Publications: Finders operate without understanding legal risks

"Finders" are well-connected individuals who offer capital matchmaking services. A finder may assist with raising capital for a new private equity fund, help find money to build a new hotel or aid an entrepreneur who seeks seed money for a new business. The client generally pays the finder a percentage of the capital secured.  Acting as a finder, in many circumstances, constitutes acting as a "broker" under the securities laws and requires registration as a broker-dealer.   A failure to register can have serious consequences but, in my experience, many finders (and their clients), operate without any real understanding of the inherent legal risks.

Which finders are brokers?

As an initial matter, it is helpful to review the factors that are not relevant to the broker registration requirements for finders. First, what a finder calls himself or herself is irrelevant.  Using a title, whether, "advisor," "consultant" or otherwise, does not exempt a finder who is acting as a broker from having to register. Second, there is no blanket exemption from broker-dealer registration for finders who act also in other capacities (for example, as a consultant, lawyer or accountant). The SEC has been very clear in recent guidance that professional advisors of all stripes are not exempt from registration if they act as brokers. Third, there is no exemption based on the nature of the persons that a finder contacts. For example, there is no free pass if the finder targets only sophisticated investors.

So, what factors are relevant to determining whether a finder is a broker requiring registration? There are several, listed here in approximate order of importance:

1. Is the finder receiving transaction-based compensation? Is the finder receiving a fee that is tied to success in finding capital and the amount raised? Or is it receiving some sort of fixed or hourly fee? The former arrangement, which most closely resembles a brokerage commission, is a significant indicator of brokerage activity.

2. Is the finder involved in soliciting purchasers? In other words, is the finder doing more than merely "opening the Rolodex" and making introductions for the client? Is the finder, for example, arranging meetings, providing offering materials or otherwise assisting in the sale process?

3. Is the finder involved in negotiating the terms of the deal or otherwise advising either the seller or the purchaser? For example, is the finder providing advice to the client on how to structure the deal so as to appeal to targeted capital sources?

4. Is the finder's activity part of a regular and ongoing business? Or is the finder's activity rare and occasional and incidental to other business and professional activities? Has the finder previously worked for a broker-dealer (e.g., as a registered representative) or is he or she currently associated with a broker-dealer and engaging in prohibited outside sales activity (so-called "selling away")? Does the finder have a disciplinary history that would interfere with registering as, or being associated with, a broker-dealer?

The SEC has indicated that the first factor, transaction-based fees tied to success and amount raised, is the most important indicia that a finder is acting as a broker. The SEC (and those states that have publicly addressed this issue) almost invariably concludes that this type of arrangement requires broker-dealer registration. Not surprisingly, finders like commission-style arrangements and their clients like success-based fees, so flat fees are not the norm.  Accordingly, many finders fall squarely within the broker-dealer registration requirements.

Unregistered broker consequences

A finder who acts as an unregistered broker faces potential civil and criminal liability. In the case of an entity acting as a finder, this liability also extends to the finder's "control persons" (directors and officers). The finder may also be required to pay his or her client's legal fees and expenses and may be subject to bars on future involvement in the securities industry.  Even if no regulator takes notice of the arrangement, the finder risks having a court invalidate a contract with his or her client on the grounds of illegality, in which case the finder's entitlement to commissions may be completely unenforceable, notwithstanding months of work. In some cases, this last consideration (not getting paid) is the most tangible for unregistered finders.

A client who engages an unregistered finder also faces significant risks. Under federal securities law, an investor may assert the right of rescission — in effect the right to "put" the purchased securities back to the client if sold using the services of an unregistered finder. State securities laws generally provide for similar rescission rights and, in some cases, the ability to sue for damages in lieu of rescission. In addition, using an unregistered finder can destroy the availability of certain exemptions from the registration requirements of the securities laws, which are the foundation for most private capital-raising activity. 

Both client and finder should carefully consider these risks before moving forward.

Registering as a broker-dealer

A finder may register as a broker-dealer by making the required filings with the SEC, the Financial Industry Regulatory Authority (FINRA) and state securities regulators and submitting to the required examination process. There is no expedited or short-form process for finder registrations. Recent experience with this process suggests that registration could easily take nine months, so there is generally insufficient time for a finder to register once an attractive opportunity crosses his or her desk.

Is a low profile worthwhile?

Some finders conduct their business without compliance with the broker-dealer registration requirements, but doing so is inadvisable. In recent years, the use of unregistered finders has received substantial scrutiny from the SEC and state regulators. The SEC's recent written guidance, consisting mostly of situation-specific, non-precedential "no action letters," is increasingly restrictive regarding the activities of unregistered finders.

No easy way to register yet

The SEC announced several years ago that it was planning to address the need for finders to register and the securities bar expected that an expedited registration process for finders ("broker-dealer lite") might result. Unfortunately, that has not yet occurred and is not expected in the near term.

Reduce the risk

In light of the factors outlined by the SEC to determine whether a finder is acting as a broker, thereby requiring registration, finders and their clients can take steps to reduce, but not eliminate the risks outlined above.

First, finder engagement letters should contain a list of activities that the finder will not undertake, including: 1) having substantive conversations with prospective investors; 2) scheduling or participating in meetings or telephone calls between the client and prospective investors; 3) distributing information to prospective investors; and 4) assisting investors in completing subscription documents or remitting associated payments.

Second, the compensation due the finder should be fixed in amount (or based on an hourly rate) rather than a percentage of the amount raised. Naturally, many finders and clients will bristle at these suggestions, but their attorneys should advise them of the risks of not following them.

Reprinted with permission from Chicago Daily Law Bulletin.