The Securities and Exchange Commission (SEC) plays a crucial role in laying down the regulations for real estate crowdfunding. The SEC is focused on broker dealer registration, and for well-substantiated reasons too. It’s important to define the context of broker dealer registration guidelines as pertaining to private securities marketing activities. It’s clear to notice that SEC recent enforcement actions prove that there are going to be some serious penalties for acting as an unregistered broker, even if no allegations of fraud exist. This regulatory focus is very likely to continue, and may indeed increase, with the use of general solicitation and general advertising in Rule 506 private offerings permitted by the Jumpstart Our Business Startups (JOBS) Act.

Assessing Common Scenario with Risks

The broker-dealer registration issue frequently emerges when a company or private investment fund raises capital from investors in a private (unregistered) securities offering using its own employees or third party “finders” to locate investors. In the scenario where these individuals solicit investors on a regular basis or are specifically compensated for their efforts, they may be required to register as a broker or to be associated with a registered broker-dealer firm.

A company or individual acting as an unregistered broker-dealer is in violation of applicable registration requirements and may face possible government enforcement action, some monetary penalties and investor lawsuits seeking rescission of the investment and recovery of the purchase price paid. Registering as a broker-dealer is a significant undertaking and will subject the firm to extensive regulation by the SEC, Financial Industry Regulatory Authority (FINRA) and/or state securities regulators. It is normally not a practical alternative for companies engaged in limited or infrequent capital raising activities.

Defining Who is a Broker-Dealer?

The test for broker registration is broad and depends on the particular facts and circumstances. The principal factors the SEC considers include whether the individual (1) actively solicited investors, (2) advised investors as to the merits of an investment, (3) regularly participated in securities transactions and (4) received commissions or transaction-based remuneration.

Issuer Exemption. Entities issuing securities (issuers) generally are not “brokers” because they sell securities for their own account and not for the account of others. Issuers are also normally not “dealers” because they do not sell securities for their own account as a part of a regular business. According to the SEC, this so-called “issuer’s exemption” does not apply to the individual of a company who routinely engage in the business of effecting securities transactions for the company, such as general partners, employees and other related individuals seeking investors in the company.

The SEC has adopted Rule 3a4-1, a safe harbor rule that provides a broker registration exemption for those 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 the safe harbor, an associated individual will not be deemed a broker if, among other things, the individual:

• Is not compensated by payment of commissions or other remuneration based on securities transactions;
• Is not associated with a broker-dealer; and
• Limits sales activities either (1) to one offering per 12 month period and performs other substantial duties, (2) to soliciting only certain financial institutions or (3) to passive or clerical duties not involving solicitation of investors.

Finders Exemption. It is generally considered that individuals who do nothing more than introduce prospective investors to the issuer, do not participate in negotiating the transaction, and who receive compensation not dependent on or related to the purchase of a security are “finders,” not “brokers,” and are not required to be registered. Whilst a few no-action letters support this position, the SEC appears reticent to create a “finder’s exemption.”

The SEC has warned individuals who find investors for issuers, even in a “consultant” capacity, may need to register as a broker depending on a number of factors, including whether (1) the finder participates in the solicitation, negotiation or execution of the transaction, (2) compensation is related to the outcome or size of the transaction, (3) the finder is otherwise engaged in the business of effecting securities transactions and (4) the finder handles securities or funds of others. A “yes” answer to any of these factors indicates that registration may be required.

State Exemptions. Each state presents its own specified laws defining broker-dealer, agent and related registration requirements. Under the Uniform Securities Act, adopted in large measure by many states, an issuer selling its own securities is exempt from broker-dealer registration. An employee or other individual who represents an issuer is exempt if no commission or other remuneration is paid for soliciting investors. Ohio particularly exempts a finder if his or her compensation is not based on the sale of securities by the issuer to the investor.