DISTINGUISHING BETWEEN FINDERS AND BROKER-DEALERS AUTHOR: MARGARET S. NG

The Implications on a Finder’s Compensation and a Company’s Capital Raise.

When raising debt or equity, companies commonly engage finders to assist them in accessing qualified investors. However, if they are not careful, these finders may fall into the category of broker-dealers which could lead to negative consequences for them, the companies using their services and even the investors they bring to the table.

Distinction of Broker-Dealers and Finders

Under United States Federal law, any person engaged in the business of effecting transactions in securities must register with Securities Exchange Commission (the “SEC”) as a broker-dealer. Registration is a timely and costly process and requires the broker-dealer to become a member of a self-regulatory organization such as the Financial Industry Regulatory Authority. California has a similar requirement that any person engaged in effecting transactions in securities in California must be licensed with the Department of Corporations.

A finder, on the other hand, is exempt from registration under both Federal and California securities laws. As compared to broker-dealers, finders do not “effect” transactions in securities. Rather, to distinguish themselves from broker-dealers, finders must limit their activities to merely opening up their contact lists and making introductions to potential investors. Regulators have found the following activities to lead to classification as a broker-dealer and such activities should be avoided by finders:

· Negotiating the terms of the financing transaction

· Offering or providing advice or recommendations in the financing transaction

· Receiving success-based fees (i.e., fees contingent on the success of the financing transaction)

· Providing issuing companies with assistance in drafting or distributing sales and financial materials

· Soliciting investors

· Handling funds involved in the transaction

· Previous involvement and the frequency of involvement in the sale of securities

Any one of these activities could lead to classification as a broker-dealer and, therefore, require registration with appropriate regulatory authorities. Companies and finders often try to evade these factors by characterizing their arrangements as consulting relationships. However, regulators focus on the substance rather than the form of the finder arrangements, thereby making the actual terms, facts and circumstances of such arrangements more important than how they are characterized.

While all of the activities described above are important for finders to avoid, the receipt of success-based compensation and prior involvement in the sale of securities are the two activities most likely to draw scrutiny and result in classification as a broker-dealer. In response to a No-Action Request in 2010, the SEC wrote that the receipt of compensation directly tied to the success of the investments in securities would give the finder a “salesman’s stake” and heighten the incentive for the finder to engage in sales efforts and, therefore, required broker-dealer registration. Success-based compensation can include fixed fee as well as percentage based compensation so long as they are contingent on the success of the financing transaction (i.e., based on a threshold of money being raised or committed). The most cautious route is for the finder to receive a fixed fee regardless of the outcome of his or her efforts. This, of course, requires the company to pay the finder even if the financing transaction raises no money.

Another important factor is the finder’s prior involvement and the frequency of involvement in securities transactions. From a business perspective, a finder’s past experience in similar transactions is probably most determinative of his or her success in raising money. On the other hand, this very experience requires the finder to register as a broker-dealer and exposes the finder, the company and the investors to risks if he or she has not.

If either success based compensation or prior or routine involvement in the sales of securities is present, the common view among commentators is that it will be very difficult to convince the regulators that registration as a broker-dealer is not required. If it is not feasible for the finder to avoid the practices described above, the finder should consider associating him or herself with a registered broker-dealer. Of course, association would require the finder to be under the supervision of the registered broker-dealer.

Impact on Finders, Issuing Companies and Investors

Finder’s Perspective: If found to be acting as an unregistered broker-dealer, the finder may be barred from enforcing and collecting his or her finder’s fees. The SEC may issue cease and desist orders and impose civil penalties. For knowing violations, the SEC may even seek criminal fines or imprisonment. While merely failing to register as a broker-dealer is unlikely to result in criminal prosecution, if combined with questionable practices or other securities law violations, criminal prosecution becomes a real possibility.

Company’s Perspective: Under both Federal and California law, investors have the right to recover their investment on the basis that they were materially misled by not being informed that the finder was not a registered broker-dealer. Companies that engage unregistered broker-dealers could be barred from future exempt offerings under Regulation D, which is essential to most private placements. Further, under California law, an investor who no longer holds the securities could seek damages from the issuing company, which possibly includes attorneys’ fees, cost and treble damages up to $10,000.

Investor’s Perspective: If the finder involved in the securities transaction is found to have been acting as an unregistered broker-dealer, the investors accessed through that finder could rescind their investment, thereby forcing the company to refund invested capital and diminishing the quality of the remaining investors’ investment.

California Exemption for Licensed Real Estate Brokers

Notably, California law affords an exemption from registration for finders licensed as real estate brokers by the California Real Estate Commissioner. This California exemption is limited to securities transactions involving an interest in any general or limited partnership, joint venture, tenancy-in-common, or similar organization (but excluding corporations) that are (a) owned beneficially by no more than 100 persons and (b) formed for the sole purpose of engaging in investment in an interest in California real property (such as an investment in a tenancy-in-common, real estate partnership or limited liability company). Interestingly, Federal law provides no counterpart exemption from Federal registration for licensed real estate brokers involved in effecting transactions in real estate securities. So while real estate brokers dealing in real estate securities may be exempt from registration under California law, they are subject to Federal registration requirements. Given the difference in treatment on the Federal and state levels, real estate brokers and the companies that engage them should still be wary of the distinction between broker-dealers and finders for purposes of complying with, and understanding the risks entailed in any failure to comply with, Federal law.