Finders & Broker-Dealer Registration

Tight credit markets have made many companies turn to third parties to help raise capital or sell all or part of the business. Usually called business brokers or finders, they often show long lists of industry connections and extensive experience.

The largely ignored problem is that most finders are legally required to be but are not registered as brokerdealers with the SEC. Someone hiring a finder not properly registered may be buying liability. One of the risks is that investors or other parties to a transaction done with an unregistered brokerdealer could unwind the transaction.

Should the Finder be Registered?

Any broker or dealer involved in a deal where securities are bought or sold is required to be registered with the SEC. If an individual, the person needs to be legally associated with a registered broker dealer. A broker includes any person in the business of carrying out transactions in securities for others. Finders can be subject to the law even if they are not selling or handling securities.

Registered brokerdealers must be members of a selfregulatory organization like FINRA. They are subject to SEC rules on financial responsibility and conduct. The purpose is to impose standards of professional conduct and reduce abusive sales practices. SEC registration is timeconsuming, expensive and often costprohibitive for finders. There is a limited exception to these requirements called the finders exemption. The problem is that the scope of that exemption is unclear. There is practically no law on the issue and the exemption is largely based on SEC NoAction Letters that cannot be used as precedent.

In its Guide to BrokerDealer Registration, the SEC says a finder may be required to register as a brokerdealer if any of the following apply:

Participation in important parts of a securities transaction, including soliciting, negotiating or executing the transaction.

Finder payment that depends on or is related to the outcome or size of the transaction.

A history of the finder effecting or facilitating securities transactions.

The finder handling the securities or funds of others in connection with securities transactions.

The SEC also says that just the act of finding investors for companies issuing securities or finding buyers or sellers of businesses, even as a consultant may be enough to require registration as a brokerdealer.

No single factor decides whether a finder is a brokerdealer. The SEC has, however, made it clear that it considers how a finder is paid to be a critical factor. If a finder s pay is tied to whether a transaction happens ( success fee ) or the dollar value of a transaction ( commission ), there may be an inherent incentive for the finder to engage in abusive sales practices to effect the transaction.

Unregistered BrokerDealer Use Consequences

Many think the consequences of a brokerdealer not properly registering are the brokerdealer s problem. This is not true. While the brokerdealer is subject to fines and penalties under federal and state law and would have a difficult time enforcing any related fee arrangements, the penalty may be even more of a problem for the company that hires him or her.

The Securities Exchange Act voids any contract made in violation of the law or its rules and regulations. This gives the parties to a transaction arranged by an unregistered brokerdealer a right to void the agreements and unwind transactions. An investor that buys securities may have the right to unwind the purchase if the company that issues those securities later fails just because an unregistered brokerdealer arranged the purchase.

Using an unregistered brokerdealer in a deal could also cause a company to lose any exemption from the registration requirements of the Securities Act of 1933 and applicable state laws it used in that transaction. The company may have a difficult time getting a legal opinion from counsel in connection with that transaction or a future transaction. It also may subject a company to civil and criminal penalties because the company aided or abetted the unregistered brokerdealer. If the company later wants to go public, using an unregistered brokerdealer may lead to accounting and disclosure issues because of the contingency coming from any rescission right of investors. The SEC may also bar the company from conducting future private placement offerings, risking its ability to raise capital.

State Law Registration Requirements

Brokerdealer registration is not just an SEC issue. States are now imposing their own registration requirements on finders and brokerdealers. Registration requirements and penalties for failing to register vary by state. Illinois, for instance, requires the registration of business brokers, even if the broker would have been exempt from registration as a brokerdealer under federal law. While many states (including Illinois) can fine finders for failing to register, other states go further.

California says that any person who buys a security from, or sells a security to, an unlicensed brokerdealer may bring an action to unwind the sale or purchase or, if the security is no longer owned by the party, for damages.



Recent Developments

Because the law is not clear about what activities an unregistered brokerdealer can take, actual practice varies widely. Finders are often not registered with the SEC even when the law says they should be. In fact, a major disconnect between law and practice by which the vast majority of capital is raised to fund early stage businesses in the United States has been noted by a task force of the American Bar Association. Many reform proposals have been made, including a greatly simplified registration scheme for finders. Movement on reforms has been slow and most state regulators have indicated that they are not interested in lowering registration requirements. The combination of the financial markets meltdown and a new administration at the SEC has made the chances for any significant change remote. Unless and until something is done, companies should be wary of hiring finders not properly registered with the SEC even if they see others doing it.

There are indications that regulators may be becoming more active in brokerdealer registration rule enforcement. The SEC has revoked some of the noaction assurance it had previously granted. Additionally, Form D now requires companies to disclose fees paid to finders. This will make policing these activities far easier for regulators.

In June of last year the SEC announced a settlement of an administrative proceeding against a company and its two principals for acting as unregistered brokers. Between 2001 and 2005 they were in the business of identifying and soliciting investors, a majority of which were hedge funds, to participate in offerings. They also played a role in structuring and negotiating the terms of these offerings. The investors compensated them by paying a percentage of the gross amount invested and, in most instances, gave them a percentage of any warrants received in connection with the investment.

In characterizing the violation as willful, the SEC noted they knew or were reckless in not knowing that the compensation structure required them to register as brokerdealers. The settlement is unique because the only basis for the proceedings against was the failure to register.

Caution

Companies should know before hiring a finder either that (1) the finder is registered with the SEC and under applicable state securities laws or (2) the regulators will not view the finder as an unregistered brokerdealer. The latter is very tough to predict. A company can quickly know whether a finder is registered with the SEC by checking the list of registered brokerdealers maintained by FINRA on its website.

If a finder is not a registered brokerdealer, a company should consult an attorney for help in deciding whether registration is required and the risks of proceeding without registration. There are steps a company or fund can take to minimize risk when engaging an unregistered brokerdealer, including:

Researching the finder s history of involvement in securities transactions.

Excluding the finder from negotiating or making recommendations about the transaction and carefully limiting the scope of the finder s engagement in a written agreement with the finder.

Limiting compensation to a flat or hourly fee that is contingent on any transaction happening.

In M&A transactions, doing an asset sale instead of a stock sale.

Given the lack of clarity on registration requirements for finders, companies should be extremely careful when hiring one. What may appear to be a good way to identify sources of funding or willing buyers could result in creating longterm risks and liabilities that will be tough to deal with later.