Navigating Broker-Dealer Registration: Critical Compliance Issues for Fund Managers

Introduction

One of the most dangerous compliance traps for fund managers involves compensating individuals who help raise capital. The seemingly simple act of paying someone a commission or success fee for introducing investors can trigger broker-dealer registration requirements—with severe consequences including contract voidability, investor rescission rights, and SEC enforcement actions.

This issue catches many fund managers by surprise. After all, paying for successful introductions is standard practice in many industries. But in the securities world, such arrangements can violate federal and state securities laws unless handled with extreme care.

The Fundamental Question: Can You Pay for Investor Introductions?

The short answer: No, you cannot pay transaction-based compensation to unlicensed individuals for capital raising activities.

The nuanced answer: While limited exceptions may exist, they are narrow, fact-specific, and risky to rely upon. The safer approach is to work only with registered broker-dealers or structure compensation to avoid triggering registration requirements entirely.

Understanding Broker-Dealer Registration

What Is a Broker-Dealer?

The Exchange Act provides separate definitions for “broker” and “dealer,” but the statutory language is intentionally broad. Rather than rely on bright-line rules, courts have developed multi-factor tests to determine when someone acts as a broker-dealer.

This factor-based approach creates significant uncertainty. As one court noted, it essentially means “if it feels like you went too far, you’re a broker.” Making matters worse, the SEC’s position has evolved over time, creating additional complexity for fund managers trying to navigate these waters.

The Key Factors

Courts typically consider whether a person:

1. Receives transaction-based compensation (the most critical factor)
2. Is employed by the issuer versus acting independently
3. Has sold or currently sells securities of other issuers
4. Participates in negotiations with investors
5. Provides investment or tax advice
6. Actively solicits investors rather than making passive introductions

Critical insight: No single factor is determinative, but transaction-based compensation creates a strong presumption that registration is required. This “salesman’s stake” in the transaction is precisely what the SEC seeks to regulate.

What Constitutes Transaction-Based Compensation?

Transaction-based compensation includes any economic benefit tied to:

• The amount of capital raised
• The number of investors secured
• The success of the fundraising effort

Common examples include:

• Straight commissions (e.g., 2% of capital raised)
• Success fees paid upon closing
• Bonuses tied to fundraising milestones
• Carried interest linked to capital raising efforts
• Any compensation structure creating a “salesman’s stake”

The Consequences of Getting It Wrong

SEC Enforcement Actions

The SEC actively pursues unregistered broker-dealer cases. For example, in 2013, the SEC charged Ranieri Partners LLC and its principal Donald Phillips with acting as unregistered broker-dealers. The firm paid $375,000 to settle charges after raising capital for private equity funds without proper registration.

Contract Voidability Under Section 29(b)

Perhaps the most severe consequence: Section 29(b) of the Exchange Act renders void any contract made in violation of the Act. This means:

• Investors may have the right to rescind their investments
• The fund may be required to return capital plus statutory interest
• The entire offering could be unwound

State Law Complications

Federal law is only part of the equation. States have their own broker-dealer registration requirements, and violations can trigger:

• Additional penalties and enforcement actions
• Criminal liability in some jurisdictions
• Professional licensing consequences

The Rise and Fall of the “Finder’s Exemption”

The Paul Anka Letter

In the early 1990s, the SEC issued a no-action letter to entertainer Paul Anka, suggesting a limited “finder’s exemption” might exist. Anka merely provided contact information without:

• Participating in negotiations
• Soliciting investors
• Providing investment advice
• Advertising or endorsing the investment

Despite receiving a commission, the SEC indicated Anka didn’t need to register as a broker-dealer.

The SEC’s Retreat

The SEC has since retreated from this position. In the Kramer case, despite facts similar to Anka’s situation, the SEC pursued enforcement action. While Kramer ultimately prevailed in court, the SEC cautioned that the decision should be interpreted narrowly, citing Kramer’s advanced age and unlikely continued participation in securities markets.

Key takeaway: The finder’s exemption is effectively dead. Even if you might ultimately prevail in court, the cost—in time, money, and stress—makes reliance on this exemption imprudent.

Special Considerations for Fund Managers

Carried Interest Structures

Many fund managers receive carried interest as part of their compensation. Be cautious if:

• Carried interest percentages increase based on capital raised
• Vesting accelerates with fundraising success
• Distribution priorities change based on fund size

Such structures may inadvertently create transaction-based compensation.

Internal Team Compensation

Even compensating your own employees requires care. While employees raising capital for their employer generally don’t need broker-dealer registration, problems arise when:

• Bonuses are tied directly to capital raised
• Employees receive commissions on investments
• Compensation creates a clear “salesman’s stake”

Placement Agents and Registered Representatives

Working with registered broker-dealers provides the safest path, but ensure:

• The firm is properly registered in all relevant jurisdictions
• Individual representatives are properly licensed
• Written agreements clearly define permissible activities
• Compensation structures comply with FINRA rules

Practical Compliance Strategies

1. Structure Compensation Carefully

Instead of transaction-based compensation, consider:

• Fixed consulting fees unrelated to success
• Hourly or project-based compensation
• Equity participation unlinked to fundraising
• Deferred compensation not tied to capital raised

2. Limit Activities of Non-Registered Persons

Unregistered individuals should avoid:

• Discussing investment terms or strategy
• Advising investors on the merits of investing
• Handling investor funds or documentation
• Participating in negotiations or closings

3. Document Everything

Maintain clear records showing:

• The limited nature of any finder’s activities
• The basis for any compensation paid
• Compliance with written policies and procedures
• Legal review of all compensation arrangements

4. Consider Registration

For repeat players, broker-dealer registration may be the best path:

• Provides clear legal authority for activities
• Allows transaction-based compensation
• Enables broader fundraising activities
• Demonstrates commitment to compliance

Recent Developments and Future Outlook

The SEC’s 2020 Proposed Exemption

In October 2020, the SEC proposed a conditional exemption for finders that would have provided limited relief. However, the proposal:

• Has not been adopted
• Would not preempt state law
• Contains significant limitations
• May not provide sufficient protection

State Law Trends

Several states are considering their own approaches to the finder issue:

• Some states are exploring limited exemptions
• Others are increasing enforcement efforts
• Coordination between states remains limited

Best Practices for Fund Managers

1. Assume No Exemption Exists: Structure all arrangements as if finder exemptions don’t exist

2. Use Registered Professionals: Work only with properly registered broker-dealers

3. Avoid Success Fees: Never pay compensation tied to fundraising success

4. Educate Your Team: Ensure everyone understands these restrictions

5. Document Compliance: Maintain detailed records of all fundraising activities

6. Seek Legal Counsel: Review all compensation arrangements with securities counsel

Conclusion

The broker-dealer registration requirements represent one of the most significant compliance challenges for fund managers. The temptation to compensate successful fundraisers is understandable, but the risks are severe. With potential consequences including voidable contracts, investor rescission rights, and SEC enforcement, this is not an area for cutting corners.

The safest approach remains working with registered broker-dealers or structuring compensation to avoid any connection to fundraising success. While this may increase costs or limit flexibility, it pales in comparison to the potential downside of non-compliance.

As the regulatory landscape continues to evolve, stay informed and work closely with experienced securities counsel. The cost of compliance is always less than the cost of enforcement.

Disclaimer: This article is for informational purposes only and does not constitute legal advice. Securities laws are complex and fact-specific. Always consult with qualified securities counsel before structuring any compensation arrangements related to fundraising activities.