EDITOR’S NOTE: This letter has been provided to Self-Directed Investor Magazine readers courtesy of Merrill Kaliser, an attorney specializing in securities and syndications. The letter remains unedited and unchanged from the original format in which Kaliser released it in early 2020.

By Merrill Kaliser

Over the past few months, there has been an SEC inquiry into certain groups, presumably, utilizing transaction-based compensation to co-sponsors and non-co-sponsors to raise capital. To be clear, unless the party bringing capital to the fund is a broker/dealer, you cannot have transaction-based compensation for raising capital … period … end of story. 

What is a broker?

A “broker” is defined in Section 3(a)(4) of the Securities Exchange Act of 1934 as “any person engaged in the business of effecting transactions in securities for the account of others.”  Section 3(a)(4)(A) outlines the requirements to register as a broker.  

Some yellow flags:

  • More than 5 or 6 co-sponsors (I have been seeing more than 10 on some raises on social media)
  • Not having the written agreement as to the percentage of ownership prior to raising capital
  • Bringing a co-sponsor in at the last minute and offering compensation for capital from acquisition fees and/or asset management fees
  • Paying special dividends/distributions based on the amount of capital raised or a “deferred equity” structure
  • Capital raisers not listed in the Private Placement Memorandum or the company agreement for the Manager or General Partner as the case may be.

We see numerous people gathering multiple co-sponsors in order to fund deals.  This is a “yellow” flag for the SEC.  Their Salt Lake City office has filed 12 suits in the last nine months against parties violating the transaction-based compensation rule.  This should NEVER be utilized, and I am advising, again, all of our clients to steer clear of this. 

What is compensation?

When we talk about “compensation,” we mean more than just a commission. The SEC broadly interprets compensation. 

Compensation can include: a commission, cash, equity, warrants, options, deferred equity, cryptocurrency, etc. 

However, the most important factor is whether the compensation is “transaction-based” or based on the success of a transaction. 

We are generally advising clients that if they are going to bring a partner in, that person had better be a true partner. This means that they [the partner] bring value or a unique skill set to the offering, have duties and responsibilities throughout the lifetime of the deal—not just during the capital raise—and those duties should include activities that don’t involve raising capital (or investor relations or anything else relating to investors). Additionally, it means that ANY compensation an individual receives CANNOT be tied to how much capital he/she raises.

3 Examples

Example 1: 

Manager approaches Joe and says, “Joe, if you raise $1 million, I will give you 10 percent of the Manager company.”  Joe raises $1 million and Joe receives 10 percent of the Manager company.  – VIOLATION

Example 2: 

Manager approaches Joe and says, “Joe, I am giving you 10 percent of the Manager company and I expect you to raise $1 million.” Joe raises $500,000 and Manager reduces Joe’s percent to 5 percent. – VIOLATION 

Ex: 3 

Manager approaches Joe and says, “Joe, I want to offer you 10 percent of the Manager company and you should go out and raise at least $1 million in capital and oversee rehab/repair & maintenance.”  Joe raises $500,000; Joe still has 10 percent in the Manager company and oversees rehab/repair & maintenance. – Not a violation.  There is no transaction-based compensation here. No matter how much Joe raises, Joe still owns 10 percent.

If you are sent correspondence from the SEC, please forward to your lawyer or an SEC lawyer upon receipt.  Most notices are simply notices not to destroy evidence for a significant case the SEC is trying to build. 

Bottom line: If you have to think about it, either do not do it or ask your lawyer before moving forward.  If you want to discuss creating your own fund to fund other deals, we can talk about that as well.

Merrill Kaliser is a shareholder at Kaliser & Associates PC, a law firm based in Dallas, Texas. His firm provides clients with services in multiple practice areas, including corporate governance, estate planning, insurance recovery, partnership and limited liability law, real estate, securities and syndications, and venture capital and business startups. Learn more at KaliserLaw.com or email Merrill at mkaliser@kaliserlaw.com