Why Securities Issuers Should Emulate Marian the Librarian Rather Than Harold Hill
The Music Man first opened on Broadway in December 1957. It was wildly successful, winning five Tony awards, including Best Musical (for which it edged out West Side Story, which had opened a few months earlier). The Music Man's cast album spent 245 weeks on the Billboard charts and received the first Grammy Award for Best Musical Theater Album.
The musical starts when con artist “Professor” Harold Hill steps off the train in River City with a suitcase and a smile. He quickly turns the sleepy town into a fearful place, driven by an urgent mission to address the town’s moral decline, which he attributes to a pool table at a local establishment.
According to Harold, the only remedy for the town’s imminent disaster is to form a boys’ band, for which Harold conveniently can sell the town the necessary instruments and uniforms. Concerned about the welfare of their children, the townspeople quickly fall in line behind Harold and support his plans for a band.
Harold quickly identifies his primary potential adversary – the only trained musician in town, Marian Paroo, the town librarian who also teaches piano lessons. Not only does Marian know music, but in contrast to Harold, Marian lives in the world of books, writings, and documented facts, rather than dreams and a rush to act. People leave her desk knowing what to read and understanding the facts necessary for a reasoned decision whether to take action.
Employees of securities issuers should be like Marian. They should provide prospective investors with the offering materials and encourage them to make investment decisions based on the written offering materials and facts, rather than hype about imagined problems or the riches they might obtain from a wildly successful investment.
However, it’s very easy for the issuer’s employees, like the townspeople of River City, to get caught up in the sales process and move away from boring facts into hype. It’s easy for the tone to turn from the ministerial act of delivering paperwork to persuasion. Legitimately feeling a sense of urgency, they may make quick calls to encourage prospective investors to buy securities before time runs out. Or, they may stray from the offering materials and emphasize the potential for high returns at the expense of the risks of the investment.
Eventually, there will be trouble in River City. But it’s an unlicensed securities broker, not pool.
What is a Securities Broker?
The Securities Exchange Act of 1934 defines a broker as any person engaged in the business of effecting transactions in securities for the account of others. Someone might be a broker if they
Participate in the solicitation of investors, negotiation of terms, or execution of a securities transaction.
Receive "transaction-based compensation" that is contingent on the successful sale of securities or is based on a percentage of securities sold.
Handle other people’s money in connection with a securities transaction
The statute applies to all sales of securities. Under the securities laws, many investments other than stocks and bonds are securities. For instance, a real estate fund is a security when individuals passively invest in a property along with others and a sponsor manages the investment is a real estate fund. And a musician is selling a security when they promise donors who help pay for the recording and distribution of their album a percentage of the profits from the album in exchange for their “donation.”
When sale security is involved, the further an individual moves from detached distribution of offering materials toward persuading someone to buy securities, the more likely the individual will be considered a broker.
Oral communications are viewed with more scrutiny than written ones, so employees also should avoid phone calls or meetings unless they are initiated by a prospective investor. Even then, Issuer employees should avoid actively selling or encouraging the purchase of securities.
On the other hand, an employee whose functions are solely clerical or ministerial isn’t considered a broker. For example, merely providing an investor with blank subscription documents upon their request, or receiving subscription documents prepared by an investor, doesn't move an employee into broker territory.
The words “clerical” and “ministerial” aren’t well-defined in securities law. So, it's difficult to determine what activities are permitted and what activities will result in someone being considered a broker. However, an employee who is allowed to exercise judgment or customize their work to an individual investor's needs is more likely to be considered a broker than an employee who follows the same rote process for everyone.
For example, in The Music Man, Marian's librarian duties, such as checking out or shelving books, would be clerical or ministerial; however, if she moves into recommending books to library patrons, that might not be considered clerical or ministerial. If Marian's recommendations are solely based on a list of recommendations created by the library board, and she merely relays those recommendations, they may be ministerial. But if, instead, she draws on her knowledge of the library's holdings to make recommendations based on the patrons' needs, that wouldn't be ministerial.
Receipt of “transaction-based compensation” is a critical factor in determining if someone is a broker. Individuals who aren’t licensed securities professionals cannot receive any payment based on or contingent upon a successful transaction.
Therefore, issuers must be cautious not to award employees bonuses or other compensation based on the amount of securities sold or tied to the successful sale of securities. Transaction-based compensation can be a problem even if the bonus isn’t announced before the securities are sold and isn’t a motivating factor in the employee’s activities.
Why Is There an “Issuer Exemption?”
Since a broker is someone who acts on behalf of others, an issue may sell its own securities. However, issuers are legal entities, such as limited liability companies or partnerships. They must act through their officers and employees, and that’s where the trouble lies. Those individuals aren’t selling their own securities; they are selling securities on behalf of the issuer, which can make them a broker.
