A Manager launching a new fund (“Manager”) often faces numerous challenges. A primary challenge is raising the capital necessary to make the fund launch successful, especially considering all the other hurdles that come with starting an advisory firm or launching new investment programs or funds. Whether a Manager lacks the institutional knowledge and contacts to identify and court external investors, or whether it lacks the internal staffing or time necessary to be effective at doing the task, the Manager may utilize the services of one or more third parties who engage in capital raising on behalf of the Manager. These third parties are referred to as finders, marketers, promoters or solicitors (collectively, the “Marketers”), depending on the context described below. When a Manager seeks help from a Marketer but fails to allocate the proper resources to the engagement, fails to perform thorough due diligence, fails to properly vet the Marketer, or fails to ensure ongoing oversight of the Marketer, the Manager may be assuming disproportionate legal and financial risks.
This article explores the regulatory risks of engaging Marketers for introduction to investors, as well as provides an overview of some of the compliance requirements set out by the applicable regulatory authorities that require disclosures concerning the arrangements, and supervision of the third parties that are utilized for this purpose.
Broker-Dealer or Adviser Registration: When Does a “Finder” Need to be Registered as One?
In most cases, a private fund that is exempt from registration as an investment company under Sections 3(c)-1, 3(c)-5, and 3(c)-7 of the Investment Company Act of 1940 (the “Company Act”) will have its interests offered under Regulation D or another exemption from registration under the Securities Act of 1933 (the “Securities Act”). Despite these exemptions, the fund’s interests are still considered ‘securities’ under Federal securities laws. In most cases in the United States, the Marketer who is paid for successfully finding investors for such private funds is likely required to be registered as a broker-dealer with the U.S. Securities and Exchange Commission (the “SEC”) in accordance with the Securities and Exchange Act of 1934, as amended (the “Exchange Act”), and be a member of the Financial Industry Regulatory Authority (“FINRA”), a self-regulatory organization.
The Exchange Act, along with pertinent regulations and SEC guidance, defines a “broker” as someone involved in the business of effecting securities transactions on behalf of others. Additionally, Section 15(a)(1) of the Exchange Act prohibits any broker-dealer from executing transactions in or persuading or attempting to persuade the purchase or sale of, any security unless the broker-dealer is registered with the SEC and a member of FINRA. While the SEC has interpreted these rules broadly to encompass many securities transactions involving Marketers, a significant number of individuals and firms still present themselves as “advisers” or “finders” without registering as broker-dealers.
If a Manager uses a Marketer to raise assets for a fund without the Marketer being registered, and if the SEC or a court determines that the Marketer is effectively acting as an unlicensed “broker-dealer” under Federal securities laws, it could result in significant adverse consequences for the Manager. These consequences could be disproportionately severe. Although there are circumstances where using an unlicensed Marketer is permissible (as detailed below), Managers must be vigilant and exercise careful oversight when engaging a Marketer for capital raising activities with investors. This is crucial because of the potential repercussions for the Manager as an “issuer” of the private fund's securities.
Potential Consequences for Managers Using Unregistered Marketers
Some of the potential consequences for Managers whose unregistered Marketers are deemed to be unlicensed broker-dealers can include:
Criminal and Civil Liability: Managers that do not conduct their due diligence on a Marketer can be subject to civil and criminal liability for aiding and abetting violations of the Exchange Act and rules governing broker-dealers, particularly where the Manager knowingly or recklessly contributes to the violation.
Recission on Investment: Both Federal and State securities laws provide for a potential right of rescission in securities transactions involving an unlicensed broker-dealer. This means that a fund may be required to refund an investment at the original purchase price, regardless of whether the fund's net asset value has decreased.
Injunction: The SEC and State regulators have the authority to enjoin a transaction if they discover it involves an unlicensed broker-dealer. This action effectively suspends the fund's capital raising activities and may deter both current and potential investors from making future investments.
These potential consequences underscore why a Manager should carefully evaluate any potential Marketer involved in transactions with investors. First and foremost, the Manager should verify whether the Marketer is a registered broker-dealer. This verification process should include using publicly accessible resources such as FINRA’s public database, known as BrokerCheck. It is prudent for the Manager to request independent verification of the Marketer’s registration status to ensure full compliance with regulatory requirements.
If a Marketer informs the Manager that they are not registered as a broker-dealer (or it is determined that they are not registered), the Manager should carefully assess the potential risk and ensure that the parameters of the Marketer’s services do not include any activities that may require registration. Specifically, the Manager should consider whether the activities undertaken to attract investors could lead regulatory authorities to classify the Marketer as an unlicensed broker-dealer.
