“Finders” Acting As a Securities Broker-Dealer Are on the SEC’s Hit List

“Finders” Acting As a Securities Broker-Dealer Are on the SEC’s Hit List

The SEC is also focusing on securities broker-dealer issues in its OCIE compliance exams of private investment funds, and has recently instituted a significant enforcement action against a fund manager. Not surprisingly, the uptick in enforcement coincides with the use of general solicitation and general advertising in Rule 506 private offerings permitted by the Jumpstart Our Business Startups (JOBS) Act.

There are serious legal issues to be considered 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 SEC.

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” can generally do little more than make introductions in exchange for a fee. For issuers, that means contracts must be structured so that the finder gets paid regardless of whether or not any securities are sold. That would go a long way toward satisfying regulators that the issuer was not participating in a violation.

Are there any exemptions to registration as a securities broker-dealer?

Of course, as with most securities laws and regulations, there are a number of exemptions. Most notably, the JOBS Act contains an exception from broker registration for intermediaries assisting in securities offerings exempt under Rule 506 of Regulation D. The 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, or (3) provide ancillary services with respect to the offering.

The exemption further requires that online platforms (1) may not receive any compensation in connection with the purchase or sale of the security; (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 issuers or 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 acting unknowingly outside the law, or purposely seeking to act under the radar.  It is, of course, preferable that they educate themselves about exemptions that are available and act accordingly. One good reason to get educated about the exemptions, and comply with them, is that an unhappy investor may 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. While the remedy of rescission (return of the investment) may be sufficient in some instances where a violation has occurred, that might not put an end to the matter for the regulators who may seek to flex their muscles and make an example of the violation, so as to discourage others from engaging in such violations. Regulators can seek injunctive relief whether or not the issuer has already granted rescission to investors. Regulators can become aware of the violations through investor-brought court proceedings, and investors, relying on regulators’ actions, can proceed in court seeking remedies readily available to them for securities violations.

Using an unregistered broker to find funding presents a higher degree of risk for issuers in Rule 506 private offerings, including aiding and abetting liability under federal securities laws, which raises the risk of rescission being directed under state securities laws. We have advised numerous issuers on how to properly inter-act with finders. If you have any questions about this issue, or would like assistance with your legal work, please contact me or the Scarinci Hollenbeck attorney with whom you work.