Recognizing this challenge, the Securities and Exchange Commission (SEC) adopted Rule 3a4-1. Commonly known as the “issuer exemption,” Rule 3a4-1 provides a non-exclusive harbor that allows issuer officers, employees, and other issuer affiliates a limited opportunity to help the issuer sell its securities.
The rule is narrowly drawn. The rule doesn’t allow an issuer to create an in-house sales force or to hire individuals to make cold calls or to tout their securities. Selling cannot be the individual’s primary activity on behalf of the issuer.
As an aside, the term “issuer exemption” is a misnomer; issuers sell their own securities, they aren't brokers and don't need an exemption. So, I prefer to call the exemption the "issuer agent exemption," since it applies to individuals, such as officers and employees, who are acting as agents of the issuer. Nevertheless, I’ll use the more common term in this article.
Threshold Issue Exemption Requirements
The issuer exemption is only available to individuals who are officers, directors, or employees (whom I'll collectively call "employees") of the issuer (or certain affiliates of the issuer). It's not available to outside contractors, even if they are acting on behalf of the issuer.
To qualify for Rule 3a4-1, the issuer and its employee first must satisfy three threshold requirements:
Not be subject to statutory disqualification. A “statutory disqualification” generally means someone previously has been found to have violated securities laws.
Not receive transaction-based compensation.
Not be an associated person of a broker or dealer.
Three Pathways to Issuer Exemption Safe Harbor
Once an employee meets the threshold requirements, there are three pathways to safe harbor when selling securities to outside investors:
1. Securities are sold only to certain regulated buyers, such as broker-dealers, investment companies, banks, and insurance companies.
2. The employee meets the following requirements:
The employee has substantial duties for the issuer that don't involve the sale of securities.
The employee is involved in only one securities offering in any 12-month period.
The employee hasn’t been a licensed securities professional within the previous 12 months.
3. The employee provides only clerical or ministerial duties in connection with the sale of securities, which must involve only one or more of the following:
Preparing any written communication or delivering written communication through the mails, provided the content of the written communication was approved in advance by a partner, officer, or director of the issuer.
Responding to inquiries initiated by a prospective investor with content limited to information in the approved offering documents. Unlike the previous communication, this communication can be oral, but only if the prospective investor initiates the communication.
Performing ministerial and clerical work involved in effecting the transaction.
Sales Activities Issuers Should Avoid
Following is a list of activities that may seem attractive to issuers, but which should be avoided by issuers that wish to satisfy the safe harbor:
Transaction-based compensation, including employee bonuses tied to successful equity raises.
Using non-employees to sell securities. Only officers, directors, or employees of the issuer can qualify for the safe harbor.
Hiring employees to sell securities who have recently helped sell securities for another issuer. Individuals who have recently successfully secured investors for another company can be an attractive hire; however, there is a 12-month "cooling off" period after each securities offering, unless the sales are made to institutional investors or the employee only performs clerical or ministerial duties.
Using the same individuals to sell successive securities offerings in a 12-month period. The 12-month period also applies to successive offerings by the same issuer unless the sales are to institutional investors or the employee only performs clerical or ministerial duties.
Cold calling prospective investors. Any questions about why cold calling is disfavored can easily be answered by watching the 2000 movie Boiler Room.
Initiating oral communications with prospective investors. Staff may engage in oral communications initiated by prospective investors, provided their responses only involve clerical or ministerial duties.
Conclusion
We all know how The Music Man ends. The townspeople donate the money necessary to buy band instruments and uniforms from Harold, who plans to leave town without delivering what he promised. However, Marian, who somehow has fallen in love with Harold despite knowing he’s a fraud, changes all that.
Meanwhile, the townspeople figure out they’ve been duped and demand retribution against Harold. But before they can do so, the town's boys' band marches into the hall in uniform. While the quality of their music may leave something to be desired, their joy is evident. The townspeople are enthralled. Harold and Marian embrace. And all’s well that ends well in River City
Unfortunately, unlike in the musical, a successful investment doesn’t make up for unlawful activities when the securities are sold. In addition to actions that can be taken against the illegal broker, depending on the degree and nature of a violation, the consequences to the issuer of unlawful broker activity can include:
Any investments procured by the unlicensed broker might be void and give investors the right to rescind their investments.
If the issuer is complicit in the unlawful broker activity, the issuer could be charged with aiding and abetting unlawful activity.
The issuer could be named as a bad actor, which would seriously impair the issuer’s ability to sell further securities.
In an extreme case, securities sold under an exemption from registration could lose their exemption and any preemption of state law requiring qualification of securities offerings.
Given the potential severity of the consequences of a violation, rather than risking accusations of using unlicensed brokers to sell their securities, issuers should consult with an experienced securities attorney who can help them develop a marketing strategy that complies with securities laws.
© 2025 by Elizabeth A. Whitman
Any references to clients and their legal situations have been modified to protect client confidentiality.
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