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Using “Finders” To Sell Securities, Including Tokens

Selling securities is hard, and it makes perfect sense that an issuer or a portal would hire someone to help. And once you’ve hired someone, it also makes perfect sense business-wise to pay her a percentage of what she raises, aligning her interests with yours.

It’s perfect, but it might be illegal.

The Legal Issue

The Securities Exchange Act of 1934 generally makes it illegal for any “broker” to sell securities unless she’s registered with the SEC. The Exchange Act defines the term “broker” to mean “any person engaged in the business of effecting transactions in securities for the account of others.” That’s not a very helpful definition, but if you earn a commission from selling securities, like the helper above, you might be a broker.

So what? Well, if someone who’s a “broker” sells securities without registering with the SEC, lots of bad things can happen:

  • All the investors in the offering could have a right of to get their money back, and that right could be enforceable against the principals of the issuer.
  • The issuer could lose its exemption, g., its exemption under Regulation D.
  • By violating the securities laws, the issuer and its principals could become “bad actors,” ineligible to sell securities in the future.
  • The issuer could be liable for “aiding and abetting” a violation of the securities laws.
  • The issuer could be liable under state blue sky laws.
  • The person acting as the unregistered broker could also face serious consequences, including sanctions from the SEC and lawsuits from its customers.

What is a Broker?

Because the Exchange Act does not define what it means to be “engaged in the business of effecting transactions in securities,” the SEC and the courts have typically relied on a variety of factors, including whether the person:

  • Is employed by the issuer
  • Receives a commission rather than a salary
  • Sells securities for others
  • Participates in negotiations between the issuer and an investor, g., helps with sales presentations
  • Provides advice on the merits of the investment
  • Actively (rather than passively) finds investors

More recently, in court cases and in responses to requests for no-action letters, the SEC seems to be moving toward a more aggressive position:  that if a person receives a commission she’s a broker and must be registered as such, end of story.

So far, courts are rejecting the SEC’s hard-line approach. In a 2011 case called SEC v. Kramer, the court stated:

[T]he Commission’s proposed single-factor “transaction-based compensation” test for broker activity (i.e., a person ‘engaged in the business of effecting transactions in securities for the accounts of others’) is an inaccurate statement of the law. . . . . 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, multi-faceted, and controlled by the Exchange Act.

As reassuring as that statement sounds, it was made by a District Court, not a Court of Appeals and certainly not the Supreme Court. A District Court in a different part of the country might take the SEC’s side instead.

But I Know Someone Who. . . .

Yes, I know. There are lots of people out there selling securities, including tokens that are securities, and receiving commissions, and nothing bad happens to them.

There are so many of these people we have a name for them:  Finders. The securities industry, at least at the level of private placements, is permeated by Finders. I had a conversation with a guy who offered to raise money for my issuer client in exchange for a commission, and when I mentioned the Exchange Act he said “What are you talking about? I’ve been doing this for 25 years!”

I’m sure he has. The SEC would never say so publicly, but the reality is that where broker-dealer laws are concerned there are two worlds:  one, the world of large or public deals, where the SEC demands strict compliance; and the world of small, private deals, where the SEC looks the other way.

In my opinion, Crowdfunding offerings and ICOs fall in the “large or public deals” category, even though it’s hard to tell a Crowdfunding client they can’t do something the guy down the street is doing.

So What Can I Do?

If you’re selling securities in a Crowdfunding offering or an ICO, don’t hire that person who promises to go out and find investors in exchange for a commission, unless she’s a registered broker.

On the other hand, in an isolated case, if you know someone with five wealthy friends, who promises to introduce you to those friends, without participating in any sales presentations, you might be willing to offer a commission, relying on current law, as long as (1) you understand that a court might hold against you, adopting the SEC’s hard-line approach; and (2) you hire a securities lawyer to draft the contract.

The Future

Several years ago the SEC created an exemption for Finders in the mergers & acquisitions area. I am far from alone in suggesting that we need a similar exemption for Finders in non-public offerings. The current situation, where a substantial part of the securities industry operates in a legal Twilight Zone, is not tenable as online capital raising becomes the norm rather than the exception.

