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Beware Of Unregistered Broker-Dealers

There are a variety of financial intermediaries in the market who offer companies a means of identifying financing or sale opportunities.

Engaging such an intermediary who is not a licensed broker-dealer or who is providing financial services without licensing can be a risky business. Both federal law and state law prohibit a person from being engaged in the business of effecting transactions in securities unless that person is properly licensed as a broker-dealer, subject to limited exceptions. These rules apply to placement agents engaged in private placement transactions, as well as the activities of those persons who are engaged in mergers and acquisitions transactions. A finders exception for a person who merely introduces potential purchasers or investors to a seller or issuer and accepts a finders fee is recognized under both federal and state law. However, the finders exception is narrow in scope in that generally the finder can not actively participate in the transaction process or receive success-based fees.

Critics note that the problem with the present system is that it is one-size- fits-all and does not work in regulating many financial intermediaries such as private placement brokers and business brokers. Those that service small businesses are subject to the same rules and regulations as the Wall Street brokers. Financial intermediaries play a vital role in providing access to a source of funds that may not otherwise be available to a company or in locating potential buyers or sellers in connection with mergers and acquisitions transactions. Often these intermediaries play a limited role in the transactions, and in fact in many M&A transactions the structure of the transaction is driven by tax law or risk allocation concerns. Despite limited involvement in transactions, if the sale of a security is contemplated, broker-dealer registration would typically be required. (Note there is a distinction between asset sales and stock sales. Transactions structured as asset sales are not regulated by the securities laws. However, many states regulate asset sales under their real estate broker statues where real property is involved.)

Proponents of the existing regulatory system believe that it brings integrity to the financial markets and instills investor confidence because it focuses on investor protection and holds all broker-dealers to the same standard of conduct. They believe unlicensed securities activities are ripe with abuse. The National Association of Securities Dealers (NASD) oversees the regulation of registered broker-dealers, a population that includes more than 5,050 brokerage firms, approximately 172,050 branch offices and more than 663,050 registered representatives. NASD also operates the largest securities dispute resolution forum in the world, processing 8,000 arbitrations and 1,000 mediations per year.

A task force created by the American Bar Association published a report in May 2005 relating to private placement broker-dealers. This report concluded that a significant number of financial intermediaries are engaged in broker-dealer activity and are not registered and included recommendations to the securities regulators to establish a simplified registration system for private placement brokers, including brokers engaged in M&A transactions.

In addition, in April 2006, the Advisory Committee on Small Public Companies issued its final report to the Securities and Exchange Commission in which the committee recommended the creation of a streamlined registration process for private placement brokers. The committee concluded that most of the services provided by private placement brokers in support of raising capital amount to unregistered broker-dealer activity. The Advisory Committee noted that these unregulated service providers are reluctant to register under the current regulatory framework because enforcement activity seems minimal and the costs and administrative burdens are cumbersome.

On Sept. 13, 2006, the Department of Corporations of the State of California published a notice soliciting comments on whether the existing regulatory structure in California adequately addresses the issue of finders and private placement broker-dealers. The notice indicates that the state’s Commissioner of Corporations has concerns on whether the current approach may unduly impede capital formation and job creation. One of the issues addressed is whether California should adopt an exemption or limited registration system for finders and private placement broker-dealers.

The SEC has been looking at the possibility of implementing a more simplified registration process or an exemption for a number of years. Changing the current regulatory scheme has been a top recommendation of the annual SEC Government-Business Forum on Small Business Capital Formation for nine of the past ten years. While both federal and state securities commissioners are looking into modifications to the existing regulations, until the SEC makes this a top priority it is unlikely that the current regulatory system will change. Therefore, financial intermediaries are left with trying to comply under the existing regulatory scheme. Currently, those engaged in limited activities relating to securities transactions have three options:

1. License their company as a broker-dealer, which includes membership with the National Association of Securities Dealers;

2. License as a registered representative of an NASD licensed broker-dealer; or

3. Structure your engagements to comply with the finders exception under federal law and any applicable state law.

Many financial intermediaries elect a fourth option, which is to do nothing. This course could subject the financial intermediary to civil and criminal penalties, injunctions, monetary penalties, cease and desist orders, suspensions, a permanent ban from participating in the securities markets, loss of fees, and result in rescission rights for those investing in the transaction.