The SEC considers several factors when determining whether broker-dealer activities have been engaged in, including:
Does the Marketer participate in important parts of a securities transaction, including solicitation, negotiation or execution of the transaction?
Does the Marketer’s compensation for participation in the transaction depend upon, or is it related to, the outcome or size of the transaction or deal?
Does the Marketer receive other transaction-based compensation, or share of profits earned by the Manager as compensation for ‘sourcing’ investments for the fund?
Is the Marketer otherwise engaged in the business of effecting or facilitating securities transactions for others or itself?
Does the Marketer handle the securities or funds of others in connection with securities transactions?
In brief, the level of engagement by a Marketer in soliciting, negotiating and participating in various aspects of an investment transaction directly influences its potential classification as a broker-dealer. Notably, receiving a transaction-based fee, commonly referred to as a “success fee,” is a significant factor in determining broker-dealer status. Similarly, a Marketer who is actively involved in marketing efforts, including the preparation of investment marketing materials and due diligence documentation, as well as participating in negotiations related to investments, face increased scrutiny and potential classification as a broker-dealer. On the other hand, a Marketer who helps facilitate introductions for a fixed fee (and is not otherwise involved in the preparation, negotiation and execution of an investment transaction) is less likely to be deemed to be a broker-dealer, though some risk still remains.
Managers should take proactive steps to vet potential Marketers in advance, including conducting appropriate due diligence and seeking the advice of securities counsel to ensure that the Marketer’s role and compensation in a capital raising transaction does not put the Manager and the fund at odds with Federal or State securities laws. Following this guidance will help ensure that a fund is more adequately protected and able to successfully execute its capital raising strategy.
When Marketers are Not Brokers
While the Exchange Act typically mandates registration for individuals involved in broker-dealer activities, certain exemptions from registration are available provided that all requisite conditions are satisfied.
The M&A Exemption
The most claimed exemption is the statutory exemption included in Section 15(b)(13) of the Exchange Act (the “M&A Exemption”). Although potentially of limited use for a private fund adviser, under the M&A Exemption, Marketers involved in securities transactions solely in connection with certain mergers and acquisition activities (collectively, “M&A Brokers”) may qualify for exemption from broker-dealer registration. However, M&A Brokers are prohibited from relying on the M&A Exemption if they engage in any securities transactions other than those that are effected to transfer of ownership of an eligible privately held company that meets specific criteria. Furthermore, an M&A Broker is ineligible for the exemption if either the broker or its affiliates have been subject to a bar or suspension from association with a broker or dealer.
Private Placement Platforms under the JOBS Act
The JOBS Act, enacted in 2012, created a limited exemption from registration as a broker-dealer for private placements done under Rule 506 of Regulation D, where certain conditions are met. The exemption extends to investment platforms that would otherwise be required to register as a broker-dealer because of involvement in securities offerings made pursuant to Rule 506 of Regulation D. This exemption provides that an intermediary that meets the below requirements is exempted from registration as a broker or dealer solely because that person maintains a platform (e.g., website) that permits the offer, sale, purchase, or negotiation of or with respect to securities, or permits general solicitation or advertisements by issuers of such securities; co-invests in such securities; or provides ancillary services (as defined in the statute, e.g., due diligence services) with respect to such securities.
In order to qualify for the exemption, the business intermediary must not receive compensation in connection with the purchase or sale of the security, not take possession of customer funds or securities in connection with the purchase or sale of the security and not be subject to disqualification under "bad actor" provisions.
While this exemption could be read to allow an intermediary to conduct a range of private placement activities without broker-dealer registration, the SEC has interpreted it very narrowly. Generally, the more active the system and its operator are, the more likely the intermediary would be considered a broker.
No-Action for Investment Platforms for Private Funds
The SEC has issued two no-action letters to allow two web-based platforms operated by investment advisers to match accredited investors with companies seeking capital, without broker-dealer registration, given that certain conditions are met. These no-action letters were conditioned on, among other things, the advisers and their employees not receiving any transaction-based compensation for these activities, although the advisers were permitted to receive compensation in the form of traditional advisory fees. One of the no-action letters was given to a platform for "angel investing"[1], and another to an investment platform for venture capital investing.[2] These scenarios are very fact-specific and should be relied upon only if each of the conditions are the same in every material respect.