Questions? Let me know.

The Liability Of Issuers In Crowdfunding (Parental Discretion Advised)

You’re thinking about raising money using Crowdfunding, but are concerned about legal liability. Here is a non-exclusive list of ways you can be liable as an issuer.

When I say “Exchange Act” I mean the Securities Exchange Act of 1934, and when I say “Securities Act” I mean the Securities Act of 1933. The “CFR” is the Code of Federal Regulations.

Rule 10b-5

17 C.F.R. §240.10b-5, issued by the SEC under section 10(b) of the Exchange Act, makes it unlawful, in connection with the purchase or sale of any security, to:

(a)  To employ any device, scheme, or artifice to defraud,

(b)  To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(c)  To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.

Back in 1946, courts established a “private right of action” under Rule 10b-5, meaning that an investor who has been damaged by a violation of Rule 10b-5 can sue the person who made the misstatement. That often means the issuer, but can also mean an officer or other representative.

Rule 10b-5 applies to all Crowdfunding offerings.

Section 12(a)(2) of Securities Act

Section 12(a)(2) of the Securities Act imposes liability on an issuer or other seller of securities who:

Offers or sells a security. . . by means of a prospectus or oral communication, which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading (the purchaser not knowing of such untruth or omission), and who shall not sustain the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of such untruth or omission.

Rule 12(a)(2) applies to Title III and Tile IV, but not to Title II.

Section 17(a) of Securities Act

Section 17(a) of the Securities Act makes it unlawful for any person, including the issuer, in the offer of sale of securities, to:

(1) employ any device, scheme, or artifice to defraud, or

(2) obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light

of the circumstances under which they were made, not misleading; or

(3) engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.

Section 17(a) applies to all Crowdfunding offerings.

Special Liability Provision of Title III

New section 4A(c) of the Securities Act extends a similar concept into Title III. A Title III issuer is liable if:

The issuer makes an untrue statement of a material fact or omits to state a material fact required to be stated or necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading, provided that the purchaser did not know of such untruth or omission; and does not sustain the burden of proof that such issuer did not know, and in the exercise of reasonable care could not have known, of such untruth or omission.

This new provision defines “issuer” broadly:

As used in this subsection, the term “issuer” includes any person who is a director or partner of the issuer, and the principal executive officer or officers, principal financial officer, and controller or principal accounting officer of the issuer (and any person occupying a similar status or performing a similar function) that offers or sells a security in a transaction exempted by the provisions of section 4(a)(6) of this title, and any person who offers or sells the security in such offering.

The SEC says that even funding portal itself would likely fall within the definition of “issuer” and thus be subject to statutory liability under section 4A(c).

Section 4A(c) applies only to Title III.

NOTE: Rule 10b-5, section 12(a)(2), section 17(a), and section 4A(c) are very similar, but with a few key differences, including these:

  • A plaintiff making a claim under Rule 10b-5 must prove the defendant acted knowingly or was reckless.
  • A plaintiff making a claim under section 12(a)(2) or section 4A(c) must show only that the statement in question was false, leaving the defendant to prove that it did not know, and with the exercise of reasonable care could not have known, that it was false.
  • Section 12(a)(2) allows claims against the person who sold the security to the plaintiff. Section 4A(c), on the other hand, could impose liability on the issuer even in the case of a “secondary” sale, meaning a sale by an existing stockholder.
  • Section 12(a)(2) applies only to misstatements or omissions in a prospectus or made orally. Section 4A(c), on the other hand, applies to misstatements or omissions anywhere.
  • Section 17(a) does not provide a private right of action, meaning it’s about a penalty imposed by the SEC, not a lawsuit brought by an investor.
  • In making a claim under section 17(a), the SEC need show only negligence on the part of the defendant.

Failure to Register Offering

Section 5 of the Securities Act generally requires all offerings of securities to be registered with the SEC. All Crowdfunding offerings rely on statutory or regulatory exemptions from the registration requirement. Rule 506(c), Regulation A, intrastate Crowdfunding, Title III – these all provide exemptions from the registration requirement of section 5.

