SC Lawyer, July 2012, #4. Main Street Goes Wall Street.

• Author: By John Jennings and Katherine Gutierrez

South Carolina BAR Journal

2012.

SC Lawyer, July 2012, #4.

Main Street Goes Wall Street

South Carolina LawyerJuly 2012Main Street Goes Wall StreetThe Risks of Unregistered Sales Agents in Small Business Capital RaisingBy John Jennings and Katherine GutierrezEdward Entrepreneur calls you with exciting news.

For months, Edward has tried to raise money for his young company from family and friends, banks and even venture capital funds. But in a post-crash world, Edward has had no luck. His company is now a little late on some of its bills.

Edward tells you that he just had lunch with Charlie Connected, a local business person that once built and sold a company very similar to Edward's. Mr. Connected has lots of money and can introduce Edward to potential customers. He wants to invest in Edward's company and will introduce Edward to other potential wealthy investors with the understanding, of course, that Mr. Connected will receive a little fee or maybe some extra stock in exchange. Edward is ecstatic and asks, "How long will it take you to paper this?"

Before digging into exactly what the "this" is that you need to document, you pause as you remember that paying people who are not registered brokers to raise money can be a problem, but you don't recall if the recent JOBS Act has changed that.

Edward never likes it when you pause. Edward implores you not to be the "sales prevention department." As Edward then begins describing exactly how much money his company will take in and how much stock Mr. Connected and his friends will acquire, you think to yourself, "Can the company legitimately do this?"

This article will navigate through the securities laws related to capital "finders" and explore ways that Edward might legally raise money with Mr. Connected's help, without Mr. Connected registering as a broker.

Why worry?

There is a significant disconnect between the laws applicable to broker activity and the methods by which, according to an ABA task force, most of the capital for early stage businesses is actually raised.

Many smaller companies use so-called "finders"-people and entities that are not registered brokers, but who are paid to locate investors and, at least in theory, have no other meaningful role in the securities transaction. In the merger and acquisition context, finders are sometimes called "business brokers." Finders can often be the only option for smaller companies, as most investment banks and other registered brokers are not interested in small transactions.

Unfortunately, in practice, finders and business brokers are often involved in securities transactions to an extent that they are in fact acting as brokers and are violating federal and state securities laws by not registering as such. Using an unregistered broker to assist with a capital raise creates potential business, regulatory and litigation risks for the company raising the money (the "issuer" of the securities).

The Securities and Exchange Commission (SEC) has shown increased interest in preventing unregistered broker activity in recent years, and states, including the S.C. Attorney General, have brought numerous actions against people acting as unregistered brokers. Moreover, in 2008, the SEC amended Form D, a notice filing made by issuers in connection with commonly used Regulation D private placement and small offering exemptions, to include an item that requires disclosure of finders' fees paid in connection with an offering. The current Form D puts a spotlight on unregistered finder activity for the SEC.

For the finder that should have registered as a broker, the consequences can be severe. The finder's fee agreement with the issuer will be unenforceable in court because section 29(b) of the Securities Exchange Act of 1934 (Exchange Act) generally provides that contracts made in violation of the Exchange Act are voidable. In addition, non-exempt finders that engage in broker activity may face civil and criminal penalties under both federal and state law.

For the securities issuer that utilizes an unregistered finder whose activities rise to a level of broker activities, there are multiple risks, including, among others: (a) investors may seek damages or rescission of their investments under federal or state law; (b) the validity of the issuer's exemption from federal and state registration for the offering that involved the finder may be lost; (c) the SEC or state authorities may pursue the issuer as an aider and abettor of securities law violations by the finder; (d) the issuer may face fraud liability under section 10(b) of the Exchange Act for failing to disclose to investors the finder's fee arrangement in connection with the sale of securities; and (e) future capital raising efforts by the issuer may be delayed or fail due to investor concerns over prior sales involving unregistered brokers.

The broad, but uncertain, definition of a "broker"

Section 3(a)(4) of the Exchange Act defines a broker as "any person engaged in the business of effecting transactions in securities for the account of others." Section 102(4) of the South Carolina Uniform Securities Act of 2005 has a similar definition of broker.

At the federal level, Section 15 of the Exchange Act generally makes it unlawful for a broker "to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security" unless the broker is registered with the SEC. Likewise, state securities laws generally require state registration of a "broker-dealer" or "agent." See, e.g., S.C. Code Ann. 35-1-401(a), 402(a) (Supp. 2011). Some states even require registration of finders or business brokers where it would not be required under federal law.

