SEC Cracks Down on Unregistered Broker-Dealers in Private O erings

Transcription

1 SEC Cracks Down on Unregistered Broker-Dealers in Private O erings Steven R. Watts* The Securities and Exchange Commission (SEC) sta appears to be focusing on the broker-dealer registration issue in the context of private securities marketing activities. Recent SEC enforcement actions demonstrate there are serious consequences for acting as an unregistered broker, even where there are no allegations of fraud. This regulatory focus will likely continue, and could increase, with the use of general solicitation and general advertising in Rule 506 private o erings permitted by the Jumpstart Our Business Startups Act (JOBS Act). 1 Common Scenario with Risks The broker-dealer registration issue commonly arises when a company or private investment fund raises capital from investors in a private (unregistered) securities o ering using its own employees or third party nders to locate investors. When these individuals solicit investors on a regular basis or are speci cally compensated for their e orts, they may be required to register as a broker or to be associated with a registered broker-dealer rm. A company or individual acting as an unregistered broker-dealer is in violation of applicable registration requirements under federal and state law 2 and faces possible government enforcement action, 3 monetary penalties 4 and investor lawsuits seeking rescission of the investment and recovery of the purchase price paid. 5 Registering as a broker-dealer is a signi cant undertaking and will subject the rm to extensive regulation by the SEC, Financial Industry Regulatory Authority (FINRA) and/or state securities regulators. It is normally not a practical alternative for companies engaged in limited or infrequent capital raising activities. * Steven R. Watts is a Partner in the Corporate Department of Dinsmore & shohl LLP. Steve concentrates his practice in the areas of corporate and securities law, representing both public and private companies. His experience includes public and private o erings of equity and debt securities, periodic reporting, securities law compliance, acquisition and divestiture transactions, corporate governance, real estate syndications, private equity investments, hedge funds, investment adviser regulation and compliance, franchising, and general corporate and business matters. He earned his J.D. from the University of Dayton School of Law. 69

2 Who is a Broker-Dealer? The Exchange Act de nes a broker as any person engaged in the business of e ecting transactions in securities for the account of others. 6 A dealer is de ned as any person engaged in the business of buying and selling securities for its own account, unless not part of a regular business. 7 The test for broker registration is broad and depends on the particular facts and circumstances. The principal factors the SEC considers include whether the person (1) actively solicited investors, (2) advised investors as to the merits of an investment, (3) regularly participated in securities transactions and (4) received commissions or transactionbased remuneration. 8 Issuer Exemption. Entities issuing securities (issuers) generally are not brokers because they sell securities for their own account and not for the account of others. Issuers are also normally not dealers because they do not sell securities for their own account as a part of a regular business. According to the SEC, this so-called issuer s exemption does not apply to the personnel of a company who routinely engage in the business of e ecting securities transactions for the company, such as general partners, employees and other related persons seeking investors in the company. 9 The SEC has adopted Exchange Act Rule 3a4-1, a safe harbor rule, to provide a broker registration exemption for people associated with an issuer who participate in the sale of the issuer s securities, including o cers and employees of the issuer, a corporate general partner of a limited partnership issuer, or a company a liated with the issuer. Under the safe harbor, an associated person will not be deemed a broker if, among other things, the person: E Is not compensated by payment of commissions or other remuneration based on securities transactions; E E Securities Regulation Law Journal Is not associated with a broker-dealer; and Limits sales activities either (1) to one o ering per 12 month period and performs other substantial duties, (2) to soliciting only certain nancial institutions or (3) to passive or clerical duties not involving solicitation of investors. Finders Exemption. It is generally thought that persons who do nothing more than introduce prospective investors to the issuer, do not participate in negotiating the transaction, and who receive compensation not dependent on or related to the purchase of a security are nders, not brokers, and are not required to be registered. While a few no-action letters support this position, 10 the SEC has been reluctant to create a nder's exemption. The SEC has cautioned that persons who nd investors for issuers, 70

