Michael Blackham
Michael Blackham
Private Investment Funds
March 8, 2021
Am I an Unregistered Broker Dealer?
Broker Dealer requirements are onerous, time-consuming, and expensive, so many private fund sponsors take steps to avoid being a Broker Dealer. It can be difficult to understand what it means to be a Broker Dealer, because these terms are very broadly defined in the Securities Exchange Act of 1934. Courts have taken a factor-based approach without giving much guidance on how to weigh the factors. The SEC exacerbates the problem, because the SEC has taken a different stance on the issue at different times.

Am I an Unregistered Broker Dealer?

I am asked on a regular basis whether a fee is permissible when it involves the sale of securities. The question is posed in two different ways: Can I take a fee? Can I pay this fee?

Section 15(a) of the Exchange Act prohibits unregistered Broker Dealers from using interstate commerce to engage in securities transactions (I’m paraphrasing and not getting into the technical distinctions between a broker and a dealer). Acting as an unregistered Broker Dealer can lead to rescission rights for investors, civil suits, being placed a bad actor list, which could prevent those involved from participating meaningfully in the securities markets, or even criminal charges.

And if you plan to hire an unregistered broker dealer and pay them a fee, you cannot simply turn a blind eye, because there have been cases where issuers who hired unlicensed brokers ran into trouble with securities regulators.

Definition of a Broker Dealer

Since the definition of broker dealer is  broad, so courts answer the question by asking whether the person had key involvement at certain points in the chain of distribution, which likewise is broad and uncertain. So, the courts have a list of factors they use (some courts use slightly different factors). 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 single factor is necessary or sufficient to making the determination, however, 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, and the SEC could still bring an action. 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 when such an incentive is present. Think of it like this, if someone has a financial incentive based on either the amount of securities sold (number of securities or dollar amount) or that is contingent upon a successful raise, that person is likely a broker.

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.

What is the Finder’s Exemption?

What about someone who merely brings two parties together? Can they qualify for the so-called finder’s exception? The SEC has changed its opinion over time. 

In the early 1990s, the SEC cited a “finder’s exception” 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.

Since then 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. 

The SEC has been active and if you've seen the SEC's proposed conditional exemption for finders, it's too early to get excited. See it here. First, the exemption is narrow. For example, the exemption won't apply to business entities, so anyone operating through an LLC, corporation, partnership or other business entity won't qualify. Second, the proposed rule will not (as drafted) preempt state law, which means that until States align their exemptions, this finder's exemption (if passed), may have minimal impact. Third, the proposed rule was pushed forward under the Trump administration and things could change under the new Biden administration.

What About Carried Interest & the Finder's Exemption?

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. While there likely exists some incentive to engage in abusive sales tactics, carried interest is not earned based on whether a transaction is consummated. It is earned only if the fund returns a profit, so the “salesman’s stake,” if it exists, is a step removed. While two SEC no-action letters state that carried interest is not transaction-based compensation, private fund organizers should take care to not create a “salesman’s stake” in an offering.

Most private fund organizers are regulated under a different regulatory framework--investment advisers.

Some advisers wish to share a portion of their carried interest with finders based on the amount a finder raises. For example, a fund adviser may be entitled to receive carried interest of 20% and may offer to share half of that with several finders based on the amount the finders are able to raise for the fund. This is likely problematic, because it may create a "salesman's state" in the offering.

Exemple 1

Fund sponsor forms a special purpose vehicle ("SPV") that will invest in a startup company. Fund sponsor intends to receive a 20% carried interest in the SPV. Fund sponsor offers 50% of sponsor's carried interest to a partner who has assisted with forming the SPV (including raising capital) that is not contingent on being able to raise capital.

Outcome: Likely no brokers are involved.

Example 2

Fund sponsor forms a venture capital fund ("Fund") that will invest in multiple startup companies. Fund sponsor has a flexible general partner operating agreement that allows the sponsor to share carried interest on a deal-by-deal basis. As above, the general partner will receive a 20% carried interest in the Fund. Fund sponsor offers 50% of sponsor's carried interest to a partner who has assisted with forming the SPV (including raising capital) that is based on the amount of capital raised by the partner.

