One of the hallmarks of the modern American entrepreneurial economy is the relative ease with which new businesses can be formed and raise capital. More than a decade ago, a study by a task force empaneled by the American Bar Association’s Business Law Section reported that there was an informal and unstructured confluence of practices that put investors together with companies in need of capital, which it characterized as the “vast grey market of securities brokerage.”[1] While the statutory requirement for registration as a broker-dealer was well-known — Section 15(a)(1) of the Securities Exchange Act of 1934[2] — there had been less than vigorous enforcement of what was seen by some as a mere technical provision. And understandably so; the U.S. Securities and Exchange Commission was seen as lacking the bandwidth and resources to surveil for compliance among the thousands of private securities offerings each year. Typically, the fact that a finder or other solicitor of investors was unregistered would be discovered as part of the investigation of the transaction for some other reason, perhaps due to a complaint by the investor for fraud or unsuitability. Often the securities themselves were unregistered and not exempt from registration, leading to a violation of Section 5(a) and (c) of the Securities Act of 1933,[3] further compounding the problem. Indeed, if the securities are unregistered, it may be because someone failed to recognize that the instruments meet the definition of a security, and as such, a salesperson may not appreciate the need to comply with Section 15(a)(1). The two go hand in hand.
Thus, lawyers who advised issuers that they should not pay commissions to unregistered “finders” were sometimes met with the refrain, “Everyone is doing it, why not me?” To be sure, even today the SEC still cannot be everywhere and see everything. Moreover, the SEC’s formidable examination and market surveillance programs are focused on regulated (i.e., registered) entities and publicly traded securities, respectively. Though there is some regulatory reporting associated with private securities transactions,[4] for the most part no regulator is systematically policing sales activities on a stand-alone basis, without being prompted by some other serious violation that draws scrutiny to the transaction. State securities regulators do fill this gap to an extent through vigorous enforcement of their own broker licensing requirements, though this article does not discuss those efforts.
In recent years, there has been at least an anecdotally perceivable increase in interest from the SEC’s Division of Enforcement in enforcing Section 15(a)(1) by way of cases that do not involve allegations of fraud or significant investor harm, though many surely do.
Easing Restrictions on Private Capital Formation May Have Set the Stage for Enforcement
There have been a number of reforms affecting private equity capital formation, which may explain, at least in part, why the SEC appears to be more active. These reforms have eased the burdens of compliance with the federal securities laws for private placements.
First, in 2012 the Jumpstart Our Business Startups Act, or Jobs Act, was enacted.[5] Generally speaking, among other things, the Jobs Act amended a number of federal securities laws and regulations to make it easier for companies to raise capital privately. This included embracing the concept of “crowdfunding,” which has its own rules regarding the use and registration of intermediaries.[6] The Jobs Act also created what is known as the “4(c) exemption” from registration of securities under the Securities Act.[7] Under the exemption, a person may maintain a platform or mechanism to offer and sell securities in compliance with Rule 506 of Regulation D without registering under Section 15(a)(1), provided the person comply with certain requirements. Most importantly for this discussion, the person may not receive any compensation. The SEC’s interpretation of what constitutes “compensation” is broad, including both direct and indirect forms, and does not provide much room for creative interpretation. Since most finders and other intermediary solicitors will be seeking direct, transaction-based compensation for their efforts, the 4(c) exemption will generally not provide them with a safe harbor from registration as a broker-dealer. Nevertheless, because the 4(c) exemption can be used by issuers to create their own presence on the internet or in other media to advertise their Rule 506 securities offerings, it arguably reduces the need to use compensated finders and intermediaries.
In addition, the Financial Industry Regulatory Authority, which serves as the primary regulator for broker-dealers, has created a special category of broker-dealer, the capital acquisition brokers, or CABs, for firms engaged in a limited range of activities, including advising companies and private equity funds on capital raising and corporate restructuring, and acting as placement agents for sales of unregistered securities to institutional investors under limited conditions.[8] Firms that elect to be governed under the CAB rule set are not permitted, among other things, to carry or maintain customer accounts, handle customers’ funds or securities, accept customers’ trading orders, or engage in proprietary trading or market-making. Firms that qualify can meet the Section 15(a)(1) registration requirement in a more streamlined fashion, without the full array of regulatory and compliance burdens — and accompanying costs — associated with becoming a full-service broker-dealer. For individuals, the Series 82 exam, also known as the Limited Representative-Private Securities Offerings Qualification Examination — has been available since 2001, and is less burdensome than attaining and maintaining a full Series 7 registration.