3 [Vol. 42:1 2014] SEC Cracks Down on Unregistered Broker-Dealers even in a consultant capacity, may need to register as a broker depending on a number of factors, including whether (1) the nder participates in the solicitation, negotiation or execution of the transaction, (2) compensation is related to the outcome or size of the transaction, (3) the nder is otherwise engaged in the business of e ecting securities transactions and (4) the nder handles securities or funds of others. A yes answer to any of these factors indicates that registration may be required. 11 State Exemptions. Each state has laws de ning broker-dealer, agent and related registration requirements. Under the Uniform Securities Act, adopted in large measure by many states, an issuer selling its own securities is exempt from broker-dealer registration. 12 An employee or other individual who represents an issuer is exempt if no commission or other remuneration is paid for soliciting investors. 13 Ohio speci cally exempts a nder if his or her compensation is not based on the sale of securities by the issuer to the investor. 14 Recent SEC Activity Enforcement Actions. SEC enforcement actions alleging violations of the broker-dealer registration provisions of the Exchange Act overwhelmingly involve fraudulent, deceptive or illegal conduct in addition to the failure to register as a broker-dealer. However, two recent enforcement actions show that the SEC is pursuing unregistered broker-dealer claims in situations that do not involve allegations of fraud. In March 2013, the Commission found that Ranieri Partners LLC, a private equity rm, violated the broker-dealer registration requirements by paying transaction-based compensation to a consultant (1% of capital commitments obtained), who was not registered as a broker or associated with a registered broker-dealer, for soliciting potential investors in mortgage opportunity funds sponsored by the rm. 15 The consultant s activities went beyond accepted practices for nders and included sending o ering documents to prospective investors, urging an investor to adjust its portfolio allocations to accommodate an investment in the funds, and providing prospective investors with an analysis of the funds strategies and performance. There were no allegations or ndings of fraud, deception or other illegal conduct by the rm. Likewise, on June 5, 2013, the SEC led a civil injunctive action, and later obtained a preliminary injunction, charging Banc de Binary Ltd., a Cyprus-based company, with illegally selling binary option contracts to U.S. investors. 16 The SEC alleged the binary options were sold in violation of securities registration requirements and that, through its online trading platform, Banc de Binary was e ecting se- 71

4 Securities Regulation Law Journal curities transactions for its customers accounts without being registered as a broker-dealer. The company solicited customers in the U.S. via s, its website, telephone calls and other internet-based general advertising without attempting to ascertain whether they were accredited investors. Again, there were no allegations of fraud, deception or other illegal conduct by the rm. Speech. On April 5, 2013, David W. Blass, Chief Counsel of the SEC s Division of Trading and Markets, in a speech to an American Bar Association subcommittee, discussed the broker-dealer registration issue in the context of sales activities by private fund managers and sponsors. 17 His remarks followed SEC sta observations in connection with newly registered private fund advisers under the Dodd- Frank Wall Street Reform and Consumer Protection Act. 18 Blass stated that private fund advisers might want to ask themselves the following questions to help determine whether their capital raising activities require broker-dealer registration: E How does the adviser solicit and retain investors? A dedicated sales force of employees working within a marketing department (i.e., a department dedicated to selling interests in private funds rather than one that informs clients about investment advisory services) may strongly indicate the adviser is in the business of e ecting transactions in the private fund regardless of how the personnel are compensated. E Do employees who solicit investors have other responsibilities? If their primary function is soliciting investors for the private funds, the employees may be acting as brokers. E How are personnel who solicit investors for a private fund compensated? Individuals who receive bonuses or other types of compensation linked to successful investments risk being viewed as brokers. Receipt of transaction-based compensation is a hallmark of being a broker. E Does the private fund or the adviser charge a transaction fee linked to investment in the fund? If so, the adviser may be viewed as acting as a broker in connection with sales to fund investors. Blass noted that the Rule 3a4-1 safe harbor is generally not used by private fund advisers because it is di cult for them to meet one of the three conditions of the rule limiting employee solicitation activities. Blass oated the idea of an exemption written speci cally for private fund advisers to accommodate their business practices, except for payment of transaction-based compensation. Blass also addressed the broker-dealer registration issue arising when a private fund manager, its personnel or a liates receive fees for purported investment banking or other activities relating to the fund s portfolio companies. These fees are common with private equity 72

