Finders — people or entities who refer potential investors to a company issuing its own securities to raise capital—face the issue of whether they should be registered as broker-dealers under the federal and state securities laws.
This article discusses the legal problems that may arise for unregistered finders and the companies that use them.
Finders at risk
Intermediaries acting as finders are subject to significant risks, including the risk of SEC sanctions.
Company Rescission Rights: The Securities Exchange Act of 1934 provides that every contract made in violation of the broker-dealer registration requirements “shall be void” as to rights of persons who made or engaged in the performance of such contract.
A company can claim that its obligations to a finder under the finder’s engagement agreement are void if the finder is acting in violation of the Exchange Act’s broker-dealer registration requirements.
Disclosure Obligations: There is some risk that 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 issuer.
SEC Sanctions: A finder deemed to be acting as an unregistered broker-dealer may be subject to several different penalties under federal securities laws. The most typical sanction is a temporary or permanent injunction barring it from participating in the purchase or sale of securities. The SEC, however, has the power to impose more severe sanctions, including disgorgement of funds and civil penalties.
Bad Publicity: In general, the SEC publicly announces actions it has taken against persons or entities who have violated the federal securities laws.
Such announcements and censures can be highly embarrassing and negatively affect a person’s business and employment prospects for years.
Companies at Risk
Companies issuing securities in connection with using a finder who is deemed an unregistered broker-dealer face numerous risks.
Investor Rescission Rights: Using a person or entity that could be deemed to be an unregistered broker-dealer to assist with a sale of securities could create a rescission right in favor of the investors under federal securities laws.
If investors succeed in exercising their rescission rights, the issuer would be required to return the money it received from the investors for the purchase of its securities.
This requirement could devastate a company; by the time the violation is discovered, the company may not have enough funds to return the investors’ money and there may be potential claims against the insiders of the company to make up any shortfall.
Disclosure Obligations: Failing to disclose payments made to an unregistered broker-dealer in connection with a sale of securities could expose the issuer to potential liability for fraud under the federal securities laws in that offering. In addition, future offering documents and filings may need to disclose the use of unregistered broker-dealers in past offerings, which could dissuade investors from investing in the subsequent offerings.
Other Issuers Risks: As the SEC steps up its enforcement of broker-dealer registration requirements, companies that engage unregistered broker-dealers could also find themselves subject to SEC enforcement actions under the Exchange Act for aiding and abetting an Exchange Act violation (specifically, the finder’s violation of the broker-dealer registration requirements).
In addition, companies that use unregistered finders also run the risk of losing potential exemptions from securities registration requirements under federal and state securities laws that would otherwise be available.
Guidelines to Consider
Determining whether a person or entity acting as a finder has crossed the line and should be registered as a broker-dealer is murky at best. However, some general guidelines that help to negate broker-dealer registration include:
Only make introductions to suitable, accredited investors;
Do not solicit or pre-screen investors;
Do not participate in any negotiations or recommendations;
Do not handle funds; and
Stick with a non-contingent (not based on the success of the deal), fixed-fee structure; do not accept commission-based fees.
As a practical matter, it is difficult to act as a finder not registered as a broker-dealer because contacts who are introduced by the finder invariably ask the finder what he or she thinks of the company, its management and the proposed investment. Any recommendation, whether explicit or tacit, will be deemed to be giving advice about the potential investment and likely trigger the need for registration.
— David Thayer is a corporate and transaction attorney, and former CPA. He can be reached at [email protected].
This information is not intended as legal advice. Seek specific legal advice before acting. This article is part two of a series.
The first article was published in the Sept. 30 issue of Law Week Colorado.