Yesterday the Securities and Exchange Commission announced that it settled a proposed administrative and cease-and-desist proceeding against SharesPost, Inc., an online private capital marketplace, and its founder and president, Gregg Brogger, for acting as an unregistered broker-dealer.
First, What is a Broker-Dealer?
Under the Securities Exchange Act a “broker” is broadly defined as “any person engaged in the business of effecting transactions in securities for the account of others,” and a dealer as “any person engaged in the business of buying and selling securities for such person’s own account through a broker or otherwise.”
Before a broker-dealer can “effect any transactions in, or … induce or attempt to induce the purchase or sale of, any security …” it must register with the Commission and become a member of FINRA and the SIPC. Additionally, broker-dealers must comply with the registration requirements of the laws of each state in which they intend to operate.
Once a broker-dealer is registered it becomes subject to a number of specific conduct, financial responsibility and reporting requirements, as well as to periodic compliance examinations by the Commission, FINRA and the state securities commissions.
What Does it Mean to be “Engaged in the Business” of Effecting Securities Transactions?
Neither the Exchange Act nor the rules promulgated thereunder define what it means to be “engaged in the business of effecting transactions in securities,” and the courts and the Commission, by means of administrative and enforcement proceedings and through interpretive decisions in the form of no-action letters, have come to construe the phrase broadly to include activities such as:
- soliciting, structuring or negotiating securities transactions;
- providing valuation advice;
- disseminating quotation information;
- receiving transaction-related compensation;
- preparing, conveying or collecting transaction-related documentation; or
- otherwise acting as an intermediary in a securities transaction.
So, What Happened in the SharesPost Case?
SharesPost started out in June 2009 as an online bulletin board for buyers and sellers of private company securities. They charged a flat membership fee for access to their platform and left members to arrange and execute their own transactions. But private sales of securities can be complicated and many members ended up needing “substantial assistance from SharesPost and/or a representative of a registered broker-dealer” in order to complete their transactions. At this point SharesPost probably should have either registered as or merged with a broker-dealer.
Instead, in 2010, SharesPost entered into a series of agreements with registered representatives from various other broker-dealers. The representatives were designated as “Company Specialists” and were each assigned to cover certain categories of companies (e.g., social media, green tech., etc.). Their role was to facilitate transactions between buyers and sellers. As compensation for these services their supervising broker-dealer was paid a transaction based fee. The broker-dealer in turn paid a portion of that fee over to the representative, pursuant to a separate agreement between the broker-dealer and the representative.
To make things a bit more complicated, each representative also entered into an arrangement with SharesPost whereby they agreed to pay 35% of their gross commissions to another broker-dealer to be designated by SharesPost in the future. The only problem is that SharesPost never designated a broker-dealer. It did, however, keep track of the commissions owed and when one of its representatives left SharesPost itself received the accrued commissions (even though it still wasn’t a registered broker-dealer).
By late 2010 SharesPost decided “that maintaining arrangements with multiple registered representatives affiliated with multiple broker-dealers was cumbersome” and so (rather than registering as or merging with a broker-dealer at that point) SharesPost entered into a “Broker-Dealer Independent Affiliate Agreement” with “Broker-Dealer A.”
Pursuant to this latest agreement SharesPost employees who were also registered representatives of a broker-dealer, including its then CEO and other senior executives, facilitated transactions between buyers and sellers on a commissioned basis. Any commissions earned were paid into a compensation pool at Broker-Dealer A. The CEO of SharesPost would then provide Broker-Dealer A with written instructions as to what percentage of funds in the commission pool were to be distributed to each representative and to Broker-Dealer A.
Beyond the creative compensation arrangements SharesPost also engaged in other activities that made it more like a broker-dealer and less like the passive bulletin board that it started out as. Among other things, it made available through its website and suggested that members use its own copyrighted form transaction documents. SharesPost personnel, some of whom were not registered representatives, served as intermediaries between buyers, sellers, companies and transfer agents. It made available free research reports detailing information about the companies whose securities were posted on its bulletin boards and it created a “Venture Index” that aggregated and weighed certain known or estimated data for its most active companies.
Also in late 2010 SharesPost created a series of funds each designed to purchase the securities of one of the companies posted on its bulletin boards. These funds were used to create an auction process. To quote at length from the Commission’s Order:
[P]otential sellers of a company’s stock would set a reserve price for the block of shares they wished to sell. In turn, SharesPost members who posted indications of interest to buy interests in the [fund] were contacted by SharesPost personnel, who were registered representatives of Broker-Dealer A to see if they wanted to participate in the auction. The buyers were bidding on interests in the fund and the fund would in turn purchase the stock. The auction process began to feature prominently on the SharesPost website – thus, at that point, SharesPost was using the website to sell securities (interests in the fund) in which it had a financial interest. The SharesPost subsidiary management company [that oversaw the funds] charged a one-time service fee, which was five percent of the investment and a three percent fee on any distributions to the fund.
Finally, in December 2011, SharesPost acquired a broker-dealer which it also registered with the Commission as an alternative trading system, a development first announced in a press release yesterday.
Overall I think this is a good outcome, SharesPost should have registered or acquired a broker-dealer from the beginning (or at least earlier on) and it’s good to see the Commission reaffirm it’s commitment to both innovation in the market and investor protection. Or as Robert Khuzami noted in the Commission’s press release: “[w]hile we applaud innovation in the capital markets, new platforms and products must obey the rules and ensure the basic fairness and disclosure that are the hallmarks of sound financial regulation.”