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.
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.
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.