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
One of the problems with the SEC's broad interpretation of
who is required to register as a broker under Section 15 (a) (1) of the
Exchange Act is that it lumps together peoples and organizations that do very
different things, have very different impacts on securities markets and retain
investors and utilize different skill sets.
Registered brokers have to comply with a host of
requirements that add expense and do little to protect investors in deals that
finders and other unregistered deal makers handle, including:
·
Expensive registration and amendments to
registrations.
·
FINRA audits.
·
Salesman exams.
·
Churning and suitability requirements.
·
Record keeping.
·
Net capital requirements.
·
Customer account insurance requirements
·
Continuous education requirements.
As discussed in Article (1) and (10) in these series of
articles, many issuers and investors who choose to deal with finders do not
think these broker requirements are relevant to what finders do. That's why finders choose not to register. They would not choose to avoid registration
if their customers valued these securities rules. Even many attorneys who advise clients about
the risks associated with using unregistered finders to raise capital,
acknowledge that there are not better alternatives and think its bad public
policy to subject finders to all rules that regulate brokers.
Let's explore the differences between finders, investment
bankers and the tens of thousands of retail salesmen that work at registered
broker-dealers. We'll also compare what
they do with other people who provide services in connection with securities
transaction, like lawyers, accountants and other consultants, who generally are
not required to register as a broker under Section 15 (a) (1) of the Exchange
Act.
Let's start with talking about what retain sales brokers
do.
What do Salesmen
Do?
In regulating deal makers, the SEC often
focuses on the role of salesmen. The
SEC's positionabout who needs ot register makes sense if you picture a room
full of unlicensed finders cold calling unsophisticated innocent investors
about a hot new deal.
The reality is that most deal makers act
more like match makers and marriage counsellors than sales people.
Most brokers:
·
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.
Now, let's compare salesmen to dealmakers.
Deal-Makers
Deal makers identify and build on common
ground between people who need capital and investors. In some deals this is an easy process. In other deals, middlemen add substantial value,
because it is not obvious that the buyer and seller have reasons to do business
with one another, it is not obvious what the best transaction structure should
be to allow both buyers and sellers to achieve their goals and there are many
unforeseen bumps on the road to closing the deal.
That's why it’s a mistake to lump all deal
makers in with the thousands of retail securities brokers that work in the
large registered broker-dealers. A
retail securities broker usually has no connection to the company whose stock
he is selling. It’s a product he sees on
a computer screen.
Deals where businesses are raising money
through finders require a large amount of nurturing. That's why registered brokers' investment
banking departments don't do small deals.
SEC interpretations of the Exchange Act that prevent deal makers from
adding value does substantial harm to both businesses trying to raise capital
and people who would like to invest in them.
Both sides need more help than technology can provide.
New regulatory freedom and technology for
issuers selling securities is useful, but the truth is that technology and
regulatory change won't get deals done without a more vibrant deal-making
community.
Giving securities issuers more freedom and
technology only creates minimal market change, because businesses that sell
their securities to raise capital are transient players. They enter the market and leave. Sometimes they leave empty handed. Other times they leave with a wheelbarrow
full of money. Either way, they have
limited impact on the marketplace, because they are in the marketplace a
relatively short time.
Brokers and other deal makers stay in the
marketplace all the time. So, if you
want to make significant changes to the market, change should focus attention
on the dynamics among the permanent players – the middlemen.
How Do Finders and
Investors Work Together?
The situation is usually totally different
when an individual finder calls someone about a private investment
opportunity.
- The
relationship is usually more personal.
Finders usually have had some prior business dealings with one or
both the investors and the people who want to raise capital. The investor usually talks directly with
the people running the business that needs capital.
- The
investor's motives in private investment transactions are often
mixed. Investors seek profit, but
they are influenced by many other factors, including interest in the
industry, prior industry experience and social concerns.
- SEC
rules require that all investors in private deals have to be sophisticated,
whether they are accredited or not.
Sometimes the investors are more sophisticated than either the
finders or the entrepreneurs who are trying to raise capital – often for
the first time.
- Relationships
are usually transparent. Investors
usually know the finder is working for the company trying to raise capital
not for the investors.
- Investors
often have opportunities to do their own due diligence. Few investors part with their money
based solely on what finders tell them.
Investors often either have industry experience or know people who
do. Investors seldom rely only on
what finders say, unless the finder has established a track record in
prior deals.
- Risks are well known. Most people avoid private placements because they are known to be risky. People who invest in private placement deals usually make conscious decisions to take risks.
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.
Investment
Bankers vs. Finders
One might argue at finders should register
because they perform many of the functions performed by investment banks, which
are registered as broker-dealers.
But most investment banks deal with
publicly traded companies and securities and have large retail sales forces
that sell securities to retail customers.
Investment banks also issue analyst reports that make buy-sell
recommendations that circulate widely among retain investors. Finders usually deal only with private
companies in private placements and usually lack a retail sales force.
The primary public policy reason it makes
sense to require investment banks to register is their impact on public markets
and retail investors.
Investment banks simply have a much greater impact on the investing
public that finders do not have.
