Using an Unregistered Broker-Dealer for Capital Raising is a Risky Proposition

One of the most overlooked and problematic issues concerning capital raising by small businesses, venture capital funds, and private equity funds is the use of “finders” to assist issuers with raising capital. Those who act as “finders” assist in matching issuers with investors for a fee. Issuers generally desire to pay a “finders’ fee” only for a successful matching of investor and issuer (success-based compensation)—if the referred investor invests in the business/fund, then the issuer prefers to pay the finder a fee based on the amount of the investment, something that is commonly known as “transaction-based compensation.” Issuers are generally averse to paying a finder a non-transaction-based fee since that would require paying the finder for referrals regardless of whether that referral actually invests.

The problem with this payment structure is that it overlooks, and in most cases violates, the broker-dealer registration requirements of Section 15(a) of the Securities Exchange Act of 1934 (the “Exchange Act”).

Who is Considered a Broker? Under Section 3(a)(4)(A) of the Exchange Act, a person who is “engaged in the business of effecting transactions in securities for the account of others” is required to register as a broker. The fact that a securities offering may be exempt from registration under the Securities Act of 1933 (“Securities Act”)—for example, an exempt Regulation D offering—does not affect the requirement for the “broker” to be registered.

In certain situations, it is clear whether a person is acting as a broker; in others, it is less clear. Whether a person is a broker within the meaning of the Exchange Act turns on the facts and circumstances of the particular scenario. Courts and the Securities and Exchange Commission (“SEC”) have looked to certain factors to determine whether a person is a broker-dealer within the meaning of the Exchange Act. Indicators that a person may need to register as a broker include the following; however, this list is neither dispositive nor exhaustive, and each situation must be evaluated on a “facts and circumstances” basis:

1. Actively soliciting or recruiting investors, or otherwise finding investors for “issuers” (entities issuing securities), even in a consultant capacity;
2. Finding investors or customers for, making referrals to, or splitting commissions with registered broker-dealers, investment companies (or mutual funds, including hedge funds), or other securities intermediaries;
3. Persons that market real-estate investment interests, such as tenancy-in-common interests, that are securities;
4. Persons that act as “placement agents” for private placements of securities;
5. Participating in negotiations between the issuer and the investor;
6. Advising investors as to the merits of an investment or opining on its merits;
7. Handling customer funds and securities;
8. Having a history of selling securities of other issuers; and
9. Receiving commissions, transaction-based compensation, or payment other than a salary in connection with the purchase or sale of securities.

Although the Courts and the SEC, through numerous No-Action Letters, have identified various indicators of broker-dealer activity, the receipt of transaction-based compensation in connection with securities activities such as the solicitation of potential investors has been viewed as a key factor indicating that registration with the SEC as a broker may be required. The SEC views a person’s receipt of transaction-based compensation (i.e., compensation tied directly to a successful investment in the issuer’s securities by an investor referred to the issuer by such person) for effecting a transaction in securities, or for inducing the purchase of securities, to be a hallmark of broker-dealer activity.[1] The SEC has stated that it believes that the receipt of transaction-based compensation gives a finder a “salesman’s stake” in a proposed offering and creates a heightened incentive for a finder to engage in sales efforts.[2] As a result, a finder who is not otherwise a registered broker-dealer, or associated with a registered broker-dealer, and who receives transaction-based compensation, is at risk for being considered an unregistered broker in violation of the Exchange Act. Further, an issuer who pays transaction-based compensation to an unregistered finder is also at risk of being in violation of the Exchange Act, as well as facing civil and/or criminal penalties, and being required to provide investors with rescission rights.

October 2020 Finder’s Exemption Proposal. The SEC has never formally recognized a “finders” exemption/exception from the securities laws. Although the SEC issued a proposal for a limited finders’ exemption in October 2020, that proposal was never formally adopted by the SEC. The SEC received over 90 comment letters overwhelmingly critical of the proposal. Unfortunately, no further action has been taken with respect to the proposal and it is unlikely that such a proposal will be adopted in its current form in the near future.

The SEC’s October 2020 proposal, if it had been adopted, would have created two categories of non-exclusive “safe harbors” for finders, for which registration as a broker would not be required. The proposed exemption would have permitted natural persons to engage in certain limited activities on behalf of issuers with private placement offerings.

The proposal would have created two classes of finders, Tier I Finders and Tier II Finders, that would be subject to conditions tailored to the scope of their respective activities. Tier I and Tier II Finders would both be permitted to accept transaction-based compensation under the terms of the proposed exemption.

A Tier I Finder would be limited to providing contact information of potential investors in connection with only a single capital raising transaction by a single issuer in a 12-month period. A Tier I Finder could not have any contact with a potential investor about the issuer.

