Tuesday, September 30, 2014

Who Are You Calling "Broker"? Why the SEC Casts Too Broad a Net (Article 2 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 14 articles about Deal-Makers called:


One fact of life about the deal-making world is that many small deal-makers do not register as a broker under Section 15(a) (1) of the Securities and Exchange Act of 1934. 

These finders, financial consultants and others who help make deals happen constitute a big part of the capital-raising infrastructure for small to mid-sized companies, but they ignore or try to work around the SEC's extremely broad interpretation of the definition of "broker" and the activities that require people to both register as a broker and comply with many other requirements of the Securities Exchange Act of 1934.

The basics facts of life about deal making have not changed for several decades:

·         The SEC issues very broad interpretations of who is a broker and who is required to register so that it's difficult for anyone who is compensated in securities offerings to fall outside the SEC's interpretation of the broker registration provisions of the Exchange Act.
·         Lawyers warn their clients who use unregistered finders about the risks.
·         Many thousands of deals are closed every year with the assistance of unregistered finders and financial consultants.
·         Unless investors lose money and seek to recover their investment, finders continue going about their business without too much interference by the SEC.

Neither side seems to be ready to surrender or compromise.  If anything, the conflict between what the SEC says and how people behave is likely to grow stronger for two reasons:

·         The issuance of Rule 506 (c), which permits Internet based private placement offerings and a new exemption from registration as a broker afforded by Section 201 (c) of the JOBS Act, which applies to people to perform specified activities in all Rule 506 offerings (which we will discuss in article (4), (5) and (6) of this series of articles)
·         The SEC has in recent years been broadening its interpretation of broker registration requirements.

In article (3) of this series of articles, we'll discuss several recent court cases that call into question whether the SEC's broad interpretation of the broker registration provisions of the Exchange Act is really justified.  But the truth is that many finders and financial consultants go beyond even what these court cases permit.  Reality in the capital raising marketplace for small to mid‑sized businesses is simply incompatible with current broker registration laws.  That's why so many people routinely ignore that the SEC says they should do.

Routine non-compliance with the law is unhealthy.  Let's explore why it's happening.

Finders and Securities Fraud

Before we go any further, let's take fraud out of the equation.  Yes, fraud occurs in some deals that unregistered finders and financial consultants participate in.  But fraud sometimes occurs in deals that registered brokers do and may be even more pervasive in deals where no finder or financial consultants participate. 

Let's remember that there are two types of securities fraud.  The more sinister kind is where people set out to cheat investors.  The more pervasive type of securities fraud is caused by people who are raising capital either don't know how to make the required disclosures or lack the financial resources to do the required work. 

Let's focus on the type of securities fraud that is unintentional.  For the most part, finders and financial consultants produce better disclosure to investors than small businesses produce on their own.  There are many ways to improve disclosures by small to mid-sized businesses that raise capital.  Eliminating unregistered finders and financial consultants is not one of them. 

The SEC seems to worry a lot that the lure of making commissions causes finders to pressure investors into bad investment decisions.  But let's consider entrepreneurs who have sunk their savings and lives into starting a business.  They are under a lot more pressure to close a deal to save their business than a finder is.  Finders, who do many deals, usually want to preserve their reputation and relationships with investors.  That's usually the key to their next deal.  Entrepreneurs often do one deal in their lifetime.  Who has the bigger incentive to fudge the facts when making disclosures to investors?

Finders on average have both more experience and greater incentives to avoid fraud than entrepreneurs have on average.  That's why in most situations finders improve the quality of disclosures investors receive.  That is not to say that most finders produce the same level of disclosures that occurs in a big underwritten IPO.

 We should not let the ideal of perfect disclosure become the enemy of better disclosure.  In an ideal world, a team of experienced investment bankers, accountants and attorneys would conduct due diligence and vet every statement any issuer makes to investors.  But the experienced disclosure team approach happens in only a small minority of capital raising transactions.  Most disclosures in securities offerings by small to medium sized businesses occur in informal discussions between entrepreneurs and investors at which investment bankers, accountants and lawyers are not present.  No experienced disclosure professionals are monitoring what is happening when these businesses talk to investors.  Even when businesses hire lawyers to do the deal documents, they usually can't afford to pay their lawyers to monitor the whole capital raising process.

