Startup and developing business clients of Hawley Troxell’s Business and Finance Practice Group frequently need capital. Capital-hungry businesses need to beware of resorting to “finders” to help locate investors to purchase the company’s stock, notes or other securities. Except in very limited circumstances, paying a commission or “success fee” to a finder that is not registered as a broker-dealer violates federal and state securities laws. A company that hires a finder, as well as the company’s directors, officers and owners, can be liable to investors and sanctioned by regulators for such violations.
Broker-Dealer Registration Requirement
Under the Securities Exchange Act of 1934 and state securities laws, a “broker-dealer” is “any person engaged in the business of effecting transactions for the account of others.” It is unlawful for any broker-dealer to “effect any transaction in, or induce or attempt to induce the purchase or sale of, any security” without first registering as a broker-dealer with the Securities and Exchange Commission (SEC) and applicable state regulators. Registered broker-dealers must also be members of a self-regulatory organization-generally the Financial Industry Regulatory Authority (FINRA, formerly known as the National Association of Securities Dealers)-and comply with SEC regulations regarding financial responsibility and market conduct.
The Gray Market for “Finders”
In contrast, there exists a gray market of individuals and firms who hold themselves out as being able to connect companies that wish to issue securities to raise capital (“issuers”) with investors and who charge a commission or success fee related to the amount of capital raised for the issuer. These “finders” may call themselves placement agents, business brokers or consultants. They may be CPAs, insurance brokers, investment bankers or other professionals. They often claim that they do not need to be registered as broker-dealers based on the so-called “finder exemption.”
SEC regulations do provide for a “finder exemption” from broker-dealer registration requirements, but it is very narrowly circumscribed: Securities Exchange Act Rule 3a4-1 provides a safe harbor from the broker-dealer registration requirements for an agent of the issuer in certain limited circumstances: The finder must be a natural person who is a director, officer or employee of the issuer, with substantial duties other than capital-raising; and the finder must not be compensated by an arrangement that depends on the success of the finder’s securities sales efforts.
In addition to the safe harbor rule, a “finder exception” to federal broker-dealer registration requirements has developed through SEC no-action letters and a limited number of judicial decisions. However, the finder exception is a trap for the unwary. In general, the exception applies only if the finder’s role is limited to introducing the parties or merely giving names to the issuer. For circumstances outside the safe harbor rule, the determination whether a finder is a broker-dealer subject to registration requirements is highly fact-specific. Review of SEC no action letters suggests that the following factors are indicative that a finder is a broker-dealer required to register:
conducting or assisting with sales efforts
participating in negotiations between the issuer and investors
receiving commissions or transaction-based compensation
holding investors’ funds or securities
previous involvement in the offer/sale of securities for other issuers
No single factor is determinative of whether a finder is required to register as a broker-dealer. The SEC judges each situation on its facts and circumstances.
At Hawley Troxell, we commonly see two types of finders: One category consists of “placement agents” who are in the business of matching issuers and investors and who charge a commission or other transaction-based fee. Notwithstanding their protestations, these finders are broker-dealers who, if not registered, are transgressing federal and state law.
The other category consists of owners, directors, officers or employees of an issuer (“agents of the issuer”), who seek to obtain capital from friends, family and other acquaintances. If a company’s owner, director, officer or employee has substantial other duties to the company and is not otherwise in the business of raising capital or transacting securities for the account of others, then the insider is arguably not required to register with the SEC as a broker-dealer. However, paying a success fee would violate the Idaho Securities Act, which requires state broker-dealer registration of an “individual who represents an issuer with respect to an offer or sale of the issuer’s own securities” unless the individual “is not compensated in connection with the individual’s participation by the payment of commission or other remuneration based, directly or indirectly, on transactions in those securities.”
Harsh Penalties for Issuer Using Unregistered Broker
A finder’s failure to properly register as a broker-dealer may subject the finder to potential liability, including investor rescission claims as well as civil administrative penalties, criminal penalties, and imprisonment. More critically for the issuer, the company and its controlling persons (directors, officers, controlling shareholders) may also be held liable to investors and regulators. The risks undertaken by an issuer that hires an unregistered broker to place the issuer’s securities include:
Regulatory sanctions for employing an unregistered broker or for aiding and abetting the violation of federal/state law by the unregistered broker, including administrative fines, inability to rely on certain securities registration exemptions, and criminal penalties.
10b-5 securities fraud liability to investors and regulators for failure to disclose use of an unregistered broker. (We regularly see, in Idaho Securities Bureau enforcement action complaints, a securities fraud count against the issuer based on the failure to disclose that the broker is unregistered and has sold the securities in violation of Idaho’s broker-dealer registration requirements.)
Rescission claims by investors demanding return of invested funds plus statutory interest and attorney fees.
Loss of the securities registration exemption. (For example, Idaho’s isolated transaction exemption expressly prohibits payment of a commission or other remuneration, directly or indirectly, to any person other than a registered broker-dealer.)
Responsibility for the unregistered broker’s actions such as general solicitation (prohibited by Regulation D), and fraudulent misrepresentations by the broker.
Unavailability of legal opinions on legality of the issuer’s stock.
Loss of institutional investors’ interest in the offering.
Tainted financial statements (disclosure of contingent liabilities to investors and regulators).
Idaho startups typically rely on SEC Regulation D to exempt the sale of securities from the securities registration requirements of the Securities Act of 1933, in part because that federal exemption pre-empts state securities registration requirements (other than the requirement to pay a fee, consent to service of process and file the Form D Notice of Sale). For private placements under Regulation D, the issuer must give notice of the sale of its securities to both the SEC and any state in which it sold securities by filing a Form D, which requires the issuer to disclose finders’ fees and the recipient’s Central Registration Depository (CRD) number if the recipient is a registered broker-dealer. Therefore, securities regulators are able to determine whether finders’ fees are being paid to persons not registered as broker-dealers.
In our experience, an additional problem of dealing with unregistered brokers is that startup companies not familiar with capital markets are frequently induced to enter into onerous contracts that contain unreasonable fee arrangements and impede the issuer’s ability to raise capital through other sources. Although contracts with an unregistered broker may be void and unenforceable, the costs and aggravation of fending off the broker’s fee claim can be substantial.
Caution dictates that the use of finders be discouraged because the risks to the issuer and its control persons of engaging an unregistered broker are considerable.