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
What if you were in a desert and the only
people allowed to sell you something to drink refused to sell less than one
thousand gallons?
What if you didn't have enough money to
buy one thousand gallons?
What if you only had enough money buy one
gallon?
What if you met people who had water and were
willing to sell you one gallon, but selling one gallon was against the law?
If you were dying of thirst, would you
obey the law and die?
Or would you break the law and live?
If you had one gallon, would you let
someone die of thirst, because the law required it?
Even most law abiding people would buy the
one gallon and live or save a life.
Then they would probably go home and
complain about stupid government laws that stop people from buying a gallon of
water when they are thirsty.
Laws that force good people to choose
between obeying the law and acting both rationally and ethically are bad public
policy.
That sounds crazy - doesn't it?
Why would anyone have a law like that?
But this is the type of law that
limits young business' ability to raise the capital they ungently need.
The SEC says that "transaction based
compensation" in the form of success fees is illegal, unless the person
you hire to raise money for you is a registered broker-dealer.
But most registered broker-dealers don't
want to raise money for young businesses:
·
The liability risks are
too high.
·
The transaction sizes
are usually too small to compensate the broker for incurring the cost of complying
with broker-dealer registration and regulation laws. They have to sell you at least 1 thousand
gallons to make a profit. So, they search
for customers who do deals that are bigger than a thousand gallons and pass up smaller
deals.
Many unregistered "finders" are
willing to do your small (one gallon deal), but the SEC thinks it's illegal for them to do it.
- The
unregistered finder can be penalized.
- You can be penalized for using an unregistered finder, because the government will give your investors the right to get their money back from you if you us an unregistered finder.
Comparison
to M & A Brokers
We discuss in article (8) of this series
of articles, the M & A broker exemption that the SEC explained in a recent
no action letter. The SEC bowed to the
reality that small businesses need unregistered finders to help them sell their
businesses.
For many years, people who know about
capital raising deals have tried to persuade the SEC to create a similar exception
for finders in capital raising transactions.
Prohibiting the use of unregistered finders creates bigger problems in
capital raising transaction than in sales of businesses. The reasons why the problem is bigger in
capital raising transactions than in business sales include:
·
When you sell an entire
business, the amount of money in the deal is based on the value of the entire
business. If instead you try to sell a
20% interest in the same business, the deal size usually shrinks
proportionately. While commission
percentages in private placements are often higher than the percentage
commissions are for sales of businesses, the broker usually makes less money in
the smaller capital raising deal.
·
Businesses use the
capital they raise to grow. Therefore,
valuations are usually much higher when the business is sold than when the
business raises capital. This
contributes to an even bigger differential in transaction size and commissions.
·
Liability risks are
usually higher for everyone in capital raising transactions than in business
sales. Business buyers are usually more
sophisticated than individual investors.
The buyer is often in the same business as the seller so the buyer
usually knows more about the industry and its risks than investors know in a
capital raising transaction. Disclosures
focus on the individual business being sold, whereas in capital raising
transactions you usually have to devote substantial effort to disclosing risks
about the industry, including competitors.
·
When businesses are
sold, they usually have historical financial statements on which valuations are
based. Businesses often raise capital
using projections of future financial performance. Since the future is more speculative than the
past, it often takes much greater effort to sell an investment round than to
sell a business.
·
Many capital raising
rounds require you to find and sell to multiple investors. Selling to one buyer is often a simpler task.
For these reasons, the SEC's very
expansive views about who is a broker and who needs to register when they are
paid to provide services in capital raising transactions cause young businesses
bigger problems in finding suitable assistance when they try to raise capital
than when they sell their businesses.
Most young businesses are forced to go it
alone or suffer the risk of using an unregistered finder. As we discuss in article (6) in this series
of articles, unregistered finders may not always produce perfect disclosures
for investors, but they usually improve the quality disclosures compared to when
inexperienced business owners try to do it themselves.