 We might wish this wasn't so, but that's the reality of how deals are done by small to mid‑sized businesses in modern America.

 Who is in the room when this informal disclosure takes place?  Often its unregistered finders and financial consultants who introduce investors to businesses that want to raise capital.  They are in the room for three reasons: 

·         They know both the investor and the management of the business that is trying to raise capital, because they introduced them.
·         They want to facilitate communication between the people they introduced.
·         They usually don't charge by the hour, because they are only paid if a deal closes.  Transactions that don't close can generate large expenses that seriously damage small companies.  So, companies limit the participation of hourly advisers at meetings with investors and rely heavily on finders who are compensated with success fees.

Better disclosure would be a net improvement for investors in small capital raising deals and unregistered finders and financial consultants on the whole make positive contributions to achieving better disclosure compared to what would occur when young businesses are left to their own disclosure devices. 

We discuss disclosure, because we should remember that broker registration rules for private placements are not an end unto themselves.  Broker registration rules for private placements really primarily exist to prevent fraud.

So, as we explore how to apply to broker registration rules to finders, we will consider a number of factors, including whether the SEC's interpretation of Exchange Act's broker registration requirements:

  • Promote better disclosure.
  • Are supported by the Exchange Act's actual language.
  • Are consistent with recent court cases.
  • Are practical in light of how actual deals are done. 
We'll ask the question: Is the SEC going beyond the statute's language and intent in casting such a big net?

Put another way:

·         In the SEC's efforts to catch tuna, how many dolphins are drowning in the net?
·         Can we really afford to kill the dolphins?
·         Should capital starved businesses launch protests to save unregistered deal makers the way people protested to save the dolphins? 

Let's examine how the SEC fishes and look for a remedy to the law of unintended consequences that harms both small businesses and investors.

Before we jump into the SEC's interpretation of the Exchange Act, I note that in article (8) of this series of articles we'll discuss the exemption for M & A brokers who buy and sell companies instead of raising capital.  In article (10) of this series of articles, we'll discuss proposed finders exemptions for capital raising activities and in articles (4), (5) and (6) we'll explore special broker registration exemptions that apply to Rule 506 offerings, including to Internet based technology platforms that connect investors and businesses that are trying to raise capital.

The general principles we discuss here will apply to all these situations.

Registration Requirements: What the Securities and Exchange Act Actually Says

The Exchange Act says you have to do two things before you are required to register as a broker-dealer: 

·         You have to fall within the Exchange Act's definitions of the terms "broker" or "dealer."

·         You have to do the things described in Section 15(a)(1) 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 (9) of this series of articles.

 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."

The primary issues we will examine to better understand who is required to register as a broker and why include:

·         What does "engaged in the business" mean?  As we will see when we discuss "dealers" in article (9) of this series of articles, engaging in the business can have a fairly narrow meaning.  But the SEC seems to interpret the same words much more broadly with brokers.  Is this different treatment justified?  Why would the same words mean different things?

·         What does "effecting transactions" mean?  How much do you have to do in an offering to "effect the transaction"?

·         Does the term "effecting transactions" that is used in both the definition of broker and in the activity that requires registration under Section 15 (a) (1) mean the same thing in both the definition of "broker" and the definition of "dealer"?

Notice that Section 15(a) (1) requires you to register if you are a "broker" when you either (i) "effect transactions" or (ii) "induce or attempt to induce the purchase or sale of a security." 

