Unregistered Finders and Financial Intermediaries in Securities Offerings

Unregistered Finders and Financial Intermediaries in Securities Offerings

Protecting investors and preserving the integrity of the securities markets are the primary duties of the federal securities laws and the United States Securities and Exchange Commission ("SEC"). Investments in securities are not provided the same guarantees as certain bank deposits, thus, investors must perform the proper due diligence and ask the right questions in order to protect their investments. Congress enacted the Securities Act of 1933 ("Securities Act") to ensure "full and fair" disclosure is made to investors as to the character of certain offered securities. All investors, from private individuals, to sophisticated businesspersons, to large organizations, are entitled to disclosure of this information. 
Many investors, rather than dealing directly with the issuer of securities, will utilize brokers or dealers to facilitate the transaction. Thus, Congress enacted the U.S. Securities Exchange Act of 1934 ("Exchange Act") to regulate securities exchanges and over-the-counter markets and to prevent unfair practices by the participants within those exchanges and markets. The Exchange Act, by regulating the activities of brokers and dealers, is an important safeguard for investors and the securities market. In recent years, however, the good intentions of the Exchange Act have created obstacles to raising capital for smaller issuers because of the strict regulations imposed on broker-dealers. Many broker-dealers will not work with smaller issuers offering under twenty-five million dollars because there is no financial incentive for the broker-dealer. Therefore, smaller issuers sometimes seek out so-called unregistered finders and financial intermediaries to assist them in finding investors. This activity both places the issuer and its investors at a heightened risk and creates confusion as to how these finders and intermediaries fit into the current regulatory system. 
As a result, one of the top issues in securities law facing small and mid-size issuers, as well as securities professionals, is the lack of clear guidance from the SEC regarding finders and other intermediaries in securities transactions, particularly private placements. Under the current SEC rules and regulations, as well as those of the states, many of these finders and intermediaries are actually unregistered broker-dealers. This is the case even if all parties involved in the transaction are highly sophisticated, wealthy, experienced, and accredited investors engaging in a private offering exempt from registration. 
Registration as a broker-dealer is a burdensome and time-consuming process that requires ongoing reporting and compliance throughout the year. The unregistered broker-dealer faces penalties and possible civil and criminal liability for failing to register, and investors may seek to void their investment and seek rescission. Thus, even though a finder or financial intermediary is neither a full-fledged broker-dealer nor ever intends to engage in traditional broker-dealer activities, the current regulatory system treats that individual as such. 
Recognizing this problem, the 2003 Government-Business Forum on Small Business Capital Formation ("Forum") recommended that the SEC address the issue of unregistered finders and intermediaries. Subsequently, in 2005 a special task force within the American Bar Association's ("ABA") Section of Business Law published a report ("ABA Report") regarding so-called "private placement broker-dealers." The ABA Report urged the SEC to establish a simplified registration process for private placement broker-dealers. The ABA Report also identified certain minimum criteria that private placement broker-dealers should meet in order to qualify for simplified registration, including that the private placement broker-dealer restrict its participation to private offerings involving accredited investors and qualified purchasers, as defined by the SEC. 
The ABA Report, however, did not address the roles of the suitability doctrine or of sophisticated investors. Further, it did not discuss private investment funds, which are a subcategory of private offerings and typically involve sophisticated, accredited investors on all sides of the transaction. Therefore, this Comment will examine the current broker-dealer regulatory regime and suitability doctrine as they pertain to private placement broker-dealers involved with private investment funds that make offerings solely to sophisticated, accredited investors in exempt offerings. It will demonstrate that the suitability doctrine legitimizes the proposed regulatory regime for private placement broker-dealers. 
II. Background 
A. Private Investment Funds 

Private investment funds ("Fund" or "Funds") are pooled investment vehicles through which the Fund's investors and [*708] principals contractually agree on certain investment objectives. These Funds perform many roles in the capital and investment markets, including providing venture capital to start-up companies and capital formation to existing companies. The Funds also function as investment vehicles through which investors pool their capital under a common investment strategy. There are several major categories of private investment funds, with each possessing a different investment strategy. The organization and structure of most Funds, however, is the same. 
B. The Private Offering Exemption, Regulation D, and Rule 506 

The offering of interests sold by most Funds are exempt from SEC registration under the Securities Act and Rule 506, under Regulation D. Rule 506 provides that the offering of securities is exempt from registration as long as there are thirty-five or fewer "non-accredited" investors and that the offering complies with the provisions of Rules 501 and 502. Most Funds typically only sell to accredited investors. Thus, the average investor in a Fund is generally either a wealthy individual or entity that meets the regulatory definition of an accredited investor. 
C. Broker-Dealer Rules and Regulations 
1. Requirement of Registration and Statutory Definition of "Broker" and "Dealer" 

