NY State Attorney General Targets Finders and Business Brokers in Pandemic Rule-MakingApril 28, 2020 – Articles
“Finders” or “business brokers” may be the unsung heroes of early stage and emerging growth companies, or, as the New York State Attorney General (“NYSAG”) and, seemingly, the United States Securities and Exchange Commission (“SEC”) believe, unregistered broker-dealers.
Now, despite being in the middle of a pandemic, the NYSAG has proposed new regulations that would prohibit finders and a newly created class of business brokers called “solicitors,” who do business in the State of New York from receiving any compensation without being registered.
Who Needs to Register Under Current Laws
Finders raise capital for companies that might not otherwise have capital on their own, or, more importantly, would not draw the attention of investment bankers, who by definition are licensed broker-dealers. Finders and those who employ them must be aware of the risks associated with their services, and the requirements imposed upon them by federal securities laws that require registration. Generally, finders are required to be registered if they advise companies that engage them and are paid some form of success based compensation - that is, compensation directly or indirectly tied to the capital raise itself. A finder’s failure to register can result in serious consequences on both the finder and the company that engages the finder.
The broker-dealer registration requirements of the Securities Exchange Act of 1934 (“Exchange Act”) Section 15 do not explicitly require finders to register with the SEC. However, despite some believing labeling oneself as a finder means that registration is unnecessary, when a finder acts as a broker-dealer, registration is in fact required. The SEC’s Enforcement Division has consistently undertaken investigations and has used its powers to seek sever penalties against those who claim to be finders, but are, in fact, seeking to evade the broker-dealer registration requirements. Similarly, the SEC’s Trading and Markets Division has repeatedly rejected attempts to widen the exemption and permit finders to act in this capacity.
Generally, a broker or dealer needs to register with the SEC. Exchange Act Section 3(a)(4) states that a “broker” is “any person engaged in the business of effecting transactions in securities for the account of others.” Such brokers (and dealers) are required to be registered under Exchange Act Section 15(a)(1), and it makes it unlawful for “any broker or dealer … to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security … unless such broker or dealer is registered[.]”
These registration requirements are significant. Broker-dealers must register with the SEC by electronically filing an application, become a member of a self-regulatory organization such as the Financial Industry Regulatory Authority (“FINRA”), as well as a member of the Securities Investor Protection Corporation (“SIPC”). Further, broker-dealers are required to be licensed in the states where they conduct business as a broker-dealer, and certain individuals employed by broker-dealers must also pass certain exam qualification requirements, such as the Series 7 exam. See Guide to Broker-Dealer Registration, Division of Trading and Markets U.S. Securities and Exchange Commission (April 2008).
These burdens often discourage many from registering, but to remain involved in capital-raising activities, individuals often may operate as a finder or business broker so as not to trigger the Exchange Act’s registration requirements. Although, not defined under either federal or state securities laws, a finder has been described as “someone who finds, interests, introduces and brings parties together for a transaction that the parties themselves negotiate and consummate.” Northeast General Corporation v. Wellington Advertising, Inc., 82 N.Y. 2d 158, 163 (1993). A finder essentially “fill[s] a void that is created by the lack of interest on the part of licensed brokerage firms and venture capital funds in smaller equity transactions.” See American Bar Association’s Task Force on Private Placement Broker-Dealers to the SEC Advisory Committee on Small Public Companies; and Letter from Gerald V. Niesar endorsing the “Report and Recommendations of the Task Force on Private Placement Broker-Dealers” (Sept. 12, 2005).
The Evolution of the SEC’s Approach to Finders and Business Brokers
Over the years, various individuals and entities have sought guidance from the SEC Staff on the appropriateness of certain activities described as falling within the purview of the work of a finder or business broker through a series of no-action letters. No-action letters allow the SEC staff to evaluate a finder’s proposed activities, and determine if registration as a broker-dealer is required prior to the undertaking of any of the stated activities. In the absence of statutory authority, these no-action letters are relied upon by securities practitioners as well as industry insiders to determine if the proposed party would be required to register as a broker-dealer.
