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Mandatory Registration of Finders as Private Placement Brokers: SEC Action On The Way (Part 1)

Joseph W. Bartlett, Special Counsel, McCarter & English, LLP



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The Forecast

The issuance of a suite of proposed rules by the SEC Staff, requiring the registration of finders as "private placement brokers" is close at hand. The problems to date with that forecast is that this corner has been making it for a number of years, following clear and consistent signals by the SEC Staff that they did not believe there was an implicit exemption from the '34 Act registration requirements for "finders." That said, in my view the penultimate act in the drama occurred on July 6th 2005, with the publication of an ABA Task Force Report on the subject.

Speaking now not as a member of the Task Force (which I am), but as a long time observer of the passing show in this sector and based on sources, as they say, deemed reliable, my current prediction is that a Regulation will surface in proposed form from the SEC Staff no later than the end of the year … or at least no later than the end of the first quarter of 2007. The scope of the regulation is (substantially) set out in the Task Force Report and indeed in earlier symposia the SEC has held on the subject … described as "broker/dealer lite." If I am wrong on the timing of this Regulation, my only plea for mercy and understanding is that I have been consistently wrong over the past several years.

The Issue

The issue whether an individual or entity which is, and only is, a placement agent (a/k/a "finder") must register under the '34 Act and join the NASD as a broker/dealer is thorny. Describing the agent firm as an 'adviser' or a 'finder' rather than a 'broker' is deemed, by some at least, to be evidence of non-broker status … assuming the only activity is raising private equity or M&A matchmaking.

The definition of a broker/dealer in the '34 Act is quite broad. It defines a broker as "[a] person engaged in the business of effecting transactions in securities for the account of others." The Act, § 15(a)(1), further requires the registration of any broker or dealer that elects to: "effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security." However, the argument is that a finder is not a 'broker' because she does not engage in the business of brokerage in the conventional sense but merely brings issuer and investors together … no retail sales; no custody of client funds, no underwriting.

The 'finder' exemption has historical roots, based on old language in the leading hornbook on Securities Regulation by Prof. Loss.[1] However, there are only a handful of reported cases; moreover, even if the No-Action Letters (of which there are several) are considered as precedents, the results are highly fact-specific and, indeed, often appear to be conflicting. Moreover, while in the past there was some support in SEC statements for the "finders exemption,"[2] the Staff's recent pronouncements on this issue reflect a viewpoint that the 'exemption' is history.

That said, the present situation is unstable. There are literally thousands of individuals and firms, unregistered and non-members of the NASD, which rely on the 'finders exemption' in raising private capital. Some critics have formally recommended the Staff back off … that, absent fraud, the SEC should formally bless the exemption.[3] However, it is reasonably clear that the Commission is not going to back off. The Staff is unconvinced that raising capital for small businesses will be hurt if finders are required to register; the attitude inside the Agency seems to be that a rational system of registration will help in the process, in that it will separate out the legitimate agents from those who seem inexorably drawn to the Boca Raton culture. Thus, I believe it is only a matter of time before the Staff and the Commission get into gear on this issue; and, I suggest the ramifications will be widely felt.

In fact, I now suggest that the penultimate act in the drama occurred on July 6, 2005 with the publication of an ABA Task Force Report.[4] I believe that the issuance of the Report will finally force the Commission's hand. To be sure, there may be further delay. The issue has been around for years; as a straw in the wind, consider that the question was, as I understand it, on the schedule for discussion at the latest SEC Speaks presentation under the auspices of the Practicising Law Institute last Spring … but did not in fact come up for discussion. That said, the Report is now widely publicized, by virtue of its appearance in the most current issue of The Business Lawyer (a publication of the ABA, Section of Business Law, under the auspices of the University of Maryland Law School), which everyone in this business reads. Accordingly, I think we are coming to the end of the line.

I speak as a member of the Task Force, although not on behalf of the Task Force: I think it will be helpful to the readers of this publication that I quote, along with personal remarks and comments, various paragraphs from the Report. I strongly urge each professional and interested layperson to read the Report in its entirety because of what I deem to be its importance; of course, it is too long to republish in these pages; indeed republication is unnecessary in view of its availability in the current edition of The Business Lawyer (and online at: http://www.ibba.org/_files/ABATaskForceReport6-2-05.pdf). However, it should be understood that the quoted paragraphs are qualified by the entire text of the Report and should be, again to stress the obvious, read in the context of the entire Report, to get the appropriate meaning and full significance thereof.