A Tier II Finder could solicit investors on behalf of an issuer, but the solicitation-related activities would be limited to:

1. Identifying, screening, and contacting potential investors;
2. Distributing issuer offering materials to investors;
3. Discussing issuer information included in any offering materials, provided that the Tier II Finder does not provide advice as to the valuation or advisability of the investment; and
4. Arranging or participating in meetings with the issuer and investor.

The proposed exemption for Tier I and Tier II Finders would have been available only where:

• The issuer is not required to file reports under Section 13 or Section 15(d) of the Exchange Act;
• The issuer is seeking to conduct the securities offering in reliance on an applicable exemption from registration under the Securities Act;
• The finder does not engage in general solicitation;
• The potential investor is an “accredited investor” as defined in Rule 501 of Regulation D, or the finder has a reasonable belief that the potential investor is an “accredited investor”.
• The finder provides services pursuant to a written agreement with the issuer that includes a description of the services provided and associated compensation.
• The finder is not an associated person of a broker-dealer; and
• The finder is not subject to statutory disqualification, as that term is defined in Section 3(a)(39) of the Exchange Act at the time of his or her participation.

Because Tier II Finders would have been able to participate in a wider range of activity and have the potential to engage in more offerings with issuers and investors, the SEC proposed the additional requirement for a Tier II Finder of disclosure of the Tier II Finder’s role and compensation, prior to or at the time of the solicitation. Further, the Tier II Finder would have been required to obtain from the investor, prior to or at the time of any investment in the issuer’s securities, a dated written acknowledgment of receipt of the required disclosures.

However, the SEC’s Tier I and Tier II Finder proposal was not adopted and thus cannot be relied upon.

Issuer’s Exemption. While not considered a “finders’ exemption,” it may be useful to point out the “Issuer’s Exemption” from registration as a broker (Exchange Act Rule 3a4-1). This rule provides that an employee of an issuer who participates in the sale of the issuer’s securities is not required to register as a broker-dealer if that person, at the time of participation, among other requirements, is not compensated by payment of commissions or other remuneration based directly or indirectly on securities transactions. The Issuer’s Exemption would not apply to any employee (1) subject to a “statutory disqualification” as defined in Section 3(a)(39) of the Exchange Act or (2) who is an associated person of a broker-dealer.

Real Estate Brokers/Agents. It may also be useful to point out that, when a real estate investment is offered as part of a pooled investment vehicle, it may constitute a security. There is no general exception from the broker-dealer registration requirements for licensed real estate brokers or agents who engage in the business of effecting transactions in real estate securities, including tenants-in-common interests in real property, and the above analysis on whether such person is required to be registered with the SEC as a broker-dealer must be conducted.

Engaging an Unregistered Broker is a Risky Proposition. There is no safe harbor or clear delineation of a finder’s exemption in the securities laws. Involving finders that are not registered broker-dealers in capital raising activities, and in particular paying those finders a contingent, transaction-based compensation, carries significant risks. The unregistered broker-dealer can face sanctions from the SEC, criminal prosecution under both federal and state law, and lose the ability to enforce its agreement for fees. Fund managers and companies that use an unregistered broker-dealer can face civil and criminal penalties and be subject to SEC enforcement actions for aiding and abetting a finder’s violation of the broker-dealer registration requirements; additionally, an issuer’s use of an unregistered broker-dealer in its capital raising activities may create a right of recission in favor of investors, allowing investors the right to require the issuer to return the money invested. Fund managers, issuers, and other companies should be aware of these risks when seeking out finders to raise capital.

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This alert should not be construed as legal advice or a legal opinion on any specific facts or circumstances. This alert is not intended to create, and receipt of it does not constitute a lawyer-client relationship. The contents are intended for general informational purposes only, and you are urged to consult your attorney concerning any particular situation and any specific legal question you may have. We are working diligently to remain well informed and up to date on information and advisements as they become available. As such, please reach out to us if you need help addressing any of the issues discussed in this alert, or any other issues or concerns you may have relating to your business. We are ready to help guide you through these challenging times.

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1. See, e.g., Brumberg, Mackey & Wall, P.L.C. SEC No-Action Letter (May 17, 2010).
2. Id.; see also SEC Guide to Broker-Dealer Registration (April 2008); Nemzoff & Company, LLC, SEC No-Action Letter (Nov. 30, 2010); Hallmark Capital Corporation, SEC No-Action Letter (June 11, 2007); John W. Loofbourrow Associates, Inc., SEC No-Action Letter (June 29, 2006); Country Business, Inc., SEC No-Action Letter (Nov. 8. 2006); Paul Anka, SEC No-Action Letter (Jul. 24, 1991); IMF Corp., SEC-No-Action Letter (May 15, 1978).