Companies seeking capital are frequently approached by finders who offer to locate investors in exchange for a fee. This is particularly true in going public transactions. Most finders are not registered as broker-dealers with the Securities and Exchange Commission (the “SEC”).
The possibility of receiving capital even through the efforts of a finder creates a tempting opportunity for issuers who need capital.
Matching companies with investors can be a lucrative proposition for the finder. While it may seem harmless enough, the SEC does not think so
and in fact, the SEC frequently brings cases against unregistered finders and those who aid and abet them.
Compensation of Finders
Compensation of finders based upon the success or completion of the sale or the amount of securities sold is likely to be viewed as unregistered broker-dealer activity. Similarly, compensation, which is a percentage of the amount of securities sold is also likely to be viewed as unregistered broker-dealer activity.
The Broker-Dealer Registration Provisions
The use of unregistered finders also creates liability for both reporting and non-reporting issuers who engaged a finder. Section 15(a) of the Securities Exchange Act of 1934 (the “Exchange Act”) generally requires any person who effects securities transactions to register with the SEC as a broker-dealer. Finders may become involved in various securities transactions including matters other than raising capital, including reverse mergers and direct public offerings. In limited circumstances, companies may compensate a finder who is not registered without violating the federal securities laws.
The determination of whether a finder is required to be registered as a broker-dealer typically involves an analysis by the finder or issuer’s SEC lawyer of several factors including:
i. Prior Securities Transactions
ii. Any previous compensation or other evidence of previous involvement in securities offerings increases the likelihood that the SEC will view the finder as engaged in activities that require registration as a broker-dealer.
Prohibited Activities l Finders
The more involved the finder is in the negotiations for the sale of the securities, the more likely the SEC is to view the finder as engaged in activities that require registration as a broker-dealer. Discussing details of the securities sold and making recommendations increases the likelihood that the SEC would require registration. Finders should avoid the following activities:
i. Actively soliciting potential investors;
ii. Advising potential Investors about the merits of an investment;
iii. Participating in the negotiations;
iv. Participating in the valuation or creating terms of the securities to be sold;
v. collecting, holding or disseminating Investor funds;
vi. reviewing or drafting any agreements related to an investment;
vii. providing assistance to investors in completing the purchase agreement, subscription agreement or other documentation pertaining to an investment.
viii. providing financing to any investor;
ix. providing assistance to the Company in drafting or distributing any materials including financial data or sales materials; and
x. introducing an issuer to commercial banks, lawyers or other professionals to facilitate an investment.
Risks of Using Finders
The temptation of using a finder can lead to potential liability for the finder as well as the issuer. Failure of a finder to be properly registered as a broker-dealer may subject that person to potential liability, including criminal penalties, fines, suspension, and disbarment.
The potential harm to the companies that use unregistered finders includes investor rescission rights. Investors will have a rescission right, meaning that they could demand repayment of their entire investment without set-off or deduction. Companies could also be subject to sanctions and penalties from federal securities regulators as aiding and abetting the unregistered broker-dealer including fines, prohibition on future securities offerings, and criminal actions. If used, the finder should do no more than make introductions of investors to issuers, and should only be compensated by a flat fee which is not based upon the sale of securities. An agreement between the issuer and the finder should define the duties and compensation of the finder.
Most importantly, in order to comply with the antifraud provisions of the securities laws, the issuer and finder must disclose to investors all compensation paid to finders.