When Finders Aren't Keepers: Understanding and Mitigating Risks Related to Unlicensed Brokers
So-called "finders" of capital play an important role in capital markets. They are critical to many small businesses raising early-stage funding in amounts too small to attract venture capital or licensed broker-dealers. They also are a vital part of the private investment in public equity (PIPE) market.
Use of finders, however, can be associated with an array of risks. Finders can engage in certain activities that fall within the broad definition of broker-dealer. And the consequences of using a finder who should be registered as a broker-dealer can be severe for both the issuer and finder.
The Securities and Exchange Commission is, according to a variety of sources, developing rules related to finders' activities. New SEC rules may provide a finder registration process and address current ambiguities related to working with finders. In the meantime, companies or individuals who plan to engage a finder or serve as a one should be aware of the activities that make a person a broker-dealer and understand the potential consequences of using or acting as a finder.
Current Broker-Dealer Regulations
Who is considered a broker-dealer?
Under Section 15(a)(1) of the Securities Exchange Act of 1934, it is "unlawful for any broker or dealer…to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security...unless such broker or dealer is registered" with the SEC. States have similar regulations requiring most brokers and dealers to register with the state commerce department. The Exchange Act defines a broker to be any person engaged in the business of effecting transactions in securities for the account of others; a dealer is any person engaged in the business of buying and selling securities for his own account.
The SEC broadly interprets activities that qualify as effecting a securities transaction. Activities such as recommending the purchase of securities, negotiating terms of a securities offering or purchase, performing due diligence, attending meetings where the merits of a proposed investment are discussed, providing valuations, and handling the funds of others have all been found to qualify a person as a broker-dealer. In addition, a person who accepts a fee for introduction of capital more than once may be "engaged in the business" of effecting securities transactions.
Due to the broad broker-dealer definition and interpretation, people connected to sources of capital who perform limited services—such as providing business plans or helping prepare private placement memoranda—may be unaware their activities require registration with the SEC.
Broker-dealer requirements impose significant burdens
Broker-dealers, whether individuals or businesses, must register with the SEC by filing an application on Form BD. Generally, each registered broker-dealer must also be a member of the Financial Industry Regulatory Authority (FINRA) and the Securities Investor Protection Corporation. In addition, each state has its own requirements for people conducting business as a broker-dealer in that state.
Each broker-dealer employee engaged in or supervising individuals in the investment banking or securities business must register with FINRA and pass FINRA's exam qualification requirements. Many individuals fulfill these requirements by taking the comprehensive Series 7 exam. Employees of broker-dealers are not required to register separately with the SEC, but they must register with state regulators in most states where they transact business.
The scope of FINRA's qualification requirements vastly exceeds the knowledge required to perform the limited services typically provided by smaller financial intermediaries or sporadically provided by individuals. For example, many FINRA qualifying exams relate to market-making activities that are irrelevant to the private securities offerings and acquisition markets where smaller intermediaries operate.
Burdens imposed on broker-dealers and their employees by the SEC, FINRA and state regulators have led many people involved in limited capital-raising activities to avoid registration. Limitations on regulators' resources, however, significantly impair their ability to enforce current laws. This has created a perception that many unregistered intermediaries currently operate in a gray market of brokerage activity.
Finder exception from registration is ambiguous
In contrast to broker-dealers, finders are not required to comply with the SEC and state registration requirements. Finders principally are a construction of regulatory interpretation and are not explicitly recognized in federal or most states' securities laws. Because the finder exception is a product of various SEC no-action letters, its application is unclear in many instances. The lack of codified federal and state exceptions also leaves regulators free to narrow the scope of permitted finder activities at any time.
Distinguishing Finders From Broker-Dealers
Conventional wisdom is that one who does nothing more than provide the name and phone number of a potential purchaser is the only person sure to be a finder under federal law. Any activity beyond that can raise issues associated with using an unregistered broker-dealer.
Factors the SEC considers in determining whether someone is a broker-dearer or a finder include:
- Receipt of transaction-based compensation. A person who receives transaction-based compensation in connection with a securities transaction is almost always deemed to be a broker-dealer.
- Negotiation or advice. A financial intermediary involved in negotiations or who provides detailed information or advice to a buyer or seller of securities is likely to be deemed a broker-dealer.
- Solicitation of investors. Solicitation is a factor that weighs in favor of finding a person to be a broker-dealer.
- Previous securities sales experience or disciplinary action. Previous experience selling securities and/or discipline for violations of securities laws indicate that regulators will consider a person a broker-dealer. Regulators do not want the finder exception to allow past violators to operate in the securities industry and compromise investor protection.
