By Scott Dondershine, CPA, Esq.

Introduction

Under the Securities Act of 1933 (the “1933 Act”) every offer or sale of securities must either be registered or exempt from registration. Section 5 of the 1933 Act. One of the most significant and prevalent exemptions is contained in Regulation D. The vast majority of private placements relying on Regulation D have to be undertaken without any “general solicitation or general advertising.” Rule 502(c) of Regulation D.

The primary factor relied upon to ensure the lack of general solicitation and general advertising is for there to be a documented substantive and pre-existing relationship between the issuer and any prospective investor. Woodtrails-Seattle, Ltd., SEC No-Action Letter (August 9, 1982). In broad generalities, a substantive pre-existing relationship occurs when a significant period of time has elapsed between the time the issuer learns from the prospective investor the investor’s financial goals and objectives and the time the investor is approached concerning his or her interest in the securities offering at issue.

Finders are agents hired by issuers to help sell securities. Many finders work by having a list of potential pre-screened accredited investors with whom the finder has developed a sufficient pre-existing relationship prior to the offering at issue. Potential investors with whom a finder enjoys a pre-existing relationship are deemed to have the same pre-existing relationship with an issuer hiring said finder.

While the use of finders is widespread, issuers need to be alert for two potential problems. First, an issuer may not rely upon an exemption from securities registration if the finder does not strictly follow all applicable requirements for the exemption. Second, an issuer may not be able to utilize a planned exemption as a result of using a finder that should be but is not registered as a broker. This Article will address both problems.

Failure of a Finder to Follow Requirements of an Exemption

As discussed above, one of the main benefits of an issuer using a finder is access to potential investors pre-screened by the finder. Any potential investor with whom the finder already has a documented substantive and pre-existing relationship sufficiently in advance of the offering can be introduced to the issuer without violating the condition of no general solicitation and general advertising. If a finder does not have a sufficient list of pre-screened investors and the finder cold-calls new investors to measure interest in a current offering, then the no general solicitation requirement could be violated resulting in a loss of a planned exemption, regardless of an issuer’s good faith reliance on a finder’s compliance with the rules. Other areas where a finder’s lack of diligence can cause loss of an exemption for the issuer is failure to follow the strict rules regarding disclosure and properly screening for qualified potential investors.

An issuer issuing unregistered securities in violation of the 1933 Act can be responsible for reimbursing investors for the investment (or damages if the investment already has been sold), interest, costs and attorney fees. Liability is also possible if state blue sky laws are violated. In addition, under both the 1933 Act and the laws of many states, a person indirectly or directly controlling an issuer liable for a securities violation can be held personally jointly and severally liable for the damages discussed above.

In order to reduce exposure to loss of an exemption, issuer’s counsel should meet with potential finders to ensure compliance with the no general solicitation and general advertising requirements. It may also be prudent to insist that the finder warrant compliance with the exemption rules and indemnify the issuer for any violation as part of the agreement between the issuer and finder. Any finder should also maintain adequate internal record keeping for all activities in order to document compliance with the exemption rules.

Requirement of a Finder to Register as a Broker

The second potential area of concern for an issuer is whether a finder should be but is not registered as a broker under Section 15 of the Securities Exchange Act of 1934 (“1934 Exchange Act”) and applicable state law. A broker is defined under Section 3(a)(4) of the 1934 Exchange Act as “any person engaged in the business of effecting transactions in securities for the account of others.” Important factors considered by the SEC in determining whether a finder is really a broker include (a) receiving transaction-based compensation, (b) involvement in negotiations, (c) making any recommendations or discussing details concerning securities, and (d) previous involvement in security transactions.

Of the above factors, the most damaging to a finder trying to avoid broker status is whether the finder receives transaction-based compensation such as a commission. According to the SEC, a commission is a red flag and generally indicates that a finder is effecting transactions in securities for the account of others.

The SEC refused to issue a no-action letter, in part, because the individual in question “would also receive transaction-based compensation, one of the hallmarks of being a broker-dealer.” John R. Wirthlin, SEC No-Action Letter (January 19, 1999). In Wirthlin, Wirthlin wanted to contact certain professionals such as tax accountants or real estate brokers who may have clients interested in investing in a real estate limited partnership. Wirthlin then would introduce professionals expressing interest to a representative of the issuer. Wirthlin would have no further involvement after the introduction and, in fact, would never even meet the investors who might ultimately purchase the investment.

