Know Your Finder – Risks of Using a Finder Deemed an Unregistered Broker

Whether you are selling an existing small business, or are the owner of an early-stage company in need of capital, the relatively small transaction amounts may not be attractive to investment bankers that are registered brokers. For many companies, reliance on individuals or entities known as “finders” becomes the only option. A finder is a person who places potential buyers and sellers of securities in contact with one another for a fee. However, the use of finders may carry some risks. A finder may describe himself as a consultant or facilitator, but if he is deemed a broker pursuant to the Securities Exchange Act of 1934 (“Exchange Act”) and is not registered, the consequence may be ruinous not only for the finder who can be sanctioned, fined and even imprisoned, but also for the company using the finder’s services.

Who is required to register?

According to Section 3(a)(4) of the Exchange Act, a broker is a person who is in the business of effecting transactions in securities for the account of others. Given the broad nature of this definition, a finder acting as a broker will be deemed a broker regardless of the denomination or designation he uses to describe himself. Section 15(a) of the Exchange Act requires brokers and their firms to be registered with the Securities and Exchange Commission (“SEC”), and to make important information public.

Is your finder a broker?

Although the SEC has generally taken a broad interpretation of the definition of broker, it has developed an exemption for finders through a series of no-action letters. The “true” finder not subject to registration as a broker is the finder that does not “effect” securities transactions, but merely “finds” and “places” in contact potential buyers and sellers of securities who then negotiate and complete any resulting transactions. The SEC relies on various factors to determine whether a finder is required to register as a broker. These include the method of compensation, solicitation of potential investors, involvement in negotiations and providing investment advice.

Transaction-based Compensation

The SEC has taken the position that receiving commissions or other transaction-related compensation is one of the determinative factors in deciding whether a person is a broker subject to the registration requirements of the Exchange Act. Transaction-related compensation such as percentage commissions and other compensation arrangements that depend on whether the transaction is consummated or vary depending on the amount raised, create a substantial likelihood that a finder would be viewed as a broker subject to the registration requirements of the Exchange Act.  Whether this fee is labeled a “commission,” a “success fee,” or a “consulting fee” is irrelevant. Therefore, many arrangements in which someone is paid to do anything more than merely introducing the two parties for a flat non­contingent fee could potentially trigger the registration requirements under the Exchange Act.

Solicitation of Investors

Generally, solicitation can be any action designed to persuade or incentivize another person to purchase a security. Participating in activities as broad as general newspaper advertisements or as targeted as individually-addressed emails could constitute solicitation. The finder, who engages, without registration, in pre-screening of potential investors to determine their eligibility to purchase the securities, or pre-selling the securities to gauge the investors’ interest, would be in violation of the Exchange Act.

Recommendations or Involvement in Negotiations

Unless the finder is a registered broker, he should only introduce the parties and not take part in anything further. He should not recommend or evaluate the investment, or discuss the details of the transaction. Providing advice, particularly about the value of the securities involved, or assisting investors in negotiating the terms of a sale of securities brings a finder within the definition of broker, and triggers the registration requirements.

What are the consequences of using an unregistered broker?

Using a finder that is deemed to be an unregistered broker to assist with a sale of securities may create a private right of rescission in favor of investors under both federal and state securities laws. There are other risks, including those relating to disclosure obligations.

Rescission Rights

Section 29(b) of the Exchange Act provides that contracts made in violation of any provision of the Exchange Act (or any rule thereunder) are void. This has been interpreted to void a securities purchase contract with any investor located through a finder that was acting in violation of the broker registration requirements. An investor who successfully asserts this claim has the right to get his money back from the company, and potentially, the company’s officers and directors. This private right of rescission applies to any purchaser in the transaction, and not just those purchasers located by the finder. The risk is heightened by the fact that the company would have no assurances that any investor who is or later becomes dissatisfied with the direction of the company would not exercise this right.

Disclosure Obligations

The use of an unregistered broker may hurt the company’s ability to raise capital in the future. A company is required to disclose in SEC filings related to registered offerings and private placements under Regulation D the compensation it paid to finders in connection with the offering, as well as in many filings required under state securities laws. Disclosure of an unregistered finder could deter future investors who may be concerned about potential rescission claims.

Other Risks 

Companies that engage unregistered broker may find themselves subject to enforcement actions for aiding and abetting the finder’s violation of the broker registration requirements. In addition, the use of an unregistered broker in a transaction could cause a company to lose potential exemption from the registration requirements of the Securities Act of 1933 and from applicable state law qualification requirements it could otherwise use. This may significantly limit the company’s ability to raise capital from accredited investors, including angel investors and venture capital funds.

Conclusion

Finders who remain within the narrow confines of activities defined by the SEC may still provide significant value to companies using their services without the necessity of registration as a broker. However, given the severe consequences of using  an  unregistered  broker,  companies should carefully review any proposed participation  of  finders   in  a  transaction  involving  the  sale  of securities. Companies should find out whether their finders are registered as brokers with the SEC, applicable state regulators and Self-Regulatory Organizations. If a finder is not registered, the company should consider consulting with legal counsel to ensure that the finder’s activities do not require registration as a broker.

If you have any questions about the information presented here, need assistance, or would like to learn more about how Prince Lobel can address any of your concerns, please contact: Matar Diouf, at 617 456 8065 or mdiouf@PrinceLobel.com.

 

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