Differences in Many
Professional Service Providers
In the world of deals, many people provide
services in connection with sales of securities, including attorneys, accountants,
consultants, appraisers, engineers and other professionals.
Likewise,
newspapers and other media have long provided advertising for sales of
registered securities without being required to register under Section 15 (a)
(1).
Since
these service providers all play important roles in securities transactions,
but are not required to register as a "broker," unless they do more
than provide their normal services, we logically conclude that you have to do
more than provide services in a securities transaction to "effect the
transaction" or to induce a purchase or sale of securities.
This
poses several questions:
- Where is the line between what brokers do and
what other service providers do?
- Can someone be acting as a broker in one
transaction and not be acting as a broker in another transaction?
- Or does acting as a broker in one transaction or many transactions pollute the service provider for all transactions?
This
last question might seem irrelevant to whether the person has violated the
law. What does it matter if there is one
violation or many violations? The answer
is that is that it matters to determining the liability to investors in
specific deals.
Both
companies that raise capital and the person accused of being an unregistered
broker have potential civil liability to investors in to specific investors in
specific transactions. What happens on
other transactions is irrelevant to determining liability to specific investors
in another transaction. The fact that
you might have been speeding yesterday does not earn you a speeding ticket if
you are obeying the speed limit today.
So, both the business that raised capital by selling its securities and
the unregistered broker have defenses, if the unregistered broker did nothing
in this transaction that required it to be registered.
But
the defense that someone did not act as a broker in a single transaction does
not settle the issue for the unregistered finder. As we discuss in articles (2) and (3) of this
series of articles, the Exchange Act definition of a broker requires a finding
that someone is "in the business."
Some courts have indicated that a single instance of someone accepting
compensation for the same thing a broker does is not enough for them to be
"in the business" of effecting securities transaction.
Keep these three questions in mind as we
analyze whether the SEC's treatment of different situations is consistent with
the Exchange Act's language.
As we discussed, the SEC's broadly interprets
these key three phrases. But if it is
more reasonable to interpret the Exchange Act's actual language more narrowly
than the SEC does:
- Courts
are free to adopt a narrower interpretation of the Exchange Act's
definition of broker and registration requirement, if the courts find
public policy reasons to give unregistered finders greater leeway.
- And the SEC is free to conclude that forcing investors into the hands of large registered brokers has not produced good results for either businesses trying to raise capital or investors, which could cause the SEC to narrow its interpretation of the scope of these parts of the Exchange Act
Therefore,
carefully parsing the Exchange Act's actual language helps us understand the
latitude both the courts and the SEC have to change course to meet the needs of
businesses that are trying to raise capital.
Rule 506 Technology
Platforms
Now, let's move from fees to technology platforms.
The technology platform part of the Section 201 (c)
exemption will probably be most important for Rule 506 (c) offerings that
permit issuers to advertise and conduct general solicitations. But technology platforms that restrict access
to qualified accredited investors were used in Rule 506 offerings before Rule
506 (c) permitted advertising and general solicitation. Such Rule 506 (b) platforms are just technology
based implementations of the principle that it's not a general solicitation if
you hire a broker-dealer to solicit the broker-dealer's customers in a private
placement.
Because these platforms were open only to persons who
registered as accredited investors as customers of the platform, they did not
constitute a general solicitation. But
you have to be careful about how you drive people to register at these
platforms. Issuers cannot conduct a
general solicitation to ask people to register to see their offering, if they
are conducting a Rule 506 (b) offering, like they can in a Rule 506 (c)
offering.
Likewise, the parts of the Section 201 (c) exemption that
permit intermediaries to invest in the deal and also provide ancillary
services, whether or not a technology platform is used, also could apply to any
traditional private offering, not just to Rule 506 (c) offerings
Platform Technology is
not the Key Issue
Focusing on the technology platform being used in an
offering tells us very little about the securities regulations that govern the
offering. The technology might be the
same, but the most important difference between earlier Rule 506 offerings that
utilized technology and new Rule 506 (c) offerings are that you do not have to
restrict access to your website to registered customers and you can use Social
Media, the Internet, traditional advertising and general solicitations to drive
people to your technology platform. Rule
506 (c) offerings can use websites that are open to anyone. Rule 506 (c) requires that your buyers must
be verified accredited investors, but it places no limits on who you make
offers to or how you contact them.
This difference results in greater offering effectiveness
and cost efficiencies.
The ability to communicate outside your technology platform
is a big advantage of Rule 506 (c) offerings.
It means that non-accredited investors, who learn about your offering,
can forward information to accredited investors they think might be interested
in your offering. This is important
because there are many more non-accredited investors than there are accredited
investors. Each person who learns about
your offering is a potential salesman, if you communicate to community members
in ways that motivate them to forward your messages to others who share their
interests.
The bottom line is that "going viral" in certain
target communities creates efficiencies in both the time it takes to complete
an offering and marketing expenses.
For these reasons, it's important to businesses raising
capital that platform operators be able to provide basic services that will
enable the investor who use their platforms to efficiently make reasonable
decisions that are consistent with processes investors use to make investment
decisions when a technology platform is not used.
Or you can check out
my eLearning course at www.YouTube.com/eLearnSuccess
or read my newspaper
articles at
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