5 [Vol. 42:1 2014] SEC Cracks Down on Unregistered Broker-Dealers funds that execute a leveraged buyout strategy. Examples include fees paid to the fund adviser in connection with the acquisition, disposition, initial public o ering or recapitalization of a portfolio company. Such fees appear, to the SEC sta, to involve transaction-based compensation linked to a securities transaction and make the adviser a broker. Other Remarks and Initiatives. On August 10, 2013, John Ramsay, Acting Director of the SEC s Division of Trading and Markets, told an ABA committee that the Division continues to focus on broker-dealer registration issues in the private fund area, including whether additional guidance is needed. On January 9, 2014, the SEC O ce of Compliance Inspections and Examinations National Exam Program (NEP) published its examination priorities for The NEP s Investment Adviser/Investment Company Program will continue the 2012 initiative to examine investment advisers registered since the e ective date of the Dodd-Frank Act and to prioritize examinations of private fund advisers where there are indicia of broker-dealer status concerns. JOBS Act The JOBS Act, among other things, directed the SEC to revise its rules to permit general solicitation and general advertising in o erings under Rule 506 of Regulation D under the Securities Act, provided all purchasers in the o ering are accredited investors. 19 The JOBS Act also added a new exemption from broker-dealer registration for online platforms that are used to market securities in Rule 506 offerings (so-called Regulation D portals ). 20 These changes can be expected to impact the broker-dealer registration issue in private o erings. General Solicitation in Rule 506 O erings. Issuers can now offer and sell securities under Rule 506(c) of Regulation D using general solicitation and general advertising 21 such as advertisements in newspapers and magazines, unrestricted websites, widely disseminated solicitation and mass mailings provided that: E E All purchasers are accredited investors; and The issuer takes reasonable steps to verify that the purchasers are accredited investors. Accredited investors are (i) natural persons with a net worth in excess of $1 million (excluding primary residence) or income in excess of $200,000, or joint income with spouse in excess of $300,000, in each of the last two years and expect to reach the same income level in the current year and (ii) entities such as banks, insurance companies, registered investment companies, employee bene t plans with total assets in excess of $5 million, corporations and other business entities or trusts with total assets in excess of $5 million, and entities owned 73

6 Securities Regulation Law Journal exclusively by accredited investors. 22 The SEC allows issuers to satisfy the reasonable veri cation requirement by relying either on a principles-based method or on one of four non-exclusive veri cation methods. Under the principles-based method of veri cation, whether steps are reasonable is an objective determination by the issuer in the context of the particular facts and circumstances of each purchaser and transaction. Factors that issuers should consider include the nature and type of accredited investor the purchaser claims to be, the amount and type of information the issuer has about an investor, how the investor was solicited, and the terms of the o ering, such as a high minimum investment. 23 The four non-exclusive methods for verifying accredited status of natural persons are (1) income veri cation by an IRS form such as Form W-2, Form 1099, Schedule K-1 or Form 1040, (2) net worth veri cation by brokerage or bank statements or independent appraisal for assets and consumer credit report for liabilities, (3) written con rmation from a broker, investment adviser, attorney or certi ed public accountant and (4) self-certi cation by people who were accredited investors in prior Rule 506 o erings by the issuer. 24 Lifting the general solicitation ban in accredited-only private placements will make these o erings more visible to securities regulators and likely increase scrutiny on broker-dealer registration and other compliance issues. Previously, public notice of these o erings was limited to Form D led with the SEC and states in which sales were made that require disclosure of any sales commissions or nder s fees paid and any broker or dealer involved. 25 Regulators will now be able to review advertising, websites and other widely disseminated sales material and focus on o erings that raise suspicions or concerns about fraud, broker-dealer registration, or non-compliance with other legal requirements. Exemption for Regulation D Portals. The new JOBS Act exemption from broker-dealer registration for online platforms in Section 4(b)(1) of the Securities Act permits a person, in a Rule 506 o ering, to do the following without registration: (1) maintain a platform or mechanism that permits the o er, sale, purchase, negotiation, general solicitations, general advertisements, or similar activities by issuers, whether online, in person, or through other means, (2) co-invest in the o ering, and (3) provide ancillary services (due diligence services or standardized documents), if certain condition are met. Online platforms relying on the exemption (1) may not receive transaction-based compensation (but may charge other types of fees), (2) may not have possession of customer funds or securities, and (3) may not receive separate compensation for investment advice to issuers or investors. 74