One way to possibly reduce the risk associated with receiving transaction-based compensation is by receiving a flat fee for any and all transactions that occur (preferably pursuant to a consulting arrangement) in contrast to a commission that provides a finder with a greater return as the level of investment increases. For instance, the SEC in Richard S. Appel, SEC No-Action Letter (Feb. 14, 1983) indicated that a finder not involved in negotiations and receiving a flat fee of $5,000 plus a 2 ½% royalty interest in proceeds from oil or gas produced as a result of an investment does not have to register as a broker.

The SEC has also denied no-action relief for merely providing matching services for a profit. For instance, in Progressive Technology, Inc., SEC No-Action Letter (October 11, 2000), the SEC indicated that it could take enforcement action against an operator of a planned website where issuers and investors would be matched with a flat sign-up fee paid to the operator for use of the site. The fee would not be contingent upon the outcome or completion of any securities transaction. The adverse ruling in Progressive for a planned matching service run by a for-profit entity contrasts to the favorable ruling received by a planned matching service run by a network of non-profit entities in Angel Capital Elec. Network, Sec No-Action Letter (Oct. 25, 1996) (no participation in negotiations and no compensation other than nominal flat fees not made contingent upon the success of any transaction).

Another important red-flag is whether the finder is participating in negotiations. The SEC summarized the consideration of this factor in IMF Corp., SEC No-Action Letter (May 15, 1978) where it indicated that:

“Individuals who do nothing more than act as finders by bringing together merger or acquisition-minded persons or entities and who do not participate in subsequent negotiations probably are not brokers or dealers in securities and would not be required to register with the Commission. On the other hand, persons who play an integral role in negotiating and effecting mergers or acquisitions that involve transactions in securities generally are deemed either a broker or a dealer depending upon their particular activities, and are required to register with the Commission pursuant to Section 15(a).”

See also Gary L. Pleger, Esq., SEC No-Action Letter (October 11, 1977) and Corporate Forum, Inc., SEC No-Action Letter (December 10, 1972).

A finder who plays no role in negotiations may have a colorable argument that he or she is not acting as a broker even if he or she receives a success fee. Paul Anka, SEC No-Action Letter (July 24, 1991). In Anka, the SEC granted no-action relief in a situation where the finder – Anka – arranged with the Ottawa Senators to provide the hockey club with a list of prospective investors. The hockey club would then contact investors to gauge their interest. Anka would not participate in any negotiations and would not even have any contact with the investors concerning their investment in the club, either before or after the club contacted them. The club would pay Anka a commission for any investments resulting from names provided to the club.

Another favorable no-action letter is Russell R. Miller & Co., Inc., SEC No-Action Letter (August 15, 1977). In Miller, the finder (Miller) provided a variety of business consulting services including the identification of potential purchasers and sellers of insurance agencies. Miller received a fee in some transactions based on a percentage of the consideration paid or received in sale of an agency. Miller’s involvement after identification of a prospect was to provide advice in matters of valuation or other consulting matters. The SEC recognized that the finder was a consultant “retained to bring to bear its knowledge and expertise to the task of identifying an acquisition prospect” and not a broker.

Finally, the SEC in Victoria Bancroft, SEC No-Action Letter (August 9, 1987), indicated that a real estate broker did not have to register since her planned activities were limited to arranging for a meeting with an issuer or its representatives. Bancroft indicated in her request for no-action relief that she would receive a flat fee or a percentage of the purchase price, although curiously the SEC in the action letter only discussed the flat fee, an element that probably strengthened Bancroft’s position that registration is not required.

Although the no-action letter in Anka stands for the proposition that a finder can receive transaction-based compensation as long as he or she has no role in the negotiations, the SEC is rumored to be bothered by the result and is considering revoking the letter. If the SEC revokes the letter or takes a harder line in situations where a finder does not have a substantive role in negotiations but does receive transaction-based compensation, then the importance of the negotiation factor will be diminished, marginalizing the impact of no-action letters such Anka, Miller and Bancroft. It is also important to note that the finders in Anka (a self-described world class entertainer with no prior involvement as a finder) and Bancroft (a real estate broker) focused the majority of their time providing non-investment banking services, an element that strengthens the case for not requiring registration.