These and other reforms have made it easier to become a registered broker-dealer and thus comply with Section 15(a), and have ameliorated some of the practical excuses for anyone to run the risk of nonregistration when participating in activities that require it.
Basic Requirements of Broker-Dealer Registration
Section 15(a)(1) requires any person that acts as a “broker” or “dealer” in securities in interstate commerce to register with the SEC. A “broker” is defined as “any person engaged in the business of effecting transactions in securities for the account of others,”[9] while a “dealer” is defined as “any person engaged in the business of buying and selling securities (not including security-based swaps, other than security-based swaps with or for persons that are not eligible contract participants) for such person’s own account through a broker or otherwise.”[10] Individuals or firms who engage in such activities without registration face SEC enforcement actions and risk civil monetary penalties, disgorgement, bars from future activities, and other consequences. Issuers who utilize such individuals or firms could also be subject to SEC enforcement actions for causing or aiding and abetting the violations. Perhaps even more importantly, the offering may be subject to rescission by investors.[11]
Whether a finder or other intermediary meets the definition of a broker or dealer is evaluated based on the facts and circumstances of each situation. While the Exchange Act itself does not refer to compensation as part of this evaluation, in practice, the method of compensation is the chief driver of the determination. Though there is some variation in the case law, at least as far as the SEC staff is concerned, receipt of commissions or other compensation that is based on the size or completion of securities transactions, which is often referred to as “transaction-based compensation,” creates a strong presumption that registration as a broker-dealer is required.[12]
Notably, there exist a significant number of SEC no-action letters, beginning with the famous Paul Anka no-action letter of 1991,[13] and more recently the M&A broker no-action letter of 2014,[14] that have carved out situations where transaction-based compensation can, in fact, be earned by a finder or intermediary without registration as a broker-dealer. The M&A broker no-action letter, which is limited to transactions for private companies and is subject to many limitations, remains a viable source of comfort in some situations. Many of the other letters, however, contain inconsistencies, and due to their age and changes in the commission staff over the years, have questionable viability as reliable guidance.
The Last 18 Months of SEC Enforcement
The following are some nonexhaustive highlights of the SEC Division of Enforcement’s efforts in policing the “vast grey market” of unregistered finders and intermediaries.[15] Many cases include Section 15(a)(1) charges as part of a broader scheme to mislead or harm investors. Some, however, show a willingness to enforce the law based solely on the sale of unregistered securities, or as in an EB-5 case, as a stand-alone violation. Some of the cases discussed below may be subject to further proceedings in light of the SEC’s decision to vacate, remand and/or allow new hearings in various stayed or pending cases, in light of the U.S. Supreme Court’s decision in Lucia v. SEC, which held that SEC ALJs were not properly appointed inferior officers under the Constitution.[16]
In the Matter of Edwin Shaw LLC[17]
In a settled administrative proceeding, Edwin Shaw, a taxi and livery company organized as a limited liability company, consented, without admitting or denying, to findings that it violated Section 15(b)(1) in connection with the sale of its LLC interests to foreign investors for the purpose of allowing them to obtain visas under the Immigrant Investor Program, also known as “EB-5.” A principal of Edwin Shaw received an administrative fee for each successful investment. Edwin Shaw was censured, and ordered to cease and desist from committing or causing any violations and any future violations of Section 15(a) and to pay disgorgement of $400,000, prejudgment interest of $54,209.20, and a civil monetary penalty of $90,535.
In the Matter of Retirement Surety LLC et al.[18]
In this case, the respondents consented to violations of Section 5(a) of the Securities Act for the sale of unregistered nine-month promissory notes, as well as Section 15(a)(1). The decision of the ALJ on the issue of disgorgement of compensation earned by the unregistered brokers is noteworthy. When the issuer failed to pay investors, it engaged the brokers to contact the investors and procure forbearance agreements, for which the brokers received additional 4 percent commissions. Despite the fact that the forbearance agreements were not securities, the ALJ ruled that the profits from extending the terms of the notes were necessarily derivative of the original unregistered sales, and included the additional commission in the disgorgement amount.
