One practice question frequently raised by private fund sponsors, including exempt reporting advisers (“ERAs”), is whether they may compensate third parties for introductions to potential U.S. investors without engaging a registered broker-dealer or placement agent. The question often arises where a principal of the sponsor knows or is introduced to a well-connected individual who can supposedly make useful introductions to potential investors, in exchange for a finder’s fee. The sponsor agrees, wishing to pay a one-time success-based finder’s fee and everyone involved assumes that the arrangement is permissible if the payment is fully disclosed. While that commercial instinct is understandable, sponsors should be aware that U.S. securities laws provide only limited flexibility. In most circumstances, a success-based finder’s fee paid to someone other than a registered broker-dealer and tied to a U.S. person’s investment in a U.S. private fund presents significant risk under the Securities Exchange Act of 1934 (the “Exchange Act”). [1] The following summarizes the governing framework around such question and outlines what structures are and are not generally defensible.

I. Statutory Framework and SEC Approach

In 2020, the SEC proposed a conditional exemption from broker registration for certain natural-person “finders” engaged solely with accredited investors and subject to activity limits and disclosure requirements;[2] however, the SEC never adopted the exemption as a final rule, so it does not provide a current safe harbor, leaving in-place the formal broker-dealer regime.  15 U.S.C. § 78c(a)(4) of the Exchange Act defines a “broker” as, subject to certain exemptions, “any person engaged in the business of effecting transactions in securities for the account of others” and requires such brokers to register as a broker-dealer.[3] To determine if a person is in fact engaged in such business and is therefore a broker, the Securities and Exchange Commission (“SEC”) and staff guidance applies a facts and circumstances analysis that focuses on several items, such as whether such a person is: (i) soliciting investors or otherwise participating in a securities distribution; (ii) advising or negotiating with respect to an investment; or (iii) receiving transaction-based compensation, meaning compensation contingent on or connected with the execution or size of a securities transaction.[4] Among these factors, the SEC has repeatedly emphasized that transaction-based compensation is a hallmark of broker activity and a central indicator that registration may be required as it creates a “salesman stake” in the transaction.[5]

These restrictions absolutely apply to the securities of private equity funds, growth equity funds, venture capital funds, private credit funds, hedge funds and similar private fund vehicles which offer securities relying on exemptions on Sections 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940.

II. Are One-Off Transactions Free From Broker-Dealer Issues?

Either not knowing the legal standard or focusing on the concept of a person being “in the business of” brokerage activity, many sponsors assume using someone in their network as a one-off connector, even if compensated for it, is permissible. In defending the position, such sponsors will point to (i) the introduction and payment being one-off and non-recurring; (ii) the arrangement being fully disclosed to investors and/or (iii) the fee payment not being linked to the sponsor’s receipt of management fees or carried interest. None of these factors are typically sufficient to cure the problem. Disclosure is insufficient as broker-dealer registration is a structural requirement, not a disclosure obligation;[6] separating the finder’s fee from those received by the sponsor does not impact broker risk;[7] and one-time compensation can still be transaction-based compensation,[8] which is the core issue. SEC enforcement history confirms regulatory scrutiny in the private-fund context with the core issue remaining whether the compensation received by such person is effectively tied to a securities transaction.[9]

Evidence that such compensation is tied to a securities transaction includes whether compensation is only offered if an investor subscribes or if such compensation is calculated as a percentage of invested capital. If so, the SEC typically views the arrangement as transaction-based compensation requiring broker-dealer registration. This requirement is not diminished even if the compensation is paid only once, is transparently disclosed and/or is economically separate from advisory-fee streams. Consistent with this finding, SEC enforcement action in the private funds context has maintained that using an unregistered finder who receives success-based compensation can expose both the finder and the sponsor to liability, including aiding and abetting or causing violations of Section 15(a) (e.g., “prohibiting unregistered broker activity”).[10]  In addition, under many states’ securities laws, use of an unregistered broker-dealer in a securities transaction can subject the offering to partial or potentially even entire rescission.  Furthermore, standard offering documents often require the issuer to represent that no unlicensed broker-dealers, or broker-dealers other than those explicitly disclosed, have assisted with the offering.  If such a representation is not correct, that could subject the issuer to regulatory and civil liability to the SEC as well as to investors.

III. Pure Introductions

What can work, in theory, however, is a bona fide non-soliciting introducer making an introduction. The SEC staff has previously issued no-action relief suggesting that a person who merely provides contact information for a potential investor, without solicitation, recommendation, negotiation, or other participation, may fall outside broker status in limited circumstances.[11] However, in practice, replicating such a fact pattern in a modern fundraise is unlikely as it would require the introducing party simply to make the connection or provide contact information, without follow-up communications with the investor, encouragement or endorsement of the fund or securities, the coordination of diligence discussions or the receipt of compensation contingent on investment. The presence of any of these elements increases broker-dealer risk. Accordingly, while a true non-soliciting introducer may be theoretically distinguishable, the model is operationally fragile, is highly fact-sensitive and likely precludes the type of compensation that both sponsors and such unregistered “finders” typically favor.

IV. Structures that Work

1. Engaging a registered broker-dealer for U.S. investor solicitation remains the best practice and safest path, particularly where compensation is success-based.

2. As stated above, if practically feasible, a narrowly constrained name-only referral arrangement is also acceptable, but sponsors should be cautious given the difficulty of maintaining strict non-solicitation boundaries.[12]

3. The appropriate use of internal personnel (e.g., employees, but not outside third-parties or contractors) is typically permitted. Fundraising by such internal personnel who are paid a salary and a discretionary non-transaction or success-specific bonus is generally viewed as acceptable under the “Issuer’s exemption;”[13] provided that such employees must also have responsibilities beyond fundraising, and depending upon the nature of the investment and fundraising targets, are often limited to working only one offering during any twelve-month period. Subject to these limitations, fundraising by such internal personnel is permitted, as such persons are not considered to be “in the business of effecting transactions in securities for the account of others.”[14]

4. Finally, the use of outside consultants or contractors, so long as such persons are paid a flat consulting fee (which may include a discretionary non-transaction or success-specific bonus) for services and such services are defined and not directly related to securities solicitation (e.g., market research, event logistics, branding, etc.) is also generally acceptable. In such cases, individuals may make one-off introductions (without compensation for success), but solicitations may not be a part of their professional activities. Ultimately, regulators will evaluate substance over form and a nominal “consulting” label will not mitigate risk if the payment functionally rewards successful capital introduction.[15]

V. Practical Takeaways

Sponsors should understand that without the proposed 2020 relief being operational, they should assume that any use of a U.S. third-party finder to solicit U.S. investors for success-based compensation creates broker-dealer risk, which cannot necessarily be cured through structuring or disclosure. Rather, unless such activity falls within the “pure introduction” model (which is typically difficult) or one of the other recognized workable solutions, sponsors should either be engaging a registered placement agent or limiting compensation to properly structured internal personnel to generally avoid such risks.