We should all be able to agree that unrealistic
SEC policies that produce less disclosure to investors and lower quality
disclosures cannot be justified on the grounds that if everyone just stopped
behaving rationally we might achieve better disclosure. People will continue to act imperfectly
driven by reality. Pretending that will
change is bad public policy.
SEC
vs the Courts
We discuss in article (3) of this series
of articles why some courts disagree with the SEC's broad views about who has
to register as a broker.
Such courts are carving out their own exemptions from
registration as a broker based on their view that Section 15 (a) (1) of the
Securities Exchange Act of 1934 never intended to regulate all payments to
everyone who provides assistance to businesses raising capital.
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 receives payment 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 both 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 a single transaction does 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.
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.
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.
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.
Although there is no safe harbor, situations
where finders have the best defenses against being required to register as
brokers under Section 15 (a) (1) of the Securities Exchange Act of 1934 include
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 does participate in establishing deal terms, it is as a consultant
to the issuer and the finder communicates only with the issuer and 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.
Because the SEC disagrees with these court
decisions, however, 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.
Proposals
for Formal Exemptions for Unregistered Finders
This conundrum has cause many people and
organizations who are familiar with private placements by young businesses to
advocate that the SEC and Congress create reliable exemptions from registration
for the capital raising activities of finders.
As we discuss in articles (4), (5) and (6)
of this series of articles, Section 201 (c) of the JOBS Act created a specific
exemption from the broker-dealer registration requirements of Section 15
(a) (1) of the Securities Exchange Act of 1934 in Rule 506 offerings for people
who operate technology devices that permit others to offer and sell securities,
people who co-invest in securities offerings, people who provide due diligence
services and people who provide standard forms for issuers or investors to use
in securities transactions. The SEC is,
however, trying to neuter this statutory exemption by claiming that Section 201
(c) does not permit you to charge fees for any of these services.
If the courts strike down the SEC's fee
assertions, Section 201 (c) will certainly help young businesses in their
capital raising efforts. But Section 201
(c) by itself will not solve the capital raising problems caused by
broker-dealer registration requirements.
As we discuss in article (9) of this
series of articles, technology platforms may be useful tools for introducing
people, but most transactions require in person interaction by people who know
how to get deals done. That's the valuable
role finders often play.
For these reasons, Section 201 (c) is not
an adequate substitute for a broader finders exemption from the broker-dealer registration
requirements of Section 15 (a) (1) of the Securities Exchange Act of
1934.
Generally, exemption proposals for finders
who help businesses raise capital fall into two categories:
·
Proposals to totally
exempt certain finders. The exemption
criteria often involve transaction size or the number of transactions a finder
does in a year.
·
Proposals to provide a
limited form of registration and exemption from some of the most burdensome rules
registered brokers have to comply with.
The problem of how small to medium size
businesses can raise capital through informal middlemen isn't a new one.
Many groups have suggested solutions to
the SEC.
The development of the online single
purpose venture capital fund industry (which we discuss in article (13) of this
series of articles) may cause the SEC to reevaluate past proposals to create a
finders exemption from broker-dealer registration requirements.
·
Changes to the
Investment Advisers Act of 1940 that were made by the Dodd-Frank Act of 2010 may
provide a model.
·
Smaller advisers are
totally exempt from Federal registration.
·
Larger advisers to
certain types of "private funds" must identify themselves to the SEC,
but are exempt from most of the requirements of the Investment Advisers Act
that do not make sense for fund advisers.
Broker-dealer registration and regulation
would make more sense if we adopted rules that Are tailored to both the size of
the operation and the nature of the activities.
If Section 201 (c) of the JOBS Act is any
example, however, the SEC is unlikely to act absent a new Federal statute that
is carefully written to prevent the SEC from limiting the exemption. In most situations, the SEC has traditionally
used the existence of a "success fee" that measures the finder's
compensation by how much money the finder helps the company to raise. But faced with the new exemption from
registration as a broker afforded by Section 201 (c) of the JOBS Act, the SEC
indicated that any type of compensation for services was enough to disqualify you
from using the exemption
ABA
Finder's Exemption Proposal
Many finder exemptions have been proposed
from time to time, because this has been a long-term and widespread problem for
young growth companies and small businesses.