Outcome: Likely problematic. The partner may be an unregistered broker dealer. On the one hand, the partner has a salesman's stake in raising capital and on the other, the carried interest is structured in such a way that the partner will only receive valuable cash or property if the overall investment generates a profit for the investors in the Fund.

Alabama

Investment Advisers in Alabama are required to register with the state by filing Form ADV with the Financial Industry Regulatory Authority. Alabama does not have an exemption, so an adviser with either a place of business in Alabama or more than 5 clients who are residents of Alabama must file in the state.

Alaska

Alaska does not have any relevant exemptions for private fund advisers. Advisers must register with the state unless they have no place of business in the state and fewer than 6 clients in the state or the adviser is federally registered.

Arizona

Advisers are not required to be licensed or make notice filing if the adviser (1) advises private funds and (2) satisfies each of the following:The adviser and its affiliates are not subject to a disqualifying event that would disqualify an issuer under SEC rule 262 of Reg A;If the adviser advises funds other than venture capital funds, the adviser files truncated Form ADV and pays the relevant fees.

Arkansas

By Rule, Arkansas exempts certain private fund adviser and venture capital fund advisers. Advisers that qualify for these exemptions must file for truncated form ADV.

California

California private fund advisers may rely on a private fund exemption, which is a better exemption for advisers to “Venture Capital Funds.” California’s definition of venture capital fund is broader than the federal definition. Other private fund advisers are exempt from some of the provisions, but they have additional requirements they must follow.

Colorado

Colorado passed, by rule, an exemption for both private fund advisers and venture capital fund advisers. VC fund advisers must file truncated Form ADV. Other private fund advisers have additional requirements such as, if the fund is a 3(c)(1) fund, the investors in the fund are “qualified clients,” additional disclosure is made to the investors, and the adviser obtains audited financial statements annually.

Connecticut

Any adviser that meets the federal definition of a venture capital fund adviser is exempt under CT law if the adviser files truncated Form ADV.

Delaware

Delaware exempts investment advisers who provides advice solely to one or more qualifying private funds, other than a private fund that qualifies for the exclusion from the definition of “investment company” provided in section 3(c)(1) of the Investment Company Act of 1940, 15 U.S.C. §80a-3(c)(1). The adviser cannot be subject to disqualification and the adviser must file truncated Form ADV.

District of Columbia

The District of Columbia exempts venture capital fund advisers if they file truncated Form ADV. Otherwise, there is no exemption for private fund advisers.

Florida

Florida exempts from the definition of investment adviser any adviser who (1) doesn’t hold itself out as an investment adviser; and (2) has, in the past 12 months, fewer than 16 clients in the state of Florida. States can increase the “De Minimis Exemption,” but they cannot make the requirement more restrictive. Here, FL is more lenient than most states.

Georgia

Georgia exempts from the definition of investment adviser an adviser who, during the preceding 12 months, has had fewer than 6 clients in the state.

Hawaii

Hawaii does not have a private fund or venture capital fund exemption. Advisers that (1) are not federally covered, (2) have a place of business in Hawaii, or (3) have more than 5 clients in the state must register as an investment adviser in the state.

Idaho

Idaho does not have an exemption for private fund or venture capital fund advisers. Advisers that are not federally covered must file as investment advisers with the state.

Illinois

Illinois exempts from registration investment advisers who, during the preceding 12 months, have had five or fewer clients in the state. There is no specific exemption for private fund advisers or venture capital fund advisers. Typically, each fund is a client, not each investor, so many private fund advisers would qualify for the exemption in the state.

Indiana

Indiana’s Securities Commissioner will not institute enforcement action against a person for failing to register as an investment adviser if the person:maintains a place of business in Indiana; has had 5 or fewer clients in the preceding 12 months; does not hold itself out to the public as an investment adviser; and advises only private funds and is not subject to disqualification.If the private funds are not venture capital funds, the adviser must make additional disclosures to the investors and obtain audited financial statements for each 3(c)(1) fund, which must be provided to the investors annually.

