Unregistered Broker-Dealer Activity on the Rise By: Brenda Hamilton

Unregistered Broker - Going Public Lawyer

The Securities and Exchange Commission (“SEC”) Division of Enforcement is pursuing unregistered broker-dealer activity which runs rampant in the penny stock markets.  Since Rule 506(c) was created many unregistered broker-dealers have appeared in the OTC marketplace touting their skills as capital raisers despite not being registered with the SEC. 

Recent SEC enforcement actions demonstrate there are serious consequences for those who engage in unregistered broker-dealer activity. We expect the regulatory focus on unregistered broker dealer activity to increase with the use of general solicitation and general advertising in Rule 506(c) offerings now permitted by the Jumpstart Our Business Startups (JOBS) Act.

On May 15, 2014, the SEC charged Behrooz Sarafraz with acting as an unregistered broker dealer for selling oil and gas investments in TVC Opus I Drilling Program, LP and its managing partner, Tri-Valley Corporation. According to the SEC, Sarafraz received at least $18 million in commissions despite not being registered.  The SEC stated that “[b]y failing to become associated with a registered broker-dealer, Sarafraz denied investors the protections of regulatory oversight and firm supervision.”  Sarafraz agreed to settle the case without either admitting or denying the allegations by paying more than $22.4 million in disgorgement plus interest and consenting to an injunction prohibiting him from future violations of the securities laws. The settlement must be approved by the US District Court for the Northern District of California.

What is Unregistered Broker-Dealer Activity?

Unregistered broker-dealer activity frequently arises when a company raises capital from investors in a private securities offering using persons not registered as broker-dealers who claim to act as investment bankers, consultants, advisers and/or finders. When these persons solicit investors on a regular basis or receive transaction based compensation, they must be registered with the SEC and Financial Industry Regulatory Authority (“FINRA”) as a broker and be associated with a registered broker-dealer firm.

Registering as a broker-dealer is a significant undertaking and will subject the person and their corporate ego to extensive scrutiny and regulation by the SEC, FINRA and/or state securities regulators. Many persons engaged in capital raising activities cannot pass the scrutiny or satisfy the regulatory requirements to become registered.

A company or individual acting as an unregistered broker-dealer is in violation of applicable registration requirements. Such persons and the issuers hiring them risk SEC enforcement action and monetary penalties and investor lawsuits seeking rescission and the return of their investment.

Who is an Unregistered Broker?

The test for broker registration is broad and based on the particular facts and circumstances. The principal factors to determine unregistered broker-dealer activity include whether the person (i) actively solicited investors, (ii) advised investors as to the merits of the investment, (iii) drafted documents for the investment (iv) regularly participates in securities transactions and (v) received  transaction-based compensation or commissions.

Exemptions From Broker-Dealer Registration.

Companies selling securities for their own account are generally not brokers.  Similarly they are not dealers because they do not sell securities for their own account as part of their regular business.

SEC Rule 3a4-1 provides a safe harbor for people associated with an issuer who participate in the sale of the issuer’s securities, including officers and employees of the issuer, a corporate general partner of a limited partnership issuer, or a company affiliated with the issuer. Under 3a4-1, such persons will not be deemed a broker if the person (i) does not receive commissions or other transaction based compensation based on securities transactions; (ii) is not associated with a broker-dealer; and (iii) limits their sales activities to either (a) one offering in each 12 month period and performs other substantial duties for the issuer, (b) to soliciting only certain financial institutions,  and (c) passive or clerical duties not involving solicitation of investors for the issuer’s offering.

Finders Exemption.

It is generally believed that those who do nothing more than introduce prospective investors to a company, who do not participate in negotiations, and who receive compensation not dependent on or related to the purchase of a security are “finders” who are not required to be registered as broker-dealers.  The SEC has been reluctant to allow market participants to rely upon the finder’s exemption.

The SEC has consistently stated that even a “consultant” may be required to register as a broker-dealer if such person engages in any of the following activity:  (i)   solicitation, negotiation or execution of an investment, (ii) receives transaction based compensation, (iii) is engaged in the business of effecting securities transactions, or (iv) handles securities or funds of investors.

State Regulation of Finders.

Each state has adopted regulations governing broker-dealer, agent and registration requirements. Under the Uniform Securities Act, an issuer selling its own securities is exempt from broker-dealer registration and its employees are exempt so long as no commission or other remuneration is paid for soliciting investors.

The JOBS Act Creates an Exemption.

The JOBS Act created an exemption from broker-dealer registration for online platforms which market securities in Rule 506 offerings. This exemption is separate from the JOBS Act exemption for crowd funding portals.

The new online platform exemption permits a person, in a Rule 506 offering to: (i) maintain a platform that permits the offer, sale, purchase, negotiation, general solicitations, general advertisements, or similar activities by issuers, whether online, in person, or through other means, (ii) co-invest in the offering, or (iii) provide ancillary services such as due diligence, if certain condition are met.

Online platforms relying on the exemption (i) may not receive transaction-based compensation but may charge other types of fees, (ii) cannot handle funds or securities, and (iii) may not be compensated for investment advice to issuers or investors.

The exemption is a narrow one intended to assist companies in locating angel investors by allowing online investment intermediaries to provide services.  The SEC has stated that employees or other persons who receive a salary or other compensation to promote the issuer’s securities cannot rely on the exemption.  .

Companies using employees or other unregistered persons to raise capital must be cautious and closely monitor their activities to avoid regulatory action.  Regulatory action will likely increase with the use of general solicitation and general advertising in Rule 506(c) offerings to accredited investors under the JOBS Act.