital rarely agree to that, because they cannot afford to pay fees until they raise money.

Some finders may be able to limit their activities as described above.  But that is not a viable solution for all finders.  Many finders go beyond what the courts have indicated they are allowed to do without registering, because:

  • Even most small deal makers have to do at least several transactions per year to pay their bills. 
  • Securities laws are often preoccupied with whether investors are "sophisticated."  But in many transaction issuers are unsophisticated.  This may be their first time trying to raise capital.  Therefore, finders also often advise unsophisticated issuers about how to interact with investors, structure deals and communicate with both the issuer and investors during the course of the transaction. 
  • And, of course, some finders actively try to sell deals to investors, which places them squarely in the middle of activity that requires registration as a broker.
All these activities that are common practice put finders in jeopardy of having to register as a broker even under the court decisions discussed above.

People who provide multiple services to issuers or to investors should attempt to separate their activities.  For example, charging an hourly fee or a fixed fee for helping an issuer write a business plan under one contract and charging a success fee under another contract for introducing investors would be helpful, especially in situations where an issuer is trying to avoid paying the finder for advisory services under Section 29 (b) of the Exchange Act, because the finder was not a registered broker. 

 Separate contracts and separate fees would not, however, be as helpful in a situation where the SEC or a state securities regulator is taking action against the finder for acting as a broker without being registered.  If the finder engages in activity that requires registration, regulators are likely to evaluate the finder's total basket of services as one sales effort.

Because the SEC disagrees with the court decisions described above, unregistered finders and the businesses that use them to raise capital place themselves at risk of spending both time and money defending against SEC and investor legal actions with no guaranty of success.

 Section 201 (c) of JOBS Act Issues for Finders

We note that Section 201 (c) of the JOBS Act provides an exemption from registration as a broker under Section 15 (a) (1) of the JOBS Act for all offerings conducted under Rule 506.  While most of the attention has focused on the parts of Section 201 (c) that relate to Internet based technology platforms, this exemption has implications for all finders who work with issuers in Rule 506 offerings.  These implications include the following:

·         Provisions of Section 201 (c) that provide an exemption from registration to people who operate technology platforms reinforce the concept that introducing issuers and investors does not by itself require registration as a broker.

·         Provisions of Section 201 (c) that provide an exemption from registration for people who provide certain due diligence services or standardized investment documents may provide a safe haven for some finders who do more than introduce investors and issuers.

We discuss Section 201 (c) of the JOBS Act and the SEC's initial limited views that it prohibits receiving compensation for these services at length in articles (4), (5) and (6)  of this series of articles.  We mention Section 201 (c) here only to make finders aware that it is not limited to Internet based offerings.

We also note that, because Rule 506 offerings pre-empt state registration requirements, an issuer that conducts a Rule 506 offering does not have to worry about losing a state law exemption that many states condition on not using an unregistered broker in the offering.  The unregistered finder still has to deal with state registration issues, but using the unregistered finder does not automatically cause the issuer to lose a state exemption for the offering, which has caused some issuers to refuse to deal with unregistered finders.  Securities regulators would, however, argue that paying fees to unregistered finders are material facts that should be disclosed to investors.  We discuss state law issues in greater detail in article (14) of this series of articles.

 Issuers are not totally free to ignore the issue of whether a finder should be registered as a broker under Federal law.  SEC Form D requires issuers to report payments to brokers and whether the brokers are registered.  Filing an inaccurate Form D may destroy the issuer's Rule 506 exemption.  Failure to disclose to investors payments to brokers and finders and whether the person is registered or unregistered may also be a fraud violation under both Federal and state securities laws.  Whether a disclosure violation occurs would be subject to the materiality standards for securities laws, but the SEC and state regulators would argue that any payment to an unregistered person who should be registered is material.

 Grey Areas Behind the Scenes

 One problem in dealing with finder issuers is that issuers and finders sometimes collude with one another.  Their written contract tries to comply with the factors the courts indicate are important, but in reality the finder is more active than the contract states and the fee is based on success in selling. 

