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 read my newspaper articles
at
This article is one of
14 articles in a series of articles about Deal-Makers called:
LET'S MAKE A DEAL: REGULATING DEAL-MAKERS ON WALL STREET, MAIN
STREET AND IN SILICON VALLEY IN THE CROWDFUNDING ERA
Our other articles in this series have
focused on agents, because the definition of the word "broker" in
Section 3 (a) (4) (a) of the Exchange Act says a broker is: "any person
engaged in the business of effecting transactions in securities for the account of others."
But agents aren't the only people who do
deals.
- What if
the biggest change to deal making isn't related to changing the definition
of brokers or providing more exemptions for brokers?
- What if the real action in deal making relates to the brokers little brothers: "dealers" and investment advisers?
If you are not an agent in a securities
transaction, you are either a principal or a service provider.
In Article (5) of this series of articles,
we explained why the people who operate technology platforms should be treated
like other media service providers.
Lawyers, accountants, appraisers and
technology platform operators all provide services that help securities
transactions occur. These professionals are
neither agents nor principals in the securities transaction as long as they
confine themselves to providing their services that assist others people who
make the decisions.
So not everyone who helps close a securities
transaction for the account of others has to register as a broker under
Section 15 (a) (1) of the Exchange Act.
Now, let's examine dealers more
closely. There are two basic types of
principals in securities transaction:
·
Issuers who sell their
own securities.
·
Dealers who both buy
and sell the securities of issuers.
Dealer
Registration Issues
Merely acting as a principal and not as an
agent does not necessarily determine the registration issue . Section 15 (a) (1) of the Exchange Act also requires
dealers to register. So, who is a
dealer? Section 3 (a) (5) of the
Exchange Act defines a dealer (which is required to register) as "any
person engaged in the business
of buying and selling securities . . . for
such person's own account through a broker or otherwise."
Here are some of the questions you should ask
to determine whether you are acting as a dealer:
Before we examine dealers further, note
how the words "in the business" appears in both the definition of a
"broker" in Section 3 (a) (4) (a) and the definition of
"dealer" in Section 3 (a) (5) of the Exchange Act. Then look at how the SEC more narrowly
defines being "in the business"
for dealers compared to brokers. When
the SEC talks about who is a "broker," the SEC does not limit brokers
to people who:
·
"hold themselves
out… on a continuous basis;"
·
advertises;
·
does business with the
public.
As discussed in Article (2) of this
series, the SEC treats brokers and dealers differently on the issue of what
constitutes being "in the
business" even though the Exchange Act uses the same words "in the business" in both definitions. Whenever a regulatory agency interprets the
same language in the same statute differently it is fair to ask the
question: Has the SEC exceeded its
authority under the Exchange Act when it applies the broker registration
requirements:
- To people
who are only sporadically involved in securities transactions?
- To
people who do not hold themselves out as being in the securities business?
- To people who operate technology platforms or provide other services that are useful to other people who conduct securities transactions?
A number of court cases have applied these dealers principles to brokers and reached different conclusions tyan the SEC does about whether someone is in the business of effecting securities transactions for others.
Now, let's return to "dealers."
It is clear that not everyone who buys and
sells securities is "in the
business" of buying and selling securities. Investors buy and sell securities. So, are all investors dealers? Capturing appreciation in securities is
considered to be investing and not "conducting a business of buying and
selling securities," which is the key part of the definition of the term
"dealer".
Tax laws recognize this principle by
giving dealers ordinary income and losses, while investors who are not "in
the business" have capital gains and losses. This distinction applies to both individuals
and entities. For example, venture
funds, private equity and hedge funds and their managers are generally not
considered to be "dealers" for either securities law or tax
purposes. Such investment funds invest
to capture of the appreciation of the securities they purchase. Dealers buy and sell to take advantage of
temporary changes in market value.
Dealers generally do not make buy and sale decisions based on analysis
of the fundamentals of the business operations of issuers.