Often the difference between registration or not was based upon the SEC’s focus on if the intermediary would earn compensation from its activities, and the intermediary’s level of participation in the transaction. For example, in 1972, the SEC Staff issued a no-action letter at the request of Corporate Forum, Inc. (“Corporate Forum”). See Corporate Forum, Inc., SEC No-Action Letter, 1972 WL 9128 (Dec. 10, 1972). Corporate Forum’s proposed activities included seeking out merger and acquisition candidates as well as conducting any financial analysis requested by its client. The SEC Staff stated that it would not recommend enforcement action if Corporate Forum did not register as a broker-dealer and conducted these activities. The SEC Staff seemed to emphasize Corporate Forum’s lack of participation in negotiations between its client and the merger and acquisition candidates.
However, the SEC Staff has not always been consistent in its position. In another 1972 no-action letter, the SEC Staff denied the relief sought by Fulham & Co., Inc. (“Fulham & Co.”), for similar proposed activities, indicating that Fulham & Co. needed to register as a broker-dealer because, apparently, Fulham & Co. intended on directly participation in the negotiations between the interested parties. See Fulham & Co., Inc., SEC No-Action Letter, 1972 WL 9129 at 2 (Dec. 20, 1972). Similarly, the SEC Staff’s no-action letter to the Russell R. Miller Corp. (“RRM”), continued to focus on participation (or lack thereof) in negotiations, allowing the payment of the fee to occur upon consummation of a transaction, but where RRM would not participate in negotiations, nor would it provide any input as to if its fee would be paid in cash or securities. See Russell R. Miller & Co., Inc., SEC No-Action Letter, 1977 WL 10938 (Aug. 15, 1977).
The SEC Staff further elaborated on the finder’s proper role in conjunction with potential compensation in other no-action letters as well. Among these, the SEC staff issued a no-action recommendation regarding the proposed activities of International Business Exchange Corporation (“IBEC”). IBEC was involved in the advertising and sale of closely-held entities where its role was limited to the transmission of documents between the interested parties. IBEC did not participate in negotiations and IBEC’s fee would be based upon the value of the transaction, determined prior to the time the parties agreed to the form of the consideration required to close the transaction. See Int’l Bus. Exch. Corp., SEC No-Action Letter, 1986 WL 67535 at *1-*2.
Additionally, in a 1991 no-action letter involving Paul Anka, the entertainer, the SEC Staff stated it would not recommend enforcement of the broker-dealer registration requirement against him. Although, there were several factors present indicating registration would be requested since Mr. Anka seemed to have been offered a contingent investment commission in exchange for providing a list of potential investors to a professional hockey team, the SEC Staff granted no-action relief. See Paul Anka, SEC No-Action Letter (July 24, 1991). Apparently, the SEC Staff seems to have focused on the financial acumen of the potential investors in making this determination.
In later years, the SEC Staff, nonetheless, went further in defining certain standards it would consider in determining finder or business broker status as opposed to requiring broker-dealer registration. Accordingly, the SEC Staff issued a no-action recommendation regarding the proposed activities of Country Business, Inc. (“CBI”). See Country Bus., Inc., SEC No-Action Letter, 2006 WL 3289777 at 1. CBI anticipated “providing services that are more extensive than simply acting as a finder of potential purchasers of the business.” See Letter from Craig McCrohon, Counsel for Country Bus. Inc., to Catherine McGuire, Chief Counsel and Assoc. Dir., Div. of Mkt. Regulation, Sec. & Exch. Comm’n at 1 (Nov. 8, 2006). CBI intended to assist with the sale of closely-held entities by, among other things: (1) transmitting documents between the parties; (2) valuing the assets of the business as a going concern; (3) providing the seller with administrative support; and (4) assisting the seller with preparation of financial statements. In granting the no-action relief, the SEC Staff, apparently, relied upon CBI’s avoidance on advising the interested parties on the form of consideration to be used in completing the transaction, and that CBI’s fee was to be determined prior to a decision on the structure of the transaction. Further, this fee would potentially be “a fixed fee, hourly fee, a commission, or a combination thereof, that is based upon the consideration received by the seller, regardless of the means used to effect the transaction, and will not vary according to the form of conveyance (i.e., securities rather than assets).”