The problem of unregistered brokers is very significant. A lot of finders take the position that they do not have to register since they are not “working the deal.” There often is a misperception as to how little it takes to be considered a broker-dealer, especially if the issuer pays the finder transaction-based compensation (see discussion of Wirthlin above). The finders do not want to register since they do not want to be subject to regulation by state and federal regulatory agencies. Finders may also believe that enforcement of the broker registration requirements is lackadaisical.

Unfortunately, however, a lot of the finders who refuse to register probably should. The finders generally receive a success fee (usually a sliding scale of commissions based upon the amount of money raised), have some input into the offer terms and conditions, do more than merely introduce the parties, and provide such services on a routine basis for multiple clients.

Recent actions by the SEC have actually pointed to a stricter viewpoint on the requirements to register. For instance, in 1985 the SEC issued no-action relief to Dominion Resources, a company providing expertise in structuring securities transactions in exchange for a fee that generally was not payable unless the financing successfully closed. Dominion Resources, Inc., SEC No-Action Letter (August 22, 1985). In 2000, the SEC revoked the no-action relief previously provided to Dominion Resources citing instances where it subsequently denied relief in somewhat similar circumstances and holding that “technological advances, including the advent of the Internet, as well as other developments in the securities markets, have allowed more and different types of persons to become involved in the provision of securities-related services.” Dominion Resources, Inc., SEC No-Action Letter (March 7, 2000).

It also may not be that difficult to catch unregistered brokers since the information is highlighted in a Form D that must be filed with the SEC and states for offerings pursuant to Regulation D. The Form D, for instance, specifically requests information for each person who has been or will be paid or given any commission or similar remuneration for solicitation of purchases in connection with an exempt offering covered by the Form D. I recently attended a conference in which it was disclosed that approximately one-third of the state regulatory agencies review Form D statements to determine if persons listed as receiving commissions on Forms D are registered as brokers.

Danger of Using an Unregistered Broker

Use of an unregistered broker can cause forfeiture of an issuer’s reliance on an exemption from registration. As discussed above, if an issuer sells unregistered securities since the planned exemption from registration is forfeited, then the general remedy enables the investor to (1) rescind the investment and receive repayment of the purchase price, interest, costs and attorney fees or (2) seek a commensurate amount of damages if the security has already been resold by the investor. Perhaps most frightening is the potential under applicable law for joint and several personal liability of individuals controlling the issuer.

Issuers using unregistered brokers may also be potentially liable for aiding and abetting the securities law violations of such unregistered brokers. The SEC could also require disclosure of the issue in an initial public offering (‘IPO’) prospectus if an earlier fund raising round involving an unregistered broker took place near in time to the IPO. Generally accepted accounting principles may also require accrual of a liability for any resulting rescission responsibility.

In addition to the liability discussed above to the issuer and control persons, an unregistered broker can be subject to a variety of different liabilities, including injunctions, criminal sanctions, damage suits and rescissions. The SEC, NASD and the United States Department of Justice as well as private parties may target an unregistered broker.

Solutions to the Problem of Unregistered Brokers

An obvious solution to the problems caused by unregistered brokers is for issuers to only use registered brokers. Unfortunately, however, a lot of finders refuse to register for the reasons discussed above. If an issuer is not able to locate a suitable registered broker, then the issuer may want to (1) pay a flat consulting like fee that is not based on the outcome of the securities issuance and require that the finder play no role whatsoever in any negotiations with investors or (2) use a non-profit matching service.

Issuers should also require that any finder provide a representation (from the finder and his or her counsel in the form of an opinion letter) that the finder is properly registered (or is not required to register) and a promise to indemnify the issuer for any harm resulting from the failure to properly register. It is important to note however that indemnification is only beneficial to the extent a finder has sufficient resources from which to reimburse an issuer for the damages discussed above.

Conclusion

The danger in writing this Article is instilling fear of using finders. Although one must be careful to ensure that finders follow the applicable exemption requirements and are registered as brokers if they really are brokers, the use of finders can be invaluable. Finders who maintain a significant list of pre-screened investors with whom they have a pre-existing relationship can often locate investors much faster than can an issuer. An issuer may have difficulty on its own navigating the prohibitions against general solicitation and general advertising.

While the use of finders is therefore often helpful, issuers should implement the safeguards discussed in this Article for ensuring that finders (1) comply with applicable exemption requirements and (2) sufficiently consider whether they have to register as brokers. Issuers should discuss the issues with finders and where necessary obtain sufficient representations, warranties and legal opinion letters as to compliance with the same. This Article provides general guidance only and should not be relied upon for legal advice.