But if you are not engaged "in the business" of effecting transactions in securities, you are not a broker - even if:
  • You actually sometimes effect transactions in securities or
  • You actually sometimes induce or attempt to induce purchases or sales of securities
If you are not a broker, you would not have to register as a broker under Section 15 (a) (1) of the Exchange Act even if you do one or both of the two things Section 15 (a) (1) says requires brokers to register:
  • "Effecting transactions" in securities.
  • "Inducing or attempting to induce" purchases and sales of securities.
That is why whether you are "in the business" of effecting transactions in securities is the important thresh hold issue that limits who is required to register as a broker.  If you are not either a "broker" or a "dealer," Section 15(a) (1)'s registration requirements do not apply to you not matter what you do.
Because Section 15 (a) (1) states there are two types of activities that cause brokers to have to register, we should assume that these are two different activities.  There would be no need to refer to two activities if they are the same. 
If they are two different activities, then it necessarily follows that a person who is not a broker or a dealer (because they are not in the business of effecting transactions in securities) could "induce or attempt to induce the purchase or sale" of a security" without being required to register.  
This distinction will become important when we discuss in article (3) of this series of articles court cases that recognize a distinction between:
·         Introducing issuers and investors to one another and letting the issuer and investors take the transaction from there.
·         Becoming actively involved in negotiating deal terms that help to case securities transaction on specific deal terms.
Some of these court cases we discuss at in article (3) of this series of articles are based on the premise that the act of introducing the issuer and the investor by itself is not the same as "effecting transactions" in securities.  The courts focus on the role the unregistered person plays in creating the specific terms of the sale to determine whether the unregistered person is "effecting transactions." 
Introductions might be deemed to be inducing or attempting to induce a purchase or a sale, but these curt cases indicate you do not fulfill all the conditions to being required to register, unless you participate in the negotiating process or otherwise participate in causing the issuer and the investor to agree to the specific transaction terms, because "effecting transactions" requires specific deal terms, not just a notion that two people might enter into a transaction if you introduce them.
This distinction between being in the business of introducing people who might do a deal and being in the business of negotiating or otherwise actively creating a specific transaction is the heart of what some people call the finder's exemption from broker registration requirements.
As we will see in article (3) of this series of articles when we compare the SEC's interpretation of the Exchange Act with several recent court cases that disagree with the SEC and with the actual provisions of the Exchange Act, the SEC sometimes considers participating in negotiations a factor in determining whether someone should register as a broker, but the SEC expands broker registration requirements to other situations where someone collects a fee for introductions and/or other services. 
Such other often services include providing advice to the issuer about the offering even if the person never directly negotiates with investors.  This may bring into the broker registration loop behind the scenes financial consultants who refer companies to investors from past transactions, but who never directly negotiate with investors.
Since the SEC enforces laws and does not make laws, we should analyze the SEC statements about who is a broker that has to register in light of whether they are justified by the provisions of the Exchange Act we discussed above. 
How the SEC Interprets the Broker Registration Requirements of the Exchange Act
The SEC provides the following guidance about who is a "broker:" 
"Sometimes you can easily determine if someone is a broker. For instance, a person who executes transactions for others on a securities exchange clearly is a broker. However, other situations are less clear.  For example, each of the following individuals and businesses may need to register as a broker, depending on a number of 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;
·         foreign broker-dealers that cannot rely on Rule 15a-6 under the Act (discussed below);
·         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 (for information on "associated persons," see below)."
"In order to determine whether any of these individuals (or any other person or business) is a broker, we look at the activities that the person or business actually performs.  You can find analyses of various activities in the decisions of federal courts and our own no-action and interpretive letters. Here are some of the questions that you should ask to determine whether you are acting as a broker:
·         Do you participate in important parts of a securities transaction, including solicitation, negotiation, or execution of the transaction?
·         Does your compensation for participation in the transaction depend upon, or is it related to, the outcome or size of the transaction or deal?  Do you receive trailing commissions, such as 12b-1 fees?  Do you receive any other transaction-related compensation?
·         Are you otherwise engaged in the business of effecting or facilitating securities transactions?
·         Do you handle the securities or funds of others in connection with securities transactions?"
The SEC goes on to say that: "A 'yes' answer to any of these questions indicates that you may need to register as a broker."
Some parts of the SEC's website positions described above can be justified by the language of the Exchange Act.  But other parts of the SEC's position are only viable, because of prior SEC positions that interpret the Exchange Act very broadly.  Over the past two decades, the SEC has even retracted no-action letters that evidenced a narrower interpretation of the scope of the Exchange Act's broker registration requirements.
When the SEC uses its own prior broad interpretations of the Exchange Act as justification for what the Exchange Act means or says the Exchange Act requires broader interpretation now than in earlier decades, the SEC is building its regulatory house on a foundation of sand.  The SEC's structure may not survive a storm. 
In this case, the storm consists of:
·         The Exchange Act's actual language.
·         The reality of modern deal-making practices.
·         Courts that are trying protect investors without bringing the economy to a halt, unless the Exchange Act's language requires it.
If all unregistered people who do deals stopped doing the things the SEC says the Exchange Act requires you to register as a broker, a substantial part of the American economy would disappear.  Some SEC positions are simply inconsistent with long-standing practices for how deals are done.  Many professionals, including lawyers, would have to answer yes to one or several of the questions the SEC's website says mean you have to register as a broker.  Examples of common deal practices cited by the SEC for which people normally do not register as a broker include:
  • Lawyers often hold money and stock certificates in escrow and negotiate securities transactions.  The same lawyers often introduce clients to people they know have invested in the transactions the lawyer did for other clients.  Lawyers also work on a stated or practical contingency fee basis, knowing that all or part of a fee will not be paid if the deal does not close.
  • People often introduce friends and family into deals and receive compensation of some type.
  • People who serve on boards of advisers often add value to businesses by making introductions.  Who they know (including investors) is often as important as what they know.
At Risk of Penalties from the SEC and Civil Liability