Iowa

Iowa has a private fund exemption and a venture capital fund exemption. Each must file truncated Form ADV. Advisers of non-venture capital 3(c)(1) funds must only advise funds whose owners are “qualified clients,” must make additional disclosures to the investors, and must obtain annual audited financial statements for the funds.

Kansas

Kansas exempts investments advisers that:maintains its principal place of business in Kansas; provides investment advise to fewer than 15 clients; does not hold itself out as an investment adviser; and does not advise any registered investment company. Advisers must file truncated form ADV.

Kentucky

Kentucky does not have an exemption for private fund advisers or venture capital fund advisers. Advisers with a place of business in or that have more than 5 clients in Kentucky must register as an investment adviser if the adviser is not registered with the SEC.

Louisiana

Louisiana exempts an adviser who, during any twelve month period, has had fewer than 15 clients in the state and does not hold itself out to the public as an investment adviser.

Maine

Maine exempts from registration venture capital fund advisers and private fund adviser if the adviser has a place of business in the state and the adviser does not hold itself out to the public as an investment adviser. Advisers that adviser 3(c)(1) funds that are not venture capital funds must provide additional disclosure to the investors and obtain annual audited financial statements. These exempt advisers must file truncated Form ADV.

Maryland

Maryland exempts advisers if they are not disqualified and solely adviser private funds. If the private fund is a 3(c)(1) fund and not a venture capital fund, the adviser must make additional disclosures to the investors and provide audited financial statements. Exempt advisers must file truncated Form ADV.

Massachusetts

Massachusetts exempts private fund advisers and venture capital fund advisers. Advisers must file truncated Form ADV. Advisers of 3(c)(1) funds that are not venture capital funds must provide additional disclosure and audited annual financial statements to all investors.

Michigan

Michigan will have a private fund adviser exemption effective in January 2020.

Minnesota

Minnesota exempts private fund advisers that are not subject to disqualification. The adviser must file truncated Form ADV. Advisers that advise 3(c)(1) funds that are not venture capital funds have additional disclosure and audit requirements.

Mississippi

Mississippi does not have a private fund adviser exemption or a venture capital fund exemption. This means that an adviser with either a place of business in the state or more than 5 clients must register as an investment adviser.

Missouri

Missouri exempts investment advisers that advise private funds. Private fund advisers are exempt in Missouri if they are not subject to disqualification. The adviser must file truncated Form ADV. If the private fund adviser advises any 3(c)(1) funds that are not venture capital funds, the adviser must reasonably believe that all the beneficial owners are either (1) an “accredited investor” or (2) is a qualified client. Missouri, however, excludes an person from the definition of an “accredited investor” if the person would only be accredited based on his or her income (or joint income with a spouse).

Montana

Montana does not have an exemption for private fund advisers or venture capital fund advisers. This means that advisers that either (1) have a place of business in the state or (2) have more than 5 clients who are residents of the state must register in the state of Montana.

Nebraska

Nebraska exempts from registration private fund advisers that are not subject to disqualification and that file truncated Form ADV. Advisers to 3(c)(1) funds that are not venture capital funds have additional disclosure requirements and must obtain annual audited financial statements for each 3(c)(1) fund that is not a venture capital fund.

Nevada

Nevada exempts advisers if their only Nevada clients are “accredited investors” as defined in Rule 501, so most private fund and venture capital fund advisers are exempt from registration in Nevada.

New Hampshire

New Hampshire exempts any investment advisers who solely advises “venture capital funds.” The adviser must file truncated Form ADV.

New Jersey

New Jersey exempts advisers that have no more than 5 New Jersey clients, regardless of whether the adviser has a place of business in the state or not. Typically, each fund is a client, so advisers with 5 or fewer funds as clients will not be required to register.

New Mexico

New Mexico, by order, exempts advisers that are not disqualified by the SEC and that solely advise private funds. If the adviser advises 3(c)(1) funds that are not venture capital funds, the adviser must comply with additional disclosure requirements and the fund must obtain annual audited financial statements. Exempt advisers must file truncated Form ADV.

