Legal issues can arise when a start-up company or private investment fund uses its own employees or other third party “finders” to identify and solicit investors to provide capital via a private securities offering. In many cases, these individuals perform activities that require registration with the Financial Industry Regulatory Authority (FINRA) and the Securities & Exchange Commission (SEC).
Using an unregistered person or entity to find funding creates risk for issuers in securities offerings, including aiding and abetting liability for violating federal or state securities laws. Investors can seek the return of their invested funds via claims for rescission.
Who is required to register as a broker-dealer?
The Exchange Act prohibits a person from engaging in the business of effecting transactions in securities without a license. As set forth in SEC guidance, registration as a broker-dealer is generally required if a person (1) actively solicited investors, (2) advised investors as to the merits of an investment, (3) regularly participated in securities transactions, and (4) received commissions or transaction-based remuneration. If the SEC finds that an individual satisfies any of the above factors, registration may be required. Accordingly, true “finders” should not do more than make introductions in exchange for a fee. For issuers, that means contracts should be structured so that the finder gets paid regardless of whether or not any securities are sold.
Are there any exemptions to registration as a broker-dealer?
Of course, as with many securities laws, there are a number of exemptions. Most notably, the JOBS Act contains an exception from broker registration for a distinct class of intermediaries assisting in securities offerings who are exempt under Rule 506 of Regulation D. This narrow exemption applies to online intermediaries used in connection with Rule 506 offerings. To qualify for the exemption, the “finder” must (1) maintain a platform or mechanism that permits the offer, sale, purchase, negotiation, general solicitations, general advertisements, or similar activities by issuers, whether online, in person, or through other means, (2) co-invest in the offering, and (3) provide ancillary services with respect to the offering.
This exemption further requires that the online platform (1) may not receive any compensation in connection the purchase or sale of the security; and (2) may not have possession of customer funds or securities in connection with the purchase or sale of the security, and (3) may not receive separate compensation in connection with providing investment advice to the issuers or to investors.
What penalties do issuers face in using unregistered brokers to raise capital?
While there are legal pitfalls for securities issuers who utilize unregistered “finders” to solicit investors, that practice continues, with issuers, “finders” and brokers seeking to act, knowing or unknowing, under the radar. However, should an unhappy investor seek resolution, by lawsuit or complaint to a regulatory body (SEC, FINRA, State Blue Sky regulator), the radar can be aroused and the regulators may take a look, whether or not rescission is granted by the issuer in a settlement, or ordered by a court.
Issuers and unregistered finders are not the only ones subject to legal pitfalls here. The SEC is increasingly aggressive in bringing enforcement actions and imposing sanctions on private equity firms, fund managers and brokerage firms who aid or abet finders’ violations of broker-dealer registration requirements. The SEC also looks at unregistered broker-dealer issues in its compliance exams of private investment funds. While there is SEC guidance available from no-action letters, rules and interpretations for brokers, investment platforms and crowdfunding, there is not sufficient public awareness of issues involving unregistered finders. Further regulatory actions and pronouncements can be anticipated.
Do you have any questions? Would you like to discuss the matter further? If so, please contact me, Dan Brecher, at 201-806-3364.