The Ohio Division of Securities administers and enforces Ohio’s "Blue Sky" Law (the Ohio Securities Act), which includes licensing requirements for securities brokers, dealers and salespersons. It is unlawful in Ohio, as in all states, to engage in business as a securities dealer without being licensed unless an exclusion or exemption from the requirement is available. The use of compensated, unlicensed "finders" by issuers or sponsors of private securities offerings is a perennial concern of both regulators and issuers, and the Ohio Division of Securities most recently issued a further caution that acting as an unlicensed, compensated finder "is most often illegal and can result in any number of criminal, civil and administrative sanctions for violators." Ohio Securities Bulletin 2013:2 (May 2013).
A Federal Wake-Up Call
This latest pronouncement from Ohio’s securities regulator comes in the wake of a March 2013 administrative enforcement action by the U.S. Securities and Exchange Commission (SEC) brought against a fund sponsor, its Senior Managing Partner, and an individual who acted as a compensated independent consultant in the private offering of interests in two funds. The SEC found that the independent consultant, who engaged in activity considered by the Commission to be solicitation of investors in return for transaction-based compensation, and the fund sponsor engaging him, violated provisions of the federal securities laws requiring SEC registration of securities broker-dealers. Neither the fund sponsor, its Senior Managing Partner, nor the individual consultant admitted or denied the allegation, but consented to findings by the SEC that in connection with the fund offerings, the consultant engaged in activity making him an unregistered broker-dealer. The SEC found that while working as an independent consultant for the fund sponsor, the individual actively solicited investors on behalf of the funds and, in return, received transaction-based compensation totaling some $2.4 million. Activity the SEC viewed as constituting solicitation included:
- Sending private placement memos, subscription documents and due diligence materials to potential investors;
- Urging at least one investor to consider adjusting its portfolio allocations to accommodate an investment in the funds;
- Providing potential investors with his analysis of the funds’ strategy and performance record; and
- Providing potential investors with confidential information relating to the identity of other investors and their capital commitments.
For this activity the individual was paid a flat fee of 1 percent of all capital commitments made to the funds by investors he introduced. By these actions, said the SEC, the individual had engaged in the business of effecting transactions in securities without being registered as a broker or dealer or being associated with a registered broker or dealer. Moreover, the SEC concluded that the Senior Managing Partner of the fund manager, who provided the individual with key documents and information related to the funds did not take adequate steps to prevent him from having "substantive contacts with potential investors."
Announcing the enforcement action, the SEC concluded that the role of the consultant went far beyond that of a finder – that he consistently communicated with prospective investors and their advisers, and provided them with key investment documentation. Sanctions imposed in this matter included a civil money penalty of $375,000 imposed on the fund sponsor, a $75,000 money penalty on the Senior Managing Partner, and an order that the individual consultant disgorge $2.4 million received as a result of his unlawful activity. He was additionally barred from the securities industry. ( In re Ranieri Partners LLC and Donald W. Phillips, SEC Admin. Proc. File No. 3-15234; In re William M. Stephens, SEC Admin. Proc. File No. 3-15233).
Ohio Speaks Out
As part of the dual federal/state securities regulatory structure in the United States, state securities laws also regulate the conduct of individuals who act as securities brokers, dealers or salespersons, such that they must be licensed in each state in which they conduct a significant amount of securities activity. In its most recent pronouncement on compensated "finders" in private offerings, the Ohio Division of Securities cautioned that all compensated sellers of securities fall within Ohio’s definition of a securities "dealer" and therefore must be licensed or exempt from licensure with the Division.
"Dealer" is a defined term in the Ohio Securities Act:
Dealer... means every person who engages or professes to engage, in this state, for either all or part of the person’s time, directly or indirectly, either in the business of the sale of securities for the person’s own account, or in the business or the purchase or sale of securities for the account of others, in the expectation of receiving a commission, fee, or other remuneration as a result of engaging in the purchase or sale of securities.... ( Ohio Rev. Code § 1707.01(E).