New York

New York exempts advisers that have sold, during the previous 12 months, advisory services to fewer than 6 persons residing in the state. Fund advisers with 5 or fewer funds as clients (that were signed within the preceding 12 months) are exempt from registration. No truncated form ADV is required.

North Carolina

North Carolina exempts investment advisers from the registration requirement if, during the preceding 12 months, the adviser has had fewer than 15 clients and the adviser does not hold itself out to the public as an investment adviser.

North Dakota

North Dakota does not exempt private fund or venture capital fund advisers. Advisers with either a place of business in North Dakota or more than five clients in the state must register as an investment adviser in the state.

Ohio

Ohio exempts advisers who, during the preceding 12 months: has had fewer than 15 clients; does not hold itself out to the public as an investment adviser; and only has “accredited investors” as clients, as defined in Rule 501 of Regulation D.

Oklahoma

Oklahoma exempts from the registration requirement advisers that solely advise private funds. This will include venture capital funds. Advisers of 3(c)(1) funds that are not venture capital funds have no additional requirements. Private fund advisers in Oklahoma must file truncated Form ADV and they cannot be disqualified.

Oregon

Oregon exempts advisers who conduct no public advertising or general solicitation in the state and who’s only clients are “accredited investors.”

Pennsylvania

Pennsylvania exempts from registration advisers that have a place of business in the state that have 5 or fewer total clients, either within or without the state.

Rhode Island

Rhode Island exempts from registration advisers that solely adviser private funds. Advisers that advise 3(c)(1) funds that are not venture capital funds have additional disclosure requirements to the investors and must provide investors of those funds annual audited financial statements.

South Carolina

South Carolina does not exempt private fund advisers. Private fund and venture capital fund adviser must register with and comply with the laws of South Carolina unless the adviser is federally covered.

South Dakota

South Dakota exempts from registration advisers that solely adviser private funds or venture capital funds as defined federally under Sections 203(l) or 203(m).

Tennessee

Tennessee exempts advisers who, during the preceding 12 months, has had fewer than 15 clients and who doesn’t hold itself out to the public as an investment adviser.

Texas

Texas exempts private fund advisers subject to the following: (i) The private fund adviser files truncated Form ADV; (ii) The adviser is not subject to disqualification; (iii) Advisers to 3(c)(1) funds that are not “private equity funds,” “real estate funds,” or “venture capital funds” must comply with additional disclosure and audit requirements.

Utah

Utah has not updated its exemption since prior to Dodd-Frank and, while its exemption is targeted at private fund organizers, it requires a significant level of control over portfolio companies.

While there is a no action letter out there providing relief under the Model Rules, relying on a no-action letter is not air tight.

Vermont

Vermont exempts private fund and venture capital fund advisers. Advisers that advise 3(c)(1) funds that are not venture capital funds must comply with additional disclosure requirements and the fund must provide audited financial statements to investors.

Virginia

Virginia exempts private fund and venture capital fund advisers. Advisers that advise 3(c)(1) funds that are not venture capital funds must comply with additional disclosure requirements and the fund must provide audited financial statements to investors.

Washington

Private Fund Exemption
Under Washington’s private fund exemption, Washington exempts advisers to 3(c)(7) funds, which includes funds that only sell interests to Qualified Purchasers. Private fund advisers must file truncated Form ADV.
Source


Venture Capital Fund Exemption
Advisers to venture capital funds are exempt under Washington law from registration as an investment adviser. Venture Capital Fund advisers must file truncated Form ADV.
Source

West Virginia

West Virginia does not have a private fund or venture capital fund adviser registration, which means any adviser that either has a place of business or more than 5 clients in West Virginia must register as an investment adviser unless the adviser is a federally covered adviser.

Wisconsin

Wisconsin exempts advisers that solely adviser private funds or venture capital funds. Advisers to 3(c)(1) funds that are not venture capital funds must provide additional disclosure to the investors in the funds and the funds must provide annual audited financial statements to the investors. Advisers must file truncated Form ADV.

Wyoming

Wyoming incorporates, by reference, NASAA’s registration exemption for Investment Advisers to Private Funds Model Rule, adopted December 16, 2011.

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