Issuers
The SEC offers the following explanation on its website for
why issuers generally are not brokers or dealers:
"Issuers generally are not "brokers"
because they sell securities for their own accounts and not for the accounts of
others. Moreover, issuers generally are not "dealers" because they do
not buy and sell their securities for their own accounts as part of a regular
business."
The SEC offers the following guidance on issuers who might
be broker-dealers.
"Issuers whose activities go
beyond selling their own securities, however, need to consider whether they
would need to register as broker-dealers. This includes issuers that purchase
their securities from investors, as well as issuers that effectively operate
markets in their own securities or in securities whose features or terms can
change or be altered."
Broker-dealer registration requirements do not stop at
the level of the business entity.
Individuals associated with issuers must find their own exemption. The SEC offers the following guidance about
persons associated with issuers.
"The so-called issuer's exemption
does not apply to the personnel of a company who routinely engage in the
business of effecting securities transactions for the company or related
companies (such as general partners seeking investors in limited partnerships).
The employees and other related persons
of an issuer who assist in selling its securities may be "brokers,"
especially if they are paid for selling these securities and have few other
duties."
Primary
Differences between Issuers and
Brokers
Let's go beyond the distinction between
agents and principals and examine several function differences between issuers
and their owners and brokers.
Do issuers have to register as brokers,
because issuers will benefit from the transaction closing? No, merely benefitting from the deal closing
is not enough to make the issuer a broker.
Issuers differ from brokers in three basic ways:
- Transaction Roles: The nature of the roles issuers and
brokers play in investment transactions are different. Brokers are agents or service providers
who provide advice and make introductions.
Issuers are principals and make decisions and exchange securities
for capital.
- Post-Transaction Roles: The nature of the roles issuers and
brokers play after investment transactions are different. A broker's activity and relations with
both issuers and investors usually ends when the investment transaction
closes. The issuer's relationship
with the investors just begins when the investment transaction closes.
- Transaction Benefits: The benefits issuers and brokers derive from investment transactions are different. The broker walks away from the closing table with cash (we discuss warrants and other equity compensation below) that the broker can immediately spend on anything the broker wants. The issuer must spend the cash the issuer receives in the investment transaction to grow the issuer's business (and pay the broker's commission). So, the issuer's benefit is longer term than the broker's benefit. Any benefit to the owners of the issuer derives from the investment transaction will come from the increase in the value of the issuer's business, which is usually a long-term process. Aside from timing, the other difference is that the increase in value is not automatic. The benefit depends on the decisions the issuer makes as the issuer tries to grow its business. If the issuer makes the wrong decisions, the issuer and the owners of the business will derive no benefit from the investment transaction.
The SEC recognizes that everyone who
participates in an investment transaction is expecting to derive some benefit
from the transaction. No one would do
deals, if they do not hope to benefit in some way. So, unless you want everyone to have to
register as a broker, the nature of the benefit must play a role in determining
who has to register as a broker.
Persons Associated
with Issuers
The issuer exemption from registration as a broker-dealer
has little value, if the issuer's employees, partners, managers or officers
have to register as broker-dealers. By burdening
the people who operate the issuer's business, the SEC would be indirectly
placing that regulatory burden on the issuer itself. So, let's examine the exemptions from
registration for people who are associated with issuers.
SEC Rule 3a4-1 creates a "safe harbor" that
protects certain "associated persons" of an issuer from broker-dealer
registration requirements. An associated
person can be a partner, officer, director, employee of the issuer or of any
affiliate or registered investment adviser.
Rule 3a4-1 is a "safe harbor" provision. You are not necessarily a broker-dealer, if
you do not satisfy the requirements of the safe harbor. The SEC's staff has indicated that they
believe it would be difficult for the managers of "private funds" to
qualify for this safe harbor, but most managers of venture capital, private
equity, hedge funds and other private funds do not register as broker-dealers,
which illustrates that the bank industry operates outside protection afforded
by the safe harbor. Despite general
industry practice not to register, fund managers must be careful not to conduct
activities that make them a broker-dealer.
