Fund sponsors often engage investment banking or placement firms to help raise capital or generate deal flow for their funds. In exchange, the sponsor may offer a cash fee, a piece of the sponsor’s carried interest, equity in the applicable portfolio company, or some other form of compensation. Many sponsors and advisors are unaware that these activities can trigger broker-dealer registration requirements under federal and state law. The registration process is cumbersome and expensive, but the unregistered status of a firm that engages in such activities can create serious consequences for the firm, the sponsor, and the sponsor’s fund.
Under the Securities and Exchange Act of 1934, persons acting as brokers or dealers must register with the SEC. A broker is “any person engaged in the business of effecting transactions in securities for the account of others.” For purposes of the Exchange Act, persons are “engaged in the business” of buying and selling securities if they show a “regularity of participation” in such transactions. A person’s participation in a single, isolated transaction is probably insufficient to require registration. Still, the SEC and the courts interpret the phrase “engaged in the business” broadly, and generally, engagement by a person in more than one broker-dealer transaction is sufficient to satisfy this prong of the definition.
The courts and the SEC have identified several business practices that constitute broker-dealer activity. These so-called “badges” of broker-dealer activity include, but are not limited to, (1) actively soliciting investors for a securities transaction, (2) advising investors as to the merits of a securities transaction, and (3) actively participating in the negotiation or execution of a securities transaction. If a person engages in any of these activities and receives compensation, the person likely must register with the SEC as a broker-dealer.
There is no express “finder” exception from the broker-dealer registration requirements. Rather, finder status is a matter of regulatory interpretation and the product of various SEC no-action letters. Essentially, a finder is another name for someone who doesn’t have sufficient “badges” of broker-dealer activities to require registration. Still, SEC guidance suggests certain types of “finding” activities may require broker-dealer registration, such as finding investors for funds or target companies, even if only in a “consultant,” “venture partner,” or other similar capacity. The SEC requires a low threshold of involvement to transform a finder into a broker-dealer. The SEC has indicated, almost uniformly, that finders with a history of involvement in securities transactions must register as broker-dealers before participating in another transaction.
Some people falsely believe that if the advisor does not receive “transaction-related” compensation tied to the outcome or size of the transaction (e.g., a referral fee or commission), then the advisor is not providing broker-dealer services. Although transaction-related compensation significantly increases the likelihood that broker-dealer activity exists, it is not a requirement. A person may still be “engaged in the business” of effecting securities transactions when they receive other forms of compensation, including a fixed fee that does not depend on a closing.
There are some limited exceptions to the broker-dealer registration requirements for firms that provide platforms for securities offerings or services ancillary to the primary offering, and crowdfunding intermediaries, but these exceptions generally are not applicable to a traditional fund capital raise. There is also a simpler broker-dealer registration process with FINRA for firms that will act solely as “capital acquisition brokers,” but this process does not preclude the need for registration altogether.
Contracts entered into with an unregistered broker-dealer are generally voidable, meaning an unregistered person cannot enforce their fee arrangements. Moreover, the failure to comply with broker-dealer registration requirements may result in various penalties for the unregistered person. First, the SEC may take injunctive or disciplinary action against an unregistered person. Second, the SEC may deny future broker-dealer registration to an offending party. Third, a willful violation of the Exchange Act can lead to criminal prosecution and sanctions. Fourth, unlawful non-registration may give rise to private litigation. Finally, an unregistered broker-dealer may be subject to penalties under state securities laws.
Hiring an unregistered broker-dealer violates federal and many state laws and may subject the issuer to potential civil and criminal penalties as well. Notably, using an unregistered broker-dealer may give investors a right of rescission with respect to their securities investments.
In the past, unregistered broker-dealers were rarely pursued by the SEC absent a complaint, and unregistered broker-dealers were sanctioned only in connection with a bad act, such as fraud or misrepresentation. However, the SEC now follows a more aggressive enforcement policy against unregistered broker-dealers, and it will impose liability in connection with a person’s non-registered status even if there are no bad acts.
A Form D, which is commonly filed in connection with private investments in funds and portfolio companies (and is a public record), requires the issuer to identify any person who received compensation in connection with the transaction. The issuer must list the person’s broker-dealer registration number on the Form. This highlights, in a public way, any use of an unregistered broker-dealer.
Sponsors should ensure their placement agents are registered broker-dealers and then enter into a customary engagement letter to evidence the terms of the engagement. In addition to addressing the commercial points of the arrangement, such a letter should include representations and warranties about the firm’s broker-dealer status, covenants regarding its compliance with securities laws, and indemnification protection for breaches of such laws.
