Interpretive letter to Jonathan D. Wiley, The Forbes Securities Group

A capital acquisition broker may accept equity securities issued by privately held companies as compensation for its services, subject to the stated conditions discussed in the letter.


Dear Mr. Wiley:

In your letter of May 9, 2019, you request interpretive guidance on behalf of The Forbes Securities Group, LLC (“FSG”), a FINRA member that has elected to be regulated as a Capital Acquisition Broker (“CAB”). You have inquired whether FSG may accept compensation for its services in the form of equity securities issued by the client to which FSG is providing services, based on the representations in your letter.

Background

You state that FSG works with lower-middle market and middle-market privately-held companies in various industries by advising on mergers and acquisitions (“M&A”) and private placement activities. You state that FSG’s private placement clients typically are established operating companies that seek capital for reasons of growth, recapitalization, or to withdraw money from the company. You have represented that FSG’s M&A and private placement activities are consistent with the limitations imposed on CABs’ activities under CAB Rule 016(c) and that you do not engage in impermissible activities described in CAB Rule 016(c)(2).

You state that FSG’s compensation for its private placement activities is generally in the form of success fees based on the total amount of capital raised for the client. You also state that in some (but not all) cases, the success fees may include a combination of cash and equity, the latter often in the form of warrants. You state that FSG’s clients may choose to pay compensation to FSG in the form of equity either because the client wishes to retain as much of the capital raised as possible within the company, or in the case of an earlier stage company or in circumstances that add risk and complexity to the transaction, because the inclusion of equity in FSG’s success fees provides some potential future compensation to offset associated risk.

You state that such warrants generally set a stated time period during which the warrants must be exercised, and set an exercise price based on a company’s valuation upon closing of the private placement transaction. You also state that it is possible the warrants could have an exercise price that is not tied to the company’s valuation upon closing, and instead have a nominal exercise price. You state these warrants allow FSG to pay an exercise price in exchange for a predetermined number of shares. You also state that your client engagement agreements often contain a cashless exercise provision that allows FSG to elect not to pay the full exercise price and in return it receives a discounted number of shares. You state that after a warrant’s expiration date, the warrant is no longer a valid security. You seek confirmation that, based upon these facts, FSG may receive compensation in the form of equity securities consistent with the requirements of the FINRA Rules governing CABs.

Discussion

CAB Rule 016(c)(1) provides that a “capital acquisition broker” is any broker that solely engages in any one or more activities described in sub-paragraphs (A) through (G) of CAB Rule 016(c)(1). Sub-paragraphs (A) through (E) list various advisory and consulting services that CABs may provide to their clients, such as advising issuers concerning their securities offerings or other capital raising activities, advising a company regarding an M&A transaction, and assisting in the preparation of offering materials on behalf of an issuer.

Sub-paragraphs (F) and (G) describe the private placement activities in which CABs may engage. Sub-paragraph (F) permits a CAB to engage in qualifying, identifying, soliciting or acting as a placement agent or finder (i) on behalf of an issuer in connection with newly-issued, unregistered securities to institutional investors or (ii) on behalf of an issuer or control person in connection with the change of control of a privately held company.1 Sub-paragraph (G) permits CABs to effect securities transactions solely in connection with the transfer of ownership or control of a privately-held company to a buyer that will actively operate the company or the business conducted with the assets of the company, in accordance with the terms and conditions of a Securities and Exchange Commission 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 Securities Exchange Act of 1934.

CAB Rule 016(c)(2) provides that the term “capital acquisition broker” does not include any broker or dealer that engages in certain specified activities. These prohibited activities include, among others, acting as an introducing broker with respect to customer accounts, holding or handling customers’ funds or securities, accepting orders from customers to purchase or sell securities either as principal or agent for the customer (except as permitted by sub-paragraphs (c)(1)(F) and (G)), and engaging in proprietary trading of securities or market-making activities.

The CAB Rules do not specifically address whether a CAB may receive compensation for its services in the form of equity securities. Provided that compensation is for services in which CABs are permitted to engage under CAB Rule 016(c)(1), and FSG does not engage in activities that are specifically prohibited under CAB Rule 016(c)(2), FSG may accept equity securities issued by privately held companies as compensation for its services as described in your letter. Thus, for example, upon receiving equity securities as compensation, FSG may not accept orders from customers to purchase or sell securities either as principal or agent for the customer, and may not engage in proprietary trading or market making activities.

The opinions expressed in this letter are staff opinions only and have not been reviewed or endorsed by the FINRA Board of Governors. This staff letter responds only to the issues raised, and does not address any other rule or interpretation of FINRA, or all the other possible regulatory or legal issues involved. In addition, you should be aware that any changes in the facts as you have described them will require further consideration and may cause us to reach a different conclusion.

If you have any questions regarding this letter, please contact me at (240) 386-4534.

Sincerely,

 

Joseph P. Savage

cc: Shannon K. Fitzgerald, Managing Director, Regulatory Ridge, LLC
Lance Burkett, District Director, Sales Practice, Denver District Office

 


  1. For purposes of sub-paragraph (F), a “control person” is a person who has the power to direct the management or policies of a company through ownership of securities, by contract, or otherwise. Control is presumed to exist if, before the transaction, the person has the right to vote or the power to sell or direct the sale of 25% or more of a voting class of securities, or in the case of a partnership or limited liability company, has the right to receive upon dissolution or has contributed 25% or more of the capital.