Unregistered Finders: The Kramer Case. Etc.

Joseph W. Bartlett, Special Counsel, McCarter & English, LLP

On the question of what activity crosses the line between an unregistered financial adviser and a firm required to register under the `34 Act as a broker dealer and apply for a membership in FINRA, these items may be of interest. 

For whatever it is worth, Appendix A sets out a sampling of my writing on this issue … which dates way, way back to when I had conversations with the SEC Staff, amongst others, indicating that Agency inaction in the face of a gray area of this magnitude had created what I sometimes called a crime wave.  We are getting nearer the resolution, it appears, at least in one of these upcoming decades. 

In terms of recent authority, I draw your attention to the opinion by K&L Gates which appears on the AngelList site.  Many of us in this business are using the K&L Gates opinion, on both registration as a broker and registration as an investment adviser as canon law in and of itself & in the land of the blind, the one eyed man is king.  Of interest in the K&L Gates opinion is the listing of a number of activities which, taken as a whole, indicate a given firm or individual is acting as a broker; let me highlight, for this purpose, a remark:

"The Staff puts a particularly heavy emphasis on the receipt of transaction-based compensation, as a significant indication of a person being ‘engaged in the business' of a broker."

And, as the SEC's Staff tempo on this issue has stepped up, there is a memorandum, which I attach as Appendix B from Bingham McCutcheon on a bankruptcy matter in which the SEC Staff got tough on the unregistered finder issue and the debtor's accountants wound up refusing to certify the financial statements. 

Given this apparent determination by the SEC to close in on parties stretching what the Staff perceives as the envelope, one question in is whether there is a more than a trivial possibility that, in light of the manifold use of unregistered finders to raise capital, the issuer and its Board are exposed to liability if, as and when the issuer tanks or depreciates for exogenous reasons. 

But then, lo and behold, the worm has turned once again.  Let me quote liberally from an excellent piece, Badway & Schnapp "Is the Tide Turning Against the SEC in Favor of Finders," ABA Section of Litigation Securities Litigation, Nov. 17, 2011.  As the authors point out:

"Recently, the SEC's enforcement of the broker-dealer registration requirements against finders was thrown into uncertainty in a case arising from the U.S. District Court for the Middle District of Florida, SEC v. Kramer, No. 8:09-cv-455-T-23TBM (M.D. Fla. Apr. 1, 2011). The decision in this case has caused uncertainty, requiring enforcement lawyers to consider alternatives. This article explores the background of the finder's or business broker's exemption, the no-action letters that attempted to construe the exemption, and the Kramer court's rationale, before looking ahead to the next steps the SEC may take in an increasingly complex landscape involving broker-dealer registration and the raising of capital."

"The decision in SEC v. Kramer … may be the beginning of the end for the SEC's transaction-based compensation approach. In Kramer, defendants Kenneth Kramer and Bruce Baker, neither of whom were registered brokers at the time, were business partners. Baker had facilitated a reverse merger on behalf of Skyway Communications Holding Corp. and continued to be compensated, pursuant to an agreement with Skyway, for his promotional efforts.

"Kramer, Baker's partner, helped promote Skyway, and Skyway also compensated him directly if he introduced potential investors who ultimately invested in Skyway. Id. at 16–18. As a result, Kramer earned compensation for arranging a successful meeting between Skyway management and a broker interested in selling Skyway securities. Kramer also received compensation from Baker when Kramer's family, close friends, and business acquaintances bought shares in Skyway. Kramer had informed these individuals that Skyway was a good investment and encouraged them to read Skyway press releases and visit its website. Id. at 19–21.

"Not surprisingly, given its previous no-action guidance, the SEC sued Kramer, alleging that he violated the act's broker-dealer registration requirement. However, noting that "the distinction between a finder and a broker . . . remains largely unexplored," the federal court entered judgment for Kramer. Id. at 29. The court explained that there is a six-Factor test to determine whether a person or an entity is required to register as a broker-dealer. The six Factors are as follows:

'[A] person (1) works as an employee of the issuer, (2) receives a commission rather than a salary, (3) sells or earlier sold the securities of another issuer, (4) participates in negotiations between the issuer and an investor, (5) provides either advice or a valuation as to the merit of an investment, and (6) actively (rather than passively) finds investors.'

