Private Placement Broker-Dealers

Both federal and state securities laws require registration of “every person engaged in the business of effecting transactions in securities . . . . ” And such registration, of course, requires that principals and RRs take initial and continuing examinations, and that firms meet net capital and extensive ongoing record-keeping and reporting requirements. The examinations require an understanding of the public securities markets, evaluation of the nature of publicly-held securities vis-à-vis the suitability of various investors, the structure of mutual funds, annuities, derivatives and other types of investments, and other concerns of full-service B-Ds.

So, you might ask, do these not simply assure that B-Ds and their RR know how to carry out their business and report their financial well-being, thereby protecting the investing public? What is the problem?

But what about those persons assisting, or who desire to assist, new and entrepreneurial companies seeking to raise start-up and seed stage capital from angel investors. If they are to be paid for this assistance, they are “engaged in the business of effecting transactions in securities…”, so they fit the definition of a B-D. Should they be subject to the testing and regulation required of full-service RR and brokers noted above, notwithstanding their subject matter are largely irrelevant to the actual activities of such persons.

The Problem

The ability of such entrepreneurs to raise capital to grow their businesses is crucial to the U.S. economy. Typically successful entrepreneurial companies outgrow their ability to finance their own expansion but are not yet large and mature enough to attract financing from venture capitalists or other institutions. This occurs typically when they need to raise between $250,000 and $5,000,000. In this range, historically funding has best been provided by “angels”, i.e., wealthy, investment-sophisticated individual investors. But “angels” typically do not advertise their status as such, and thus are difficult to find. Expertise is needed to find and educate angels about the value of the entrepreneur’s business. Such expertise is typically provided by unregistered intermediaries whose role is similar to that of investment banking departments of large brokerage firms putting together registered public offerings – similar, but requiring very different skills and market knowledge from that of those departments.

(Similarly, there are [unregistered] persons whose business is the introduction and assistance in consummation of merger and acquisition (“M&A”) transactions. That is, they help business owners seeking to sell their businesses and persons seeking to buy businesses to find and acquire them. When such a transaction involves the buyer acquiring the stock of the purchased company (as opposed to its assets), the intermediaries also fit the definition of “B-Ds”).

These private offering and M&S intermediaries have recently come to be known as private placement  broker-dealers ( hereafter called “PPBDs”).

The market segments in which PPBDs operate — (i) of transactions between $250,000 and $5,000,000, (ii) with securities of entrepreneurial firms in the “pre-earnings” stage in (iii) the seemingly high legal risk area of “private offerings” – are seldom of interest to full service B-Ds registered under present regulations with the NASD and state securities commissions. And the skills, knowledge and contacts held by those PPBDs (1) are seldom possessed by such registered B-Ds, and (2) are not those required to pass the present NASD testing regime for RR and B-D principals.

And, other requirements for registration and status as a B-D under present law – e.g., net capital requirements – are not meaningful when applied to, and cannot be met by, private offering and M&A intermediaries.

The Position of the Regulators

The SEC has rarely, if ever, brought enforcement actions against PPBDs based solely on their being unregistered. However, in response to requests for “no-action letters” (i.e., interpretive letters) the SEC has held that most activities conducted by such intermediaries constitute B-D activities requiring registration as such. State securities commissions have taken essentially the same position. Further, in enforcement actions brought primarily in response to evidence of fraud, such enforcing regulators typically include charges and findings of unregistered B-D activity and seek enforcement sanctions (such as injunctions) against such activity, as well as against the fraudulent activity which was the cause for the regulators’ enforcement action, in the first place.

Efforts to Resolve the Problem

The organized bar, through the American Bar Association, and the Alliance of Merger and Acquisition Advisors, an organization comprised primarily of M&A intermediaries, have thus far led efforts to resolve the problem.

Lawyers representing small businesses and entrepreneurs and M&A consultants over the years saw these issues, particularly as entrepreneurism flourished in the late 1990s. Recently the Business Law Committee of the American Bar Association established its Task Force on Private Place Broker-Dealers in response to “a widely held perception by many members of the Committee . . . that there exists a major disconnect between the various laws and regulations applicable to securities brokerage activities, and the methods and practices actually in daily use by which the vast majority of capital is raised to fund early stage businesses in the United States.” The objectives of the Task Force were (i) to survey the issues, (ii) to propose a regime of regulation more applicable to the actual activities of legitimate intermediaries and the needs of their customers.

The ABA Task Force, in its Report and Recommendations of October 12, 2006, recommended that a simplified system of registration of PPBDs be created by the SEC, the NASD and state securities administrators. The Task Force also presented a working draft of regulations to implement that system. These suggested regulations would allow PPBDs to introduce buyers and sellers in connection with sales of businesses effected as sales of securities, to structure transactions and negotiate between buyers and sellers of securities; to introduce buyers and sellers in securities transactions exempt under the 1933 Act if the buyers are accredited or otherwise qualified, and to provide advice on the use of and introduction to fully registered B-Ds. Also, the requirements for NASD membership, record keeping, reporting, net capital, testing and continuing education would be modified to be appropriate to the actual activities of PPBDs.

The proposed system would also significantly limit the activities of PPBDs; under it, PPBDs could not:

• participate in SEC – registered public offerings;
• make offerings to persons other than accredited and otherwise qualified investors, and could make them only on a best efforts basis;
• handle or take possession of funds or securities;
• engage in secondary market or trading activity.

The Regulators’ Unenthusiastic Response to Such Efforts

The Securities and Exchange Commission (“SEC”). In an exposure draft of its “recommendations” in response to an early report on these issues, the SEC Advisory Committee’s Forum on Small Business Capital Formation on February 28, 2006 “supported the concept” of development of a more appropriate system of regulation of PPBDs. And in November, 2005, the staff of the SEC Division of Market Regulation, in discussions with the PPBD Task Force, indicated they plan to issue a new interpretative release, potentially modifying some of the SEC’s restrictive positions. Perhaps more importantly, the SEC staff was also receptive to streamlining the application process and regulatory requirements for PPBDs, including a possible exemption from the net capital rule. The staff’s chief counsel suggested the ABA Task Force prepare new rules and/or amendments. As noted above, it did so last October. The SEC has not yet responded to the October 12, 2006 ABA report and recommendations.

The NASD. The NASD staff, on the other hand, was blunt in its disinterest. In a meeting with the Chairperson of the ABA Task Force, the NASD staff noted (1) its concern that (1) PPBDs are smaller than most present NASD members, and their membership fees would probably be insufficient to support their own regulation, requiring subsidization by larger members; (2) creating a regime accommodating what the NASD staff members called a “special class” of B-Ds might cause other “niche businesses” to ask for similar treatment, and (3) adopting a simple notice filing requirement for PPBDs might, if a “notice filer” PPBD got into trouble, cause the press and the SEC to be critical of the NASD for not “knowing what is going on”

State Regulators. A Draft Report of the ABA Task Force was “well received” when presented in July, 2005 by its chairperson to a training seminar of the North American Securities Administrators’ Association, the major organization of state securities regulators. But no action was taken then or since by NASAA, although the New Jersey Securities Commission is working on a draft of PPBD rules for that state.

Conclusion

The reaction of the NASD, indefinite as it is thus far, appears negative. The state regulators as a group have indicated no reaction. The SEC has appeared positive but has taken no discernible action to amend the present regulatory scheme, which is untenable. In the opinion of the undersigned, some action by Congress, either by legislation, or at least by hearings followed by directions to the SEC to take action, will be required if the problem is to be treated within a reasonable time.

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