When a company needs to raise capital, people often look to others in their network to connect them with potential investors. These mediating friends are called finders. Finders introduce a private company to potential investors and are often paid a fixed fee (typically 5%- 6%) for each successful investment his or her connection makes in the company. Many finders are licensed with the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA), yet others are unregistered. Unregistered finders run a number of risks for themselves and for the issuing company under state and federal law. Because the Securities Exchange Act of 1934 (the “Exchange Act”) gives very loose definitions, there is a broad range of interpretations.
Issues for the Unregistered Finder to Consider
Under the Exchange Act, a broker is defined as “any person engaged in the business of effecting transactions in securities for the account of others.” This broad definition can be interpreted to include locating issuers, soliciting new clients, aiding in the structuring or negotiation of a securities transaction, and providing advice regarding the value of securities. Section 15(a)(1) of the Exchange Act states that “it shall be 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. Because the Exchange Act provides such a loose definition of a broker-dealer, many finders do not realize that their activities require registration with the SEC. A finder who is found to be in violation of the regulations promulgated by the Exchange Act can face many consequences, including, but not limited to, significant fines. Section 29(b) of the Exchange Act states that every contract made in violation of the Exchange Act shall be void. Thus, the issuer can claim the obligations to the unregistered finder to be void.
There are a few exceptions to the activities an unregistered finder is allowed to partake in, such as identifying sources of capital, preparation of business plans, or certain financial services. The general rule to follow is for the role of the finder in a securities transaction to end once the initial introduction has been made. The more involved the finder is in the process, the more likely it is the finder will be required to be a registered broker with the SEC.
Considerations for the Issuing Company
Although it is tempting to use their connections, there are many legal risks in working with an unregistered finder. Section 29(b) can also be interpreted to make void the sale between the issuer and the investor. Using an unregistered broker can potentially create a rescission right for the investor. The issuing company would have to return the money it received for its shared and could potentially incur interest and attorney fees. This can be harmful for the company’s future business because under federal law the rescission right extends to three years after the date of issuance of the securities or one year after the date of discovery of the violation. Additionally, if a company does not properly monitor the finder’s actions, the company could potentially lose the ability to use certain registration exemptions for those securities.
A written agreement with the finder is important and can save the sale of securities from future rescission. The agreement should explicitly state the finder’s role and enumerate permitted and prohibited activities to ensure that none of the activities require broker registration. It should also include the financial compensation the finder is receiving as well as an acknowledgement by the finder of an awareness of broker-dealer laws. Raising capital is a vital part of the growth of a business, but when using a finder, it is imperative to ensure that both the company and the finder are complying with federal and state laws in order to prevent costly liability.
Our firm has been working with issuers and finders throughout the capital raising process for more than 20 years. For more information regarding potential liability as a company working with a finder or as a finder seeking to make connections for companies for a fee, please contact Larry Horwitz at email@example.com.