"Finder" is not defined in the Ohio Securities Act, but is used by the Ohio Division to mean
"unlicensed persons or entities that match investors with issuers." Ohio Sec. Bulletin 2013-2, at 10 (emphasis added). Labeling oneself as a "finder," according to the Division, is not a work-around for this licensing requirement.
Guidance as to what activities render a person subject to licensing in Ohio or any other state is fairly sparse. Some telltale factors have emerged through federal and state court and regulatory enforcement
actions, and most significantly among them is the receipt of transaction-based compensation, which has always been considered to be the hallmark of dealer status. Other factors include:
- Actively soliciting investors;
- Advising investors on the merits of an investment;
- Handling subscription documents and funds;
- Involvement in negotiations; and
- Prior involvement in securities transactions.
This kind of finder activity, coupled with transaction-based compensation, will invariably be seen by regulators as unlicensed broker-dealer activity. Even where activity is limited to a more passive role with no direct interaction in the purchase process, regulators have observed that conduct which constitutes "pre-selling" or "conditioning" a potential purchaser will nevertheless constitute broker-dealer activity when there is transaction-based compensation.
On the other hand, there are activities, in circumstances where compensation of an intermediary is transaction-neutral, that do not suggest any significant "pre-selling" involvement of a finder in a transaction or the offering as a whole. Consider, for example:
- Identification of sources of capital and potential investors;
- Providing access to contact information;
- Making introductions between investors and companies; and
- Arranging for meetings.
The Ohio Division of Securities had made clear its view, however, that for purposes of the Ohio licensing requirement, "dealer" activity is determined simply in terms of matching investors with issuers. Moreover, as discussed further below, the Ohio Division has cautioned that there will only rarely be circumstances in which a finder’s compensation will be considered as not being tied directly or indirectly to the sale of securities.
The Compensation Conundrum
While reminding issuers, their counsel and other active participants in the offer and sale of securities of dealer licensing requirements, the Ohio Division has in its latest pronouncement also noted that there are certain exceptions from the dealer licensing requirement, and that one or may be available to specific types of finders. These exceptions are in the form of statutory exclusions from the definition of "dealer," and cover:
- Any person that brings an issuer together with a potential investor and whose compensation is not directly or indirectly based on the sale of any securities by the issuer to the investor;
- Any "business broker" who, for the account of others, engages in the purchase or sale of securities that are issued and outstanding before such purchase or sale, if a majority or more of the equity interest of an issuer is sold in that transaction, and if, in the case of a corporation, the securities sold in the transaction represents a majority or more of the voting power of the corporation in the election of directors.
The specific Ohio statutory exclusion from dealer licensing for a person who is not compensated directly or indirectly based on the sale of securities by the issuer presents a conundrum. Indeed, in its most recent pronouncement, The Ohio Division has also stated: "This provision is extremely limited, as it is a rare situation that a finder’s compensation is not tied directly or indirectly to the sale of securities."
Ohio Sec. Bulletin 2013:2, at 10. This appears to state a position that any compensation of a finder, however derived, in the context of a securities offering is tied directly, or indirectly, to the sale of securities. Reconciliation of this position with the straightforward statutory exclusion is more than problematic for issuers.
Because transaction-based compensation is the hallmark of dealer status, issuers and their counsel might look to cash compensation of finders based on a flat fee, or perhaps even an hourly fee, not tied to the value or completion of any investment, or in any way contingent on the completion of the offering. Such guidance as is available at the federal level indicates that the key consideration is whether a finder or any other intermediary has a "salesperson’s stake" in the offering. Where compensation for services is not linked to the success of the offering or the value of any particular transaction, finding a "salesperson’s stake" is problematic. Making it a "rare situation," as characterized by the Ohio Division, that the express statutory exclusion will ever be available is unfortunate because does not address good faith compliance efforts undertaken by issuers to pay only transaction-neutral compensation to finders, and to engage them for a defined, limited role.