Disqualification Provisions
The Scope of Disqualification under the Rule 506 “Bad Actor” Amendments
Prior to engagement, a Manager should try and confirm that the Marketer is not disqualified under the law. Rule 506 of Regulation D under the Securities Act provides a safe harbor for issuers who wish to privately place securities without registration of the securities under the Securities Act. On September 23, 2013, an amendment to Rule 506 went into effect. This amendment incorporated “bad actor” or “bad boy” provisions, which disqualify an offering from relying on the exemptions if a “covered person” (which includes the issuer, adviser, and any principals and officers affiliated with or advising the issuer, and most relevant for purposes of this article, persons compensated for soliciting investors, including their directors, general partners, managing members, and promoters associated with pooled investment fund issuers) has a relevant criminal conviction, regulatory or court order or other disqualifying event that occurred on or after September 23, 2013. An issuer may be required to disclose any disqualifying events that occurred with respect to any Marketer before September 23, 2013, within a reasonable time before sale. The disqualification provisions, which would make the person a “bad actor”, do not apply if the issuer establishes that it did not know, and in the exercise of reasonable care could not have known, that a disqualification existed. It should be noted that there are numerous disqualifying events that can trigger disclosure obligations and threaten exemption from registration under Rule 506. As a result, Managers involved in private placements should be familiar with the rules. An issuer, including one who issues private fund interests, is therefore required to conduct a reasonable initial and ongoing inquiry into whether anyone involved in soliciting investors for the private fund is a “bad actor” or suffer the consequences of having its private placement be deemed ineffective in violation of the Securities Act subjecting the issuer to various risks, including potential recission of transactions, fines and penalties, and public censure.
Disqualification under the new Marketing Rule
On May 4, 2021, the SEC’s amended Rule 206(4)-3 of the Investment Advisers Act of 1940, as amended (the “Advisers Act”), commonly referred to as the Marketing Rule, became effective, with a compliance date of November 4, 2022. The Marketing Rule underwent revisions in 2020, expanding its definition of an “advertisement” to encompass any communication that promotes or offers investment advisory services on behalf of registered investment advisers, including private funds. This includes testimonials, endorsements, and solicitations conducted by third parties, including Marketers, now specifically called “Promoters” under the updated rule. This rule requires Managers to comply with specific oversight and disclosure requirements with respect to the Marketers that meet the definition of promoter under the Marketing Rule. Similar to Regulation D’s bad actor provisions, a Manager that is a registered investment adviser is prohibited by Rule 206(4)-3 from compensating a person, directly or indirectly, for a testimonial or endorsement (or otherwise acting as a Marketer) if the adviser knows, or in the exercise of reasonable care should know, that the person giving the testimonial or endorsement is an ineligible person at the time it engaged in activity for the adviser. Again, a wide variety of factors can make such a Marketer deemed ineligible. The Marketing Rule provides an exemption from its own bad actor disqualification rule. If the Manager is an issuer of private fund interests that relies on and complies with the Regulation D safe harbor and its bad actor provisions, the Marketing Rule’s bad actor provisions will not be applied. Nevertheless, the Marketing Rule disqualification provision will apply if a Marketer is helping a Manager find clients for separately managed accounts. This is important to keep in mind because these types of third-party arrangements often provide for a Marketer to be compensated by the Manager both for bringing in private fund investors (which may rely on Regulation D) and for bringing in separately managed account clients to the Manager (which will require compliance with the Marketing Rule bad actor provisions).
State Registration
It would be remiss to ignore State laws that may bear on the registration requirements for Marketers. To illustrate the point, we use New York law as an example. In April 2020, the Investor Protection Bureau of the New York State Attorney General’s office (“OAG”) announced plans to modernize the State’s securities laws. As part of this initiative, the OAG proposed registering “solicitors” (as described below) as investment adviser representatives. Any solicitor who works for an investment adviser[3] with more than five clients in the State of New York must register as an investment adviser representative, under the new rule.
In New York, a “solicitor” is defined as someone who, as part of their regular business, provides investment advice to a limited extent and receives compensation for introducing potential investors to an investment adviser, including SEC-registered advisers (who have more than five New York clients and work from a place of business located in New York), with some exceptions. Solicitors who must register are held to the same standards for registration and examination as investment adviser representatives. Moreover, principals and representatives affiliated with these solicitors must also meet equivalent registration and examination requirements applied to representatives of investment advisers.
From the State regulators standpoint, this ensures consistency and compliance across the board in regulatory oversight. From an investment adviser’s standpoint, when using a Marketer, it should be ascertained whether the Marketer is registered properly or is operating pursuant to a valid exemption, if available under applicable State laws as well as Federal laws.