"However, the court stated that these Factors were not exclusive, and some Factors, typically tied to broker-dealer activity, may be more likely to indicate broker-dealer conduct. In fact, the court cited another case, SEC v. Bravata, 2009 WL 2245649, at *2 (E.D. Mich. 2009), which stated that "the most important Factor in determining whether an individual entity is a broker" is whether there is a "regularity of participation in securities transaction at key points in the chain of distribution." Kramer, No. 8:09-cv-455-T-23TBM, at *33. However, the court qualified its opinion in that certain nonexclusive Factors also were to be evaluated to determine whether a finder engaged in broker activity, among them, whether the finder engaged in negotiating the terms or details of a transaction, offering advice or valuation information, and aggressively pursuing investors, in addition to receiving transaction-based compensation. Id. at *33–37.

"In dealing with the SEC's position, the court emphatically concluded that "the Commission's proposed single-Factor ‘transaction-based compensation' test for broker activity . . . is an inaccurate statement of the law." Id. Further, the court criticized the SEC's reliance on no-action letters, pointing out that they have no binding legal authority and noting "[a]s this order exhaustively explains, an array of Factors determine the presence of broker activity. In the absence of a statutory definition enunciating otherwise, the test for broker activity must remain cogent, multifaceted, and controlled by the Exchange Act." Id. at 37.

The SEC has appealed to the U.S. Court of Appeals for the Eighth Circuit in June 2011, and the appeal is sub judice.

Where do we now come to rest?  The first answer is: who knows?  The jury is out and will not, presumably, return until the Eighth Circuit decides and, assuming the loser appeals to the Supreme Court, the Supreme Court does as well.  There may, of course, arise a conflict amongst the Circuits; I am told there are other Federal District Court cases in which the SEC has been less than successful and, as a consequence, is bringing more enforcement actions in administrative courts where its track record is much better, and we may go on and on.  What to do? 

One obvious approach is for individuals and firms to review the six Factors test listed in Kramer and frame the agreement with the client accordingly.  Thus, assume an individual contracts to find capital; Factor (6) is yes and the individual receives … Factor (2) … transaction related compensation.  But, the deal is a one off … Factor (3) … no participation in negotiation … Factor (4) … or in addressing the merits or valuation of the securities … Factor (5).  The scorecard is two for the SEC Staff and three for the individual.  If the individual is an employee … Factor (1); I understand Kramer is suggesting this is a pro-finder Factor … the employee gets the success fee in the form of a bonus and that smells like compensation for a good job qua employee vs. a brokerage commission.  Indeed, if the individual signs up as consultant on various strategic issues and receives regular monthly stipends over an extended period, this may tilt Factor (1) in his or her favor, unless it is all a fake. 

Then let's go to the canon, the K&L Gates opinion, and its reading of the relevant tests:

"The Commission and the Staff look to Factors similar to those used by the courts in determining whether an entity is a broker. According to the Commission and the Staff, Factors indicating that a person is "engaged in the business" include, among others : receiving transaction-related compensation [Factor (2)]; holding oneself out as a broker [a new Factor, Factor (7), in my parlance] such as by executing trades or by assisting in settling securities transactions; and participating in the securities business with some degree of regularity [Factor 3]. The Staff puts a particularly heavy emphasis on the receipt of transaction-based compensation as a significant indication of a person being "engaged in the business" of a broker.

Like the courts, the Staff also looks to whether an entity that may be a broker participates in the transaction "at key points in the chain of distribution." According to the Staff, such key points may include, but are not limited to: assisting an issuer in structuring prospective securities transactions [new Factor (8)], negotiating between the issuer and the investor [Factor (4)], providing advice as to the merits of an investment [Factor (5)]; or taking, routing or matching orders [new Factor (9)], or facilitating the execution of a securities transaction [I'll call this Factor (6)]."