The terms "engaged in the business" and "effecting transactions" are not defined in the Exchange Act or the related regulations. The terms have generally been interpreted broadly by the SEC and some courts. An extensive array of factors has been considered in determining the presence of broker activity. As a result, the determination of whether a person is engaged in broker activity is highly fact specific, and it can be difficult to determine whether certain conduct constitutes broker activity.

Engaged in the business?

Many factors affect whether a person is viewed as being "engaged in the business," but key indicia include: (a) receiving transaction-based compensation (generally, compensation that is dependent upon the success or size of an offering); and (b) participating in the sale of securities with sufficient recurrence to support the inference that the activities are part of the person's business.

The SEC views transaction-based compensation as "a hallmark of broker-dealer activity" because it gives a person a "salesman's stake" in the completion of a transaction. Brumberg, Mackey Wall, P.L.C., SEC No-Action Letter, 2010 WL 1976174 (May 17, 2010) (BMW Denial) (an SEC no-action letter is the SEC's response to a private inquiry requesting that the SEC confirm that it will take "no action" if the requestor engages in the conduct described in the request letter). The SEC believes that transaction-based compensation incentives may lead to abusive or even fraudulent sales activities, which the registration and regulation of brokers are intended to deter. As a result, the SEC's view is that any person receiving transaction-based compensation in connection with another person's purchase of securities typically must register as a broker or be an associated person of a registered broker, even if there are virtually no other indicia of broker activity.

Receipt of a flat one-time or periodic (e.g., hourly, weekly, monthly) fee that is paid regardless of whether a securities offering is completed, rather than a transaction success fee, can significantly mitigate the risks that a person would be deemed to be a broker.

Effecting transactions?

The SEC and courts have stated that "effecting transactions" involves participation in securities transactions "at key points in the chain of distribution." BondGlobe, SEC No-Action Letter, 2001 WL 103418 (Feb. 6, 2001). Activities associated with effecting transactions include soliciting investors, making recommendations to prospective investors or otherwise discussing the details of an investment, and participating in negotiations with potential investors.

There is a common mispercep-tion that simply labeling a person involved in a securities offering as a "finder," "business broker" or "consultant" exempts the person from broker registration. The SEC is not persuaded by these titles and focuses on a person's activities to determine whether the person is acting as a broker.

What about the JOBS Act?

The recently adopted Jumpstart Our Business Startups Act (JOBS Act) directs the SEC to amend Rule 506 (a popular private placement exemption) to allow general solicitation and general advertising in offerings under Rule 506, provided that all purchasers are accredited investors (generally entities or individuals that meet specified financial criteria). The JOBS Act also permits issuers to raise capital through "crowdfunding," which generally allows start-up companies to solicit small investments from many investors through any medium (including the Internet), for offerings of up to $1 million every 12 months, subject to various restrictions and requirements that the SEC is to adopt by December 31, 2012. These changes may result in more expansive capital raising activity for smaller companies, which may attract more people to the business of finding investors.

While the SEC may amend its broker regulations in order to facilitate robust application of these new offering-related freedoms, it is also possible that the SEC and states will even more strictly enforce broker registration and regulation in an effort to deter fraud and other unsavory sales practices by those involved in the new, more open offering regime. Such an approach would be consistent with the JOBS Act's approach to crowdfunding. While the JOBS Act permits broad solicitation for crowdfunding transactions, such transactions must be effectuated through an "intermediary" registered as a broker-dealer or funding portal with the SEC, and the intermediary cannot compensate "promoters, finders, or lead generators" for providing the intermediary with the identifying information of potential investors.

Can Mr. Connected act as a "true finder"?

Assuming Mr. Connected is not a registered broker, Edward's company may be able to engage him as a true finder, who is not a broker because he either does not effect transactions and/or his securities services are not sufficiently recurring to constitute engaging in a business. However, the finder exemption is extremely narrow and uncertain.

Finder's analysis generally involves a 1991 SEC no-action letter for the singer, songwriter and actor (but not registered broker) Paul Anka. Paul Anka, SEC No-Action Letter, 1991 WL 176891 (July 24, 1991). Mr. Anka, a Canadian, agreed to invest in a professional hockey team (the Senators). Mr. Anka also proposed to introduce potential accredited investors to the Senators, for which he would receive a finder's fee equal to 10 percent on the units sold. He was also to receive a one percent fee on all sales of units sold after a specified date to persons not introduced to the Senators by Mr. Anka.

Mr. Anka advised the SEC that he would have no contact with potential investors regarding the investment, but rather would merely provide the name and phone numbers of persons with whom he had a personal or business relationship that he believed might be interested in investing. Directors, officers or employees of the Senators would contact the potential investors.

