finders, but not keepers
Frank T. Morgan , Esq.
Recovering lawyer ? Tech writer ? The line starts here ?? #NextGen
SEC statutes do not define clear boundaries between Finder and Broker-Dealer activities in venture capital raisings. Finders, and the small businesses and startups they serve, are threatened by onerous & outdated registration requirements tailored toward big venture capital and private equity firms. But California's finder regime could serve as the model for a kinder and more rational federal approach.*
Small businesses and start-ups desperately need outside capital investment in order to survive, particularly during their tenuous early phases of growth. Linking up small enterprises with investors willing to help them grow is a difficult task. It often falls outside the experience and competency of business owners struggling to keep up with daily demands. Investment capital finders play a vital role in survival and success of small business. They receive consideration for steering investors toward deals and enterprises that are beneath the interest of big private equity and venture capital firms. Finders receive consideration for their important service, but SEC rules loom as a constant threat to their activities.
Bent on protecting big investment firms, the SEC (a) ignores finders as a distinct business class; (b) lumps their activities in under the inaccurate heading of “broker-dealers”; (c) makes it unclear whether some finders must even register as such; and (d) metes out harsh punishments when it adjudges that a finder’s activities have crossed the undefined boundaries of broker-dealer territory.
Thus finders face a two-edged regulatory sword: either register as broker-dealers at considerable cost, or forego registration at considerable peril. Recissions, disgorgements, fines, and sometimes even criminal liability can follow an SEC pronouncement of unlicensed broker-dealer activity. In this article, we argue that a more rational finder regime is long overdue at the federal level. That regime should be modelled on the successful regulatory framework which is now well established in the state of California. California recognizes finders and their activities as distinct from broker-dealers. Finder registration is easy and inexpensive in California. California finder regulation is far less onerous than broker-dealer rules imposed by the SEC. They serve the purpose which the SEC so far fails to achieve: to protect small businesses and small-deal investors alike. A similar regime enacted nationwide would obviate overlapping state rules. It would serve the public’s vital interest in fostering the small-business sector, the bedrock of America’s economy.
Many small businesses walk an equity tightrope. The ability to raise investment capital can mean the difference between expansion and extinction for a small business which relies upon growth to survive. But for most entrepreneurs caught up in the day-to-day operations of their businesses, finding investors to help take the enterprise to the next level is not something they can manage alone — enter the “finder.” The function of a finder, at its most basic, is to link businesses seeking equity with investors, and the finder gets a fee in return.
Depending on how a finder performs this function, they may need to register with the U.S. Securities and Exchange Commission (SEC) and sometimes with other regulatory bodies as a broker or dealer. This process can require significant time and incur significant expense. Small businesses may need outside professional help, if they are to meet capital requirements. And sometimes the costs associated with SEC registration outstrip the finder’s own profits. As a result, many finders avoid operating in this space, or simply risk the consequences of ignoring registration.
In the past the SEC has largely failed to provide definitive guidance in this area, despite a long history of commentators raising the problem. The SEC belatedly addressed the issue of finder registration in 2020, but federal rules are often unclear. Finders can only discern their regulatory obligations by navigating a ream of cases and often-inconsistent no-action letters. At its heart, the problem is that many participants in the industry do not understand how broad the registration requirements can be or the severity of the consequences when these provisions are breached.
We believe that California, a longtime leader in venture capital investment, has implemented a more rational regime at the state level. The California regime makes a clear distinction between finder and broker-dealer activities, and provides an intrastate broker-dealer registration exemption for operators acting exclusively as finders according to state rules. In this article we aim to set forth both the current federal and the current California rules, and we argue that federal lawmakers should use California as a model for enacting a clearer and fairer regulatory framework for finders and broker-dealers alike.
Small Business and the US Economy
It is almost trite to say that funding and growing small businesses is critical to the U.S. economy. But this is more than just a political talking point. Many people are unaware of just how critical this vast and diverse sector is to the nation’s economic life. A few statistics might help –
Small businesses:
When it comes to the financing and growth of small businesses:
Because Small businesses are clearly the engine room of the United States economy, finders play a vital role in keeping us moving ahead at full steam.