Finally, assume that the investors solicited are all large and experienced players [new Factor (10)].

In short, the hypothetical is a typical one-off finder who, before the SEC Staff had recanted its view, would have relied on the July 24, 1991 Paul Anka No-Action letter …one bite of the apple is O.K.

What, in the above scenario, are the risks to the individual (and those around him, or her … i.e., the issuer), if he or she is a one-off and structures the deal so that all the Factors are in favor except the receipt of transaction-based compensation?  What comfort, if any, can counsel give its client in this regard?  Do we have to wait and see how Kramer fares in the Eighth Circuit and perhaps SCOTUS?

My view, in several parts:

  • If the SEC loses Kramer with finality, the Agency may fight back with a Regulation which is proposed and enacted with requisite formality and tightens the noose … if there is transaction–based compensation and one (and only one) other Factor pops up, e.g., one of the investors is not in the Super Accredited or institutional investor category.  In fact, we believe, this may already have happened, see below.
  • When Form D is filed and truthfully answered … the finder was not registered … the State Securities regulators may step into the fray, depending on the State statutory landscape. [1]  Assume for this purpose, however, none of the investors are Alabama residents.  (The cognoscenti know why that State is named.)
  • Some years ago I published a piece which set out a letter from counsel to the client as follows:

"We understand that Newco Inc. has employed a placement agent, Finder Inc. ("Finder") to assist in the placement referred to in the body of this letter and proposes to compensate Finder on a basis which includes a success fee. Moreover, it is anticipated by Newco that Finder will participate in the negotiating the placement . . . amount and terms . . . with potential investors."

"You are hereby cautioned that, as we understand it, Finder may be required to register, but currently is not registered, as a broker/dealer under Section 15 of the Securities & Exchange Act of 1934 and to join, but has not joined, the NASD as a member [plus any requirements under State law arguably applicable]. Although there is no controlling precedent of which we are aware, at least some authorities have suggested (and there are, to be sure, opposing views) that the participation of an unregistered broker/dealer in the placement might involve legal responsibilities and consequences imposed on Newco as the issuer of the securities in question by virtue of, e.g., Section 29(b) of the Exchange Act. We are also cognizant of the various proposals to the SEC that this issue be clarified by the promulgation of rules on the subject … but such clarification has not yet been published. In view of the lack of authority on this issue, we express no opinion on the likely outcome of any controversy involving Newco and the provisions of the '33 and '34 Acts, and/or State securities law, including but not limited to a challenge to the status of the transaction as a private offering exempt from registration under Section 5 of the Securities Act of 1933. We call the issue to your attention and will be happy to discuss it further with you."

Is this where counsel winds up?  The firm warns the client but does not walk away?

Next installment: on February 5th, well after Kramer, SEC previewed the Title II JOBS Act Rules … out in proposed form that but as yet (to the dismay of many) finalized … with a suite of Frequently Asked Questions ("FAQs"), leading off with the statement that:

"These FAQs are not rules, regulations or statements of the Commission. The Commission has neither approved nor disapproved these FAQs."

Then, the Kramer postscript pops up in the following:

Question "The exemption in Securities Act Section 4(b) [of the JOBS Act, Title II] is not available to anyone who receives (or whose associated persons receive) ‘compensation in connection with the purchase or sale of such security.' What forms of compensation would cause me to be unable to rely on the exemption?"

Answer. "Congress conditioned the exemption on a person and its associated persons not receiving any ‘compensation' in connection with the purchase or sale of such security. Congress did not limit the conditions to transaction-based compensation. The staff interprets the term ‘compensation' broadly to include any direct or indirect economic benefit to the person or any of its associated persons. At the same time, we recognize that Congress expressly permitted co-investment in the securities offered on the platform or mechanism. We do not believe that profits associated with these investments would be impermissible compensation for purposes of Securities Act Section 4(b)."  (Emphasis added.)"

Talk about FAQs.  How about these?