 This practice of obscuring the facts is one reason why people refer to the border between being a finder and a broker as a "grey area." 

 The other reason people refer to this being a "grey area" is that the SEC has been inconsistent in its interpretations over the decades. 

 Administrative Convenience vs Statutory Provisions

 The regulatory tasks of the SEC and state regulators would undoubtedly be more difficult, if they have to prove what a finder actually does in each offering and then measure each action they can prove the finder took against what the Exchange Act and state laws say rather than imposing broad rules about compensation.

 Avoiding having to deal with this burden of proof is one explanation for the SEC's policy to so broadly define both the terms "in the business" and "effecting transactions" in securities.

We see this regulatory principle at work in the SEC's denial of a no-action request of Brumberg Mackey & Wall (March 2010), because the SEC took the position that merely accepting transaction based compensation would trigger the requirement to register.

In Brumberg, the SEC indicated introducing investors to issuers constitutes "pre-screening" the investors to determine eligibility to purchase securities and "pre-selling" the investors on the merits of the investment, because transaction based fees would give the finder a strong incentive to "pre-screen" and "pre-sell.

 Essentially, the SEC is saying that, if a finder has a motive to do something that would make the finder a broker, the SEC is entitled to assume that motive results in action and any action the finder takes crosses the line into "effecting transactions."

The SEC's staff is free to try to make its own life easier by not having to prove what the finder actually did and then argue these specific actions constitutes effecting transactions, but the courts have an obligation to interpret the language of the Exchange Act to determine whether the finder actually takes any action that constitutes "effecting transactions."

While the courts generally give weight to how a regulatory agency interprets a statute, when courts suspect that a regulatory agency is issuing interpretations to make its enforcement job easier rather than basing interpretations on a statute's language, the courts feel greater freedom to ignore the regulator's opinions.  The courts then interpret the statute ignoring the regulator's opinions. 

 Because courts have a duty to be impartial between prosecutors and defendants, courts are not allowed to interpret statutes in a way that makes proving guilt easier.

Finally, recent court cases may be influenced by marketplace realities.  Many legitimate businesses use finders, because the market for small businesses raising money is underserved by registered brokers and most unregistered finders deliver reasonably satisfactory services.  Whenever an issuer hires an unregistered finder and an investor meets an issuer through a finder, the market is making a judgment about the value finders offer in the capital raising process compared to the value registered brokers provide.  The many transactions that utilize unregistered finders give courts a reason to create a judicial exemption for unregistered finders despite the SEC's opposition as long as the courts determine the exemption they create is consistent with the language of the Exchange Act.  We'll discuss proposals for a more formal rule based exemption for finders in articles (8) and (10) of this series of articles.

 Courts may also be influenced by the fact that many of the things a registered broker is required to do simply have no practical relationship to the roles finders play in private placements.  We discuss this disconnect between the regulatory framework for registered broker-dealers and what finders do both in articles (1) and (8) of this series of articles.  If the courts saw a closer connection between what the regulations require and actual protection of investors, the courts would be more likely to support the SEC's views about finders being required to comply with at least some parts of the rules that apply to registered brokers.

 The number of cases described above are too few to say that the court system as a whole have overruled the SEC's views about who must register as a broker under Section 15 (a) (1) of the Exchange Act.  However, the cases do indicate that at least some courts are willing to closely examine the facts involved in broker registration cases and try to apply the Exchange Act's language rather than rely solely on the SEC's views. 

In our next article, we'll discuss how the principles we discussed here apply to the JOBS Act's exemption from registration under Section 15 (a) (1), which was created for Rule 506 offerings, including offerings that are conducted using Internet based technology platforms to introduce investors and issuers.

If you would like to learn more, you can reach me at JFV@WardandSmith.com.
Or you can check out my eLearning course at www.YouTube.com/eLearnSuccess
or read my newspaper articles at




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