The SEC has repeatedly stated that none of these factors is dispositive.
State Exceptions for Individuals Who Represent Issuers in Exempt Transactions
Minnesota is one of three states whose laws recognize the disproportionate burden imposed on finders by regulations similar to those under federal law and FINRA rules. Minnesota law exempts individuals who represent issuers in exempt transactions from registering as agents. The exemption has several conditions, including the absence of any disciplinary history. It also prohibits the handling or possession of funds and securities. Michigan and Texas have similar laws.
Minnesota's exception, however, does not vitiate the requirements under federal law. Since use of the mail, telephone or Internet effectively puts the finder under federal jurisdiction, state exemptions are of limited value.
The SEC recently amended Form D, effective September 15, 2008 on a voluntary basis and March 16, 2009 on a mandatory basis. The amendments require an issuer to separately list the fees paid to finders and the fees paid to broker-dealers. Moreover, an issuer will be required to include a broker-dealer's registration number on the Form D. Since the amended Form D will be filed electronically via EDGAR, FINRA, the states and other regulatory authorities will have greater access to these filings, permitting easier (and greater) enforcement.
Increased enforcement of broker-dealer regulations was highlighted by a recent SEC action against Robert MacGregor, an employee of Duncan Capital who was ordered to pay $655,000 in disgorgement, fines and interest to settle SEC charges. MacGregor, who was not registered with FINRA, allegedly conducted brokerage activities on at least 33 PIPEs, raising $156.6 million from 2003 through 2006. The case is significant because it raised no legal issues other than those surrounding registration. Historically, the SEC has sanctioned unregistered brokers in connection with other securities law violations.
Penalties for Using Unregistered Broker-Dealer
The consequences of using an unregistered broker-dealer can be steep for both issuers and purported finders.
Problems for issuers
Under the Exchange Act, every contract made in violation of any provision of the Exchange Act is void. This means purchasers have a right to rescind their purchases until expiration of the statute of limitations, which is the later of three years from the date of violation or one year from the date of discovery of the violation. Issuers also expose themselves to civil and criminal penalties for using an unregistered broker-dealer. Potential securities law violations can create disclosure and accounting issues for private companies that engage in an initial public offering. They can also lead to problems with potential purchasers in the acquisition context. In addition, even if a finder is not required to register as a broker-dealer, issuers should carefully monitor the finder's activities to ensure the finder does not void the issuer's exemption from registering the securities being offered. This can occur if the finder approaches non-accredited investors or undertakes a general solicitation of potential investors.
Problems for finders
Intermediaries who violate federal and state securities laws by failing to register as broker-dealers subject themselves to potential civil and criminal liability. Courts may compel a finder to return its commissions, fees and expenses or allow an issuer to refuse to make payments for those items at closing. Injunctions may be issued against unregistered broker-dealers and civil and criminal monetary penalties may be assessed. The SEC may also use a violation of the registration requirements as grounds to deny a future application for broker-dealer registration.
Interim Considerations in Working With Finders
While SEC staff have declined to comment on provisions to be included in any new regulations, rule changes are expected to provide a simplified registration process for finders who may perform limited broker-like services. Such a reform would sensibly remove uncertainties that accompany issuers' use of finders to access capital without significantly compromising investor protection provided by current laws.
In the meantime, companies or individuals who plan to either engage a finder or serve as a one should consider the following:
Issuers should inquire into and obtain representations regarding the finder's previous involvement in securities transactions, including the number of transactions (if any) for which the person has served as a finder, and type of compensation (fixed fee vs. performance based) paid in those transactions.
- The finder's agreement should carefully describe the finder's permitted actions in matching the issuer with potential investors, including limiting the number and types of potential investors that may be contacted.
- The finder's agreement should prohibit the finder from presenting information regarding the issuer to potential investors. It should also prevent the finder from structuring the investment or negotiating the investment terms.
- The finder's agreement should prevent the finder from advising potential investors on the investment. The subscription agreement between the issuer and the investor should include representations that the finder did not undertake these activities.
- The finder's agreement should avoid use of performance-based compensation—an hourly or flat fee not dependent upon the amount actually invested in the transaction will limit the likelihood that the finder is serving as an unregistered broker-dealer.
Until the SEC announces definitive rule changes, issuers should be aware of current definitions and requirements that apply to finders and broker-dealers. An experienced finance and securities adviser can also help in evaluating risks related to working with finders—and ensuring finders' services comply with the law.
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