RIA Compliance Blog
A new limited broker/dealer classification framework at the federal level has been created as the result of a recent SEC Order approving a FINRA rule proposal seeking to address the longstanding industry desire for augmented exemptive relief and/or limited registration classifications for broker/dealers that restrict their activities to certain designated corporate finance transactions. The new federal broker/dealer registration category known as Capital Acquisition Brokers (“CABs”), which some observers have dubbed a “lite” form of broker/dealer registration, is the latest development in this area of securities regulation, and follows a recent string of federal and state no-action letters providing exemptive relief to so-called Mergers and Acquisitions (“M&A”) Brokers. However, enthusiasm for the new CAB Rules should be tempered somewhat in that: (1) the CAB Rules do not provide exemptive relief—i.e., they do not allow firms to avoid registration but instead set up a form of registration that is meant to be somewhat less onerous; (2) CAB registration still requires that CAB firms adhere to many of the same strictures required of full broker/dealers; and (3) opting to be regulated as a CAB may require reassessment as time goes on to the extent that a firm’s business activities change. While formally approved by the SEC, FINRA’s CAB Rules are not as yet effective. FINRA will publish the effective date in an upcoming Regulatory Notice. The full set of CAB Rules approved by the SEC may be found online at http://www.finra.org/sites/default/files/SR-FINRA-2015-054-amendment-2.pdf.
At the outset, we note that the CAB classification is not a registration category per se, but instead a FINRA Membership category. That is, broker/dealers that meet the definition of a CAB and elect to be governed under the CAB Rules, may apply for Membership with FINRA as a CAB. Electing CAB status is purely voluntary on the firm’s part. Existing FINRA Members may become CABs by seeking to amend their existing FINRA membership agreements. Firms seeking to become new FINRA Members for the first time will in turn select CAB status on their New Membership Application.
FINRA explains its rationale for creating the new CAB category by noting that there are corporate financing firms that solely advise companies on M&A, advise issuers on raising capital in private placements with institutional investors, or provide corporate advisory services on a consulting basis. FINRA notes that these firms often are registered with the SEC under the Securities Act of 1934 (“1934 Act”) as broker-dealers because of their activities and because they may receive transaction-based compensation as part of their services. Nevertheless, FINRA believes that these firms do not engage in many of the types of activities typically associated with traditional broker-dealers, such as handling customer funds or securities, accepting orders to buy/sell securities, or engaging in proprietary trading or market-making activities. Therefore, FINRA’s CAB Rules subject CABs to the FINRA By-Laws, as well as “core” FINRA rules that FINRA believes should apply to all of its Members.
The CAB Rules define the term “capital acquisition broker” to mean any broker that solely engages in one or more of the following activities: (1) advising an issuer, including a private fund, concerning its securities offerings or other capital raising activities; (2) advising a company regarding its purchase or sale of a business or assets or regarding its corporate restructuring, including a going-private transaction, divestiture or merger; (3) advising a company regarding its selection of an investment banker; (4) assisting in the preparation of offering materials on behalf of an issuer; (5) providing fairness opinions, valuation services, expert testimony, litigation support, and negotiation and structuring services; (6) qualifying, identifying, soliciting, or acting as a placement agent or finder (i) on behalf of an issuer in connection with a sale of newly-issued, unregistered securities to institutional investors or (ii) on behalf of an issuer or control person in connection with a change of control of a privately-held company; or (7) effecting securities transactions solely in connection with the transfer of ownership and control of a privately-held company to a buyer that will actively operate the company, 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.
Alternatively, a “capital acquisition broker” does not include any broker or dealer that: (1) carries or acts as an introducing broker with respect to customer accounts; (2) holds or handles customers’ funds or securities; (3) accepts orders from customers to purchase or sell securities either as principal or as agent for the customer (except as explicitly permitted by the CAB Rules); (4) has investment discretion on behalf of any customer; (5) engages in proprietary trading of securities or market-making activities; (6) 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 (“1933 Act”); or (7) effects securities transactions that will require the broker or dealer to report the transaction under the FINRA Rules 6300 to 6700, 7300 or 7400 Series.
