Finders vs. Brokers: Navigating SEC Compliance in Capital-Raising
R Tamara de Silva
Understanding the difference between a finder and a broker is important for financial firms engaged in capital-raising activities. The SEC has specific rules regarding who must register as a broker-dealer, and these rules hinge on the nature of the activities undertaken by the individual or entity involved in connecting investors with issuers.
Let’s consider a scenario this practice is often asked to address. A startup is seeking funding through a series of informal connections. The start-up hires a consultant to introduce them to potential investors. The consultant, eager to help, begins discussing the investment strategy and provides materials to potential investors. Unknowingly, they may have crossed into broker-dealer territory, exposing both themselves and the startup to significant legal risks.
The Legal Framework: Securities Act of 1933 and Regulation D
Under the Securities Act of 1933 (the “1933 Act”), every offer or sale of securities must either be registered with the Securities and Exchange Commission (SEC) or qualify for an exemption from registration as mandated by Section 5. One of the most significant exemptions is found in Regulation D, which permits private placements of securities without requiring registration. However, this exemption comes with strict conditions, particularly the prohibition against “general solicitation or general advertising” as detailed in Rule 502(c).
To comply with this requirement, issuers must establish a documented substantive and pre-existing relationship with any prospective investor. This principle was notably established in the Woodtrails-Seattle, Ltd., SEC No-Action Letter (August 9, 1982). A substantive pre-existing relationship is typically recognized when a significant period has passed between the issuer’s initial learning of the investor’s financial goals and the investor being approached regarding a securities offering.
The Role and Risks of Using Finders
Finders, acting as intermediaries or agents for issuers, play a crucial role in connecting issuers with potential accredited investors by leveraging their pre-existing relationships. These investors, by virtue of the finder's prior relationship, are deemed to share a substantive pre-existing relationship with the issuer.
However, issuers must be cautious in their use of finders to avoid regulatory pitfalls. Two primary concerns arise: ensuring that the finder’s activities comply with the requirements for an exemption from registration, and determining whether the finder needs to be registered as a broker-dealer under the Securities Exchange Act of 1934 (“1934 Exchange Act”).
The Finders Exemption: Limited Scope and Increasing Scrutiny
A Finder is generally not required to register as a broker-dealer because they are not “engaged in the business of effecting transactions in securities” due to their limited role in the capital introduction process. According to various SEC staff no-action letters, a finder's role is typically limited to introducing potential investors to the issuer of securities. However, the SEC has narrowed the definition of what constitutes a permissible finder, increasingly scrutinizing activities that go beyond mere introductions.
The concept of the Finders Exemption is not a statutory exemption under the 1934 Exchange Act but originates from SEC no-action letters, such as the 1991 Paul Anka No-Action Letter. In this letter, the SEC Staff indicated that they would not recommend enforcement action against an unregistered broker-dealer who provided a list of potential investors to a company in return for a transaction-based commission, provided certain conditions were met:
- The finder’s role in negotiations between the purchaser and seller was limited.
- The businesses involved were operational and not “shell” organizations.
- The finder refrained from advising the parties on issuing securities or assessing the value of any securities sold.
- The finder did not assist in obtaining financing.
- The finder did not prepare or distribute transaction materials.
- The finder did not conduct due diligence or perform transaction analysis.
However, the SEC has since distanced itself from this lenient stance. The Eighth Circuit Court has explicitly rejected the notion of a broad Finders Exemption that allows individuals to avoid registration as broker-dealers. For example, in 2010, the SEC denied a no-action request from Brumberg, Mackey & Wall, P.L.C., affirming that anyone receiving transaction-based compensation related to another person's purchase or sale of securities typically must register as a broker-dealer or be associated with a registered broker-dealer.
Compliance with Exemption Requirements
Issuers who utilize finders would be advised to ensure that these intermediaries strictly adhere to the requirements for maintaining an exemption from registration. This includes ensuring that finders do not engage in general solicitation or cold-calling new investors, as doing so could invalidate the exemption, potentially leading to significant liability under the 1933 Act and state blue sky laws. Such violations could require issuers to reimburse investors, including the possibility of joint and several liability for control persons.