The Exchange Act requires brokers and dealers who "effect any transactions in, or ... induce or attempt to induce the purchase or sale of, any security" to register with the SEC. The Exchange Act defines a broker as "any person engaged in the business of effecting transactions in securities for the account of others." A dealer is "any person engaged in the business of buying and selling securities for such person's own account through a broker or otherwise." However, a person who does not buy and sell securities for his or her own account "as a part of a regular business" is not a dealer under the Exchange Act. 
Before a broker-dealer can conduct any regulated business, he must: (i) file a Form BD (Uniform Application for Broker-Dealer Registration) with the SEC, which must then be accepted by the SEC; (ii) join a self-regulatory organization (SRO); (iii) join the Securities Investor Protection Corporation (SIPC); (iv) comply with the appropriate state rules and conditions; and (v) ensure all associated persons of the broker-dealer are properly qualified. 
2. The Suitability Doctrine 

The suitability doctrine refers to the principle that a broker-dealer must only recommend securities that are suitable to a customer, given that customer's investment objectives and financial condition. The broker-dealer ascertains the customer's investment objectives and financial condition based upon facts disclosed by the customer to the broker-dealer. The SEC enforces this principle through the anti-fraud provisions of the Securities Act, the Exchange Act, and the rules promulgated under those Acts. The NASD's Conduct Rule 2310 sets forth detailed suitability requirements that member broker-dealers must follow before recommending a security to a customer. The national exchanges have similar, albeit less specific, rules that are commonly referred to as the "know your customer rule." 
D. Exemptions to Broker-Dealer Registration 

The two main exemptions to the broker-dealer registration requirement are the Rule 3a4-1 "safe harbor" for associated persons of an issuer and the limited exemption for "finders" who bring potential investors and issuers together. 
1. Rule 3a4-1 Safe-Harbor for Associated Persons of Issuers 

The safe-harbor exemption, on a very limited basis, allows an associated person of an issuer to effect securities transactions without registration. In short, that person cannot: (i) be [*713] disqualified by statute; (ii) receive transaction-based compensation; and, (iii) be associated with a registered broker-dealer at the time of the participation. In addition, that person must meet other conditions that limit his or her involvement to either certain limited investors, certain exempted securities, or certain limited activities. 
2. Finder's Exemption 

The Exchange Act does not explicitly set forth an exemption for finders. Rather, the finder's exemption is limited to narrow circumstances as set forth in a collection of SEC no-action letters granted pursuant to the exemptive authority of the Exchange Act. Generally, this exemption is limited to those who introduce investors to issuers, but who do not take part in the negotiations and do not receive commission or compensation relative to the size of the transaction. 
Given the Forum's findings, the ABA Report, as well as comments from at least one SEC representative, the current broker-dealer regulatory system is not appropriate for private placement broker-dealers, and a less restrictive, "lighter" regime is necessary. In order to determine the boundaries of a possible new regulatory regime, especially with respect to the suitability doctrine, it is necessary first to analyze how courts interpret the statutory definition of "broker" and second to analyze the current regulatory regime and doctrines as they apply to private investment funds. 
III. Analysis 
A. The Federal Regulatory Regime 

The primary purpose and goal of the Exchange Act is investor protection. Therefore, any changes to the existing regulatory system must not conflict with the SEC's mission. 
1. Definition of Broker 

As noted, the Exchange Act defines a broker as "any person engaged in the business of effecting transactions in securities for the account of others. There are three required criteria within this definition: (1) "engaged in the business"; (2) "effecting transactions in securities"; and (3) "for the account of others." The first two criteria have received the most analysis by courts and commentators. 
a. "Engaged in the Business" 