Importantly, with respect to the various activities that a CAB may engage in on behalf of an issuer in connection with sales to institutional investors, the CAB Rules define “institutional investor” to include persons meeting the definition of a “qualified purchaser” as defined in Section 2(a)(51) of the Investment Company Act of 1940 (“1940 Act”), but NOT “accredited investors” as defined in Reg D under the 1933 Act. This distinction is especially relevant to CABs engaging in private fund placement agent activity. Specifically, by choosing to include qualified purchasers but not accredited investors in the definition of “institutional investor,” the CAB Rule thereby dictates that such private fund placement agent activity by CABs shall be limited to so-called 3(c)(7) private funds as opposed to 3(c)(1) private funds. Private funds relying on section 3(c)(7) of the 1940 Act must, among other things, only admit qualified purchasers as investors; while, on the other hand, private funds relying on section 3(c)(1) of the 1940 Act may also admit accredited investors. Note that the accredited investor standard is a substantially looser one than the qualified purchaser standard.
A CAB applicant will generally follow the same procedures for membership as any other FINRA applicant except that an applicant for membership that seeks to qualify as a CAB will have to state in its application that it intends to operate solely as such. Accordingly, in reviewing an application for membership as a CAB, the FINRA Member Regulation Department will consider, in addition to FINRA’s general standards for admission, whether the applicant’s proposed business activities are consistent with the limitations imposed on CABs.
Once an applicant’s membership is approved, a CAB is subject to all of FINRA’s By-Laws and the CAB Rules. While a full discussion of the entire CAB Rule set is beyond the scope of this post, some notable distinctions are as follows: (1) on the compliance front, CABs are relieved of the obligations to conduct an annual compliance meeting, obtain annual written CEO certification of the effectiveness of the firm’s compliance program, establish and maintain a business continuity plan (“BCP”), post fidelity bond coverage, and, while CABs must still implement a written anti-money laundering (“AML”) program, CABs may conduct the required independent testing for AML compliance every two years (rather than annually as FINRA Rule 3310 requires of non-CABs); (2) CAB Rule 221 is an abbreviated version of FINRA Rule 2210 (Communications with the Public), essentially prohibiting false and misleading statements, but not requiring any extensive principal review procedures or filings with FINRA’s Advertising Regulation Department; (3) CAB Rule 221 does not include FINRA Rule 2210’s prohibition on predictions or projections of performance; (4) FINRA does not believe that FINRA Rule 3110(b)(2), which requires members to adopt and implement procedures for the review by a registered principal of all transactions relating to the member’s investment banking or securities business, or FINRA Rule 3110(d), which imposes requirements related to the investigation of securities transactions and heightened reporting requirements for members engaged in investment banking services, should apply to CABs; and (5) FINRA does not believe that FINRA Rule 3110(c), which requires members to conduct internal inspections of their businesses, should apply to CABs.
On the flip side, CABs will remain subject to numerous provisions generally applicable to all FINRA Member firms. For example, CABs must still: (1) satisfy all 1934 Act financial requirements, such as obtaining an annual audit from an independent CPA and complying at all times with the SEC’s net capital rule; (2) comply with all of FINRA’s general books and records requirements; (3) license all of its associated persons (i.e., CAB registration in no way lessens the burden on a CAB’s associated persons to take and pass “Series” exams (and comply with ongoing “continuing education” mandates for that matter)); (4) appoint a designated principal as Chief Compliance Officer (“CCO”); and (5) maintain active broker/dealer registrations with the SEC under the 1934 Act as well as all applicable states under relevant “Blue Sky” law.
In conclusion, while the industry has generally reacted positively to the new CAB framework, it is unclear how useful it will ultimately prove to market participants. Many firms, especially those in the private fund placement space will likely consider the new CAB construct, accordingly assessing the costs and benefits involved. However, as noted above, the CAB Rule definition of “institutional investor” effectively precludes CABs from marketing the more widely available 3(c)(1) private funds (which cast their net to accredited investors as well as those more affluent qualified purchasers). An additional concern for private fund placement participants may be CAB Rule 328, which prohibits any person associated with a CAB from participating in any manner in a “private securities transaction,” defined in FINRA Rule 3280(e) as “any securities transaction outside the regular course or scope of an associated person’s employment with a member.” FINRA does not believe that an associated person of a CAB should be engaged in selling securities away from the CAB, nor should a CAB have to oversee and review such transactions, given its limited business model. This restriction may prove unworkable for CAB firms that employ or otherwise retain the services of dually-registered associated persons.
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