Before I explain an exemption or exception to the rule, I always start with the general rule and purpose.
Section 15 of the Exchange Act of 1934 (“Act”) makes it unlawful for any broker or dealer to purchase, sell, or effect transactions in securities, using the means or instrumentalities of interstate commerce, unless they have been registered with the Securities and Exchange Commission (“SEC”).
Who is a Broker?
A broker is someone, who buys or sells securities for the account of someone else. (1) On trading floors, this is called a riskless agency transaction, matching buyers with sellers. Much like a residential real estate agent, no inventory is involved.
Who is a Dealer?
A dealer is someone, who buys or sells securities for its account in the regular course of business. (2) Dealers use long and short securities positions as inventory, to facilitate or satisfy customer orders. Most dealers act regularly as brokers; however, their department’s profit is supplemented by running a concurrent portfolio, alongside the riskless agency brokerage business.
Most dealers gladly act as brokers unless there is inventory to be moved. Should a customer wish to buy a particular corporate bond or stock that is on a dealer’s books, that dealer will likely sell in-house securities inventory, rather than reaching out to competitors or wholesalers to broker a riskless agency broker transaction.
If a person buys or sells stock for their own account, would they be deemed as a dealer? Not quite.
A dealer does not include a person who buys or sells securities individually or in a fiduciary capacity. Such activities are “not as part of a regular business.” In other words, both institutional and retail traders are generally excluded from the “dealer” definition.
In contrast, market makers fall well within the definition of a “dealer.” Designated market makers (formerly called NYSE floor specialists) operate as dealers, holding themselves out as the buyer or seller of last resort, when other market participants are not willing to bid nor offer at the current trading price.
Combining the facilitation of market participant buy and sell orders with the self-motivation to trade the market volatility, market makers match buyers with sellers yet stand in, when few others will do so. They perform riskless agency brokerage style matchmaking trades when possible but also will buy and sell, in order to provide a fair and orderly market.
Weighing the Factors
Admittedly, there is some ambiguity in the definitions of broker and dealer, especially dealer. As such, the SEC has provided guidance through a balancing test that weighs a series of factors in determining whether a person has “engaged in the business” of effecting or facilitating transactions for others or for their own account such that they are subject to registration as a broker or dealer. (3) The factors are:
- What type of compensation does a person receive for holding funds or securities for others?
- Does the person hold its services out to the public as a broker or dealer?
- Do the transactions occur with “sufficient recurrence to justify the inference that the activities are part of the person’s business?”
- Whether the person receives transaction-based compensation for purchase or sale of securities.
This creates a fact-intensive inquiry.
The “Issuer Exemption”
The colloquially known “issuer exemption” allows an issuer of securities to sell its own securities to investors and not be subject to the registration requirements of § 15. The issuer is not selling securities for someone else nor is the issuer engaged in the business of selling securities for its own account. This is an important component in the private placement world, because “small-time” issuers generally do not rely upon underwriters nor broker-dealers to sell their securities.
In other words, the local gourmet biscuit shop can sell its own securities, (4) without being subject to the registration requirements of a broker-dealer.
However, we must be careful when employees of the issuer (5) sell securities for the issuer, especially when employees receive commissions, bonuses, or some other form of compensation for such sale of securities. This makes an employee an intermediary, qualifying him or her as having received “transaction-based compensation.” Securities sold by a non-issuer trigger the registration requirements.
The Associated Person Safe Harbor
The SEC provides a non-exclusive safe harbor under Rule 3a4-1 promulgated under the Act to allow partners, officers, directors, or employees of the issuer to sell securities of the same issuer and not be subject to the registration requirements if they:
- Are not subject to the bad actor disqualifications;
- Do not receive transaction-based compensation;
- Are not an associated person of the broker; and
- Meet one of the following conditions:
- Only sells securities to registered broker or dealers; or
- (A) Performs substantial duties not related to securities transactions for the issuer; (B) was not an associated person of a broker or dealer for the preceding 12 months; and (C) does not participate in more than one offering for the issuer in a 12-month period;
There will not be a presumption that there is a violation of the law, even if the conditions of this safe harbor are not met. Such situations will be evaluated on a case-by-case basis. You should consult an attorney to discuss the nuances.
Bad Things Can Happen if the Registration Requirement is Triggered
Violations of the registration requirements can trigger civil liabilities both by rescission of transactions by investors (who had purchased the securities) and by regulatory action. (6)
Furthermore, criminal action could also be brought by the Department of Justice for violations of the Act.
- § 3(a)(4) of the Act defines broker as “any person engaged in the business of effecting transactions in securities for the account of others.”
- § 3(a)(5) of the Act defines Dealer as “any person engaged in the business of buying and selling securities . . . for such person’s own account.”
- Advisers Act Release (In Touch Global, LLC). November 14, 1995.
- Assuming an exemption from registration of securities has been claimed.
- Also includes: corporate general partner of a limited partnership that is the issuer; company that is controlled by, or is under common control, with the issuer; registered investment adviser to a registered investment company that is the issuer.
- See § 21 of the Act.