Articles

SEC Calling: The Trouble With Finders in Connection With the Sale of Securities

By David Thayer

Originally published in Law Week Colorado.

Picture this: You have a successful business that has grown over the years, but you have hit a wall. Your growth has become stagnant and you need to infuse a hefty sum of money into the business to take it to the next level.

So, you began the process of raising money. That’s not as easy as you thought it would be and you struggle to find investors. Finally, a business acquaintance mentions that she has financially well-to-do contacts she would be happy to introduce you to and assist with helping to raise money from these contacts.

Of course, there needs to be something in it for her — perhaps a 10% commission on the amount raised from her contacts. Sounds good, right? What’s the harm if she can assist you in achieving your financing goals?

There are, however, risks involved with both acting as and using finders, primarily relating to potential violations of the Securities and Exchange Commission’s broker-dealer registration requirements. Your acquaintance may unwittingly be subjecting herself to SEC sanctions and fines if she is found to be operating as an unregistered broker-dealer. More importantly, you as the business owner could be running significant risks to both you and your company.

 

UNREGISTERED BROKER-DEALERS

A “finder” refers potential investors to a company issuing its own securities to raise capital, typically in the context of a non-public offering. The primary issue facing finders is whether they should be registered as broker-dealers under the federal and state securities laws.

Under the Securities Exchange Act of 1934, a broker is defined as “any person engaged in the business of effecting transactions in securities for the accounts of others.” There is no broad-based finder’s exemption, either in the federal securities laws or SEC guidance.

Whether a person should be registered or not is in part due to Section 15(a)(1) of the Exchange Act, which provides that it is unlawful for any broker or dealer to induce or attempt to induce the purchase or sale of any security unless such broker or dealer is registered with the SEC.

Given the broad nature of the broker-dealer definition, many finders do not realize when their activities trigger a registration requirement.

The federal securities laws have no formal statutory definition of a finder, so determining whether a finder may be deemed an unregistered broker-dealer under the Exchange Act can be difficult. The SEC and courts have developed several key attributes as guidance when determining if a person should be registered as a broker-dealer.

Receiving compensation contingent on the success of a securities transaction or based on the amount or value of a securities transaction (i.e., commissions).

  • •  Engaging in solicitation of potential investors.
  • •  Providing advice or engaging in negotiations.
  • •  Previous history of finder or securities sales experience or a history of disciplinary action relating to the same.

 

 

NO ABSOLUTES

Unfortunately, there is no hard and fast rule about how many of the above factors must be met to be deemed an unregistered broker-dealer. While no one factor is expressly more important than the others, SEC materials on finders indicate that receiving compensation contingent on the success of a securities transaction or based on the amount or value of a securities transaction is a hallmark factor relating to whether a person is acting as a broker-dealer.

Currently, it appears the SEC staff’s position is that even one instance of transaction-based compensation may be enough for a finding that a person was “engaged in the business” of broker activity, and thus subject to registration. What does this all mean to companies seeking private funding? What are the risks both to unregistered finders and the companies that use unregistered finders? Legal issues may arise in connection with unregistered finders and guidelines for staying on the right side of the law.

 

FINDERS AT RISK

Intermediaries acting as finders are subject to significant risks, including the risk of SEC sanctions.

Company Rescission Rights: The Securities Exchange Act of 1934 provides that every contract made in violation of the broker-dealer registration requirements “shall be void” as to rights of persons who made or engaged in the performance of such contract. A company can claim that its obligations to a finder under the finder’s engagement agreement are void if the finder is acting in violation of the Exchange Act’s broker-dealer registration requirements.

 

Disclosure Obligations: There is some risk that a finder’s failure to disclose the fact that it is not registered as a broker-dealer could itself be characterized in regulatory enforcement proceedings or private litigation as a misleading omission that amounts to fraud on the issuer.

 

SEC Sanctions: A finder deemed to be acting as an unregistered broker-dealer may be subject to several different penalties under federal securities laws. The most typical sanction is a temporary or permanent injunction barring it from participating in the purchase or sale of securities. The SEC, however, has the power to impose more severe sanctions, including disgorgement of funds and civil penalties.

 

Bad Publicity: In general, the SEC publicly announces actions it has taken against persons or entities who have violated the federal securities laws. Such announcements and censures can be highly embarrassing and negatively affect a person’s business and employment prospects for years.

 

COMPANIES AT RISK

Companies issuing securities in connection with using a finder who is deemed an unregistered broker-dealer face numerous risks.

Investor Rescission Rights: Using a person or entity that could be deemed to be an unregistered broker-dealer to assist with a sale of securities could create a rescission right in favor of the investors under federal securities laws. If investors succeed in exercising their rescission rights, the issuer would be required to return the money it received from the investors for the purchase of its securities. This requirement could devastate a company; by the time the violation is discovered, the company may not have enough funds to return the investors’ money and there may be potential claims against the insiders of the company to make up any short-fall.

 

Disclosure Obligations: Failing to disclose payments made to an unregistered broker-dealer in connection with a sale of securities could expose the issuer to potential liability for fraud under the federal securities laws in that offering. In addition, future offering documents and filings may need to disclose the use of unregistered broker-dealers in past offerings, which could dissuade investors from investing in the subsequent offerings.

 

Other Issuers Risks: As the SEC steps up its enforcement of broker-dealer registration requirements, companies that engage unregistered broker-dealers could also find themselves subject to SEC enforcement actions under the Exchange Act for aiding and abetting an Exchange Act violation (specifically, the finder’s violation of the broker-dealer registration requirements). In addition, companies that use unregistered finders also run the risk of losing potential exemptions from securities registration requirements under federal and state securities laws that would otherwise be available.

 

GUIDELINES TO CONSIDER

Determining whether a person or entity acting as a finder has crossed the line and should be registered as a broker-dealer is murky at best. However, some general guidelines that help to negate broker-dealer registration include:

  • •  Only make introductions to suitable, accredited investors;
  • •  Do not solicit or pre-screen investors;
  • •  Do not participate in any negotiations or recommendations;
  • •  Do not handle funds; and
  • •  Stick with a non-contingent (not based on the success of the deal), fixed-fee structure; do not accept commission-based fees.

 

As a practical matter, it is difficult to act as a finder not registered as a broker-dealer because contacts who are introduced by the finder invariably ask the finder what he or she thinks of the company, its management and the proposed investment. Any recommendation, whether explicit or tacit, will be deemed to be giving advice about the potential investment and likely trigger the need for registration.

David Thayer is a corporate and transaction attorney, and former CPA. He can be reached at dthayer@joneskeller.com. This information is not intended as legal advice. Seek specific legal advice before acting.

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