‘Broker-Dealer Lite’ Legal Gray Area Puts Entrepreneurs at Risk As JOBS Act Opens Internet to Pitching Accredited Investors
BY JOSEPH W. BARTLETT
The chore of raising capital can be extraordinarily time-consuming for entrepreneurs. Occasionally, the founder of an emerging-growth startup will run into someone who offers to help in the fund-raising process. The individual or firm making such an offer is styled as a “finder” and the compensation is typically a success fee . . . a percentage of the money raised.
Years ago, the understanding of the legal and financial community was that finders needn’t register under the Securities Exchange Act of 1934 as broker-dealers because, in most cases, the finder’s only function was finding money. . . no customer funds or securities held in custody, no retail brokers; no trading on the stock exchanges; no underwriting public offerings. . . just a finder.
Over time, however, the view of the Securities and Exchange Commission staff changed and, by virtue of a number of pronouncements, the SEC made it known it considered (with limited exceptions) finders to fit within the definition of broker in the 1934 Act and, therefore, were required to register as such and join what was then the NASD, and is now FINRA. Curiously, although the SEC’s views became relatively well known, the Enforcement Division made little or no effort to pursue finders, the consequence being thousands of finders in the U.S. performed vital functions helping emerging-growth companies get the needed capital.
I started writing on this anomaly . . .a rule honored principally in its breach . . . back in the 1980s and have continued to do so over time. In recent years, however, pressure from the SEC on unregistered finders has increased until, at present, and coincident with the enactment of the JOBS Act (Jump Start our Business Startups), a line in the sand has been drawn. Since 2006, the American Bar Association has urged the SEC to adopt an in between position, authorizing finders to register as a (using a slang term) “broker-dealer lite,” in keeping with the fact that their function is limited to classic finder activities and not any of the other accoutrements of a broker-dealer.
Broker-dealer “lite” still has not gotten traction with the Commission and law firms are becoming increasingly wary of participating in deals while the law (as it is interpreted by the SEC) is violated. Thus, the entrepreneur is often between a rock and a hard place; the finder brings an investor to the party; the money is needed if the company is going to get off the ground or meet next months’ payroll. The violation is recognized but, though enforcement has been stepped up, it is still spotty and today there are any number of finders operating in the shadows.
That said, however, the stakes have risen. There is a school of thought gaining traction that the entrepreneur’s company can be held complicit in the finder’s violation and accordingly exposed to liability. The investors in any round which has been enabled by an unregistered finder may well have rescission rights, demanding their money back from the company and maybe the directors. Consequently, law firms are increasingly uneasy if a client comes to them with an unregistered finder in tow. As a former partner of mine, Ed Fleischman, an ex-SEC Commissioner remarked, the Agency is “regulating by opinion.” Thus, most law firms currently will not give an opinion that the transaction is legal and in many cases will simply resign from the assignment if a violation is threatened.
All that said, a gray area persists. The 1934 Act definition is that one must register if “engaged in the business of affecting transactions in securities.” What does that mean? Assume a finder has once, and only once helped a transaction close; does that equal “engaged in the business?” At least one case, SEC vs. Kramer, has taken the position that simply negotiating a success fee, and the definition is broad . . . any “transaction related compensation” in the eyes of the SEC . . . may not be enough to constitute a statutory violation.
Where this will all wind up, particularly as Title II of the JOBS Act is opening up the Internet to entrepreneurs pitching for accredited investors (meaning investors with significant net worth and/or annual salaries), is anyone’s guess. The point of the story at this stage is that entrepreneurs need to be wary if a finder brings money to the party and be prepared to suffer the consequences unless the entrepreneur can afford to convince a U.S. District Court that the facts fit within the holding of the Kramer case . . . not a recommended path for entrepreneurs to take when they have so much else on their plates.
A final note. As the ban on general solicitation is lifted this month, intermediaries, also known as “platforms,” are springing up to assist the high -growth companies and their entrepreneur and founders navigate the web. However, the gray area extends to the allowable compensation to those intermediaries (many of them) which are not registered broker dealers; such platforms are typically described as curators (also known as chaperones) and they need to recoup their costs plus a dollar or two for working capital.
If the SEC’s “transaction related compensation” net continues to widen, there may be trouble ahead for the curators. We’re staying tuned to see what impact this may have on the objectives of the JOBS Act . . . to “jump start our business startups.”