Question.  How come FAQs on Title II are published before the long awaited Regulations themselves are published?

Answer. The public needs to get this under its belt as Platforms, pre-Title II but anticipating the same, proliferate online.

Question.  How about the language in Kramer that a single factor test … transaction-based compensation… is "an inaccurate statement of the law."

Answer.  Kramer is on appeal to the Eighth Circuit.

Question.  If Section 4(b) of Title II is not protective of the Platform, does the Staff's FAQ mean that Platforms functioning under Quiet 506 … i.e., no general solicitation [2] … cannot enjoy any "direct or indirect economic benefit" in connection with the purchase or sale of a security?  Does that mean all the Platforms currently operating under Quiet 506, e.g., Circle Up … are illegal?  It would seem any "economic benefit" (other than the carried interest in a side car fund) would include, for example, recovery of the Platform's costs.  An indirect benefit might mean that the Platform need register if an "associated person" … or SecondMarket in the case of AngelList … is "indirectly" benefitted by, and only by, the opportunity to take on new clients.

Answer.  No Comment.

Question.  Does "associated persons" include broker dealers … for example SecondMarket, which is linked to AngelList … if they "benefit economically" in any way from their introduction to the emerging growth companies which AngelList chaperones through the Quiet 506 process?

Answer.  See above. 

Now for my guesstimate: Until the picture clarifies (Kramer is decided in the Eighth Circuit perhaps), finders who carefully structure compliance with the 10 Factor test may well achieve their goal … money in the bank.  The law firms will not, I assume, opine nor, indeed, present a point of view or a forecast … too much gray in the atmosphere.  They will content themselves to (a) drawing the clients' attention to Kramer and the commentary (including this piece) arising as a consequence and (b) advising strict compliance with all the Factors except transaction related compensation, including any new Factors which may arrive on the scene.  If the SEC enforcement staff goes after one or more of the existing Quiet 506 Platforms or a one-off finder for getting any "economic benefit," this event may well be brought to the attention of the Eighth Circuit reviewing Kramer

In short, the players are on the field warming up, awaiting, e.g., an opinion on Kramer.  In the meantime, however, the sky remains overcast and gray. 

March 2013  

[1] See O'Bierne, Bartlett & Kortmansky, "Consequences of Violating Section 29," The Daily Deal, May 10, 2010, where the authors remark:

"…state securities laws grant investors additional rights. For example, in California, Section 25501.5 of the Corporate Securities Law provides, in part, that a person who purchases a security from or sells a security to a broker-dealer required to be licensed but which has not, at the time of the sale or purchase, secured from the commissioner a certificate authorizing the broker-dealer to act in that capacity, may bring an action for rescission of the sale or purchase or, if the plaintiff or the defendant no longer owns the security, for damages. In fact, six state statutes contain voidability provisions, all of which specifically give a right of rescission to the buyer. Four states make any sale made in violation of any provision of the Blue Sky statutes voidable. Arizona limits its voidability provision to the sale of unregistered securities, transactions by unregistered dealers or specified fraudulent practices; Florida and Illinois grant rescission as a remedy to a violation of registration provisions of the securities dealer, associated person and investment adviser."

[2] "Quiet 506: A Study In Irony," is available at



Writings on Unregistered Finders by Joseph W. Bartlett

"Consequences of violating Section 29," May 10, 2010.

Unregistered Finders: The SEC Begins Enforcement Actions (8/4/2009)

Private Equity Alert - Unregistered Finders - The Last Chapter? (6/9/09)

Mandatory Registration of Finders as Private Placement Brokers: SEC Action On The Way (Part 1) (1/11/07)

Mandatory Registration of Finders as Private Placement Brokers: SEC Action On The Way (Part 2) (1/16/07)

Unregistered Finder; Can Issuer's Counsel Participate in the Deal?(6/1/06)

Can You 'Find' Capital: NASD Action vs. John Hancock (5/13/03)

Finder's Keepers? (9/30/00)

