Question: What are the rules regarding paying unlicensed “finders” to refer investors to a real estate syndication?
The Issuer Exemption Under Regulation D, Rule 506
Since passage of the National Securities Markets Improvement Act of 1996 (NSMIA), in a Regulation D, Rule 506 securities offering, the issuer may sell its own securities in any state without: a) registering the securities offering, or b) being registered with the SEC or state as a broker or dealer. However, anyone else who is compensated for selling securities on behalf of the issuer is not exempt from registration.
Under the Securities Exchange Act of 1934 (“Exchange Act”), Section 3(a)(4)(A), a “broker” is broadly defined as “any person engaged in the business of effecting transactions in securities for the account of others.”
Think of this like a real estate transaction. Most people understand that a person may sell his or her own real estate without a license (the proverbial “FSBO”—for sale by owner), but he or she cannot be compensated for selling someone else’s real estate unless he or she has a real estate broker or sales agent license. The issuer exemption for securities offerings operates in much the same way.
Who is the Issuer?
Persons who claim the issuer exemption must generally be involved in management and control of the company and must have substantial responsibilities associated with management of the company other than referring investors. Additionally, the amount of their compensation must not be related to the amount of money they refer or raise, or it could be deemed a commission paid to an unregistered broker. The Texas State Securities Board’s website contains the following illustrative explanation:
… Since a business can act only through natural persons, such as its owners, officers or directors, the exemption from dealer registration will extend to these persons acting on behalf of the issuer, but only if they meet three important criteria:
- The person cannot have been hired for the purpose of offering or selling the securities.
- Any securities activities of the person must be incidental to his or her bona fide primary non-securities-related work duties.
- The person’s compensation must be based entirely on that person’s non-securities-related duties.
If these criteria are not met, the person offering the securities must be registered with the State Securities Board as a dealer or agent. Similarly, any person who is not an owner, director, officer or employee of the issuer who offers or sells the issuers securities is subject to the dealer registration provisions of the Act.
Paying Unlicensed Finders May Blow Your Exemption
States generally recognize the Regulation D, Rule 506 exemption, provided they are given notice within 15 days of the sale and/or offer of a security within the state, and no compensation is paid to unregistered persons for selling the securities. For example, the Texas State Securities Board lists as one of its requirements for recognition of a Regulation D, Rule 506 exemption, that: “No commissions, fees or other form of remuneration may be paid to any person who solicits investors in Texas under this exemption unless that person is licensed in Texas as a securities dealer or agent.”
Most state securities laws contain similar provisions, meaning if the state determines that an issuer compensated an unregistered person for selling its securities, the state could deny the federal securities exemption, and apply its own registration or exemption criteria to the securities offering. If the state determined the offering did not comply with its rules, it could prosecute or impose penalties.
Penalties for Violations
Failure to comply with these requirements may result in possible civil or criminal charges filed: a) against the finder for selling securities without registration as a broker or dealer, and b) against the issuer for the sale of unregistered securities. Further, such securities violations may give investors a right of rescission (i.e., the ability to unilaterally void the contract) whose statute of limitations does not begin to run until the violation is discovered, which could be many years after the securities were originally sold. Where a right of rescission is exercised, the company may be required to return all of the investors’ original investment plus interest within 30 days, and doing so may not preclude further prosecution.
Private securities offerings are self-policing, in that there is little likelihood that anyone will audit your offering for securities violations—until something goes wrong.
Violations are usually discovered when the investment fails or an investor wants out of a deal, and that investor hires an attorney or complains to a regulator in an effort to get his or her money back. Violations will likely be discovered during pre-litigation depositions or securities investigation. Once discovered, the disgruntled investor may exert his or her right of rescission or use it as leverage against the issuer to force a settlement.
NOTE: This post specifically pertains to paying finders fees to unlicensed persons for referring investors to an exempt securities offering under federal Regulation D, Rule 506. While the rules discussed herein are largely applicable throughout the U.S., there may be some variations for individual states, or for other exemptions offered under state or federal securities laws. This article is for educational purposes only and is no substitute for legal advice.
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