Of course, the SEC ignores the fact that its positions are inconsistent with both reality of the roles different people play in securities transactions and the SEC's own enforcement policies.  The SEC doesn't prosecute lawyers for holding money in escrow or for negotiating deals or even introducing investors.  But the SEC's interpretation of the Exchange Act means that many unregistered finders, placement agents, business brokers and even business people who sporadically arrange deals risk penalties from the SEC and civil liability to investors in deals. 

Does this liability risk make sense when so many deals depend on unregistered finders and so few unregistered finders are prosecuted? 
 Does this liability risk make sense when finders do not do any of the things most registered brokers actually do, such as:

·         Execute buy orders and sell orders on public securities exchanges.
·         Underwrite registered public offerings.
·         Sell mutual funds for commissions.
·         Hold money and securities for clients.
·         Trade at the broker's discretion under an agreement with the client.
·         Design retirement, education or other financial plans for clients.

In order to reach its broad interpretation of the Exchange Act, the SEC has to justify its positions using the three terms of the Exchange Act we discussed earlier:

·         "Effecting transactions" in securities, which appears in both the Exchange Act's definition of the term "broker" and the term "dealer" and in the registration requirement provision of Section 15(a)(1) of the Exchange Act.

·         Being "engaged in the business," which appears only the Exchange Act's definition of the term "broker" and the term "dealer," but does not appear in the registration requirement provision of Section 15(a)(1) of the Exchange Act.

·         "Induce or attempt to induce the purchase or sale of a security," which appears in the registration requirement provision of Section 15(a) (1) of the Exchange Act, but does not appear in the Exchange Act's definition of the term "broker" or the term "dealer."

The SEC often simply justifies its position by defining these activities so broadly that they include all activity related to securities transactions.  The SEC's positions would both make more sense and be more effective in shaping how deals are done, if the SEC defined a set of activities related to securities transactions for which people could charge a fee without being required to register.  That would demonstrate an honest attempt to tie specific activities to the Exchange Act's language, while helping issuers and advisers better understand who is allowed to perform which services.

The SEC considers you to be "effecting transactions":

  • If you take any action other than introducing the parties to the transaction.
  • If you introduce investors and you receive "transaction based compensation." 
"Transaction based compensation" and "success fees" are concepts the SEC uses to describe the economic rewards that causes the SEC to determine they are "engaged in the business" of effective transactions, but these economic terms do not appear in the Exchange Act.  The SEC has indicated that transaction based compensation can include some types of compensation that are not success fees.