Assuming the SEC is going to act, the odds are high that it will come up with a proposed regulation setting forth a system of registration called in the trade, 'Broker/Dealer Lite.' The dividing line will be somewhere in the area of two or three transactions a year; any more and you must comply … you are "in the business;" some, in fact, will argue that any activity in a given year beyond one deal is over the line.

Broker/Dealer Lite will expressly put the kibosh on the notion that finders can "rent" a license from an NASD member.[5] Many unregistered finders justify their status by saying that they run the commissions through an NASD member and then share in proceeds; the NASD rules are quite specific … no sharing with non-members … and Broker/Dealer Lite will make that clear.

Assuming the SEC issues a proposed rule on Broker/Dealer Lite, what will it look like and who will it cover?

First, I assume it will be available for, and only for, certain qualified individuals and firms … Private Placement Broker Dealers ("PPBDs") as described in the Report … meaning persons and entities doing business along the following lines:

  • No statutory disqualifications of the firm or its principals.
  • Offerings by PPBDs could be made only to accredited investors and qualified purchasers as the SEC defines the term. Issuers however could separately offer to any investor qualified by the type of exemption.
  • The firm may not handle or take possession of funds or securities.
  • All funds from offerings will be placed in escrow in an unaffiliated financial institution and in accordance with escrow requirements in SEC Rule 15c2-4.
  • The firm must not engage in secondary market or trading activity, including assisting with maintenance of "desk drawer" markets at the issuer or the broker-dealer.
  • Principals and representatives shall have successfully completed NASD examinations appropriate to the scope of activities of the PPBD.[6]

Given an eligible PPBD, the question which naturally comes to mind is: What will Broker/Dealer Lite look like? The Report has a series of quite detailed recommendations. For a 'quick and dirty' summary, however, I recommend reference to the provisions which have surfaced at symposia sponsored by the SEC Small Business Policy Group; I quote from the 2003, recommendations adopted in the final report as made:

" … a limited broker-dealer licensing category for financial intermediaries who are not registered through a broker-dealer firm within the following parameters:

a. NASD membership required;

b. Abbreviated application form;

c. Lower fees for application and renewal;

d. Appropriate testing requirements (emphasis added);

e. Applicants must certify that there are no "bad boy" disqualifications;

f. Annual renewal of registration;

g. No custody of client funds or securities permitted;

h. No minimum net capital requirements;

i. Appropriate bonding requirements;

j. Explicit recognition that these persons may accept transaction-based remuneration;

k. No discretionary authority permitted;

l. Record-keeping appropriate to the business; and

m. Applicable sales practice rules."[7]

The first shock will be if, as is almost certainly the case, all the members of the newly registered PPBDs are required to take the Series 7 exam. The fall out could be significant … and the consequences hard to predict.

The Task Force thought of that issue and suggested, quite, wisely in my view:

"Examination Requirements.

Traditional examination requirements are not appropriate for PPBDs, since the scope of their coverage vastly exceeds the knowledge required to perform obligations which we anticipate they must meet. Accordingly, we recommend that the Regulators develop new targeted examinations for registered representatives and principals, testing only relevant topics.

The skills needed for principals are dramatically different for private offerings or merger and acquisition transactions, than the skills needed in a full service firm. Development of written supervisory procedures should be keyed into what is needed to do the job; not to a laundry list of inapplicable topics. The Task Force would be pleased to work with the Regulators to develop a more relevant examination structure."

Assume that Broker/Dealer Lite is proceeding to its long overdue appearance, the current problem is: "What to do until the doctor comes?" What do issuers, finders and their lawyers do pending the appearance of Broker/Dealer Lite or, if no Broker/Dealer Lite is forthcoming, during the existing period of ambiguity and uncertainty as to the legal consequences of various actions. The Report is meant to stimulate and not to close off questions on that score; however, the Report is helpful in many ways and should stimulate discussion amongst the players on various questions of professional obligations, risks and liabilities.

One option, of course, is for any individual or firm in the gray area to register under existing SEC and, in particular, NASD rules and policies. From personal experience, I can attest that the process can be onerous and extraordinarily expensive. In a case in which I was personally involved, while there were special circumstances (none involved fraud or prior bad conduct), the legal expense exceeded $100,000. That is not a practical number, as the Report acknowledges, for a number of perfectly legitimate PPBDs.