The Exchange Act does not define this phrase; rather, its definition comes from case law and SEC no-action letters. An essential element in determining whether one is "engaged in the business" is the "regularity of participation" in securities transactions. In discussing various rulings and SEC no-action letters that have construed what activities encompass "regularity of participation," one commentator states that such regularity is necessary in order for one to be considered to be "engaged in the business" of securities transactions. 
The SEC and courts analyze past and future experiences in securities transactions when determining regularity. For instance, an issuer is not considered a broker-dealer if it has not offered or sold securities in the past and does not intend to in the future apart from the present transaction. Conversely, if an issuer was involved in similar offerings in the past and planned on similar offerings in the future, that issuer is likely a regular participant in securities transactions and would have to register. Finally, the offer and sale of securities does not have to be the primary business of the broker-dealer in order to be "engaged in the business." 
Given these parameters, most courts would classify many finders and intermediaries involved with private investment funds to be broker-dealers. Some private investment intermediaries participate in only one or two transactions, which make it likely they would be exempt from registration. There are, however, many other such intermediaries who are involved in more than one such transaction, and many of them make such activities their primary business, thereby clearly satisfying the "engaged in the business" criterion. 
b. "Effecting Transactions in Securities" 

In addition to being regularly "engaged in the business," the finder's or intermediary's activity must amount to "effecting transactions in securities." Courts identify several activities or factors that may bring a finder or intermediary within this definition. These are all simply factors that the courts will examine when determining whether the defendant acted as a broker-dealer. No particular combination of factors will qualify one as a broker-dealer. 
For example, in SEC v. Thorn, one of the defendants argued he was not an employee of the issuer and did not receive any compensation for his services because the investment scheme suffered a loss. According to the court in that case, even if it accepted these arguments, the defendant was still a broker-dealer because he frequently communicated with and recruited investors to purchase securities. 
Another court held the defendant corporation was a broker-dealer based on the number of investors solicited and the dollar amount collected from those investors. In that case, the defendant corporation's exclusive purpose was to take part in trading programs, and it had solicited over forty investors who had pledged to invest over $ 17.45 million, collecting over $ 1.7 million from twelve of those investors. 
Transaction-based compensation seems to be an important factor in determining whether broker-dealer registration is required. The SEC has indicated that this factor is important in determining whether one is acting as a broker-dealer because such compensation can attract abusive sales techniques by unregistered individuals. Based on court decisions, however, it is uncertain whether this factor alone is enough to warrant registration. For example, one court noted that a defendant's receipt of transaction-based compensation was especially important in holding that the defendant acted as an unregistered broker-dealer. In addition to the transaction-based compensation, the defendant in that case actively solicited investors and gave securities recommendations to investors. 
Most private investment intermediaries will have an arrangement with the issuer to receive transaction-based compensation rather than a flat finder's fee. Therefore, although courts generally do not find such compensation to be the sole determinant in holding a broker to be unregistered, the SEC hints that such a compensation agreement may be enough to require registration. 
Finally, at least one district court decision suggests certain intermediary activities, including assisting with securities transactions among others, may fall outside the statutory definition of a broker. That court stated that "businessmen (who identify potential merger partners) and opportunists (who like to take a small cut of a big transaction)" are not commonly regarded as brokers. 
B. Exemptions in Broker-Dealer and Securities Law 

1. Rule 3a4-1 Safe Harbor for Associated Persons of Issuers 
The policy underlying the broker-dealer rules and regulations of the Exchange Act and the various self-regulatory organizations is to provide protection to investors by ensuring that registered broker-dealers both possess the necessary training and are obligated to conduct their business under certain prescribed standards. The Rule 3a4-1 safe harbor codifies past SEC interpretive advice and no-action letters concerning broker-dealer registration requirements when an issuer intends to sell its securities through its partners, officers, or employees rather than hiring a registered broker-dealer. This rule gives certain associated persons of an issuer a safe harbor from the broker-dealer registration requirement. 
Under the safe harbor, unregistered principals in a private investment firm cannot offer investment interests in a Fund more than once in a twelve-month period without either registering as a broker-dealer or hiring a registered broker-dealer. Further, those principals are limited as to whom they may offer the interests. Generally, a finder or intermediary will not fall within the scope of the safe-harbor because he does not meet the regulatory definition of an "associated person" and because he will likely receive transaction-based compensation. A private placement broker-dealer is likely to receive transaction-based compensation rather than a flat fee, thus disqualifying him from the safe harbor even with no statutory disqualification or association with a broker-dealer. 
2. The Finder's Exemption 

The level of finding activity may have some bearing on whether or not registration is required, such that if one's finding activities are more than passive, registration may be required. For example, one court identified "active and aggressive" activities as one factor in ruling that an unregistered broker-dealer violated the Exchange Act. The court indicated the defendant was an aggressive finder because of his combined "advertisements, correspondence, and oil and gas development seminars." Additionally, the defendant in that case received sales commissions, previously sold securities of another issuer, and often gave extensive advice to investors. According to that court, those activities, combined with the "active and aggressive" finding activities, amounted to broker activities under the Exchange Act. 
The SEC has addressed the registration requirements of certain finders or intermediaries through no-action letters issued on a case-by-case basis. Those letters set parameters similar to those drawn in various courts' definitions of a broker-dealer. The parameters focus on whether the finder was involved in negotiations, solicited investors, received transaction-based compensation, gave advice, or participated in securities transactions in the past. 
C. The State Regulatory Regimes 

