Selling Real Estate Securities: Promoter Compensation (and why Kim Kardashian is paying a $1.26 million settlement to the SEC)

Private music teachers' roles go beyond teaching their students to play an instrument. Teachers often advise their students regarding which music camps to attend, which competitions to enter, and which orchestras to audition for. As a student becomes more advanced, their private teacher also may advise them on upgrading their instrument.

Purchasing a new violin or bow frequently involves the teacher contacting a dealer to explain the student's needs and price range. The dealer then will provide the student with several options meeting those requirements for the student to try out. With their teacher's guidance, a student will select the instrument that best meets their needs.

Unless lesson time is used to try out instruments, students rarely pay their teachers for helping with the instrument selection process. I can’t speak for today’s practices, but when I was a young musician, certain violin dealers compensated teachers by paying them a commission when their students purchased instruments. Although this practice wasn't a secret in the music industry, teachers rarely told students when they received those commissions.

Some musicians considered the commissions to breach the trust students place in their teachers to guide their careers. The thinking was that when teachers received a commission, they might steer students to particular dealers or instruments, even if they didn’t best meet the students’ needs or caused a student to pay more for an instrument to cover the commission. Objections to teacher commissions were amplified where the student was unaware of the arrangement.

Teachers deserve to be paid by someone for their time and expertise. Even as a teenager, I was aware of the commission practice, so I’d be surprised if more seasoned college students were not. Regardless, undisclosed commissions became a concern among some musicians, even though few believed they were unlawful.

The situation is different in the securities industry, which is more heavily regulated than the violin industry. Securities laws and Securities and Exchange Commission (SEC) regulations require that individuals and companies paid to promote or sell securities disclose their compensation to investors.

On September 30, 2022, the SEC charged Jonathan William Mikula and five other individuals with securities fraud for promoting securities without disclosing their compensation. The issuers of those securities also were charged with securities fraud and other securities law in connection with those sales.

Then, on October 3, the SEC announced a charge against Kim Kardashian for unlawfully promoting a crypto asset on her Instagram account without disclosing that she was paid. Kardashian agreed to a $1.26 million settlement, to cooperate with the SEC’s investigation, and not to promote any crypto for three years.

This article is part of a series discussing real estate securities offerings. The SEC alleges numerous violations in the Mukula complaint. This article focuses only on the compensation paid to Mikula and his associates and why Kim Kardashian’s Instagram posts violated securities laws.

The SEC’s Allegations Regarding Promotional Payments

The SEC alleges that Mikula acted as a promoter for several Regulation A issuers. Mikula utilized a middleman to negotiate a consulting agreement with the issuer. According to the SEC, the consulting agreement was an attempt to disguise compensation for promoting the issuer's offerings and that that compensation was tied to a percentage of investor proceeds.

The SEC further alleges that the middleman submitted fake invoices for services that hadn’t been performed and that the parties understood that Mikula would receive a portion of the amounts paid to the middleman. Also, Mikula allegedly received more than $80,000 in entertainment in exchange for promoting one issuer’s offering.

The SEC claims Mikula also persuaded one issuer to put his associate on its board and that that associate also received 3% of funds raised from investors plus approximately 10% of the company’s stock. The associate’s compensation allegedly was split with Mikula.

The SEC alleges that with that understanding, Mikula’s newsletter recommended the issuers’ offerings in his newsletter, falsely claiming it received no compensation for doing so. The issuers also didn’t disclose these compensation schemes to investors.

The findings against Kardashian say she touted a crypto asset security on her Instagram account without disclosing that she had been paid $250,000 through the issuer’s intermediary for the promotion. Kardashian’s promotion included an introductory video with a link to the EthereumMax website with instructions on how investors could purchase EMAX Tokens.

Transaction-Based Compensation is Prohibited

Several payments issuers allegedly made to Mikula’s associates were "transaction-based compensation." Transaction-based compensation is compensation based on the successful sale of securities. Transaction-based compensation may be a percentage of the dollar amount of securities sold or a flat fee paid for each successful investment. Any compensation conditioned on a successful sale of securities can be transaction-based compensation.

Transaction-based compensation need not be paid in cash. In the Mikula case, one individual allegedly received stock, and Mikula is said to have received free entertainment. Transaction-based compensation could be a free rental, use of a luxury vehicle, or any other item with monetary value. Even an issuer's payment of a bonus to salaried employees may be transaction-based compensation if based or conditioned on the successful sale of securities.

The SEC has for years stated that receipt of transaction-based compensation is a hallmark of broker-dealers. So, individuals who receive transaction-based compensation may be considered brokers or dealers who must be licensed. Failure to have a license when required also violates securities laws.