7 [Vol. 42:1 2014] SEC Cracks Down on Unregistered Broker-Dealers The exemption is a narrow one intended to assist sophisticated angel investors to connect with startup companies by removing the uncertainty of broker-dealer registration faced by online services that match buyers and sellers in private placements. The exemption incorporates several of the requirements in prior SEC no-action letters in the online matching services area. 26 The SEC sta has stated that persons associated with an issuer in a Rule 506 o ering may rely on the exemption to maintain an online platform, but that employees or other persons who receive a salary or other compensation to promote and sell the issuer s securities cannot. 27 While the exemption provides a safe harbor from broker registration for the speci c activities described, other activities in connection with the o er and sale of securities in a Rule 506 o ering may still require broker registration as discussed above. Crowdfunding Through Registered Intermediaries. The JOBS Act created a new securities registration exemption, Section 4(a)(6) of the Securities Act, for crowdfunding o erings using the Internet, 28 subject to certain conditions, including: E Aggregate o ering amount cannot exceed $1 million in any 12 month period; E Amount sold to any single investor cannot exceed (i) the greater of $2,000 or 5% of annual income or net worth if annual income or net worth of the investor is less than $100,000 or (ii) 10% of annual income or net worth to a maximum of $100,000 investment if annual income or net worth of the investor is $100,000 or more; E The o ering is conducted through a broker or funding portal (intermediary) registered with the SEC and FINRA; E The issuer les with the SEC and provides investors and the intermediary with speci ed information about the issuer, the offering, the securities, risks and other information speci ed in the statute or as the SEC may prescribe by rule, including income tax returns and certi ed nancial statements, or reviewed or audited nancial statements, depending on the target o ering amount, as well as reports of operating results and nancial statements on an on-going annual basis; E The intermediary provides investors with disclosures related to risks and other investor education materials as the SEC may determine by rule, takes measures to ensure investor understanding of risks and other matters determined by SEC rule, and complies with other investor-protection requirements; and E Issuers cannot advertise the o ering except for notices which direct investors to the intermediary. The crowdfunding o ering exemption is separate from permitting 75

8 Securities Regulation Law Journal general solicitation in Rule 506 o erings. 29 The crowdfunding exemption also provides a limited exemption for funding portals from full broker-dealer registration which is separate from the broker-dealer exemption for Regulation D portals in Rule 506 o erings. 30 Section 4(a)(6) crowdfunding o erings, because they must be conducted through an intermediary registered with the SEC and FINRA, should not raise the same registration issues as using employees and unregistered third parties in selling Rule 506 o erings. The SEC has proposed new Regulation Crowdfunding to implement the requirements of Title III of the JOBS Act, including a framework for regulation of funding portals and brokers that issuers must use as intermediaries in Section 4(a)(6) crowdfunding o erings. 31 The proposed template for funding portal regulation is less rigorous than registration for rms conducting a general securities business and tailored to the speci c activities of these portals. One SEC o cial has suggested that the crowdfunding portal rules may o er insight into possibly looking at other types of broker-dealer registration regimes and potential relief for nders or others acting in a limited brokerdealer capacity. 32 A crowdfunding intermediary must be registered with the SEC either as a broker or as a funding portal, and become a member of FINRA. 33 A registered funding portal will be exempt from the brokerdealer registration requirements of Section 15(a) of the Exchange Act. A funding portal may not (1) o er investment advice or recommendations, (2) solicit purchases or sales of securities o ered on its online platform, (3) compensate employees, agents or other persons for such solicitation or based on the sale of securities displayed on its platform or (4) hold or handle investor funds or securities, which must be handled by a third party bank. 34 A funding portal, and its directors, o cers or partners, may not have a nancial interest in an issuer offering securities through the portal s platform, or receive a nancial interest in an issuer as compensation for services provided to the issuer in connection with the o er or sale of such securities. 35 Funding portals would be required to perform investor protection and o ering related functions, including (1) taking measures to reduce risk of fraud, (2) providing educational materials to investors, (3) making available to investors information about the issuer and the offering, (4) providing communication channels to permit discussions about o erings on the platform and (5) giving noti cations and directions to facilitate the o er and sale of crowdfunded securities. 36 Funding portals would be permitted to engage in certain limited activities under a non-exclusive safe harbor, 37 including: E Limiting securities o ered through, or highlighting o erings on, its platform using objective criteria; 76