Michigan is the only state with a registration system for finders. The state defines a finder as "a person who, for consideration, participates in the offer to sell, sale, or purchase of securities or commodities by locating, introducing, or referring potential purchasers or sellers." Presently, Michigan's system involves the finder registering as an investment advisor. Other states allow registration of agents of an issuer that sell securities in private placements. 
D. The Suitability Doctrine and Accredited Investors 

With respect to accredited investors, the NASD's position is that the investor's assets alone do not satisfy the broker-dealer's suitability responsibilities under the NASD's suitability Rule 2310. Yet, the NASD has hinted that accredited investors do have some level of sophistication. However, this may not necessarily mean that sophisticated investors can make their own suitability determinations. 
The SEC's 1984 Safe Harbor Release solicited comments regarding whether the then proposed Rule 3a4-1(a)(4)(i)(A) should include sales to accredited investors. Following that, the SEC's 1985 Safe Harbor Release noted that some commentators felt that accredited investors have the capability to require issuers to make full disclosures about the offering, and such investors can protect themselves from possible sales pressures from the issuer's employees. But the SEC ultimately excluded accredited investors from the final rule. The SEC reasoned that the ability of some accredited investors to transact business without the protections provided by registration under the Securities Act does not mean "that a broad exemption from broker-dealer registration is appropriate." The SEC also stated that the existing rules under the Exchange Act and the self-regulatory organizations are "no less important" in the context of accredited investors than they are in others. 
1. Sophisticated Investors 

With the exception of the definition of an accredited investor, there is little mention of sophisticated investors in the securities laws. Courts do, however, make a distinction between sophisticated and unsophisticated investors. For instance, in deciding Rule 10b-5 cases involving fraud and deceit, courts take various approaches in determining whether there is a connection between the plaintiff's injury and the defendant's conduct. Regardless of the approach taken, the sophistication of the investor is an issue. In a Rule 10b-5 case, courts look at an investor's "background, education, special expertise, and general investment sophistication" in determining whether the investor reasonably relied on the defendant's alleged misrepresentations. Sophisticated investors face higher standards in determining reliance, which makes it more difficult for them to show causation in Rule 10b-5 cases. 
2. Pre-existing Relationship between Intermediary and Investor 

As set forth in the State of New York's Policy Statement 101 and Policy Statement 105, New York allows for certain exemptions to the registration of securities offerings when those offerings, inter alia, involve persons with whom the issuer has a pre-existing relationship. Notwithstanding the separate broker-dealer registration and notice requirements in New York, these exemptions, involving investors with a pre-existing relationship to the issuer, indicate that such a relationship is a factor in determining certain exemptions to registration of the offering. Further, Policy Statement 101 and Policy Statement 105 both state that accredited investors (as defined by Rule 501 of Regulation D) are automatically assumed to be sophisticated investors. This indicates that, with respect to certain sophisticated investors with whom the issuer has a pre-existing relationship, less formality is required with the disclosure and registration requirements of New York's securities laws. 
Given the findings set forth above, it is evident that most private placement intermediaries would likely be required to register as broker-dealers even though the finding activity is not their primary business and even though they deal exclusively with sophisticated, accredited investors. But given the findings of the ABA Report, as well as the comments of at least one court, the current regime does not fit these particular transactions. Finally, the proposals offered by the ABA Report do not address either private investment funds or how the suitability doctrine fits within the new regime. 
IV. Proposal 

In light of the foregoing analysis and the ABA Report, this Comment proposes a relaxed regulatory regime that takes into account the suitability doctrine imposed by the NASD and implicit in the Exchange Act. This new regime will allow private placement broker-dealers to introduce accredited investors to issuers and receive payment based on that transaction. It will also set forth certain due diligence requirements, including restrictions upon private placement broker-dealers who have a pre-existing relationship with sophisticated, accredited investors. Finally, it will propose a limited registration exemption for private placement broker-dealers who deal with only one transaction per year. 
A. Private Investment Fund Private Placement Broker-Dealer: NASD Membership & Limited Registrations 

