For early-stage companies seeking capital, finding potential investors can be difficult. For many companies, using a “finder,” an individual or entity that identifies, introduces and negotiates with potential investors, to help locate potential investors may be critical. This is particularly true in situations where neither the company nor the size of the transaction attracts the interest of professional sources of capital.
Under federal securities laws it is unlawful for any broker or dealer to induce or attempt to induce the purchase or sale of any security unless such broker or dealer is registered with the SEC. A broker is any person engaged in the business of effecting transactions in securities for the account of others. This means any person who accepts transaction based compensation may have to comply with the licensing and registration requirements of federal law. State laws have similar regulatory schemes. For example, California law prohibits a person from “being engaged in the business of effecting transactions in securities” unless licensed as a broker-dealer.
No statutory guidance indicates what activities trigger the definition of a “broker-dealer. The use of finders has often resulted in inadvertent violations of broker-dealer licensing requirements. Guidance issued by the SEC, judicial decisions, and interpretive opinions have narrowly construed the scope of permissible activities in which a finder may engage. But, any person who accepts any form of compensation based on the success of a securities transaction risks acting as an unlicensed broker-dealer in violation of federal and state securities laws.
The same laws and regulations govern the activities of those persons whose business is introduction and assistance in consummation of merger and acquisition transactions.
Factors generally reviewed to determine whether a person is acting as a finder include: (i) participation in the solicitation, negotiation, or execution of the transaction; (ii) compensation based on the outcome or size of the transaction; (iii) otherwise engaging in the business of effecting securities transactions, and (iv) handling securities or investor funds. Routinely acting as a finder may in and of itself evidence of “engaging in business”.
Companies and finders face risks if broker-dealer licensing requirements are not satisfied. For the company using an unregistered broker-dealer to assist with a sale of securities could create a rescission right in favor of the company’s investors under federal and state law. Failing to disclose payments made to an unregistered brokerdealer in connection with a sale of securities could expose the company to potential liability for fraud. Companies that engage unregistered broker-dealers could also find themselves subject to SEC enforcement actions for aiding and abetting a violation of the broker-dealer regulations.
Finders are themselves subject to significant risks, including the risk of SEC sanctions. Specifically, a company could claim that its obligations to a finder under the finder’s engagement agreement are void if the finder is acting in violation of the federal and state broker-dealer registration requirement. A company could rescind its engagement letter with the finder and the finder could be barred from collecting its fees. A finder’s failure to disclose the fact that it is not registered as a broker-dealer could itself be characterized in regulatory enforcement proceedings or private litigation as a misleading omission that amounts to fraud on the company.
New California Legislation
In September 2015, the California legislature enacted Section 25206.1 of the California Corporate Code to provide an exemption from the broker-dealer licensing requirements in the state of California. A finder operating in California that meets the definition of “finder” and complies with the streamlined disclosure and other requirements of section 25206.1, will not be required to be licensed as a broker-dealer under California law, even if he or she receives transaction-based compensation.
The exemption is available only to natural persons, and only in connection with the introduction or referral of accredited investors to a company in relation to a transaction or a series of related transactions with an aggregate securities purchase price of $15 million or less.
The finder must limit his or her activities to introductions and referrals, and must not: (i) participate in negotiating any terms of the investment; (ii) advise any party regarding the investment; (iii) sell any securities owned by the finder as a part of the proposed investment; (iv) take custody of investor funds; (v) conduct due diligence in connection with the transaction; (vi) make disclosures to investors other than permitted disclosures; or (vii) knowingly receive compensation in connection with an offer or sale of securities that is not qualified or otherwise exempt from qualification.
Section 25206.1 requires that certain disclosures be made to the Department of Business Oversight (the “Department”) and directly to the investors introduced by the finder that are less burdensome than the information required for a licensed broker-dealer. The finder must file an initial statement of information with the Department prior to engaging in any finder activity with the name and business address of the finder. A $300 filing fee is also required.
An annual renewal statement must be filed including an affirmative representation by the finder that the finder has complied with and will continue to comply with the conditions of section 25206.1(a) and will not engaged in certain illegal securities activities, and, that the finder has obtained a written agreement with each investor with respect to each transaction in which the finder has participated in the prior twelve months. A $275 filing fee is required for each renewal statement.
The finder must make certain written disclosures directly to each investor it introduces to the company concurrent with that introduction. This written disclosure must be in the form of a written agreement between the investor, the finder, and the issuer and include: (i) the type and amount of compensation payable to the finder; (ii) a statement that the finder is not providing advice to the company or to any person introduced or referred by the finder to a company as to the value of the securities or as to the advisability of investing in, purchasing, or selling the securities; (iii) disclosure as to whether the finder is also an owner, directly or indirectly, of the securities being offered or sold; (iv) disclosure of any actual or potential conflict of interest in connection with the finder’s activities related to the transaction, and (v) a statement that the parties to the agreement have the right to pursue any available remedies at law or otherwise for any breach of the agreement. The investor must represent that the investor is an accredited investor and that the investor knowingly consents to the payment of the described compensation.
Section 25206.1 also requires that the finder maintain a copy of all disclosure items and other records relating to any transaction in which the finder receives compensation for a period of five years.
Section 25206.1 is only available for California transactions and does not provide any relief from the federal requirements. Therefore the issues raised in this article will continue to be applicable. Persons who find themselves faced with possible broker-dealer licensing violations should review their circumstances with experienced legal counsel.