Risks In Using Unregistered Finders To Find Capital
Using finders, instead of investment bankers that are registered broker-dealers, involves significant risks that could threaten a company’s ability to successfully raise capital now and in the future.
The biggest risk is that if the finder is deemed to be an unregistered broker-dealer, under federal and some state securities laws an investor may have the right to cancel its securities purchase and get its money back. Under federal law, this rescission right can be exercised until the later of (1) three years from the date the securities are issued or (2) one year from the date of discovery of the violation. Every purchaser in the capital raise has a rescission right, not just those purchasers located by the finder, so if an investor becomes dissatisfied with the company’s direction, he could exercise that right.
An investor’s rescission right may also hurt the company’s ability to raise capital in the future. Certain Securities and Exchange Commission and state filings require that payments to finders be disclosed; that could deter future investors from investing because of concerns about potential rescission claims.
If the finder is an unregistered broker-dealer, the SEC may prohibit the company from using the private placement exemption in future offerings, thus limiting its ability to raise capital from private investors. The company could also be subject to regulatory action by the SEC and state securities commissioners for aiding and abetting the finder’s violation of broker-dealer registration requirements and lose potential exemptions from securities registration requirements under federal and state securities laws.
In determining whether a finder is acting as a broker-dealer the SEC staff typically weighs whether the finder:
- was compensated on a transaction-related basis (recently, the staff has placed greater emphasis on this factor)
- was involved in negotiations
- engaged in solicitation of investors
- discussed details of the nature of the securities or made recommendations to the prospective buyer or seller
- was previously involved in the sale of securities and/or was disciplined for prior securities activities.
Interestingly, in 2012 the JOBS Act created an exemption for activities of certain intermediaries that previously would have required broker-dealer registration under federal law. Under that exemption, solely in connection with the new Rule 506 exemption in which all purchasers are “accredited investors” (pending final SEC rules and therefore not yet in effect), an intermediary may do the following without broker-dealer registration:
- maintain a platform or mechanism that allows offers, sales, purchases, negotiation, advertisements and general solicitation;
- co-invest in the offered securities; and
- provide ancillary services related to the offering.
However, to use the exemption, the intermediary cannot:
- receive compensation in connection with the purchase or sale of securities in connection with the offering;
- possess customer funds or securities in connection with the offering; and
- be subject to a specified statutory disqualification under the Securities Act of 1933.
The JOBS Act exemption doesn’t affect any requirement to register as a broker-dealer under state securities laws.
If you are considering using a finder, first find out whether the finder is registered as a broker-dealer with the SEC (or, in the case of an individual, whether he or she is an associated person of a registered broker-dealer) and with applicable state regulators and whether he is a member of the Financial Industry Regulatory Authority. If the finder doesn’t tell you, you can easily find the information online. If the finder isn’t registered, you should strongly consider not using that finder, or consult with counsel to determine whether the finder’s activities or the transaction can be structured to minimize the likelihood that the finder will later be found to have acted as an unregistered broker-dealer, whether under the JOBS Act exemption or otherwise.
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