Many entities in the health care industry, including new practice groups, joint ventures, and other new businesses, seek to raise money through the sale of securities. Most of these sales of securities are accomplished through private offerings. When offering securities, most businesses tend to focus on whether the securities are exempt from registration under the Securities Act of 1933, as amended (Securities Act), and comparable provisions under state securities laws. Generally, entities seek to rely on the exemption provided by Rule 506 of Regulation D under the Securities Act, and, in writing this article, we have assumed that offers and sales of securities are being made pursuant to Rule 506. It should be noted that under the National Securities Markets Improvement Act of 1996 (NSMIA), the states are preempted from regulating securities offerings under Rule 506 under state registration provisions. However, NSMIA does not preempt the states from regulating securities offerings under other federal exemptions. However, the securities laws analysis should not be limited to the question of whether registration of the securities is required, but should also include the question of whether the person or persons selling the securities must register as a broker-dealer under the Securities Exchange Act of 1934, as amended (Exchange Act), or as an agent or salesperson under state securities laws.

In this connection, it should be noted that while the transaction involving the offer and sale of the stock may be exempt from federal registration pursuant to Rule 506 (and state registration due to federal preemption), this does not mean that the person or persons selling securities are exempt from registering as a broker-dealer under the Exchange Act. In addition, federal preemption of state registration requirements does not include federal preemption of state regulation of persons as agents or salespersons. Accordingly, even in connection with a Rule 506 offering, it is necessary to review both federal regulations regarding broker-dealers, and state regulations regarding agents and salespersons before any securities are offered or sold.

Section 3(a)(4) of the Exchange Act defines a broker as any person "engaged in the business" of effecting transactions in securities for the account of others. Section 3(a)(5) defines a dealer as any person "engaged in the business" of buying and selling securities for his own account, through a broker or otherwise. Issuers may use a registered broker-dealer to offer and sell securities. However, in a typical Rule 506 transaction, officers and/or directors will be relied upon to offer and sell securities to investors. Since the Securities and Exchange Commission (SEC) takes a broad view of the phrase engaged in the business, such persons could be deemed brokers. However, the SEC has adopted a rule that creates a safe harbor from broker-dealer registration for such persons.

Rule 3a4-1 of the Exchange Act provides a safe harbor from federal broker-dealer registration requirements. This safe harbor states that an associated person of a company offering securities shall not be deemed a broker solely by reason of his participation in the sale of securities if that person complies with the requirements of Rule 3a4-1. The definition of associated person includes an officer, director, or employee of the company selling securities or a company that controls, is controlled by, or is under common control with the company selling securities. Thus, the safe harbor may extend to an officer, director, or employee of the company offering and selling securities or a parent or subsidiary company. It is also important to note that the safe harbor only applies to natural persons, not corporate entities.

Under Rule 3a4-1, an associated person of an issuer of securities will not be deemed a broker if he:

is not subject to a statutory disqualification (commonly referred to as "bad boy" provisions);
is not compensated in connection with his participation in the offering by the payment of commissions or other compensation based either directly or indirectly on transactions in securities; and
is not at the time of his participation an associated person of a broker or dealer.

The following are some examples of statutory disqualifications: (i) conviction within 10 years of the offering of any felony or misdemeanor in connection with the purchase or sale of any security, involving the making of a false filing with the SEC, or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, or investment adviser; (ii) being subject to any order, judgment, or decree, entered within five years prior to the offering, that temporarily or permanently enjoins or restrains a person in connection with the purchase or sale of any security as described in (i) above; (iii) suspension or expulsion from membership in, or suspension or disbarment from association with, a member of a national securities exchange or national securities association for any act or omission to act constituting conduct inconsistent with just and equitable principles of trade; or (iv) being subject to a United States Postal Service false representation order.

Additionally, in order to qualify for the safe harbor, the associated person must meet one of three sets of conditions. The set of conditions that many associated persons rely on requires that the associated person:

primarily performs, or is intended to perform at the end of the offering, substantial duties for or on behalf of the issuer otherwise than in connection with transactions in securities;
was not a broker or dealer or an associated person of a broker or dealer, within the preceding 12 months; and
did not participate in selling an offering of securities for any issuer more than once every 12 months.

As indicated, there are two other sets of conditions that, if met, will qualify an associated person under the safe harbor of Rule 3a4-1. One condition requires that the associated person restrict his participation to certain types of transactions involving offers and sales of securities: (i) to a registered broker-dealer, registered investment company, insurance company, bank, or similar financial institution supervised by a state or federal banking authority or registered investment adviser; (ii) that are exempted from the registration provisions of the Securities Act, because the securities are issued through a receiver as part of a bankruptcy or part of a securities exchange; (iii) that are made pursuant to a plan or agreement submitted for the vote or consent of the security holders who will receive securities of the issuer in connection with a reclassification of securities of the issuer, a merger or consolidation or a similar plan of acquisition involving an exchange of securities, or a transfer of assets of any other person to the issuer in exchange for securities of the issuer; or (iv) pursuant to a bonus, profit sharing, pension, retirement, thrift, savings, incentive, stock purchase, stock ownership, stock appreciation, stock option, dividend reinvestment, or similar plan for employees of the issuer or a subsidiary of the issuer. It is unlikely that the persons offering and selling securities pursuant to Rule 506 would be able to satisfy this set of conditions.

The last of the three conditions requires that the associated person restrict his participation to any one or more of the following activities: (i) preparing any written communication or delivering such communication through the mails or other means that does not involve oral solicitation of a potential purchaser; provided, however, that the content of such communication is approved by a partner, officer or director; (ii) responding to inquiries of a potential purchaser in a communication initiated by the potential purchaser; provided, however, that the content of such responses is limited to information contained in a registration statement filed with the SEC or other offering document; or (iii) performing ministerial and clerical work involved in effecting any transaction. This set of conditions would not permit the type of offering/selling activities that are generally required in order to sell securities.

In addition to federal broker-dealer regulations, each state has its own broker-dealer (often referred to as agents or salespersons) regulations. Such regulations are not uniform throughout the states.

Most states exclude from their definition of agent or salesperson individuals who effect transactions in securities that are exempt from registration under Rule 506. In these states, any person can sell securities on behalf of an issuer relying on Rule 506 as long as no commissions or other compensation is paid in connection with the sale of securities. However, not all states have such an exclusion. For example, Connecticut specifically includes in its definition of agent any individual who sells securities in reliance on Rule 506. Connecticut does exempt officers and directors from the definition of agent as long as they do not receive compensation related to the sale of securities. Therefore, employees (unless they are also an officer or director) of an issuer may not sell securities in Connecticut relying on Rule 506 unless they register as agents. In Florida, there is no exclusion for those persons who sell securities relying on Rule 506. There is, however, an exclusion for bona fide employees of the issuer who have not participated in the distribution or sale of securities within the preceding 12 months and who will perform duties for the issuer other than in connection with securities transactions. Kansas has no exclusion; however, the Kansas Securities Commissioner has issued a no-action letter stating that no enforcement action would be taken against an employee, principal, or director for failing to register as an agent as long as no commissions are received. In Nevada and Vermont, there is no exclusion and therefore officers or directors would need to register as agents in order to offer and sell securities in these states.

In summary, in connection with a Rule 506 offering, it is necessary to consider compliance with federal broker-dealer regulation (which in most cases will require consideration of Rule 3a4-1), as well as state regulation of agents and salespersons. The failure to comply with these applicable regulations could expose those who offer and sell securities to criminal and civil liability.