The SEC says that effecting transactions includes introducing investors, advising the seller about transaction structure, preparing financial projections and business plans, participating in negotiations, making recommendations, and doing valuations (whether or not a formal valuation report is delivered). 

 These SEC positions about what constitutes being "engaged in the business" and what constitutes "effecting transactions" have expanded over the years, which makes it dangerous to rely on any SEC "no-action" letter dated earlier than the year 2000.

Transaction Based Compensation is the Key Thresh Hold Issue for Being "Engaged in the Business"

Receiving "transaction based compensation" as a service provider in a securities transaction is relevant, because you cannot be a broker, unless you are "engaged in the business."  Few people engage in any business without being paid.  Unless you are donating your services, the SEC considers you to be in the business. 

That's logical so far.  But the SEC's position is that a single transaction in which you earn transaction based compensation is enough to cause you to "be in the business."  As we will discuss in article (11) of this series of articles, this position is inconsistent with the SEC's position on dealers - you have to engage in transactions on a regular basis to be required to register as a dealer.  Many court cases that we discuss in article (3) of this series of articles also disagree with the SEC's single transaction position for dealer registration requirements.

While the SEC often focuses on receiving commissions or other success fees, the SEC's broad view is that any transaction based compensation (which is not limited to success fees, but might include fixed fees, retainers and consulting fees) is sufficient for almost any service provider to be "engaged in the business" of effecting transactions in securities.  The SEC treats stock, warrants and other securities the same as cash compensation.

 Success fees certainly are good reasons to consider whether someone might be engaged in the business of effecting securities transactions, because two things about success fees relate to the securities transaction – both whether the fee is earned and the size of the fee directly depends on the securities transaction occurring. 

 If both the size of the fee and whether the fee becomes due and payable depend on how much money is raised, the SEC seems to simply assume a service provider must have done something to effect the transaction, because they had a financial motive to do so.  But is proving that someone has a motive to do something really all you need to prove that they did the thing you accuse them of doing?

 Another thing to note about success fees is that the terms of the transaction that the investor and the issuer negotiate are usually irrelevant.  The success fee is earned when a deal closes and the amount of the success fee is determined by the amount of capital raised.  Specific deal terms like what percentage of the issuer the investors own, voting, dividend rights and preferences are all irrelevant.  We should keep this in mind when we consider cases that talk about introducing people being different from effecting transactions, which means participating in establishing deal terms. 

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. 

 Of course, brokers and unregistered finders are not the only service providers in securities offering that charge success fees.  For example, some law firms work on an explicit or implicit contingent fee basis.  Law firms sometimes agree thy will be paid less for a "broken transaction" that does not close.  Law firms and other service providers whose services facilitate closing deals often have a practical success fee.  Their contract might not say they will only be paid if there is a closing, but their client will often leave the law firm with uncollectable accounts receivable for work related to the transaction and for other work, if they cannot raise money.  That's a practical part of doing business with young companies.

 A broker's or finder's success fee often differs from law firms and other service providers, because brokers and finders often are paid their success fee only if the broker or finder introduces someone who actually purchases securities.  That is not true for most other service providers.  Their fees are usually tied to whether a deal closes, not to the source of the money.  But the same is true for brokers who operate on an exclusive basis.  Exclusive brokers or finders are usually paid a commission that is calculated on the total deal size, not just for the amount raised from investors they introduce.

 Before we end this article, we should remind ourselves that the SEC is not the final arbiter of what the Securities Exchange Act of 1934 means.

 In article (3) of this series of articles, we discuss the reasons why some courts have disagreed with the SEC's broad interpretation of what the broker registration provisions of the Securities Exchange Act mean.

 In articles (4), (5) and (6) of this series of articles, we discuss Section 201 (c) of the JOBS Act, which created a new exemption from the broker registration provisions of the Securities Exchange Act for Rule 506 offerings.

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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