The SEC should promulgate rules under Section 15 of the Exchange Act setting forth a definition for "private placement broker-dealers" and the requirements for registration. Additionally, the SEC should require NASD membership for private placement broker-dealers. Given the growth of enforcement activity by the SROs, it seems reasonable for the SEC to confer upon the NASD certain rulemaking and enforcement responsibilities with respect to private placement broker-dealers. 
The NASD should set forth certain rules for limited registrations based on the type and scope of activities of the private placement broker-dealer. For example, while an entity or individual may qualify to be a private placement broker-dealer, in order to engage in certain securities transactions, that entity or individual must register as a specific type of private placement broker-dealer. Thus, there should be limited registrations for private placement broker-dealers engaging primarily in capital-raising for start-up companies, mergers and acquisitions, private investment funds, and other private offerings. This limited registration system would be similar to the "Limited Representative" subcategories of NASD Rule 1032. 
B. Characteristics of a Private Investment Fund Private Placement Broker-Dealer 
1. Deals Only With Private Investment Funds 

"Private investment fund private placement broker-dealers," as their title suggests, would engage in securities transactions involving only private investment funds. Although finders and intermediaries may perform securities-related services in other areas, such as raising capital for start-up companies or pooling merger and acquisition candidates, given the varied nature of these transactions, it seems appropriate to differentiate among them using a limited registration. 
The question remains whether there should be a cap on either the dollar amount of an offering in which a private placement broker-dealer may be involved, or a cap on the amount of investment by the investor or investors that the private placement broker-dealer brought to the issuer. On one hand, given that full-service broker-dealers generally do not handle deals under twenty-five million dollars, it seems that private placement broker-dealers should be involved with offerings up to this amount. A more plausible solution, however, would be to either set a cap on the amount of money an investor introduced by a private placement broker-dealer may bring to the offering, or perhaps limit the number of investors brought to the issuer by a private placement broker-dealer. 
2. Accredited, Sophisticated Investors Only 

Generally, private investment funds only sell interests to accredited investors. Notwithstanding this practice, the new rule should specifically restrict registered private placement broker-dealers to dealing with accredited investors only, as defined by the SEC. Congress and the SEC previously determined that certain sophisticated and wealthy investors do not require the same level of regulation as average investors. Additionally, courts hold sophisticated investors to a higher standard in securities fraud cases. Therefore, while the accredited investors brought to an issuer by a private placement broker-dealer still receive protection under the Exchange Act, courts assume that these investors have greater investment sophistication and thus should bear a heightened burden when pursuing fraud cases against private placement broker-dealers. 
3. Suitability 

The NASD should set forth specific suitability requirements for private-placement broker-dealers. The NASD's current suitability rule contemplates full-service broker-dealers dealing with ongoing relations with their customers. Therefore, the NASD should implement a new suitability rule specifically tailored for the limited role of private placement broker-dealers. 
4. No or Very Limited Involvement in Negotiations. 

Private placement broker-dealers generally act more like finders than like traditional broker-dealers. That is, most private placement broker-dealers introduce the investor to the issuer and receive payment based on that investor's investment. The private placement broker-dealer leaves the negotiation to the issuer and the investor, or their respective attorneys. Therefore, the scope of traditional "broker" activity undertaken by the private placement broker-dealer should remain very limited and involve very little in the way of negotiation. 
C. The Exchange Act, NASD Rules, and Suitability Doctrine Legitimize the Proposed Private Placement Broker-Dealer Rule 

Essentially, the proposed private placement broker-dealer rule allows the private-placement broker-dealer to legitimately engage in traditional finder activities and receive transaction-based compensation for those activities. The Exchange Act and NASD rules further legitimize this rule because they would require the private placement broker-dealer to introduce to the investor only those Funds that are suitable to that investor. Furthermore, in keeping with the mission of the federal securities laws and the SEC, the proposed rule protects investors because, under the new rule, private placement broker-dealers will be regulated and subject to discipline. 
D. Limited Exception for Certain Defined Finders or Intermediaries 

Finally, the SEC should promulgate a rule under which private placement broker-dealers, finders, or intermediaries involved in a single transaction per year are not required to register. The individual claiming the exemption would be very limited in the scope of his or her activities. First, the offering must qualify under the proposed "private placement broker-dealer" rules. Second, the investor brought to the issuer would have to be both accredited and sophisticated, as the SEC chooses to define such terms. Third, the investor must have a pre-existing relationship with the private placement broker-dealer. If a private placement broker-dealer or finder meets this exception, he or she should be entitled to receive transaction-based compensation based on that isolated transaction without having to register. 




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