In the Matter of Steven Bailen,[19] In the Matter of Jason A. Wallace,[20] In the Matter of David B. Kaplan Esq.[21] and In the Matter of Paul E. Renfroe[22]
The SEC’s use of so-called “follow on” administrative proceedings, also known as “collateral bars,” based in part on Section 15(a)(1) violations, is relevant for gauging the remedies the SEC is seeking in this area. These four cases are only examples.
Bailen was allegedly in the business of soliciting and advising others to invest in securities in the form of fractionalized interests in claimed patents tied to a company called N1 Technologies Inc. These interests were often sold as convertible into stock. Bailen was criminally convicted on mail and wire fraud counts based on allegations that he also defrauded investors. According to the SEC order, to which he consented, he also acted as an unregistered broker-dealer and received compensation in the form of undisclosed commissions of 30-40 percent of the amounts invested. The settled administratively for associational and penny stock bars.
In Wallace’s case, in 2016 the SEC filed an injunctive proceeding in federal court based on underlying allegations of securities fraud — indeed a “boiler room” operation — in a microcap stock between 2010 and 2012. Despite obtaining a permanent injunction by default in December 2017, which included language enjoining him from violating Section 15(a)(1) by serving as an unregistered broker, in April 2018 the SEC filed an administrative proceeding seeking additional administrative remedies and bars, including a bar from “acting as a promoter, finder, consultant, agent or other person who engages in activities with a broker, dealer or issuer for purposes of the issuance or trading in any penny stock; or inducing or attempting to induce the purchase or sale of any penny stock.” Wallace’s case is still pending.
Similarly, Kaplan, who was permanently enjoined from future securities fraud and Section 15(a)(1) violations by a January 2018 order of a federal district court, settled with the SEC on a contemporaneous basis for an associational bar, as well as the same penny stock bar language sought against Wallace. Renfroe, who was associated with broker-dealers earlier in his career but not at the time of his violations, was permanently enjoined by a federal district court from selling unregistered securities in violation of Section 5(a) and from making misleading statements in violation of Section 17(a)(2), as well as from Section 15(a)(1) violations. He also contemporaneously settled with the SEC for similar bars.
In the Matter of Daniel C. Caravette[23]
Caravette, who had previously been associated with broker-dealers but at the relevant time had been out of the industry for more than a decade, served as a “consultant” to two issuers. According to the facts recited in the settled SEC order, which he neither admitted nor denied, under the terms of one arrangement, he was to receive commissions on a sliding scale from 15 to 21 percent, as well as stock equal to the number of shares he sold. The shares of that issuer’s stock were neither registered nor exempt from registration. The arrangement with the other issuer entitled him to a commission of 21 percent, plus two shares of stock for each dollar he raised. Caravette solicited investors for both companies using e-mail and his personal cell phone, conveyed information and transmitted documents to the investors. For one of the companies, he handled receipt of the subscription agreements and invested funds, including depositing the checks in an account designated by the issuer. In a settlement of both Section 5(a) and 15(a)(1) charges, Caravette consented to a cease-and-desist order, various bars and prohibitions from serving or participating, and was required to pay disgorgement of over $244,000, prejudgment interest, and a civil money penalty of $40,000.
SEC v. Hidalgo Mining Corp. et al.[24]
Hidalgo sold investment contracts to approximately 85 investors, raising approximately $10.35 million. The investment contracts were unregistered securities, and two of the company’s officers, who were also defendants in the case, together with a team of sales agents who apparently escaped enforcement, were not registered as brokers. According to the SEC’s complaint, in most instances, the officers or sales agents were paid a 10 percent commission on each sale, which came out of the investor’s principal investment. Without admitting or denying the SEC’s allegations, the company and the officers each consented to the entry of permanent injunctions, payment of disgorgement, prejudgment interest and civil monetary penalties.