9 [Vol. 42:1 2014] SEC Cracks Down on Unregistered Broker-Dealers E Providing search functions and communication channels for investors; E Advising an issuer about the structure of an o ering, including assisting in preparing o ering documentation; E Compensating third parties for referring persons to the funding portal, so long as the third party does not provide personally identi able information of a potential investor, and the compensation is not based on the purchase or sale of a security o ered on the platform unless paid to a registered broker or dealer; 38 E Advertising the existence of the funding portal and identifying issuers and o erings available; and E Accepting investment commitments and directing transmission of investor funds. Funding portals would be required to (1) implement written policies and procedures to achieve compliance with securities laws, rules and regulations, (2) comply with anti-money laundering and privacy requirements applicable to brokers, (3) permit examination by SEC and FINRA representatives and (4) maintain speci ed books and records. 39 Conclusion With the focus on the broker-dealer registration issue in relation to private securities marketing activities, companies and private funds using employees or other unregistered persons to solicit investor capital must be cautious in monitoring their activities for compliance with legal standards or face signi cant legal risk. This risk pro le can be expected to increase as issuers securities marketing activities become more visible with the use of general solicitation and general advertising in Rule 506 o erings as well as other initiatives under the JOBS Act. The regulatory framework for crowdfunding intermediaries under the JOBS Act might also provide insight to regulators to explore a basic regulatory structure, exemptive relief or other guidance for nders and limited activity solicitors in private o erings. NOTES: 1 Pub. L. No , 126 Stat. 306, signed by President Obama on April 5, Section 15(a)(1) of the Securities Exchange Act of 1934 (Exchange Act) makes it unlawful for any broker or dealer to use the mails, or any means of interstate commerce, to e ect any transactions in any security unless registered with the SEC in accordance with Section 15(b) of the Exchange Act, subject to exceptions for intrastate broker-dealers and broker-dealers that limit their business to exempted or excluded securities. Broker-dealers must also register in states in which they transact business. 3 Sections 21 and 21C of the Exchange Act. 77