Taking a different view, the SEC Staff denied relief to Hallmark Capital Corporation (“Hallmark”) based upon its proposed activities, despite the fact that the activities were very similar to those described by CBI in its no-action letter. Hallmark Capital Corp., SEC No-Action Letter, 2007 WL 1879799 at 1. Hallmark described itself as, “a financial consultant and finder for small businesses that assists the owners of businesses in raising capital, facilitates mergers and acquisitions and provides strategic business consulting services.” Id. at 2. Although the SEC did not state in detail its reasons, the difference seemed to be that Hallmark’s fee was not fixed prior to a decision by the interested parties as to the structure of the transaction, and the fee had been set prior to the transaction as detailed in both the IBEC and CBI no-action letters. Compare Country Bus., Inc., SEC No-Action Letter at 1 and Int’l Bus. Exch. Corp., SEC No-Action Letter with Hallmark Capital Corp. Seemingly, these differences would indicate that Hallmark would be acting more as a salesman where such compensation is normally tied to the transaction itself. In IBEC and CBI, the fee was akin to a “flat fee.”
This departure from the previous factors was solidified in March 2010, when the SEC Staff issued a response to a no-action request from the law firm of Brumberg, Mackey & Wall, P.L.C. (“Brumberg”). The Brumberg no-action letter moved closer to a one issue checklist – did the finder or business broker receive transaction based compensation? If so, broker-dealer registration would be required since that factor alone, according to the SEC, would trigger such requirements.
Brumberg sought to introduce potential investors to a renewable energy company. In return, Brumberg would receive a percentage of the funds raised from those investors. Brumberg claimed that it would not (1) engage in any negotiations with investors; (2) provide potential investors any information about the energy company that could be used as the basis for funding-related negotiations; (3) be responsible for, or make any recommendation regarding, the terms, conditions or provisions of any agreement for an investment; or (4) provide any assistance to any potential investor regarding any transaction involving the financing of the energy company.
This seemingly innocuous description would have placed Brumberg in the long line of previous SEC no-action relief, such as we saw in IBEC and CBI. Not so for Brumberg. The SEC switched its focus, underscoring its transaction based compensation approach. According to the SEC Staff, Brumberg’s role of introducing potential investors to the company seeking financing, constituted "pre-screening" potential investors to determine their eligibility to purchase securities, and "pre-selling" the company seeking financing. The SEC Staff emphasized that the transaction-based compensation Brumberg sought to receive would provide Brumberg a strong incentive to engage in "pre-selling," or other sales activities such that Brumberg would need to register as a broker-dealer if it proceeded with the proposed arrangement. See http://www.sec.gov/divisions/marketreg/mr-noaction/2010/brumbergmackey051710.pdf.
However, in 2014, the SEC Staff informed the industry that it would not recommend enforcement action for unregistered finders acting as M&A brokers for privately held companies, but the Staff did not comment on any state law issue. See SEC No Action Letter, M&A Brokers (https://www.sec.gov/divisions/marketreg/mr-noaction/2014/ma-brokers-013114.pdf) (Feb. 4, 2014).
Finally, the SEC Staff has suggested that it is considering recommending certain additional federal regulations to clarify the definition of finders for broker-dealer registration consideration. For example, the SEC Staff issued a concept release in June 2019, that seemed to suggest it was examining the issue. The Trading and Markets Division stated that “[t]he status of persons that provide introductions or otherwise solicit potential investors for an issuer (generally, ‘finders’) is not discussed within this release. The Division of Trading and Markets is reviewing the status of finders for purposes of Section 15(a) of the Exchange Act.” See SEC Release No. 33-10649. Nonetheless, the SEC has not initiated any action to date, or addressed any question concerning if the potential examination on the federal level would consider if it would preempt state regulation such as the regulations now being proposed by the NYSAG.