To qualify for this "associated person" safe
harbor, the person must satisfy all of the following:
·
"Is not subject to a statutory disqualification, as that
term is defined in section 3 (a) (39) of the Act, at the time of his
participation;
AND
The
"safe harbor" does not apply if you are a "Bad Actor" or if
you receive sales commissions or if your compensation is otherwise directly or
indirectly based on transactions in securities.
·
"Is not compensated in connection with his participation
by the payment of commissions
or other remuneration based either
directly or indirectly on transactions in securities;"
AND
·
"Is not at the time of his participation an associated
person of a broker or dealer;"
If you
satisfy both these requirements of Rule 3 a 4-1, you fall within the safe
harbor if you satisfy any one
of the following criteria.
(1)
"The associated person restricts his participation to
transactions involving offers and sales of securities: (i)
to certain institutional investors
including registered brokers or dealers; a registered investment companies,
insurance companies; a banks and registered investment advisers; or (ii) that are exempted by reason of section 3 (a) (7),
3(a)(9) or 3(a)(10) of the Securities Act of 1933 from the registration
provisions of that Act; or (iii) That are made pursuant to
a plan or agreement submitted for the vote or consent of the security holders
who will receive securities of the issuer in connection with certain corporate
transactions, including reorganizations, mergers and other acquisition
transactions; or (iv) that are made pursuant to the
issuer's employee benefit plans."
OR
(2)
"The associated person meets all of the following
conditions:: (i) primarily performs, or is intended
primarily to perform at the end of the offering, substantial duties for or on behalf of the issuer otherwise than in
connection with transactions in securities (this would cover people who
primarily engage in operating the issuer's business); and
(ii) was not a broker or dealer, or an "associated person of a broker or dealer", within the
preceding 12 months (this provision obviously is meant to protect against an
issuer hiring a broker or an employee to avoid the rules); and
(iii) does not participate in selling an offering of securities for any issuer more than once every 12 months
other than activity permitted by (1) above and (3) below (this would disqualify
people who raise money for multiple issuers).
Associate persons of a broker or a dealer include: any partner,
officer, director, or branch manager of such broker or dealer (or any person
occupying a similar status or performing similar functions), any person
directly or indirectly controlling, controlled by, or under common control with
such broker or dealer, or any
non-clerical employee of such broker or dealer and people required
register under state laws, unless the only reason they must register is their
affiliation with the issuer."
OR
(3)
"The associated person restricts his participation to
any one or more of the following activities: (i) Preparing any written
communication or delivering
such communication through the mails or other means that does not involve oral solicitation by the associated person
of a potential purchaser; Provided, however, that the content of such communication is
approved by a partner, officer or director of the issuer; (ii) responding to inquiries of a potential purchaser in a
communication initiated by the potential purchaser; Provided, however, that
the content of such responses are limited
to information contained in a registration statement filed under the Securities
Act of 1933 or other offering document; or (iii) performing ministerial and clerical work
involved in effecting any transaction."
The three
types of people who meet the last part of the "safe harbor"
definition include:
·
people who sell only to designated institutional investors;
·
people who do not otherwise work for brokers who both (x)
perform substantial duties for the issuer other than selling the securities of
the issuer and (y) sell securities of the issuer not more often than once in
any 12-month period;
·
people who only write descriptions about the issuer or its
business, if what they write is approved by others;
·
people who only communicate what others write or approve;
·
people who respond to questions, if their responses quote a
registration statement.
Obviously,
in a private placement there is no "registration statement" to quote
from. Quoting from a private placement
memorandum approved by others would be outside the specific words of the safe
harbor, but would be consistent with the spirit of the types of activities that
do not cause you to be broker because they merely transmit what others write or
approve.
Looking at
the safe harbor, issuers can protect their personnel by ensuring that people
only communicate messages that are approved by management and that their
personnel not communicate with investors by telephone or attend meetings with
investors.
or read my newspaper
articles at
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