2. How Does it Work?
Legislation
SEC legislation is the starting point. Registration is required for certain persons by section 15(a)(1) of the Securities Exchange Act 1934 (Exchange Act):
“It shall be unlawful for any broker or dealer which is either a person other than a natural person or a natural person not associated with a broker or dealer which is a person other than a natural person (other than such a broker or dealer whose business is exclusively intrastate and who does not make use of any facility of a national securities exchange) to make use of the mails or any means or instrumentality of interstate commerce to effect any transactions in, or to induce or attempt to induce the purchase or sale of any security (other than an exempted security or commercial paper, bankers acceptances, or commercial bills) unless such broker or dealer is registered in accordance with subsection (b) of this section.”
The term “broker” is defined in Section 3B(4)(A) of the Exchange Act:
“The term “broker” means any person engaged in the business of effecting transactions in securities for the account of others.”
Exceptions from the broker definition are detailed in section 3B(4)(B) for certain banking activities.
The term “dealer” in Section 3(5)A as:
“The term “dealer” means any person engaged in the business of buying and selling securities (not including security-based swaps, other than security-based swaps with or for persons that are not eligible contract participants) for such person’s own account through a broker or otherwise.”
Exceptions to the dealer definition include persons trading certain securities on their own account and for certain banking activities.
While the term “security” is defined broadly in section 3(10) to include notes, debentures, stock and treasury stock, derivative securities and investment contracts, some of the other terms used in the broker and dealer definitions are not defined at all. For example, the term “engaged in the business” is used extensively throughout the legislation but isn’t actually defined in either the Exchange Act or in the rules promulgated under the act. The term “effecting transactions” raises a similar issue. Despite the courts identifying this weakness on a number of occasions, there remains no concerted effort to address vague language in the legislation.
In the decision of SEC v. Kenton Capital, Ltd the U.S. District Court in the District of Columbia considered the meaning of “engaged in the business” in the context of the broker registration provisions. Several factors were examined in determining whether a person or firm was “engaged in a business”:
“’Engaged in the business’ is not defined by statute. Cases and SEC No-Action letters interpreting the phrase have indicated that regularity of participation is the primary indicia of being “engaged in the business”?.?.?. Regularity of participation has been demonstrated by such factors as the dollar amount of the securities sold.?.?. and the extent to which advertisement and investor solicitation were used.?.?. A corporation could be a broker even though securities transactions are only a small part of its business activity.” (at (12–13)).
In particular, the court found that while active or substantial solicitation is a strong indication that business is being conducted, a single, isolated case of advertising may not be enough to require registration (at 13). It is important to note that it is largely irrelevant whether or not the broker-dealer activity is only a small part of the overall business operations of a company. The legislation only requires that it be a “business.” It does not prescribe any scale or scope to trigger the registration requirement (at 13).
The “engaged in the business” test remains a live issue and continues to be used by the SEC in complaints against unregistered broker-dealers attempting to avoid registration. It is worth noting that while the SEC does not require associated persons of broker-dealers — for example, employees or independent contractors working within a broker-dealer business — to be separately registered, they must be properly supervised by a person who is registered.
Given the SEC’s broad interpretation of its powers under the Exchange Act, and the lack of clear definitions in the legislation, the steady drumbeat of opposition to SEC overreach should come as no surprise.
Finders
As discussed supra, there is currently no federal legislative definition of a “finder,” and no clear distinction between a finder and a broker-dealer. Any person or organization deemed a broker-dealer by the SEC must be registered, regardless of whether they consider themselves a finder or not. Failure to register carries significant consequences (discussed below). Thus the onus is on the finder to determine whether their activities require registration with the SEC, and yet this self-identification must be made in the absence of clear guidance.