In its no-action letter, the SEC noted that, among other things, Mr. Anka would not solicit, make recommendations or contact investors concerning the Senators, or otherwise assist with the offering. In addition, the SEC noted that Mr. Anka represented that he had never before assisted in an offering of securities and did not intend to participate in any other securities offerings in the future.

While the Paul Anka letter is frequently cited as support for unregistered finder activity, there are significant limitations on the reliability of the Paul Anka letter in this regard.

First, Paul Anka represented that he would not have any contact with investors regarding the proposed investment, which supports the position that he would not be "effecting transactions" in securities. However, the absence of even a courtesy introduction to a potential investor and a finder's unavailability to discuss the potential investment may create an off-putting sense of distance that might limit the effectiveness of most finders.

Second, Paul Anka had never acted as a finder before and did not intend to ever do it again, which provided significant support to an argument that he was not "engaged in the business" because his activities lacked regularity. By contrast, many finders seek to raise capital on a regular basis.

Third, since the Paul Anka letter was issued, the SEC has generally taken the position that "finders" should receive only flat fees paid on an up-front or periodic basis rather than transaction success fees. The SEC has indicated on multiple occasions that it would likely refuse to give no-action relief again if a person sought to earn transaction-based compensation as a finder in the context of a capital raising transaction as Paul Anka was allowed to do. Accordingly, the SEC likely would not tolerate any expansion of the limited activity permitted in the Paul Anka letter without registration as a broker, and continued reliance even on the narrow facts of the Paul Anka letter is an uncertain proposition.

The weight that the SEC places on even introductory contact with potential investors and on transaction-based compensation was evident in the BMW Denial. In the BMW Denial, a law firm proposed to introduce a company to a limited number of parties that "may have an interest" in investing in the company. In return, the law firm would receive a fee at closing equal to a percentage of the amounts raised from these investors. The law firm would not otherwise be involved in the offering.

In denying the no-action request, the SEC stated that the introduction of a company only to persons with a potential interest in investing in securities implies the law firm must pre-screen potential investors and pre-sell the securities to gauge their interest. Moreover, the SEC stated that transaction-based compensation in this context would give the law firm a "salesman's stake" in the proposed transaction and create incentives for the law firm to engage in sales efforts.

Recently, some courts have disagreed with the SEC's expansive view of what constitutes broker activity and, in particular, the SEC's insistence that receipt of transaction-based compensation alone is generally sufficient to require registration as a broker. See SEC v. Kramer, 778 F. Supp. 2d 1320, 1339 (M.D. Fla. 2011); Maiden Lane Partners, LLC v. Perseus Realty Partners, G.P. II, LLC, No. 09-2521-BLS1, 2011 WL 2342734, at *4-5 (Mass. Super. May 31, 2011). While these recent cases are not definitive, they illustrate the legal uncertainty and fact-dependent nature of the broker determination.

So, if Edward wants Mr. Connected to help raise money pursuant to the finder's exemption from registration, to comply with the SEC's current views Mr. Connected should only be paid a flat fee on an up-front or periodic basis, rather than a fee based on the success or size of the capital raised. Mr. Connected would also have to strictly limit his activities.

If Edward were to pay a transaction-based fee to Mr. Connected and, like Paul Anka, Mr. Connected were to have no involvement in the offering whatsoever other than providing names to Edward, some courts might find the arrangement permissible. However, the SEC might still view the arrangement as being illegal. Also, unless Mr. Connected's contacts are very wealthy and are not very skeptical, mere names and numbers, without introductions, may not help Edward very much.

Even if Mr. Connected's activities are permitted at the federal level, we must make sure that they are permitted at the state level as well. We also must ensure that his role does not disqualify Edward's offering from its intended state-level offering registration exemption. See, e.g., S.C. Code Ann. 35-1-202(14) (Supp. 2011) (exempting sales to 25 or fewer purchasers in South Carolina during any consecutive 12 months, but is conditioned upon no person other than a registered broker-dealer or registered agent receiving any compensation for soliciting a prospective purchaser in South Carolina).

If Mr. Connected becomes a director (or an officer or employee), can he be more involved in the offering?

Rule 3a4-1 of the Exchange Act provides a broker exemption safe harbor for associated persons (partners, officers, directors and employees) of an issuer that participate in the sale of securities of the issuer. The rule has several requirements. Generally, the rule provides that an associated person is not required to register as a broker if the associated person: (a) does not receive compensation based directly or indirectly on a securities transaction; (b) is not an associated person of a broker or dealer; and (c) meets the following conditions: (1) primarily performs, or will perform at the end of the offering, substantial duties for the issuer or on its behalf other than transactions in securities; (2) was not a broker or dealer within the past 12 months; and (3) does not take part in selling securities for any issuer more than once every 12 months.