To mitigate these risks, issuers may want to ensure that finders comply with the no general solicitation rules, obtain warranties and indemnifications from finders, and ensure that finders maintain adequate records of their activities.
Furthermore, under Section 15 of the 1934 Exchange Act, a broker is defined as anyone “engaged in the business of effecting transactions in securities for the account of others.” Several key factors determine whether a finder is acting as a broker, including:
- Transaction-Based Compensation: Receiving compensation based on the success of transactions strongly indicates broker-dealer activity.
- Involvement in Negotiations: Participating in the solicitation, negotiation, or execution of securities transactions necessitates registration.
- Regularity of Activities: Engaging in securities-related activities consistently or frequently suggests that the individual is a broker.
- Holding Out: Representing oneself as a broker-dealer requires registration.
Avoiding Section 15 Violations
To ensure compliance with Section 15, issuers are generally advised to use registered broker-dealers as finders. However, when non-broker-dealer finders are used, the risks may be somewhat mitigated by avoiding compensation arrangements tied to the success of the deal, investment amounts, or other transaction-related factors.
Additionally, finders should strictly limit their activities to making initial introductions without attending meetings, discussing terms, or handling customer funds and securities.
For example, a finder may receive a flat monthly fee for making introductions, provided they do not attend meetings, discuss the deal, assist in the preparation of materials, or handle transactions. Engaging in activities such as success-based fees, attending meetings, or structuring deals can elevate the finder's role to that of a broker, requiring registration.
Consequences of Non-Compliance
Operating as or engaging an unregistered broker-dealer carries significant regulatory and legal risks. The SEC and FINRA have the authority to investigate and take enforcement actions against unlicensed broker-dealers, which can result in civil monetary penalties, injunctions, disgorgement of fees or profits, prohibition from working in the securities industry, and reputational damage. In some cases, there could also be criminal liability and investor remedies.
A significant case highlighting the risks of using unregistered finders is the SEC's enforcement action against Ranieri Partners LLC. The SEC sanctioned Ranieri Partners and a senior managing partner for using a "consultant" to conduct investor solicitation activities without proper registration. The SEC emphasized that receiving transaction-based compensation without appropriate registration was a key factor in determining the violations and subsequent sanctions.
The Proposed SEC Finders Fee Rule
On October 7, 2020, the SEC issued a proposed rule aimed at creating a limited, conditional exemption from broker registration requirements for finders assisting issuers with raising capital from accredited investors. However, the proposed rule did not become law. Hopefully, this issue will be revisited again and add a necessary exemption and additional clarity.
Conclusion
While using finders can be valuable for issuers seeking capital, it is essential to ensure compliance with exemption requirements and carefully evaluate whether finders need to register as brokers. Issuers should implement safeguards, such as obtaining representations from finders, conducting thorough due diligence, and closely monitoring finders’ activities.
Moreover, issuers should be aware that the use of finders may come under scrutiny during an SEC audit, particularly if the finder’s activities involve undisclosed solicitation agreements. For clients hiring individuals to make capital introductions from pre-existing relationships, minimizing the use of transaction-based compensation and ensuring that dealings are limited to accredited investors may reduce the risk of being considered unregistered brokers. Structuring compensation as flat fees, maintaining detailed records, and ensuring no involvement in negotiations are further steps that may mitigate potential regulatory issues.
For specific advice on this topic and additional clarification, please feel free to contact us.
Endnotes:
https://www.sec.gov/corpfin/securities-act-rules#256.23 https://www.sec.gov/divisions/corpfin/cf-noaction/2015/citizen-vc-inc-080615-502.htm
https://www.sec.gov/divisions/marketreg/mr-noaction/2007/hcc061107-15b.pdf
https://www.sec.gov/divisions/marketreg/mr-noaction/2010/brumbergmackey051710.pdf
https://www.law.cornell.edu/uscode/text/15/78o
https://www.sec.gov/divisions/marketreg/mr-noaction/2000/dominionresources030700.pdf
https://www.sec.gov/files/national-examination-program-priorities-2013.pdf
NB This information is provided as a service to clients and friends for educational purposes. It should not be construed or relied on as legal advice or to create a lawyer-client relationship. Readers should not act upon this information without seeking advice from a legal professional