The NYSAG’s Proposed Finder Registration Regulations
Under current New York law and regulations governing broker-dealer registration, there is no provision relating to finders. The NYSAG now seeks to remedy that situation.
The proposed regulations define a finder as:
…a person, firm, association, or corporation who as part of a regular business, engages in the business of effecting transactions in securities for the account of others within or from this state [New York], to the limited extent that such person, firm, association, or corporation, receives compensation for introducing a prospective investor or investors to any broker, dealer or salesperson. Finders shall be subject to all of the filing and exam requirements of brokers, broker-dealers, and salespersons under this part and under GBL §359-e.
There seems to be no exception for those finders or issuers, who have principal places of business outside of the State of New York. It would appear that two factors would be used in determining whether one falls within the purview of registering as a finder under this regulation. Initially, if one engages in the business of effecting transactions in securities for the account of others within or from the State of New York, and if compensation is received.
If this proposed regulation were to be adopted, the NYSAG has also proposed that the finder become registered. The new requirements would include the following:
All finders not associated with a registered broker-dealer shall file Form M-1 and shall follow the supplemental filing requirements of broker-dealers herein. Finders associated with a non-FINRA member broker-dealer shall file Form M-2. Finders associated with a FINRA member broker-dealer shall file the Form U4. Finder registration periods for non-FINRA members are four (4) years. Finder registrations for FINRA members shall follow registration requirements in 10.2 for broker-dealers or salespersons as appropriate. See Proposed 13 NYCRR §10.1(a)(6).
This adds another layer of regulation for those not registered as well as expense because these newly registered finders would have to pay fees to the State of New York as part of the registration process. Further, these proposed regulations do not appear to offer any of the exceptions provided for by the SEC as discussed above in the various no-action letters.
The NYSAG’s Proposed “Solicitor” Registration Regulations
As part of the proposed regulations, in addition to broker dealers and finders, the NYSAG also proposes to add a class of brokers who would be identified as “solicitors.” As defined in the proposed regulations, a solicitor is:
. . . a person who as part of a regular business, engages in the business of providing investment advice to the limited extent that such person receives compensation for introducing a prospective investor to an investment adviser or a federally covered investment adviser, unless such person would be excluded from the definition of investment adviser under an enumerated exception under GBL359-eee(1)(a).
A solicitor would be subject to the same registration and examination requirement as an investment advisor. Although, differentiating between broker dealers, solicitors, investment advisors and finder is beyond the scope of this article, what is crystal clear is the intention of the NYSAG to increase its regulatory powers and reach over New York investment and security related activities.
New York Coordination With Federal and Other States’ Securities Filings
Additionally, the NYSAG also proposed other regulatory amendments as well. In particular, one involving an issue that has engendered debate in the securities and legal communities for years.
Currently, New York securities filing regulations require that, for all Securities Act of 1933 (“Securities Act”) Rule 506 offerings, a separate state filing must be made before the actual offering. In 2002, the New York State Bar Association’s Committee on Securities Regulation published a position paper that concluded New York’s registration laws and regulations were inconsistent with the National Markets Improvements Act of 1996, the statute that amended Securities Act §18.
Interestingly, the NYSAG never responded to this report, and certain securities practitioners, who followed the advice contained in this report, did so at their own peril. Nonetheless, after all these years, the NYSAG is now proposing an amendment to bring into line the New York and the federal filing requirements for Securities Act Rule 506 offerings with a Form D through the electronic filing depository system of the North American Securities Administrators Association.
Obviously, these proposed changes should be far less controversial than the proposals regarding finders, however, they do represent an important shift (and update) in New York State’s regulation of securities offerings.
In sum, the pandemic has not slowed the NYSAG down. It intends on pushing through various changes to the way securities and those who work in the securities industry are regulated regardless of any activity of the SEC. We strongly urge you to consult with securities counsel on these issues before undertaking any activity.