The SEC complaint doesn’t include a claim that Mikula or his associates acted as brokers or dealers without proper licenses. Instead, the complaint focuses on fraud claims tied to Mikula’s and his associates’ failure to disclose their commissions, as required under Section 17(b) of the Securities Exchange Act of 1934 (Exchange Act) and in violation of Rule 10b-5 adopted under Section 10(b) of the Exchange Act.

Section 17(b)

Kardashian didn't receive transaction-based compensation. Her payment was a flat fee and wasn't based on whether her efforts resulted in sales. However, Kardashian's actions violated Section 17(b). Mikula also is alleged to have violated Section 17(b).

A simplified explanation of Section 17(b) is that it prohibits promotion of a security for compensation without disclosing compensation received (or to be received) for the promotion activities. Section 17(b) doesn’t require that the promotional material or communications be false. Someone who publishes truthful information about a securities offering without disclosing the compensation they receive for the publication is violating securities laws.

When Section 17(b) was adopted, it was targeting people who were compensated for issuing stock tip sheets, similar to Mikula’s newsletter. However, the section has potential implications for Internet advertising platforms and even conferences that charge issuers a fee in exchange for the opportunity to tout their offerings. Section 17(b) also applies to broker-dealers and investment advisors, but they additionally are subject to FINRA and/or state regulatory requirements, which are beyond the scope of this article.

The bottom line is that anyone who receives compensation for promoting securities must disclose that compensation, even if their compensation isn’t conditioned on a successful sale.

Rule 10b-5

The SEC also alleges Mikula and his associates violated Rule 10b-5. Rule 10b-5 prohibits misleading statements, misrepresentations, or omissions of material information in connection with the sale of securities.

A simplified test for determining if information is material is whether an investor would consider the information important when deciding to invest. Selling commissions and promotional fees generally will be material. Not only can they be a considerable expense for the investment, but they also may affect the selling agent or promoter’s motivation to sell securities to the investor.

In Mikula’s instance, the SEC claims that tens of millions of dollars of securities were sold, at least in part due to his touting the securities in his newsletter. According to the SEC, Mikula not only failed to disclose his compensation—he also inaccurately stated that he wasn’t receiving compensation.

Real Estate Investments and Transaction-Based Compensation

Real estate funds and other real estate investments where a sponsor sells passive ownership in real estate usually will be securities. Established sponsors may have a track record, professional connections, and a reputation with previous investors, so they can market securities without using promoters. Larger securities offerings may use broker-dealers to sell securities, but smaller offerings may not support broker-dealer fees and commissions.

Therefore, less well-established and smaller real estate sponsors may use promoters to market their securities. Promoter compensation is an ongoing issue in the real estate industry. Promoters want to be paid. Yet, sponsors may be hesitant to pay a promoter until they have produced results. Plus, although some SEC guidance supports non-transaction-based compensation to finders, that practice has fallen into disfavor with regulators.

As a result, many sponsors enter into compensation arrangements that look like transaction-based compensation. A detailed discussion of why those arrangements frequently are illegal will be in a future article. However, regardless of how they are paid, sponsors and promoters should be sure their compensation is disclosed, lest they risk an additional securities violation.

Sponsors should disclose the compensation in the sources and uses of funds or use of proceeds section of their private placement memorandum or offering memorandum (PPM). This disclosure informs investors that those selling expenses will reduce the cash from the investment that’s available to the sponsor.

However, disclosure in the sources and uses doesn’t inform the investor of any particular promoter’s involvement in the transaction. Therefore, it's crucial that sponsors ensure that promoters disclose their compensation to investors. Sponsors also should disclose in the PPM that there are promoters. If the promoters' names and compensation aren't disclosed in the PPM, the sponsor should require investors to acknowledge in subscription documents that they have been informed of the promoter’s compensation.

The sponsor’s obligation is in addition to the promoter's. So, Kardashian was in violation for not disclosing her compensation – separate from any issuer violation for not disclosing compensation paid. Likewise, promoters should not rely solely on the sponsor's disclosure of compensation.

© 2022 by Elizabeth A. Whitman

Any references to clients and their legal situations have been modified to protect client confidentiality.

DISCLAIMER: The content of this blog is for informational purposes only and does not provide legal advice to any person. No one should take any action regarding the information in this blog without first seeking the advice of an attorney. Neither reading this blog nor communication with Whitman Legal Solutions, LLC or Elizabeth A. Whitman creates an attorney-client relationship. No attorney-client relationship will exist with Whitman Legal Solutions, LLC or any attorney affiliated with it unless a written contract is signed.