One of the most common questions raised by issuers of securities in private offerings, and those who assist them in finding investors, is whether those who find investors and provide related services must be registered as broker-dealers. With few exceptions, the answer is usually yes. However, when one then describes all of the requirements that the new broker-dealer will have to satisfy, and the detailed and extensive application process it will have to endure and the information it will be required to provide, the first reaction generally is: “how can all of that apply to our limited business model?” Indeed, the laborious process of becoming a broker-dealer has long seemed inconsistent with the SEC’s and FINRA’s efforts to get such firms to register. Quite simply, artificially high barriers to entry are no way to encourage people to join the club.
In an effort to provide at least some relief, on August 18, 2016, the SEC approved FINRA’s proposal to create a separate set of rules for broker-dealers that meet the definition of “capital acquisition broker” (CAB) and elect to be governed under this new rule set. CABs are firms that limit their business to advising companies on mergers and acquisitions, advising issuers on raising equity or debt capital in private placements with institutional investors, and providing advisory services to companies needing assistance in analyzing their strategic and financial alternatives. Understanding that such firms generally need to register as broker-dealers because they receive transaction-based compensation in return for at least some of their services, FINRA also recognized that such firms do not engage in many activities typically associated with broker-dealers, including carrying or introducing customer accounts, handling customer funds or securities, or accepting orders to purchase or sell securities for customers.
The new rule set for CABs subjects them to the FINRA By-Laws and those “core” FINRA rules that FINRA believes should apply to all firms. However, other rules are tailored to address the specific activities of CABs, including conduct rules such as suitability requirements that focus on the business of CABs. CABs will be permitted to solicit institutional investors in connection with purchases or sales of unregistered securities, and to effect securities transactions in connection with the transfer of ownership and control of a privately held company to a buyer that will actively operate the company or the business, in accordance with the terms and conditions of an SEC rule, release, interpretation, or “no-action” letter, such as the SEC’s “M&A Brokers” no-action letter of January 31, 2014. CABs would not include any broker-dealer that carries or acts as an introducing broker with respect to customer accounts, holds or handles customer funds or securities, accepts orders from customers to purchase or sell securities as principal or as agent (with limited exceptions), has investment discretion on behalf of any customer, engages in proprietary trading or market-making, participates in or maintains an online platform in connection with offerings of unregistered securities pursuant to SEC Regulation Crowdfunding or SEC Regulation A, or effects securities transactions that require reporting under applicable FINRA rules.
There are other significant limitations to CAB activities. For example, CABs can only solicit or act as a placement agent or finder for an issuer in connection with the sale of newly issued, unregistered securities to institutional investors, which includes banks, insurance companies, registered investment companies and certain other entities; “qualified purchasers” as defined in Section 2(a)(51) of the Investment Company Act of 1940; and those natural persons with total assets of at least $50 million. This means that CABs cannot solicit “accredited investors” as defined in SEC Regulation D. Moreover, FINRA will only permit a narrow range of activities by CABs. Importantly, CABs generally may not assist the owner of securities purchased in a private placement to subsequently re-sell them, and they may not sell any securities they receive as compensation for acting as placement agent in a private placement. According to FINRA, allowing CABs to dispose of securities received as compensation for placement agent services would be inconsistent with the prohibition on proprietary trading.
It is clear the new rules have a number of shortcomings that may limit their usefulness. At the same time, they subject CABs to a significant number of existing FINRA requirements applicable to non-CAB regular broker-dealers. In addition, the approval order indicates that FINRA intends to take the same amount of time for approval of new CAB member applications as it does for non-CAB applications. While this is ostensibly to ensure that FINRA has sufficient time to engage in its new member application process, it fails to remove what many view as a significant deficiency in the broker-dealer registration process. As a result of all this, many firms may choose to bypass CAB registration and simply opt for a full broker-dealer registration.
Despite the shortcomings of the new CAB rules, and the growing pains that are sure to occur as firms and FINRA sort out how this new rule set will operate, it is nice to see that the regulators are attempting to address what has long been a complaint of many market participants, including the types of firms that will likely consider CAB status — that they are subject to rules that don’t really bear a rational relationship to the types of business these firms do. While it might be a bit unwieldy for FINRA to have to manage different regimes for different kinds of firms, in the end it may make much more sense to establish registration requirements that actually focus on a particular firm’s business activities, rather than pursue a one-size-fits-all regime that leaves many firms questioning whether they should be registered at all.