As a private lender, it’s important to understand what’s legally permissible when you compensate someone who helps you raise money for your fund.

Finding investors is one of the biggest challenges fund managers face. Often, fund managers meet individuals who are willing to help raise money in exchange for a fee. Unfortunately, this type of compensation likely violates the broker-dealer registration requirements of Section 15(a) of the Securities Exchange Act of 1934 (the Exchange Act).

Understanding securities regulations, specifically the concept of “broker-dealer” activities will help you stay within permissible boundaries for compensating someone for these activities.

Broker-Dealer Activities

Under federal securities laws, Section 15(a) of the Exchange Act requires anyone engaged in broker-dealer activity to register with the Securities and Exchange Commission (SEC). The Exchange Act specifically provides that a person who is “engaged in the business of effecting transactions in securities for the account of others” is generally required to register as a broker. This rule applies to all offerings, whether or not exempt from registration under the Securities Act of 1933 (the Securities Act).

Broker-dealer activities are subject to strict regulation by the SEC and other regulatory agencies. Courts and the SEC have considered various factors when determining whether a person has violated securities laws by not registering as a broker-dealer. This often includes evaluating whether someone:

1. Helps solicit or identify potential investors for the fund.
2. Participates in discussions or negotiations with the investor.
3. Provides the investor with any advice regarding the fund’s merits or receives compensation in connection with the investor’s investment in the fund.

Receiving compensation in connection with facilitating securities transactions (including through referrals) is often classified as broker-dealer activities, and unless that person is registered under the Exchange Act, securities laws prohibit paying that person “transaction-based compensation.” This includes any compensation tied to the success of the potential investment, payments based on the outcome of the potential investment, or the amount invested by an investor into the fund.

An exception to these requirements is the “issuer exemption,” available under Rule 3a4-1 of the Exchange Act for fund manager employees who occasionally sell the fund’s securities but primarily perform other duties for the fund, whose compensation is not based on the sale of such securities (either directly or indirectly), and who meet certain other requirements. Under these specific circumstances, the employee is not required to register as a broker-dealer.

Transaction-Based Compensation

The SEC and state regulators are paying close attention to the type of compensation paid. Payment of “transaction-based compensation” alone can trigger violation of the Exchange Act. Transaction-based compensation (or success-based compensation) occurs when someone receives payments based on the outcome or size of the transaction/amount invested.

It doesn’t matter whether such payments are called finders fees, referral fees, consulting fees, or success fees. The SEC has stated that the receipt of transaction-based compensation in connection with another person’s purchase or sale of securities represents a hallmark of broker-dealer activity. (See Brumberg, Mackey & Wall, P.L.C., SEC Staff Denial of No-Action Request; May 17, 2010). This means that paying someone to assist in raising capital when the payment is premised on a transaction is not permissible unless that person is a licensed broker-dealer.

Risks of Using Unlicensed Broker-Dealers

Fund managers who involve unregistered broker-dealers in capital-raising efforts may be subjected to both civil and criminal penalties, which include SEC enforcement actions for aiding and abetting a finder’s violation of broker-dealer registration requirements and/or other enforcement actions from state securities regulators. Ultimately, such actions could lead to their prohibition from participating in or being associated with future securities offerings due to triggering ”bad actor” or “bad boy” events as defined by the Securities Act.

Additionally, using an unregistered broker-dealer to help raise capital may give investors the right to require the fund to rescind their investment and require the return of all money invested. For example, violations of Washington’s securities laws provide a private right of rescission that includes 8% interest and reasonable attorneys’ fees (see RCW 21.20.430). Similarly, Oregon investors can seek rescission of the transaction plus 9% interest (or greater) and reasonable attorneys’ fees (see ORS 82.010 – Legal rate of interest and ORS 59.115 – Liability in connection with sale or successful solicitation of sale of securities). In California, an investor can exercise its right to rescind its investment, even if it no longer owns the securities, and can be awarded attorneys’ fees and costs (see Cal. Corp. Code § 25501).

Fund managers, issuers, and other companies should be aware of these risks when working with others to raise capital.

Reducing Risks

Guidance from the SEC on these issues is limited, despite efforts over the years to push the SEC for greater clarity. Despite a common misconception, the Exchange Act does not provide a finder’s exemption and the no-action letters issued by SEC staff providing an exception to broker-dealer registration contained very restrictive conditions and would only be applicable under very narrow fact patterns and specific situations. Additionally, several states (i.e., California, New York, and Texas) have implemented or proposed state-level registration requirements on finders.

Section 15 issues may be eliminated when working with unlicensed individuals, so long as the fund managers (1) avoid compensation arrangements tied to deal success, investment amounts, or other investment-related factors and (2) ensure the individual does nothing more than make the initial introduction.

For example, a fund manager can pay a finder a flat fee for an introduction to a high-net-worth investor. However, that flat fee will need to be paid to the finder regardless of whether the high-net-worth investor ultimately invests any capital into the fund. Further, the finder must not attend meetings with the fund manager and investor, explain or discuss the investment opportunity or specific fund terms with the investor, or help prepare or distribute fund offering materials.

Conclusion

Capital raising is a complex and highly regulated area, making it imperative for fund managers to be wary of simple fixes intended to “work around” broker-dealer registration requirements and other securities issues. As the SEC continues to closely monitor private funds and their capital-raising activities, fund managers should proactively seek guidance from experienced securities counsel before paying anyone finders fees, referral fees, or commissions. Remaining vigilant, continuously learning, and staying in compliance with the ever-evolving securities rules and regulations is crucial for fund managers aiming to achieve success.