The use of unregistered financial intermediaries could have serious consequences for the issuer of the securities as well. They can taint the offering under federal and state securities laws, creating a basis for rescission rights for investors in the transaction. Under most state laws the issuer is prohibited from paying compensation to an unlicensed broker-dealer as a condition to the issuer’s reliance on the private placement exemption. The consequence of paying such compensation is that the state securities administrators can force the issuer to make a rescission offer or the investors can elect to rescind their investment. If the value of the original investment declines, investors are more apt to elect to exercise these rescission rights, which includes a return of their original investment plus interest and in many instances attorney’s fees. Persons liable under state law include not only the issuer, but also the officers, directors and promoters.

The violation of the securities laws can have long-lasting effects for the financial intermediaries, but more importantly the issuers. These violations will have implications in any future offerings because of the contingent liability and disclosure obligations. It may hamper a company’s ability to raise funds from private, public or traditional lenders. It raises significant litigation and enforcement action risks as well as damages the reputation of the issuer and officers, directors and promoters. It can also create issues for issuer’s legal counsel in connection with issuing legal opinions for current transaction or future transactions if there is a risk of rescission. More on the other options:

Option 1 Registration as a broker-dealer. Currently, broker-dealers must register with the SEC using a Form B-D and comply with numerous regulations, including compliance with oversight and financial responsibility standards like the net capital rules. There are application and membership interview requirements, specific testing and licensing requirements which must be completed before a broker-dealer license may be granted. Many financial intermediaries believe the process and regulatory scheme is cumbersome.

The costs associated with the registration process and the timeline for the approval process, which can take anywhere from six months or longer to complete, can be prohibitive for many financial intermediaries. In addition, the costs and time associated with compliance with the standards, periodic review and reporting requirements once the license has been granted may not be economical given the size of the financial intermediary and the scope and frequency of their activities.

Option 2 Affiliation with an existing broker-dealer. While this option also requires registration as a registered representative of a licensed NASD broker-dealer, it is more cost-effective and will not take as long to process, typically one to two months. A registered representative must complete a form U4 and pass certain exams.

The advantages to this option, other than time and expense which are significant advantages, are the back office support, compliance support and networking opportunities provided by the broker-dealer. Some of the disadvantages include lack of control, the oversight responsibilities of the firm, due diligence requirements, fee splitting, continuing education requirements and NASD regulations. In addition, your affiliated broker-dealer will require that you enter into an agreement with them, which may place limitations on your outside activities.

Option 3 Rely on the finders exception. The SEC has described in a series of no-action letters a very narrow scope of activities that a person may engage in under federal law without triggering broker-dealer registration requirements. These limited exceptions are based on interpretation and represent the SEC’s view at the time the no-action letter is issued. The interpretations are subject to modification or even reversal. The SEC no-action letters identify specific factors that the SEC will look at in making a determination of whether a person is engaged in broker-dealer activity, which include:

• whether the finder was involved in the negotiations;

• whether the finder engaged in the solicitation of investors;

• whether the finder discussed details of the nature of the securities or made recommendations to the prospective buyer or seller;

• whether the finder was compensated on a transaction-related basis; and

• whether the finder was previously involved in the sale of securities and/or was disciplined for prior securities activities.

While the SEC has stated that no single factor is dispositive on the issue they have also noted that receipt of transaction-based compensation is one of the hallmarks of broker-dealer activity.

For private placement brokers, those who receive transaction-based compensation, provide advice, make recommendations and are involved in negotiations, the finders exception will not be available. The more active the financial intermediary is in the process the less likely the finders exception would be available. So what happens if you fall into the gray area where you meet only one or two of the factors considered by the SEC? Unfortunately there is no bright line test or safe harbor and those that do meet one or two of the factors run the risk that they are engaging in broker-dealer activities without a license.

James M. Hill, Esq. is the Managing Partner of the law firm of Benesch, Friedlander, Coplan & Aronoff LLP. He can be reached at 216.363.4500 or by email at Leslie Drockton, Esq. is a Partner at the law firm of Benesch, Friedlander, Coplan & Aronoff LLP. She can be reached at 216.363.4500 or by email at Bryan Spaulding is President and CEO of NASD member firm Stock Sale Compliance, LLC. He can be reached at 813.926.9300 or by email at