Do You Need to Register As A Broker Dealer?

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Financial Services Practice
May 2008

Broker-Dealer Registration Update
The Securities and Exchange Commission (SEC) Division of Trading and Markets (the Division) has updated the Guide to Broker-Dealer Registration (the Guide), which is available on the SEC web site at http://sec.gov/divisions/marketreg/bdguide.htm. The Guide provides a summary of some of the significant provisions of the Securities Exchange Act of 1934 (the Exchange Act) and the rules thereunder that regulate the activities of registered broker-dealers. This Briefing focuses on those portions of the Guide that address who is required to register as a broker-dealer. The Guide also covers the process of how to register as a broker-dealer, as well as the standards of conduct and financial responsibility rules that broker-dealers must follow.

CHARLOTTE CHICAGO GENEVA LONDON LOS ANGELES MOSCOW NEW YORK NEWARK PARIS SAN FRANCISCO

Who is Required to Register?
A “broker” is defined in Section 3(a)(4) of the Exchange Act as a person that is “engaged in the business of effecting transactions in securities for the account of others.” There are three elements to the definition, each of which must be present: (i) engaging in a business; (ii) the business must be effecting transactions in securities; and (iii) the transactions must be for the account of others.1 The Guide states that while sometimes it is easy to determine that someone is a broker, as in the case of a person who executes transactions for others on a securities exchange, other situations are less clear. The Guide lists the following individuals and businesses as persons that may be required to register as a broker, depending on a number of factors: • “Finders,” “business brokers,” and other individuals or entities that engage in the following activities: • Finding investors or customers for, making referrals to, or splitting commissions with, registered broker-dealers, investment companies (or mutual funds, including hedge funds) or other securities intermediaries; • Finding investment banking clients for registered broker-dealers;

WASHINGTON, D.C.

• Finding investors for “issuers” (entities issuing securities), even in a “consultant” capacity;
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• Engaging in, or finding investors for, venture capital or “angel” financings, including private placements; • Finding buyers and sellers of businesses (i.e., activities relating to mergers and acquisitions where securities are involved); • • investment advisers and financial consultants; foreign broker-dealers engaging in activities in U.S. markets;

1. RT Madden & Company Inc. (Oct. 17, 1976), SEC No-Action Letter.

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persons that operate or control electronic or other platforms for trading securities; persons that market real-estate investment interests, such as tenancy-in-common interests, that are securities; persons that act as “placement agents” for private placements of securities; persons that market or effect transactions in insurance products that are securities, such as variable annuities, or other investment products that are securities; persons that effect securities transactions for the account of others for a fee, even when those other people are friends or family members; persons that provide support services to registered broker-dealers; and persons that act as “independent contractors” but are not “associated persons” of a broker-dealer.

out as a broker, as executing trades, or as assisting others in completing securities transactions.4 The application of these factors to the question of whether broker-dealer registration is required varies depending on the facts and circumstances of each situation. Nonetheless, there is a widely held perception by many securities law practitioners 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.”5 The perception exists that “this vast and pervasive ‘gray market’ of brokerage activity creates continuing problems for the unlicensed brokers, the businesses which rely upon them for funding, attorneys and other professionals advising both the brokers and businesses, and, last but not least, the federal and state regulators who are charged with the obligation to enforce laws and regulations that are out of step with current business practices.”6 The Guide falls short of providing clarity to the issue of when broker-dealer registration is required, but does provide a list of some of the questions that, depending on the answer(s), may indicate a need to register as a broker. As such the Guide is a helpful tool. The SEC question list is as follows: • Do you participate in important parts of a securities transaction, including solicitation, negotiation, or execution of the transaction? Broker involvement in negotiations with a customer will require registration.7 Does your compensation for participation in the transaction depend upon, or is it related to, the outcome or size of the transaction or deal? Do you receive trailing commissions, such as 12b-1 fees? Do you receive any other transaction-related compensation? This is the question that has often been emphasized by the SEC in cases involving broker-dealer activity.8 The