The finder
exemption the American Bar Association proposed to the SEC is one of the more thoughtful and
detailed proposals.
The ABA proposal, which would permit
finders to be paid transaction-based success fees that are contingent on the
closing of a transaction, covers two types of activities:
·
Activities in
which the sole intermediary would be the exempt finder, including arranging for
the purchase and sale of securities in private placements, and related due
diligence, structuring, valuation, negotiation, and assistance in obtaining
financing; and
·
Acting as a
finder between an issuer or selling shareholder and a FINRA-member,
SEC-registered broker-dealer for any type of transaction, including private
placements or public offerings, where the finder's only function is to
introduce the investment banking client or other transaction participant to the
registered broker-dealer.
The ABA's proposal suggested several
alternatives for limiting the size of businesses that can raise capital through
such finders –all of which would have included a range of small to mid-sized
companies in recognition that large investment banks have virtually abandoned
this market.
The ABA's proposal would have exempted the finder from
Federal registration and left registration up to the states. Several states have recognized that their own
rules were preventing businesses from raising capital and have created their
own finder exemptions from registration.
The ABA's proposal
recommended that states adopt a model law to promote uniformity, discourage
forum shopping, and encourage finders to register in each state where such
registration is required. To prevent bad
actors from becoming finders, the ABA's proposal recommended that the CRD
system (which tracks violations by brokers) be expanded to include exempt
finders and their agents, requiring disclosure of any events that would be
reportable in response to Item 7 of Form BD or Item 14 of Form U4. The ABA's proposal indicated there is no need
for a minimum net capital requirement for finders, because exempt finders would
not be permitted to hold investor or client money or securities and suggested
states instead require meaningful fidelity bonding to protect investors. The ABA's proposal indicated that states could
still require periodic reports on Form D and have other examination and
licensing requirements for individual sales people that finders hire.
Recognizing
that many finders are already operating in the shadows, the ABA's proposal
recommended that states adopt an amnesty policy for finders that have
previously functioned in this area without registration but only if they have
not committed fraud, larceny, or other prohibited conduct.
The SEC's M & A Broker resolves many
of the Federal issues related to brokers in M & A transactions. It's time for Congress to take similar action
for finders operating in capital raising transactions for small to medium size
businesses.
When this occurs, we'll have given small
to medium size business powerful new tools to let them utilize middlemen to
implement both their capital raising and their exit strategies at lower cost of
both time and money.
Recommendation
As a consumer protection device, the SEC or FINRA could
operate a website that allows anyone to post comments about any finder they
think violated the anti-fraud rules.
Both the SEC and state regulators could use this website to commence
investigations. Both state and Federal
regulators would be mandated to focus on securities fraud issues instead of
registration issues.
·
First, clarify that
anyone who engages in less than a specified amount of transactions is not in
the business of effecting securities transactions. This would incentivize informal finders to
use their network of business connections to sporadically assist others to
raise capital.
·
Finders who exceed the
volume of transactions to be totally exempt, could be required to identify themselves
to the SEC.
To qualify for either exemption from registration, finders
would not be allowed to:
·
Advertise themselves as brokers or investment
bankers or investment advisers.
·
Render "fairness opinions."
·
In due diligence reports or other documents
express an opinion about the value of securities.
·
Hold money or securities for clients.
·
Conduct offerings for publicly traded companies.
Finders would also be required to:
- Disclose any relationship
they may have with the business raising capital.
- Disclose all compensation
they receive in the transaction.
- Disclose that they are
not registered as a broker-dealer with the SEC or any state.
- Disclose a physical
address.
- Disclose the SEC website for consumer complaints described above.
To work effectively, the exemption should
apply to both Federal and state registration laws and all regulations other
than anti-fraud rules. Bad actor rules
could exclude people with a past history of fraud from either exemption.
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