Avoiding Broker Dealer Issues for Funds and Their Managers

Q: Can a fund pay transaction-based compensation to someone for introducing an investor to the fund?

A: No, unless the person receiving the fee is a licensed broker dealer or they manage to not meet the definition of broker dealer, despite its broad reach.

Q: What is a broker dealer?

A: Technically, the Exchange Act has separate definitions for brokers and dealers. The statutory definition is very broad, so the courts have taken a factor-based approach. Factor-based tests suck, because they don’t give clear guidance—especially when no factor is dispositive. It is really a way for courts to say, “if it feels like you went too far, you’re a broker.” There are clear cases, and there are not-so-clear cases. It depends on all the facts and circumstances. It gets worse: the SEC exacerbates the problem, because the SEC has taken a different stance on the issue at different times.

Q: What happens to me if I hire or act as an unregistered broker dealer?

A: Here’s a case where a private equity firm hired an unlicensed broker dealer: https://www.sec.gov/news/press-release/2013-2013-36htm

Additionally, under Section 29(b) of the Exchange Act, all contracts entered into in violation of the Exchange Act are void. That means that investors basically have a put right with respect to their investment in the fund—and they may be entitled to statutory interest.

Q: What are the factors?

A: Disclaimer: different courts use different factors, but they ask whether the person:

• Is employed by the issuer;
• Receives transaction-based compensation rather than a salary, such as a commission;
• Sells or has sold the securities of other issuers;
• Is part of the negotiation;
• Provides advice--tax or investment; and
• Actively, rather than passively, finds investors.

No factor is necessary and no factor is sufficient in making the determination, but the most important factor is whether the person receives transaction-based compensation. While there have been cases where a person was not a broker despite receiving transaction-based compensation, this is a rare set of facts. Transaction-based compensation is problematic for the SEC, because it creates a “salesman’s stake” in the transaction. This incentive could lead to abusive sales tactics, so the SEC requires registration and oversight through registration when such an incentive is present.

A commission is an obvious form of transaction-based compensation, but it is not the only form. A salesman’s stake implies that the person will receive more compensation based on the amount the person raises or based on the number of transactions the person sells. Any time an economic benefit is tied to either of these, there is a very good chance the person must register as a broker dealer.

Q: What is the Finder’s Exemption?

A: In the early 1990s, the SEC cited a “finder’s exemption” in its no-action letter to Paul Anka. Mr. Anka only provided contact information to the issuer and did not participate in negotiating, soliciting, giving investment advice, advertising, or endorsing the investment. Because of this, the SEC stated that Mr. Anka did not need to register as a Broker for his participation in the transaction even though Mr. Anka did receive a commission for providing the investors’ contact information.

Q: Is the Finder’s Exemption Still Available?

A: The SEC has retreated from this position. For example, the SEC recently sought to enforce an action against a finder named Kramer. Much like Mr. Anka, Kramer did not solicit, negotiate, give advice, or advertise the offering, and Kramer, like Mr. Anka, received an indirect commission for bringing two parties together. Despite the SEC’s position, Kramer convinced a court that he was not required to register as a broker dealer. After the Kramer decision, the SEC stated that the decision should be narrowly interpreted; Kramer’s case was unique, because Kramer was elderly and unlikely to continue participating in the securities markets. The SEC has stated that it would not be prudent to rely on Kramer, and it has continued to pursue actions against “finders.”

Even if a finder could win in court, doing so will likely take years of court battles, substantial attorney fees, and place an emotional toll on the person. Despite the disagreement between the courts and the SEC, potential brokers should be conservative to avoid the battle that could be required to win in court.

Q: What About Carried Interest?

A: Many private fund general partners or advisers receive carried interest, which gives them a right to a percentage of the future profits, if any, of a fund. If carried interest is tied to the amount of capital raised, it may constitute transaction-based compensation. Private fund organizers should take care to not pay compensation that create a “salesman’s stake” in an offering.

Q: When will the SEC Make Things Simpler?

A: Who knows? In October of 2020, the SEC proposed a conditional exemption for finders that, if passed, would have provided more certainty at the federal level. However, even if those rules would have passed, the rules would not have any preemptive effect over State laws, so State law could remain a burden.

https://www.sec.gov/news/press-release/2020-248

Q: What About State Laws?

The “finder’s exemption” does not preempt state law, so even if it applies, there is still risk that the fund sponsor or the person raising capital could be in violation of State securities laws.

Other helpful links:

AngelList No-Action Letter

FundersClub No-Action Letter

Disclaimer: Your facts may be different or unique. Coming up with a sound business and legal risk strategy requires careful consideration and knowledge of various securities laws. Consult your own lawyer.