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According to the Guide, in order to determine whether any person or business is a broker, the SEC looks at the activities that the person or business actually performs. The SEC has provided guidance on the application of this definition in noaction letters, cases and releases. The SEC has said that in order to qualify as a broker the activities involved must be characterized by “a certain regularity of participation in securities transactions at key points in the chain of distribution.”2 Other factors that the SEC has indicated are relevant in determining whether broker-dealer registration is necessary include the receipt of commissions or other transaction-based compensation, involvement in negotiations between an issuer and an investor, making valuations as to the merits of an investment or giving advice, and actively soliciting investors.3 The SEC also has said that factors indicating that a person is engaged in the business include, receiving transaction-related compensation, holding oneself



2. Mass. Financial v. SIPC 411 F.Supp. 411, afFd 545 F.2d 754 (1s` Cir. 1976). 3. MiniAuction, Inc., SEC No-Action Letter, 2000 WL 291007 (Mar. 13, 2000). 4. See generally, David A. Lipton, Broker-Dealer Regulation; Chapter II, “Who Must Register,” Thomson West, 2007. 5. The Report and Recommendations of the Task Force on Private Placement Broker-Dealers, by the Task Force on Private Placement Broker-Dealers, ABA Section of Business Law, Business Lawyer, May 2005. 6 Id. 7. David A. Lipton, Broker-Dealer Regulation, supra, note 4. 8. See, e.g., BD Advantage, Inc., (Oct. 11, 2000); SEC NO-ACT, WSB File No. 1127200005; Wirthin, John R., (Jan. 19, 1999) SEC NOACT, WSB File No. 020199015; and John W. Loofbourrow Assocs., Inc. (June 29, 2006), SEC NO-ACT, WSB File No. 0703200614.

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SEC’s underlying concern has been that transactionbased compensation represents a potential incentive for abusive sales practices that registration is intended to regulate and prevent.9 • Are you otherwise engaged in the business of effecting or facilitating securities transactions? The intent of this question appears to be that even if a person is not a broker in connection with a particular transaction, if such person engages in other securities activity, the reoccurrence of such activity may be enough to require registration. Do you handle the securities or funds of others in connection with securities transactions? The SEC staff has consistently taken the position that brokers handle another person’s funds or securities, whereas nonbrokers, such as investors or traders, do not.10

PAUSE
Finally, while the SEC has yet to directly address the issue of unregistered brokerage activity, except on a case by case basis, in April 2008 the SEC launched an initiative called “PAUSE” (an acronym for Public Alert: Unregistered Soliciting Entities), which is designed to provide investors with factual information that the agency has received from investor complaints and other sources, including foreign regulators, about questionable e-mail or phone solicitations involving stock or securities sales. The SEC’s PAUSE Web pages initially listed what the SEC described as “56 unregistered soliciting entities and affiliated phony agencies or organizations that investors should beware.”11 The SEC press release stated that the lists will be updated regularly based on information received by SEC staff. PAUSE may portend that the staff is preparing to take action against unregistered soliciting entities.



According to the Guide, a “yes” answer to any of these questions indicates that a person may need to register as a broker. Notably, the Guide suggests that a person on the list enumerated above may be required to register as a broker even without receiving transaction-based compensation. Unfortunately, the Guide does little to clarify the borderline between activity that requires registration and that which does not. The Financial Services Practice Group of Winston & Strawn represents a broad range of depository and other financial institutions on all regulatory matters, including regulatory compliance and powers issues applicable to national banks and federal branches and agencies of foreign banks. New York Edward Johnsen Robert Boresta Jeffrey H. Elkin Chicago Wesley G. Nissen

[email protected] [email protected] [email protected]

(212) 294-4741 (212) 294-4711 (212) 294-6711

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(312) 558-5804

9. See, e.g., John W. Loofbourrow Assocs., Inc. (June 29, 2006), SEC NO-ACT, WSB File No. 0703200614. 10. See, e.g., Jeffrey Steele (Dec. 16, 1981); SEC No-Act, WSB File No. 122181018 and Burton Securities (Dec. 5, 1977). 11. SEC Launches New Offensive to Alert Investors About Phony Investment Solicitations: http://sec.gov/news/press/2008/2008-60.htm These materials have been prepared by Winston & Strawn LLP for information purposes only, and these materials do not constitute legal advice and cannot be relied upon by any taxpayer for the purposes of avoiding penalties imposed under the Internal Revenue Code. Receipt of this information does not create an attorney-client relationship. Copyright © 2008. Winston & Strawn LLP.

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