Broker-Dealer Registration and Finder Exemptions

Recent years have brought important developments and clarifications within securities law — both on a federal level within the Securities and Exchange Commission (SEC), as well as on the state level with the Texas State Securities Board (SSB) — particularly in defining the distinction between a broker-dealer and a finder. Those individuals or companies who are act as a go-between of sorts between investors/buyers, on one hand, and issuers on the other must pay careful attention to the important distinction, as failure to heed either the strongest registration requirements for either the SEC or the Texas SSB can carry significant consequences. An unregistered broker-dealer faces the possibility of SEC sanctions, being unable to enforce payment, creating a right of recession in the underlying transaction (in the investors’ favor), or creating a right for the investors/buyers to demand a refund of consideration paid to the issuer. Similarly, brokers who operate without a license from the SSB can be subject to administrative, civil or even criminal actions. While we focus in this article on the SEC and Texas laws, in any offers of sale made from Texas to another jurisdiction, the laws of that jurisdiction must be considered as well.

The SEC issued a no-action letter in January of 2014 to exempt certain M&A brokers from registration as a broker under Section 15(b) of the Securities Exchange Act of 1934.January 31, 2014, SEC No-Action Letter (Revised February 4, 2014). Within this no-action letter, the SEC outlined an exemption for unregistered M&A Brokers who worked transaction involving the transfer of ownership of a privately held company, as long as the transaction was restricted to specific constraints. Within this no-action letter, the SEC set out its view of an M&A Broker as limited to “effecting securities transactions solely in connection with the transfer of ownership and control of a privately-held company through the purchase, sale, exchange, issuance, repurchase, or redemption of, or a business combination involving, securities or assets of the company, to a buyer that will actively operate the company or the business conducted with the assets of the company.” Specifically, the SEC noted 11 factors essential in their designation of an M&A Broker:

1. The M&A Broker will not have the ability to bind a party to an M&A transaction;
2. The M&A Broker will not provide financing for an M&A transaction;
3. The M&A Broker will not have custody, control, or possession of securities or funds in connection with the M&A transaction;
4. The M&A transaction will not involve a public offering and is exempt from registration;
5. If the M&A Broker represents both buyers and sellers, it will provide clear written disclosure as to the parties it represents and obtain written consent from both parties to the joint representation;
6. The M&A Broker can facilitate an M&A transaction with a group of buyers, but will not assist in forming said group;
7. The buyers or group of buyers will, upon completion of the M&A transaction, control and actively operate the company or the business conducted with the assets of the business;
8. The M&A transaction will not result in the transfer of interests to a passive buyer or group of buyers;
9. The securities received by the buyer will be restricted securities;
10. The M&A Broker and its officers, directors, and employees have not been barred from association with a broker-dealer by the SEC, any state or any self-regulatory organization, or
    suspended from association with a broker-dealer; and
11. No party to the M&A transaction will be a shell company.

Finders are defined by what they don’t do more so by what they are. Federal securities law do not offer a specific definition, and Rule §115.11 of the Texas Administrative CodeRule §115.11 of the Texas Administrative Code. does more to explain what a finder can not do than what a finder is. A broker is defined as “any person engaged in the business of effecting transactions in securities for the accounts of others.”15 U.S.C. § 78c(a)(4). A dealer is defined as a person that is “engaged in the business of buying and selling securities … for such person’s own account,” but excludes a person that buys and sells securities for its own account, but not as part of a regular business.Section 3(a)(5), Exchange Act. Finders are rarely mistaken for dealers, but the overlap between finders and brokers is blurry. Stemming from SEC no-action letters, as well as applicable caselaw, these are elements which would indicate a registration-exempt finder, who could avoid registering as a broker/dealer under SEC rules:

1. Introduces investors to issuers or their promoters without further involvement in discussions between the issuer and the investor(s) and without giving advice on the investment’s structure or suitability;
2. Receives compensation for making introductions and the compensation is not tied to the success of the raising of capital (i.e., not a commission);
3. Assists in transactions that convey all of a business’s equity securities or assets to a single purchaser or group of purchasers; and
4. Does not assist purchasers with obtaining financing, other than providing uncompensated introductions to third-party lenders or help with completing the paperwork associated with loan applications.

Correspondingly, these are factors which may indicate broker activity, suggesting that the person or entity involved may need to be a registered broker/dealer:

1. Participates in discussions and negotiations between the issuer and the potential investors;
2. Assists in structuring transactions;
3. Receives transaction-based compensation, i.e. a commission or some form of compensation that varies with the size or type of the resulting investment;
4. Engages in “pre-screening” potential investors to determine their eligibility to purchase securities;
5. Engages in “pre-selling” the issuance to gauge the level of interest;
6. Conducts or assists with the sale of securities;
7. Provides advice on the value of securities;
8. Locates issuers on behalf of investors;
9. Solicits new clients;
10. Disseminates quotes for securities or other pricing information;
11. Actively (rather than passively) finds investors;
12. Sends private placement memoranda, subscription documents, and due diligence materials to potential investors;
13. Advises on portfolio allocations to accommodate an investment;
14. Provides analysis of potential investments; and
15. Provides potential investors with confidential information identifying other investors and their capital commitments.

No single factor is controlling in the determination of registration exemption; rather, these factors are taken into consideration as a whole (though transaction-based compensation seems to be a particularly important red flag for the SEC). If the above lists seems daunting to you, you are not alone. Realistically, there are stringent constraints on what a finder may do before needing to register as a broker/dealer.

In an SEC open meeting on October 13, 2015, the SEC adopted final rules for a crowdfunding exemption from registration. The new rules:

1. Require all transactions under Regulation Crowdfunding to take place online through an SEC-registered intermediary, either a broker-dealer or a funding portal;
2. Permit a company to raise a maximum aggregate amount of $1,070,000 through crowdfunding offerings in a 12-month period;
3. Limit the amount individual investors can invest across all crowdfunding offerings in a 12-month period; and
4. Require disclosure of information in filings with the Commission and to investors and the intermediary facilitating the offering

However, only offerings conducted according to the requirements of Regulation Crowdfunding are eligible for the exemptions provided therein. Intermediaries conducting offerings pursuant to Rule 506 or some other exemption from registration cannot rely on the broker-dealer exemption provided for funding portals in Regulation Crowdfunding.

The general rule under the Texas Securities Act (the “TSA”) is similar to the Exchange Act analysis above. Simply put, the TSA allows an exemption from dealer registration for those acting on behalf of the issuer, but only if they meet four important criteria:

1. They must be acting on behalf of the issuer;
2. They can not have been hired for the purpose of offering or selling the securities;
3. Any securities activities they engage in must be incidental to their bona fide, primary, non-securities related work duties; and
4. Compensation must be based entirely on their nonsecurities-related duties.

If these criteria are not met, the person offering the securities must be registered with the State Securities Board as a dealer or agent. Any person that is not an owner, director, officer, or employee of the issuer who offers or sells the issuers securities is subject to the dealer registration provisions of the TSA. Any exemptions defined under the TSA are only available to someone who meets the above criteria.

As is perhaps obvious, the rules in Texas are not in harmony with the SEC distinctions between finders and brokers. Consequently, a finder may be exempt from broker registration on the Texas state level, but required to register as a broker on the federal level. Conversely, a finder may not have to register under the SEC’s exemption rules, but may have to register as a broker under Texas law. Ultimately, those who find themselves navigating the often-blurry lines between finders and brokers should discuss with their attorney (or, of course, reach out to us).

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