Are Intermediaries and Finders Required to Register as Broker-Dealers?
By Jason D. Gabbard
The Forefront Law Group
Today, many financial services businesses are seeking to expand into new areas and to provide additional services to their customers. These businesses need to be aware that many activities, however innocuous they may appear, may have serious regulatory implications, just one of which may be the need to register with the Securities Exchange Commission (“SEC”) as a broker-dealer. This article will discuss the actions undertaken by a business that may require registration with the SEC, and specifically whether certain activities undertaken by “finders” require registration. It should be noted at that outset that this determination is a very fact-specific analysis that may require consultation with the SEC, and any business that engages in activities similar to those discussed here should consult an attorney.
Section 15(b)(1) of the Securities Exchange Act of 1934 (“Exchange Act”) requires broker-dealers to register with the SEC, and Section 15(b)(8) of the Exchange Act requires broker-dealers to be members of a qualifying self-regulatory organization. Section 3(a)(4)(A) of the Exchange Act defines a “broker” generally as, “any person engaged in the business of effecting transactions in securities for the account of others,” and Section 3(a)(5)(A) of the Exchange Act generally defines a “dealer” as, “any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise.” These definitions are not self explanatory, yet their interpretation and application in individual cases can have an enormous impact on the operation of a business. Registration as a broker-dealer can be an onerous, expensive and time-consuming process that subjects the business to a complicated regime of rules and regulations as well as ongoing compliance requirements. However, conducting activities that require registration with the SEC when not registered may subject the business to regulatory actions and fines, and can also result the rescission of bilateral contracts with third parties. Thus, it is extremely important to analyze these definitions thoroughly in relation to the activities of a particular business.
The SEC has not published a list of all of the business types and models that may require registration with the SEC as a broker-dealer, but the following are just a few of the businesses that may be deemed a broker-dealer, depending on a number of factors: “Finders,” “business brokers,” “placement agents,” investment advisors, financial consultants, businesses that operate electronic trading platforms, businesses that market real estate investment interests that are securities and businesses that effect securities transactions for the account of others for a fee.
As previously noted, my focus here is solely on the activities of “finders.” This term is not defined in the Exchange Act, but is understood to describe a business that engages in one or more of the following activities: finding investors or customers for, or making referrals to, broker-dealers, investment companies, mutual funds, hedge funds or other securities intermediaries; finding investors for issuers of securities, even in a “consultant” capacity; engaging in, or finding investors for, private equity of venture capital financings, including private placements; and introducing buyers and sellers of businesses.
The SEC’s determination as to whether a particular business should be treated as a finder as opposed to a broker-dealer requiring registration depends on a number of factors, including whether the business: receives transaction-based compensation as opposed to a flat fee for its services; renders advice about the structure, price or desirability of a securities transaction; seeks investors actively rather than passively; advertises or solicits on behalf of an issuer of securities; is actively involved in negotiations between an issuer and investors; and possesses client funds and securities. See Torsiello Capital Partners, LLC v. Sunshine State Holding Corp., 2008 NY Slip Op. 30979, April 7, 2008. While all of these factors are relevant to the determination, the SEC will likely focus on two primary elements: the type of fee charged by the business for its services and the specific services provided by the business to its customers.
Regarding the type of fee charged, a business that charges a flat or hourly fee for its services, as opposed to a commission type fee that varies with the size or success of a transaction, is more likely to be deemed by the SEC to be a finder not requiring registration (the SEC has noted that “transaction-based compensation [is] one of the hallmarks of being a broker-dealer.” John R. Wirthlin, SEC No-Action Letter (January 19, 1999)). For example, in Hallmark Capital Corporation, SEC No-Action Letter (February 26, 2007), the SEC noted that Hallmark Capital (“HallCap”), a self-described “financial consultant and finder for small businesses” that assists owners of small businesses in raising capital and facilitating mergers and acquisitions, that was “compensated with a modest upfront retainer and a fee based on the outcome of the transaction,” would likely be required to register with the SEC as a broker-dealer. This was true even though HallCap always informed clients that it was not a broker-dealer, did not act as an agent for its clients and it did not effectuate transactions for the account of others. In addition, in Brumberg, Mackey & Wall PLC, SEC No-Action Letter (May 17, 2010, the SEC stated, “Any person receiving transaction-based compensation in connection with another person’s purchase or sale typically must register as a broker-dealer.”)
Regarding the services provided by the business, in general, the more actively involved the business is in the negotiation of a particular transaction, the more likely the SEC is to find that the business must be registered as a broker-dealer. Some factors to consider in making this determination are whether the business: provides valuations; negotiates or advises as to the structure or terms of the transaction; participates substantively in negotiations; performs due diligence; and/or helps to prepare the transaction documents. No single factor is dispositive. Rather the activities of a business need to be analyzed as a whole. The SEC summarized this position in IMF Corp., SEC No-Action Letter (May 15, 1978) where it stated: “Individuals who do nothing more than act as finders by bringing together merger or acquisition-minded persons or entities and who do not participate in subsequent negotiations probably are not brokers or dealers in securities and would not be required to register with the SEC. On the other hand, persons who play an integral role in negotiating and effecting mergers or acquisitions that involve transactions in securities generally are deemed either a broker or a dealer depending upon their particular activities, and are required to register with the SEC pursuant to Section 15(a).”
Section 15(a)(1) of the Exchange Act generally prohibits any unregistered broker or dealer to use any means of interstate commerce (the mails, the internet, the telephone, etc.) to “effect any transaction in, or induce or attempt to induce, the purchase or sale of any security,” and Section 29(b) of the Exchange Act provides that “[e]very contract” made in violation of the Exchange Act or the performance of which involves such violation “shall be void.” Thus, a business must know whether the activities in which it engages require registration with the SEC as a broker-dealer, or run the risk of violating the securities laws and being the subject of private litigation. If found to be in violation of the securities laws, a business can be subject to the issuance of cease and desist orders, the levying of monetary penalties and the denial of future registration.
Finally, though it is beyond the scope of this article, it is also important to note that each state has its own registration requirements that may be applicable to broker-dealers having a presence in that state. Even if a broker-dealer has fully complied with the federal registration requirements, failure to properly register in each in state in which registration is required can result in fines, denial of the right to continue to do business in the state and even rescission of transactions with residents of that state.
The bottom line is that, to avoid running afoul of the SEC, businesses and their counsel must at the very least ask themselves the following questions (and this list is not exhaustive):
- Does the business participate in important parts of securities transactions, including solicitation, negotiation, or execution of transactions?
- Does the business’ compensation for participation in a transaction depend upon, or is it related to, the outcome or size of the transaction?
- Does the business receive trailing commissions?
- Does the business receive any other transaction-related compensation?
- Is the business otherwise engaged in the business of effecting or facilitating securities transactions?
- Does the business handle the securities or funds of others in connection with securities transactions?
A “yes” answer to any of these questions indicates that the business may need to register with the SEC as a broker-dealer. As this article has hopefully highlighted, this analysis is very fact intensive and may require consultation with the SEC. If you are currently engaging in any finder-type activities, you may want to consult a qualified attorney.
Jason Gabbard is a Founding Partner at The Forefront Law Group. Jason has a diverse set of legal skills, including significant exposure to broker-dealer and other regulatory matters, and has represented a variety of companies and financial institutions.
The contents of this article are for informational purposes only. Neither this article nor the lawyers who authored it are rendering legal or other professional advice or opinions on specific facts or matters, nor does the distribution of this article to any person constitute the establishment of an attorney-client relationship. The Forefront Law Group assumes no liability in connection with the use of this publication.