Further, there is the possibility, if a PPBD goes to register, of disqualification by the NASD of applications from any PPBDs who have historically been acting as "finders," on the strength of the alleged "finders exemption," in the past. I will cite one example, without naming the individual, which illustrates my concern on this issue. Some years ago a prominent and experienced investment banker left his existing, eponymous firm and elected to organize a firm with a different business model and plan. The individual concerned was and is a multi-millionaire. As he was in the process of organizing his new firm and pre-applying for NASD membership, he came across a transaction he thought looked promising; and, since he had a keen understanding of venture capital investing (both as an agent and a principal), he elected to commit to an investment. In the process, he invited several of his friends, who had invested with him in the in the past, to co-invest. When that activity was reported, as it had to be, to the local NASD office, the Staff in that office took the position that the individual had gone across the line. At the time he organized his syndicate, he was not then, as an individual, registered as an NASD member … although he had, for any number of years, been the CEO of a registered firm. Nonetheless, certain members of the NASD Staff took the view that his interim activity was a co-called "bad boy" disqualification. The Report meets that issue head on, and in what I consider to be an enlightened way. To quote from the Report (p. 49):

"Hiatus of Inquiry into Prior Unregistered Brokerage Activity. Once the guidelines were made more clear and were widely disseminated, there may be some finders who will be able to limit their conduct to legitimately avoid (not evade) broker-dealer registration requirements. However, to make it practical for the remaining finders to come forward and register as PPBDs, as we have noted above, it would be extremely valuable for states [and, in my view, the NASD] to refrain from their current policies of scrutinizing the prior activities of applicants for possible registration violations with potentially draconian consequences. This would not require the states (or other regulators) to ignore potential fraud or other sales practice violations, or to screen applicants for prior criminal conduct, regulatory sanctions, customer complaints, or other factors that truly present a risk to the investors as well as to the issuers whom the PPBDs may represent."


[1] The exact quote from the "Bible" (Fundamentals of Securities Regulation) is as follows:

"Although a pure finder may induce the purchase or sale of' a security within the meaning of § 15(a), he or she is not normally a 'broker' because he or she effects no transactions, but merely brings buyer and seller together."

One of the more recent, Salamon v. Citran Corp. (USDS, CD Utah, Nov. 2005), 2005 U.S.Dist. LEXIS 31332, indicates that the finder's "exception" is based on SEC No-Action Letters.

[2] The following is an excerpt from the July 6, 2005 Report and Recommendations of the Task Force on Private Placement Broker-Dealers: ABA American Bar Association, Section of Business Law, Committee(s) on Small Business, Federal Regulation of Securities, Negotiated Acquisitions and State Regulation of Securities (the "Report").

"In the Division of Market Regulation October 1998 Compliance Guide to the Registration and Regulation of Broker-Dealers found on the SEC website, there is ambivalence about "finders." This is surprising in light of the history of no-action letters. The guide suggests that the determination of whether one is or is not a broker depends a number of factors, and suggests that "'finders,' or those who find buyers and sellers of securities of business or find investors for registered-broker-dealers and issuers need analyze three issues:

a. Do you participate in important parts of a securities transaction, including solicitation, negotiation or execution of the transaction?

b. Does your compensation for participation in the transaction depend upon the amount or outcome of the transaction? In other words, do you receive transaction-based compensation?

c. Do you handle the securities or funds of others?

If the answer to any of these is "yes" then the reader is cautioned that you may need to register as a broker. Those who are uncertain are told that they may want to review SEC interpretations, consult with private counsel, or ask for advice from the SEC. This is far more ambivalent than the no-action letters suggest is appropriate."

The Report, p. 38.

[3] The Report, p. 47.

[4] In the Report there is, of course, a caveat as follows: "The views expressed herein have not been approved by the section of Business Law, the House of Delegates or the Board of Governors of the American Bar Association and, accordingly, should not be considered as representing the policy of the American Bar Association."

[5] "Compensation Sharing Arrangements.

Registered broker-dealers and their registered representatives are not permitted to share commissions or transaction-based compensation with unregistered persons. This was recently made clear in the context of CPAs and their CPA firms in 1st Global, Inc., SEC No-action Letter (May 7, 2001)."

The Report, p. 26

[6] The Report, p. 3.

[7] See the Report, p. 52 for "The Final Report of the 22nd Annual SEC Government-Business Forum on Small Business Capital Formation (December 2003)."

Joseph W. Bartlett, Special Counsel, JBartlett@McCarter.com

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