But all those exemptions are conditioned on satisfying certain requirements. To qualify for the exemption under Rule 506(c), for example the issuer must take reasonable steps to ensure that every investor is accredited and form a reasonable belief that every investor is accredited. If an issuer fails to satisfy all the requirements of an exemption, then the issuer has engaged in an illegal, unregistered offering and is liable under section 12(a)(1) of the Securities Act.

Failure to Use Licensed Broker

Section 15(a) of the Exchange Act requires any person acting as broker to register with the SEC. If an issuer sells securities through a person who should be licensed as a broker but is not, the issuer could be liable under any of several legal theories:

  • Use of an unlicensed broker could cause the issuer to lose the exemption from registration.
  • The failure to notify investors that the issuer is using an unlicensed broker could give rise to liability under Rule 10b-5 or section 12(a)(2).
  • The issuer could be liable for aiding and abetting the unlawful actions of the unlicensed brokers.

Failure of Principals to Register as Brokers

Section 3(a)(4)(A) of the Exchange Act generally defines a “broker” as “any person engaged in the business of effecting transactions in securities for others.” The issuer itself is not required to register as a broker, because the issuer is effecting transactions in securities for itself, not for others. This is commonly referred to as the “issuer exemption.”

But the issuer exemption doesn’t protect employees of the issuer who engaged in selling the issuer’s securities, including the founder, the President, the CEO, the Marketing Director, and the Director of Investor Relations. A different SEC regulation, 17 CFR §240.3a4-1, provides a limited safe-harbor exemption for these so-called “associated persons.” However, it’s not hard for an issuer’s associated persons to fail to qualify for that exemption.

If an associated person should be registered as a broker but isn’t, not only is he or she personally liable, but the issuer itself now faces all the potential liabilities associated with using an unlicensed broker!

State Common Law Rules

Issuers can be liable to investors under a variety of state “common law” (as opposed to statutory law) theories, including:

  • Fraud
  • Misrepresentation
  • Breaches of fiduciary obligations
  • Breaches of contractual obligations (g., under an Operating Agreement)
  • Breach of the implied covenant of good faith and fair dealing

State Statutory Rules

States regulate the sale of securities as well. An issuer can be liable under state securities laws for:

  • The failure to register an offering under state law.

NOTE: Suppose you’re selling securities under Title II Crowdfunding (Rule 506(c)). The starting place is that sales of securities under Rule 506(c) are not subject to state registration. But if you fail to take reasonable steps to ensure that all your investors are accredited, not only do you lose your Federal exemption, you also lose your exemption form state registration as well!

  • The use of an unlicensed broker-dealer.
  • The use of deceptive offering materials.

Criminal Rules

If an issuer really screws up, it could even be subject to Federal and state criminal penalties, including:

  • Criminal penalties for intentionally violating securities laws
  • Criminal penalties for mail fraud
  • Criminal penalties for wire fraud
  • Criminal penalties for violating the Racketeer Influenced and Corrupt Organizations

Liability of People

Entrepreneurs sometimes are under the mistaken impression that operating through a corporation or other legal entity protects them from all personal liability. For example, an entrepreneur on her way to a business meeting swerves to run over a bevy of doctors and jumps from her car, laughing. “You can’t sue me, I operate through a corporation!” she says.

No. She did it, so she’s personally liable, corporation or no corporation. If her employee did it, the story might be different (unless he was drunk when she handed him the keys).

The same is true in securities laws. Assume that if you’re running the issuer, all the potential liability I’ve described applies to you personally as well.

Is Crowdfunding Too Dangerous?

No, definitely not.

With the exception of section 4A(c) of the Securities Act, which is limited to Title III, you’ll notice that all of the potential liabilities I’ve described apply to old-fashioned private placements and public offerings, not just to Crowdfunding. Crowdfunding introduces two new variables:   the number of investors and the anonymity of investors. But the legal framework is identical.

Did I ever mention that issuers should buy insurance?

Questions? Let me know.

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