In the Matter of Gregory J. Smith[25]
Smith was an insurance and retirement planner who assisted in the sale of notes for an issuer. According to the facts recited in the settled SEC order, which he neither admitted nor denied, Smith identified investors, solicited them in face-to-face meetings and phone calls and emails, advised as to the merits of the investment, and handled the mechanics of the investments, including routing funds to the issuer. He received transaction-based compensation in the form of commissions of a percentage of the amounts invested. As a result, Smith received a cease-and-desist order, various bars from future association, service or participation, and was required to pay full disgorgement of his commissions received, plus prejudgment interest. His financial condition rendered him unable to pay a civil monetary penalty.
***
Intermediaries involved in raising capital should expect the SEC’s aggressive enforcement to continue. Violations of Section 15(a)(1) are relatively easy to prove, especially since no culpable state of mind, or scienter, is required. Finders and issuers alike should be aware and alert to the boundaries of permissible conduct in this area, and steer clear of activities that might trigger SEC scrutiny.
[1] See Report and Recommendations of the Task Force on Private Placement Broker-Dealers (June 20, 2005), available at: .
[2] Securities Exchange Act of 1934, §15(a)(1), 15 USC §78o(a)(1). Other registration requirements exist for Investment Advisers under Section 203 of the Investment Advisers Act of 1940, 15 USC §80b-3.
[3] Securities Act of 1933, 15 U.S.C. §77e(a), (c).
[4] See, e.g., 17 CFR §230.503(a) (issuers relying on Rule 506 exemption are required to file a Form D notice with the SEC).
[5] Pub L 112-106, 126 Stat 306 (signed April 5, 2012).
[6] Regulation Crowdfunding, 17 CFR § 227.201, et seq.
[7] Securities Act of 1933, §4(c), 15 USC §77d(c).
[8] FINRA Regulatory Notice 16-37 (Oct. 17, 2016), available at: .
[9] Exchange Act, §3(a)(4)(A), 15 USC §78c(a)(4)(A).
[10] Id., §3(a)(5)(A), 15 USC §78c(a)(5)(A). This definition does not include “a person that buys or sells securities … for such person’s own account, either individually or in a fiduciary capacity, but not as a part of a regular business.” Id., §3(a)(5)(A), 15 USC §78c(a)(5)(B).
[11] Id., §29(b), 15 USC §78cc(b).
[12] Guide to Broker-Dealer Registration, Division of Trading and Markets, U.S. Securities & Exchange Commission, available at: .
[13] Paul Anka, SEC No-Action Letter (issued July 24, 1991).
[14] Five Attorneys Representing M&A Brokers, SEC No-Action Letter (issued Jan. 31, 2014, revised Feb. 4, 2014), available at: .
[15] For a discussion of prior SEC activity, see David C. Jenson, “The SEC Gets Aggressive With Unregistered Brokers,” Securities Law360 (July 6, 2015).
[16] See SEC Admin. Proc. Rulings Rel. No. 5954 (Aug. 23, 2018).
[17] SEC File No. 3-1838, SEC Rel. No. 34-82805 (March 5, 2018). In 2015, the SEC brought enforcement proceedings against a number of attorneys who sold EB-5 investments without broker registration. See SEC Press Rel. No. 2015-274 (Dec. 7, 2015).
[18] SEC File No. 3-18061, SEC ID Rel. No. 1250 (April 18, 2018).
[19] SEC File No. 3-18626, SEC Rel. No. 34-83801 (Aug. 8, 2018).
[20] SEC File No. 3-18438, SEC Rel. No. 34-83052 (filed April 16, 2018).
[21] SEC File No. 3-18338, SEC Rel. No. 34-82510 (Jan. 17, 2018).
[22] SEC File No. 3-18124, SEC Rel. No. 34-81455 (Aug. 22, 2017)
[23] SEC File No. 3-18240, SEC Rel. No. 34-81769 (Sept. 29, 2017).
[24] Civil Action Number 9:17-cv-80916-DDM (S.D. Fla.) (Aug. 15, 2017).
[25] SEC File No. 3-17657, SEC Rel. No. 34-80083 (Feb. 22, 2017).
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