Without doubt, policy speaks loudly, and there is no question that the policy, indeed the mission, of state securities regulation includes policing the integrity, competence and conduct of intermediaries who play a meaningful role in bringing about investment decisions, and have traditional investor protection responsibilities and duties in that process. Yet policy is also expressed by the legislature in providing the express exclusion from dealer status in Ohio for persons who "bring together" issuers and potential investors in the absence of transaction-based compensation, and as to which a fair presumption is that no traditional broker-dealer regulation is necessary. In light of the fact that the lion’s share of private offerings in which the services of a finder are desirable are made only to accredited investors and institutions, such a presumption is even more meaningful. Given the consequences discussed below, the conundrum faced by issuers and their advisers obviously presents a tough challenge.
In Ohio, as in all states, a violation of dealer licensing requirements carries significant penalties. In Ohio, a the broker-dealer licensing requirement is a felony, ranging from the fifth to first degree depending on the value of the securities involved in the transaction. Administrative cease-and-desist orders may issue, and be converted into civil injunctions, and restitution or rescission of transactions by be ordered by a court in an enforcement proceeding. Civil liability of both the issuer and finder for the full amount paid by investors may likewise be ordered in a private action permitted under the Ohio Securities Act. There are collateral consequences for an offering. State private offering exemptions from registration requirements are, as in Ohio, typically conditioned on payment of commissions or remunerations only to licensed dealers or salespersons. A "finder" violation thus precludes availability of those exemptions for the offering.
A Changing Regulatory Landscape?
Without question, state and federal securities regulators have proceeded aggressively regarding finder activities and the application of broker-dealer registration or licensing requirements. The latest pronouncement of the Ohio Division of Securities breaks no new enforcement ground. Indeed, a statement by the Division that unlicensed, compensated finders most often engage in illegal conduct reaffirms a strong regulatory bias against finders. That said, actual enforcement orders have stated that finder’s fees may be paid, but the person receiving the fee may not make offers or sales of securities on behalf of the issuer. "Sale" is a defined term in the Ohio Securities Act that incorporates "offer," and includes any attempt to dispose of a security or interest in a security. Though broadly stated, the implication nevertheless is that the involvement of a finder who, for transaction-neutral compensation, facilitates the connection between issuers and qualified potential purchasers is not engaged in the offer or sale of securities on behalf of the issuer. As a practical matter, discussed more below, private offerings today are most often directed only to accredited or institutional investors in a national regulatory environment that encourages the establishment of intermediary platforms for the specific purpose of bringing together issuers and accredited investors free of broker-dealer registration requirements where compensation is transaction-neutral -- based upon ancillary services in the operation of the platform.
As a matter of national policy, things are changing. Private offerings of securities are most often today carried out in compliance with SEC Rule 506 of Regulation D under the federal Securities Act of 1933. Rule 506 provides a safe harbor exemption from federal registration statement requirements for compliant offerings made to accredited investors (and a limited number of others). Also, compliant private offerings pursuant to federal Rule 506 are not subject to state regulation, although state authority to regulate and require licensing of intermediaries and to police against fraud remains in place. At the federal level, Congress has mandated that certain steps be taken to better facilitate the ability of issuers and accredited investors to connect. Thus, the currently existing ban on general solicitation and advertising of private offerings to accredited investors carried out under Rule 506 of Regulation D is to be eliminated, and SEC rulemaking to accomplish that is under way.
The expressed goal of Congress in doing this is to facilitate capital formation, and to create jobs, by providing greater access to sources of capital. Congress has likewise created an entirely new exemption from federal broker-dealer registration requirements for platforms or mechanisms for the offer, sale and negotiation of transactions in securities offered and sold to accredited investors in compliance with SEC Rule 506. An internet website and social media qualify for the new exemption. To be sure, these newly exempt platforms, which will also permit general advertising and solicitation once the current ban is lifted, may not receive transaction-based compensation. They may, however, be compensated for ancillary services. Here again, the new federal exemption from broker-dealer registration does not affect state licensing authority. It does, however, evidence a policy that recognizes the importance of deconstructing unnecessary regulatory barriers to capital formation.
The most recent pronouncement by the Ohio Division of Securities demonstrates that the "finder" compensation conundrum for issuers in private offerings is not likely to disappear anytime soon. However, as much as it speaks in terms that are facially inconsistent with Ohio’s statutory regulatory structure, it also invites scrutiny in a shifting national regulatory landscape.