In this tight financing market, more and more privately held companies are considering the use of so-called "finders"-- people or firms who hold themselves out as having the ability to introduce the company to interested investors in exchange for money and, often, equity compensation. Such finders may promote the sale of a new issuance of securities, provide consulting services, identify strategic opportunities (including the sale of the company), or match investors with entrepreneurs seeking financing.

The U.S. Securities and Exchange Commission (the "SEC") regulates "finders" who become "broker-dealers," as well as parties that raise money and perform related activities for companies for a living. On several occasions, the SEC has expressed its consternation (resulting in enforcement actions) with "finders" who do not, but should, be regulated by the SEC and subject to the operation restrictions provided by the SEC. This article outlines some of the legal risks and consequences for companies who hire finders not registered with the SEC.

What are the risks?

Under U.S. law, the issuer bears the burden of establishing that its securities are sold in compliance with securities laws. As a result, the issuer should be wary of retaining the services of an unregistered finder for two reasons. First, such a finder may be more likely than a registered broker-dealer to engage in wrongful conduct under either Federal or State law in connection with an offering (i.e., registered broker-dealers are generally more aware of the laws and regulations governing their activities). Second, a finder who is not a registered broker-dealer may engage in activities that are restricted by law only to registered broker-dealers.

If it is subsequently determined that a finder should have been registered as a broker-dealer, the SEC is authorized to seek a civil injunction or monetary penalties, and refer the matter to the United States Attorney General for criminal prosecution. In addition, the purchasers of securities sold with the assistance of an unregistered finder may have a right to rescind their entire investment from the issuer. If the value of the shares declines, investors who were introduced to the company by the unregistered finder might exercise their rescission rights. Furthermore, the company has no post-closing means of protecting new investors from any liability that could arise from the prior sale for which rescission rights (or "buy-out") exist. New investors would be subject to these rescission risks until the applicable statute of limitations period has expired.

A finder or a broker-dealer?

Pursuant to the Securities Exchange Act of 1934, brokers and dealers in securities are required to register with the SEC. Specifically, that Act makes it unlawful for any broker or dealer "to effect any transaction in, or to induce or attempt to induce the purchase or sale of, any security… unless the broker or dealer is registered."

A "broker" is defined by the 1934 Act as "any person engaged in the business of effecting transactions in securities for the account of others." In limited circumstances, an entity may be deemed to be a finder rather than a broker-dealer and thus not subject to SEC registration. However, this de facto exception to broker-dealer registration is narrowly construed by the SEC.

From time to time, the SEC's staff issues "no-action" letters -- written confirmation from the SEC's staff that it will not take enforcement action if a proposed activity is undertaken. A review of SEC no-action letters discussing the subject of whether a finder's activities have increased to a level requiring registration as a broker-dealer reveals that the SEC considers the following factors determinative:

(i) involvement in negotiations;
(ii) discussion of details of the nature of the securities or making recommendations about the transaction;
(iii) transaction-based compensation (a.k.a. commissions); and
(iv) previous involvement in the sale of securities.

The SEC's staff is more likely to deem entities to be finders if the entities proposing to match investors with issuers are willing to limit their activities solely to providing information (essentially serving as a "bulletin board"), and are willing to eschew receipt of any compensation based on the occurrence or value of resulting securities transactions. The negotiation, structuring and execution of the transactions must be done by others. Moreover, the finder cannot handle the funds or securities or receive any compensation other than a flat fee.

The SEC also focuses on whether an entity is engaged in the business of securities transactions, as opposed to engaging in an isolated securities transaction. The "engaged in the business" component of the definition of a broker-dealer implies a regularity of participation in securities transactions. Therefore, finder status is more likely found where an entity's involvement in the securities transaction at issue is an isolated incident, and not a recurring part of its business.

How can a company protect itself?

Based on the foregoing, any company that engages a finder that is not registered with the SEC as a broker-dealer should not allow the finder to: (1) provide advice about the merits of particular opportunities or ventures; (2) receive compensation from users other than non-contingent fees and nominal flat fees to cover administrative costs; (3) participate in any negotiations between entrepreneurs and investors; (4) directly assist entrepreneurs or investors with the completion of any transaction; (5) handle funds or securities involved in completing a transaction; or (6) hold itself out as providing any securities-related services other than a listing or matching service.

The engagement agreement with the finder should also include an indemnification of the issuer against losses resulting from any violation by the finder (not caused by the issuer) of Federal or State securities laws in connection with the offering, or any breach by the finder of any of its representations, warranties or covenants set forth in the agreement. Additionally, at a minimum, the engagement agreement should include either a representation and warranty that the finder is registered as a broker-dealer (if that is true), or a covenant that the finder will not take any action under the agreement that will require it to register as a broker-dealer. Of course, these representations and covenants are only as strong as the ability of the company to collect a payment against the finder -- nothing substitutes for due diligence. Remember, however, that you cannot contract away the commission of an infraction of the laws; if the agreement contemplates that the finder will engage in any of the activities discussed above or will be compensated based upon success or by a percentage of the proceeds of the offering, the representations and warranties might not amount to much.

When a finder is being retained to assist an issuer in connection with a proposed private placement that is exempt from registration under Regulation D of the U.S. Securities Act of 1933, it is advisable to restrict the finder's activities to a limited number of potential investors with whom the finder has previous relationships. The 1933 Act prohibits the issuer and "any person acting on its behalf" from offering or selling securities by any form of general solicitation or general advertising and the finder's actions may unwittingly place the issuer outside of the offering exemption, forcing it to either file a registration statement or abandon the offering. The finder may provide the company with a list of names and states of residence of potential investors who are "accredited investors" for the purpose of Regulation D and with whom the finder has pre-existing relationships. Such a list could help reduce the risk of the finder claiming compensation based on participation in the offering of other investors contacted by the company without the finder's assistance.

This is only a general discussion of U.S. federal securities law relevant to finders. There are many other state-specific securities laws that often impose additional restrictions on finders' activities. In drafting finder's agreements, you should always identify and address specific risks and business considerations, in addition to those discussed here, that apply to the transaction at issue with an attorney expert in this area of practice.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.