Capital Acquisition Broker Regulation- A Solution to the Finder Issue?

By Scott A. Stokes, Thomas H. Bilodeau, III and James B. Heffernan On November 16, 2016

On August 18, 2016, the Securities and Exchange Commission (“SEC”) adopted the proposal of the Financial Industry Regulatory Authority, Inc. (“FINRA”) and established rules with respect to “capital acquisition broker(s)” (“CAB”).  CABs are  a new category of intermediaries who may receive payment based on a percentage of the transaction proceeds (e.g. where a CAB has assisted a company in a private placement or with the evaluation of securities).  The new CAB registration process should help clarify the long standing uncertainty about the legality of so called “finder” activities performed without registration as a broker-dealer.
In the past, the SEC and FINRA have consistently taken the position that most, if not all, of the actions of “finders” required them to register as broker-dealers, particularly if the finder received any transaction-based compensation for its services.  For more than a decade, proposals have been floated to create a “broker-dealer light” type registration process for these intermediaries, recognizing that such firms usually do not perform all of the duties, or engender the associated risks, of a full-service broker-dealer firm.  The new CAB rules appear finally to address that need and clarify the process for registration of such individuals and entities. 
CAB Rules
What CABs are Permitted to Do
Under the new rules, a CAB is generally defined as any broker that solely engages in activities such as: 
- acting as a placement agent or finder (i.e. third party marketing and capital introduction services) on behalf of an issuer in connection with a sale of newly-issued, unregistered securities to institutional investors, or in connection with a change of control of a privately-held company;
- advising on securities offerings or other capital raising activities including assisting in the preparation of offering materials on behalf of an issuer;
- advising on M&A activities including, acquisitions, corporate restructurings, going-private transactions, divestitures and mergers;
- advising on the selection of an investment banker and providing fairness opinions, valuation services, expert testimony, litigation support, and negotiation and structuring services;
- acting as a business broker, in accordance with the terms and conditions of an SEC rule, release, interpretation or “no-action” letter that permits a person to engage in such activities without having to register as a broker or dealer pursuant to Section 15(b) of the Exchange Act.
Although noted above, it is important to reiterate that a CAB is permitted to act as a placement agent or finder on behalf of an issuer only in connection with a sale of newly issued, unregistered securities to “institutional investors.”   The definition of institutional investors generally mirrors that found under FINRA Rule 2210 (but also includes a person meeting the definition of “qualified purchaser” as that term is defined in Section 2(a)(51) of the Investment Company Act of 1940), but does not include a person who meets only the definition of “accredited investor” within the meaning of Rule 501 under the Securities Act of 1933.   This is an important distinction as many private placements seek to raise capital from investors meeting only the accredited investor standard.
What CABs are Not Permitted to Do
CABs are generally distinguished from regular broker-dealers under the rules in that a CAB generally does not include any firm that:
- carries or acts as an introducing broker with respect to customer accounts;
- holds or handles customers’ funds or securities;
- accepts orders from customers to purchase or sell securities either as principal or as agent for the customer; or
- has investment discretion on behalf of any customer;
- engages in proprietary trading of securities or market-making activities;
- participates in or maintains an online platform in connection with offerings of unregistered securities pursuant to Regulation Crowdfunding or Regulation A under
the Securities Act of 1933; or
- effects securities transactions that will require the broker or dealer to report the transaction under the FINRA Rules 6300 Series, 6400 Series, 6500 Series, 6600 Series, 6700 Series, 7300 Series or 7400 Series.
CAB Registration
In general, CABs will be subject to many of the same registration and conduct rules as traditional broker-dealers.  Additionally, the registration, qualification, examination and continuing education requirements for principals and representatives of CABs will generally remain the same as for traditional broker-dealers. The new rules do set forth a new streamlined set of conduct rules for CABs that are more appropriate for their actual business (CAB Rule 200 Series).  Since it is anticipated that CABs will provide their services generally to clients who are sophisticated enough to negotiate fair prices and reasonable service charges, the new rules do not subject CABs to the customary FINRA rules dealing with fair prices and commissions (Rule 2121), charges for services performed (Rule 2122), or new transactions with customers (Rule 2124).  Additionally, if a CAB acts inconsistently with the CAB limitations, FINRA is allowed to impose all applicable FINRA rules on the CAB.
The new rules also set forth general supervision and operational standards for CABs (CAB Rule 300 Series).  A CAB is required to designate a chief compliance officer as well as have its chief executive officer certify that the member has adopted and maintains, and is able to comply with, sufficient written compliance and supervisory policies and procedures.  CABs will also be required to implement a written anti-money laundering program.
CAB registration will generally follow the same registration and application procedures (with the same filing costs) as any other broker-dealer registration.
Summary and Outlook
The new CAB rules are an important step forward in legitimizing the actions of placement agents and finders in the marketplace.  This may be especially true for third party marketing and capital introduction businesses who are advising or assisting hedge funds, private equity funds or real estate funds with capital raises, given that funds tend to attract more sophisticated investors who will generally meet the qualified purchaser standard (especially 3(c)(7) funds, which must have only qualified purchasers).   However, it remains to be seen whether CAB registration will take root when it excludes the ability to raise funds for clients seeking capital from their traditional base of accredited investors.  Given that there are still substantial operational rules and requirements, it may be unlikely that many existing broker-dealer firms will choose to switch their registration to the limited CAB registration.  For those firms that are not registered currently but are willing to work only with institutional investors, the CAB will provide an opportunity to operate within clearly defined regulatory parameters.
The CAB rules will go into effect on April 14, 2017. FINRA will begin accepting applications for firms seeking to become CABs on January 3, 2017.  Existing broker-dealer firms may convert to CAB membership beginning on April 14, 2017.
© 2016 by Rich May, P.C., Scott A. Stokes, Thomas H. Bilodeau, III, and James B. Heffernan. All rights reserved.
Disclaimer: This summary is provided for educational and informational purposes only and is not legal advice. Any specific questions about these topics should be directed to attorneys Scott Stokes and Thomas Bilodeau, III.