Business Brokers Not Required to Register as Brokers

Mandatory Registration of Finders: ABA Task Force Report

ABA Report and Recommendations of the Task Force on Private Placement Broker-Dealers, 2006

"ABA Task Force Urges the SEC to Promulgate ‘Broker Dealer Lite:' Registration Requirements for Unregistered Finders: Many Firms Are Currently at Risk in a ‘Gray Area,' Bartlett, The Journal of Private Equity, Summer 2007,



(Footnotes omitted)

Unauthorized Payments To Unlicensed Individuals Sinks Company

By Amy Natterson Kroll, Carl A. Valenstein and Margaret (Peggy) Blake, Bingham McCutchen LLP

Law360, New York (September 13, 2012, 7:19 PM ET) -- In July 2012, Neogenix Oncology Inc., a biotech firm based in Rockville, Md., and New York, surprised investors by filing for Chapter 11 bankruptcy protection.  To those in the biotech industry, Neogenix, by all accounts, was a successful company with more than 500 shareholders and what seemed to be numerous clinical developments. Perhaps even more surprising than the actual Chapter 11 filing was the reason behind it.

It seems an inquiry by the U.S. Securities and Exchange Commission in late 2011 into the company's capital raising efforts uncovered payments by the company to unlicensed individuals (i.e., individuals who should have been licensed with a registered broker-dealer) who assisted in the company's capital raising. Reliance on unregistered persons resulted in "significant potential rescission liability and the inability to present audited financial statements" leaving the company "unable to raise funds." 

Under the Securities Exchange Act of 1934 (the "Exchange Act"), offers and sales of securities in the U.S. must be made by a registered broker-dealer or appropriately licensed individuals associated with a registered broker-dealer. Despite increased awareness in the securities industry, many issuers, public and private, continue to rely on the elusive "finders" exemption, which the SEC has all but eliminated as a possible alternative to using registered personnel in sales of securities.

A true finder, under SEC guidance, introduces the buyers and sellers of securities and then steps away from any subsequent involvement in the transaction. The SEC has noted in no-action guidance, that where a "finder" does anything more than introduce the parties (e.g., assists in negotiating on behalf of a party, participates in discussions regarding the pricing of a security), s/he may be deemed as acting as an unregistered broker-dealer. 

In addition, a finder ideally should be compensated on a flat-fee basis and not be paid a commission or a fee based on the success of a transaction. However, depending on the facts and circumstances, a finder engaging in more than introductory activity who is paid a flat fee may be deemed an unregistered broker-dealer regardless of the flat fee arrangement. In sum, the finder exemption is very narrow, and the risks associated with relying on it are very real.

In the case of Neogenix, the company engaged several "finders" to assist with the offer and sale of its securities. How those individuals were paid is not clear, but the payments and the finders' arrangements in question came to the attention of the SEC. Following its inquiry, the SEC determined the finders used by Neogenix were required to be licensed. As a result of the use of unregistered broker-dealers in the offer and sale of securities, Neogenix opened itself up to the possibility of shareholder suits for rescission of the purchases and sales of the securities. 

The company in an effort to clean its slate decided to sell itself to another entity owned by Neogenix shareholders and to declare Chapter 11 bankruptcy. In a letter, dated July 25, 2012, from the chairman to Neogenix shareholders, James Feldman set forth the details of the transaction and introduced Precision Biologics as a "stalking horse" bidder in the purchase of Neogenix.

Often considered an afterthought in capital raisings, an issuer must take care to ensure that anyone assisting in the offer or sale of its securities is properly licensed or relying on a valid exemption from licensing and is otherwise in compliance with all relevant U.S. securities laws. The story of Neogenix emphasizes how important this is for any transaction involving the offer and sale of securities. As illustrated here, the ripple effect of relying on incorrect or outdated guidance could be detrimental.

Amy Natterson Kroll and Carl Valenstein are partners with Bingham in the firm's Washington, D.C., office. Peggy Blake is of counsel in the firm's Washington office.

The opinions expressed are those of the authors and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

Joseph W. Bartlett, Special Counsel,

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