Disclosure and Supervision Requirements for the Use of Marketers
Managers that are registered investment advisers (“RIAs”) are obligated to implement reasonable measures to ensure that Marketers adhere to the requirements stipulated in the Marketing Rule. This includes conducting thorough due diligence to verify that Marketers are qualified to receive compensation and are not disqualified under Federal securities laws. Additionally, all investment advisers must maintain oversight over a Marketer’s activities to ensure continuous compliance with regulatory standards.
The requirements include ensuring that Marketers are eligible to receive compensation for testimonials or endorsements (i.e., they are not disqualified by the SEC from acting in any capacity under Federal securities law, as discussed above and further below), entering a written agreement between the RIA and Marketer, making specific disclosures to prospective clients about the terms of the solicitation agreement and any material conflicts of interest, and taking reasonable steps to ensure that Marketers themselves are complying with the Marketing Rule’s requirements.
Required Disclosures under the Marketing Rule
As noted above, when RIAs enlist the services of Marketers, they are obligated under the Marketing Rule to provide explicit and conspicuous disclosures to prospective clients. These disclosures must include:
Relationship Disclosure: An RIA must disclose whether the Marketer is a client of the RIA and whether the Marketer receives compensation for endorsing the RIA's services.
Compensation Disclosure: An RIA must disclose the exact nature and amount of compensation paid to the Marketer for its promotional activities.
Conflict of Interest Disclosure: An RIA must disclose any material conflicts of interest arising from the compensation arrangement with the Marketer.
This disclosure is required in Form ADV Part 2A at a minimum, and many practitioners recommend that the disclosure be included in any point-of-sale documents used by the Marketer or an RIA when private fund investors make investments.
Written Agreements
RIAs are required to establish formal written agreements with Marketers in accordance with the revised regulations. These agreements must delineate the specific scope of activities that the Marketer will undertake and ensure strict adherence to the provisions outlined in the Advisers Act. Additionally, the agreement must include a covenant whereby the Marketer commits to delivering mandatory written disclosures to clients at the point of solicitation.
Exemptions and Special Conditions
There are specific exemptions to the disclosure and supervision requirements. For instance, if the compensation paid to a Marketer falls below a de minimis threshold (typically $1,000 over the past 12 months), the requirement for a written agreement may not apply. Additionally, RIAs must be mindful of specific conditions governing the utilization of third-party ratings and performance advertising. These exemptions and conditions are critical considerations for RIAs to ensure compliance with applicable regulations while engaging Marketers and utilizing promotional materials.
Form ADV and Form D Disclosure
The use of Marketers has long been required to be disclosed to the SEC and State regulators. In most cases, investment advisers, whether registered with the SEC, reporting as an Exempt Reporting Adviser, or registered with a State regulator, are required to file a Form ADV with FINRA. An investment adviser who advises private funds is required to disclose the name and certain other information of a Marketer for a private fund on Form ADV Item 7.B. This applies when Marketer functions in capacities such as a placement agent, consultant, finder, introducer, municipal adviser, or similar solicitor.
Similarly, the requirement to disclose sales compensation on Form D is mandatory under SEC’s Regulation D discussed above. Issuers, including those that issue private fund interests, are obligated to disclose the names of all recipients of sales compensation and finders' fees, specify the States where they intend to solicit investors, and include Central Registration Depository (CRD) numbers if the recipient is a registered broker-dealer.
Use of Marketers that are not registered broker-dealers, for example, is immediately transparent to Federal and State regulators as a result of these disclosure requirements, and advisers should expect to be asked about these arrangements and how they are compliant with relevant laws.
Conclusion
The SEC’s disclosure requirements for the use of Marketers are designed to promote transparency both to the SEC and investors, protect investors and enable regulatory oversight. The Manager should devote resources to conduct due diligence and maintain oversight of Marketers to confirm that the Marketer is properly licensed and as best as can be determined, operating pursuant to commercial practice. By adhering to these rules and practices, Managers enhance the likelihood that their marketing practices, as well as the activities of the Marketers they employ, are both ethical and compliant with Federal and State regulations.
[3] The term “investment adviser” means any person who, for compensation, engages in the business of advising members of the public, either directly or through publications or writings within or from the state of New York, as to the value of securities or as to the advisability of investing in, purchasing, or selling or holding securities, or who, for compensation and as a part of a regular business issues or promulgates analyses or reports concerning securities to members of the public within or from the state of New York. “Investment adviser” shall not include… (5) A person who sold, during the preceding twelve-month period, investment advisory services to fewer than six persons residing in New York, exclusive of financial institutions and institutional buyers; (6) A federally covered investment adviser; (7) a “foreign private adviser…” GBL § 359-eee(a).