Under this safe harbor, assuming the other conditions are met, if Mr. Connected becomes, for example, a director of Edward's business, then Mr. Connected could actively solicit investors for Edward. However, Mr. Connected would need to be made a bona fide director of Edward's company. Mr. Connected could presumably be paid a reasonable, bona fide periodic flat fee for his service as a director, but he could not be compensated in connection with his participation in the sale of securities by the payment of commissions or other remuneration based either directly or indirectly on transactions in securities.

What if capital raising is so time-consuming, complicated and unproductive that Edward decides to just sell the business?

Broker issues can also arise when a business is sold. Businesses are often sold through a sale of the business' assets, which transaction structure will generally not constitute a sale of securities that raises broker issues. However, a company can also be sold through the sale of the company's outstanding equity (e.g., outstanding stock, limited liability company units or partnership interests), which does involve the sale of a security and raises broker considerations when an intermediary such as a business broker/finder is involved.

The analysis applicable to a business broker, MA advisor or consultant-whatever the person happens to be called-who is paid to effect a sale of a business through the sale of its securities, is similar to the analysis of a finder's activities in the context of capital raising. However, the SEC has been slightly more tolerant of transaction-based compensation and certain other limited activities for unregistered business brokers/finders where an entire business is being sold than the SEC has been in the capital raising context.

For example, in the Country Business, Inc. SEC no-action letter (CBl), the SEC noted several factors considered in granting no-action relief to a business broker that would receive a fixed fee, an hourly fee or a commission, or combination thereof. Country Bus., Inc., SEC No-Action Letter, 2006 WL 3289777 (Nov. 8, 2006). Among many other factors, the SEC appeared to look favorably upon the fact that the business broker's compensation would be established before the form of transaction was known and would not vary based on the form of the company sale (i.e., securities rather than assets), only assets (and not securities) would be advertised or otherwise offered for sale, and in any sale via a securities sale, the transaction would be a sale of all of the target company's outstanding securities to a single buyer or group of buyers formed without the assistance of CBl.

However, a few months later in the SEC's denial of Hallmark Capital Corporation's no-action request (Hallmark Capital), the SEC denied no-action relief to a business broker that also assisted in capital raising and provided strategic business consulting services. Hallmark Capital Corp., SEC No-Action Letter, 2007 WL 1879799 (June 11, 2007). The SEC stated that, based on the "general descriptions of the activities" in the request letter, Hallmark Capital would be required to register with the SEC as a broker. Id. The SEC did not specify which activities were troubling, however. The business broker activities described in Hallmark Capital appear to be similar in many respects to those described in CBl. The differing outcomes in these letters reflect the fact that, while the SEC may be slightly more tolerant of unregistered business brokers than it is of unregistered capital raisers, it is often difficult to determine exactly what activities the SEC will consider to be securities broker activities that require registration.

lf Edward decides to sell his company, and Mr. Connected wants to put him in touch with a potential buyer and receive compensation in exchange, then the company should be sold through a properly structured sale of its assets, or the limitations in CBl and the SEC's other guidance should be strictly followed if the company sale is accomplished though a sale of its outstanding securities. Additionally, in a securities sale, the applicable state law would need to be considered.

Changes in the future?

A 2010 ABA task force report recommended that the SEC clarify broker registration requirements, and do so in a way that takes into consideration the realities faced by young companies trying to raise capital. While the SEC has indicated some agreement in principal with these recommendations, in the wake of the 2008 financial meltdown and the resulting political and social climate, the SEC has not acted on these recommendations.

The JOBS Act has directed the SEC to allow more expansive solicitation for certain types of offerings. These changes represent a shift toward encouraging capital formation and business development. Perhaps clarification of broker registration requirements and potential changes to such requirements to facilitate small company securities transactions will also follow.

However, securities transactions are often complicated matters, and many-especially those transactions involving smaller companies and parties with limited financial experience-are laden with opportunities for overly-eager dreamers to inadvertently miscommunicate with investors and with incentives for elusive schemers to knowingly mislead investors. Given this fundamental reality, the SEC may not be willing to significantly reduce registration requirements for people with a "salesman's stake" in securities transactions.

Unless and until there is legal clarification or change, those who are faced with the day-to-day realities and urgencies of securities transactions, but take a longer-term view of business and legal interests, must remain mindful of the uncertainties and risks associated with unregistered sales agents and seek to structure securities transactions that comply with the existing rules and interpretations.