10 Securities Regulation Law Journal 4 Section 21(d) of the Exchange Act. 5 Section 29 of the Exchange Act. 6 Section 3(a)(4)(A) of the Exchange Act. 7 Section 3(a)(5)(A) and (B) of the Exchange Act. 8 See e.g. Securities and Exchange Commission v. National Executive Planners, Ltd., 503 F. Supp. 1066, Fed. Sec. L. Rep. (CCH) (M.D. N.C. 1980). 9 See Guide to Broker-Dealer Registration, SEC Division of Trading and Markets, Section II.D.5 (April 2008) (B-D Registration Guide). 10 See e.g. Paul Anka, SEC No-Action Letter (July 24, 1991) (activities limited to furnishing names and telephone numbers of prospective accredited investors to the issuer for a nder's fee based on a percentage of securities sold did not require registering as a broker-dealer); International Business Exchange Corporation, SEC No-Action Letter (Dec. 12, 1986) (stating the SEC has traditionally indicated that individuals who do nothing more than bring merger and acquisition-minded persons or entities together and do not participate in negotiating the sale of securities, nor share in any pro ts realized, are probably not brokers and would not be required to register as such). 11 B-D Registration Guide, Section II.A. 12 Section 401(c)(2) of the Uniform Securities Act of 1956 (Uniform Securities Act). The Uniform Securities Act has been adopted in whole or part in 37 jurisdictions, including Guam and Puerto Rico. Rapp, Blue Sky Regulation, Ch.1, 1.03 (Matthew Bender). 13 Section 401(b) of the Uniform Securities Act. 14 Ohio Rev. Code Ann (E)(1)(d). 15 In the Matter of Ranieri Partners LLC and Donald W. Phillips, Exchange Act Release No (March 8, 2013). 16 Securities and Exchange Commission v. Banc de Binary Ltd., Civil Action No. 2:13-CV (D. Nev., led June 5, 2013), Litigation Release No (June 7, 2013) and Litigation Release No (August 1, 2013). 17 SEC Speech: A Few Observations in the Private Fund Space, by David W. Blass, on April 5, Pub. L. No , 124 Stat. 1376, signed by President Obama on July 21, JOBS Act, Title II, Sec. 201(a). 20 JOBS Act, Title II, Sec. 201(c). 21 The SEC adopted amendments to Rule 506 of Regulation D under the Securities Act of 1933 (Securities Act) to implement Section 201(a) of the JOBS Act to permit general solicitation and general advertising in o ering and selling securities pursuant to Rule 506, which became e ective September 23, Release No (July 10, 2013). Regulation D is codi ed at 17 C.F.R et seq. 22 Rule 501(a) of Regulation D. Section 413(b) of the Dodd-Frank Act requires the SEC to undertake a review of the de nition of accredited investor in its entirety in 2014 and once every four years thereafter. 23 Release No , II.B.3.a. 24 Rule 503(c)(2)(ii)(A)-(D) of Regulation D. 78

11 [Vol. 42:1 2014] SEC Cracks Down on Unregistered Broker-Dealers 25 Form D Notice of Exempt O ering of Securities, Items 12 and See IPONET, SEC No-Action Letter (July 26, 1996); Angel Capital Electronic Network, SEC No-Action Letter (October 25, 1996). 27 Jumpstart Our Business Startups Act: Frequently Asked Questions About the Exemption from Broker-Dealer Registration in Title II of the JOBS Act, SEC Division of Trading and Markets, Questions 7 and 8 (February 5, 2013). 28 JOBS Act, Title III, Sec Crowdfunding involves raising capital by soliciting small amounts of money from a large number of individual investors. 29 Securities issued in crowdfunding transactions exempt from registration under Section 4(a)(6) are covered securities under Section 18(b)(4) of the Securities Act and, like securities issued in Rule 506 o erings, are not subject to state registration requirements. JOBS Act, Title III, Sec. 305(a). 30 State broker-dealer laws are pre-empted with respect to the business of crowdfunding portals registered with the SEC and FINRA, other than the state in which the registered funding portal's principal place of business is located. JOBS Act, Title III, Sec. 305(d). Regulation D portals are subject to state broker-dealer registration laws. 31 Release Nos ; (October 23, 2013). 32 Haimera Workie, Deputy Associate Director, SEC Division of Trading and Markets (ALI-CLE webcast August 15, 2013). 33 Proposed 17 C.F.R (a) and (a). A funding portal would register by ling Form Funding Portal, a scaled-down version of Form BD used to register as a broker with the SEC. 34 Section 3(a)(80) of the Exchange Act. 35 Proposed 17 C.F.R (b). 36 Proposed 17 C.F.R Proposed 17 C.F.R (b). 38 Under the proposed rules, an intermediary could pay a person a at xed fee to direct other persons to the intermediary s platform. A at xed fee is one that is not based on the success of an o ering, and so would not be transaction-based compensation. As noted above, receipt of transaction-based compensation would strongly indicate that the recipient is acting as a broker. Release Nos ; , II.C.7 n Proposed 17 C.F.R and