A more consistent approach towards “success- based compensation” has emerged from recent court decisions regarding SEC no-action letters. But courts often consider these letters just one element among many in deciding whether a finder is obligated to register. Finders are bedeviled by the fact that many older no-action letters appear to conflict, containing only limited expositions of the reasoning that led courts to conclude registration was not necessary. And no-action letters can be withdrawn, even when finders conduct business under the assumption they are permanently binding.
As recent as April 2020, state regulators such as New York’s have responded to the SEC’s confusion with attempts to clarify the definition of “finder” within their own purview. But these intrastate “finder provisions” can in fact be counterproductive. Critics note the inconsistency — often significant — of finder rules from state to state. However well-intentioned, these finder provisions can create yet another roadblock for small businesses desperate for investment capital, yet ill-equipped to navigate the complexity of interstate commerce.
Exceptions to Registration Requirements
There are a few scenarios where broker-dealer registration is not required at the federal level. This article discusses some of the more common of these situations. But we cannot overstress the fundamental problem: the SEC demands strict adherence to its rules in order to avoid federal penalties, but those rules are often vague, ill-constructed, or as in the case of no-action letters, persuasive but not precedential. We strongly recommend that finders engage an attorney with competence in the area rather than merely assume they fall within the parameters of any exception.
Intrastate Broker-dealers
Intrastate broker-dealers can claim a narrow exemption to the registration requirement. A person who (a) conducts all of their business in one state; and (b) does not use a national securities exchange, does not have to register with the SEC. But this exemption leaves finders with the burden of ascertaining where all of their customers are “located” according to the guidelines of the Exchange Act. This will often require significant and costly inquiry on the part of the finder, and a significant duty of disclaimer to their clients.
Rules 147 and 147A of the Securities Act, 1933 (the “Securities Act”) provide additional guidance on the requirements of this exemption.
“Associated Persons” of Brokers
“Associated persons” of broker-dealers do not have to register, provided they are properly supervised by a registered person. Typically, employees and independent contractors are considered “associated persons.”
Business Limited to Exempted Securities
The term “exempted security” is defined in section 3(12)(A) of the Exchange Act by reference to specific classes of security. Government and municipal securities typically fall into this category. Exempted securities are not subject to the same regulations. The mere fact a security is exempt from registration under the Exchange Act does not imply that the security automatically falls within the meaning of the exemption. For example, a person selling securities under Regulation D offerings must still be registered as a broker-dealer.
A broker-dealer that deals only in commercial paper, banker’s acceptances or commercial bills does not need to register under the Exchange Act. However, broker-dealers involved with some classes of exempted securities, while not required to register as broker-dealers, may still be required to register under still other provisions of the Exchange Act.
Issuers Exemption
Issuers selling their own securities on their own account are generally not considered brokers or dealers, and so aren’t required to register with the SEC. But issuers must still take precautions regarding associated persons involved in the sale of securities on the issuer’s behalf, commonly the issuer’s employees. Associated persons should not receive commissions on the sale, and may only engage in certain delineated activities (refer to Exchange Act Rule 3a4–1).
Foreign Broker-dealers Broker-dealers
As a general rule, all broker-dealers located in the United States that are involved in broker-dealer activities — even if those activities are directed only at foreign investors — must register with the SEC. Broker-dealers located offshore must also register if they aim any of their activities at persons within the United States. The Exchange Act contains a specific provision addressing certain foreign broker-dealers that limit their activities in accordance with Exchange Act Rule 15a-6, such as effecting unsolicited transactions, certain dealings with major US institutional investors or foreign residents temporarily in the United States, among others.
3. Why is it an Issue?
It is common knowledge that small businesses struggle to attract capital, most of all during their early phases of development. Unfortunately, this is also the stage at which injecting new funds is most critical. This is why so many startups engage a finder who is familiar, not only with the capital raising process, but also with investors willing to consider early-stage ventures. The American Bar Association (ABA) has emphasized that the function of finders is critical: without their involvement, a great percentage of small businesses would never be successful in raising enough capital to survive.
The United States Small Business Administration reported that 25% of start-ups have no capital. An additional twenty percent have insufficient capital, and have reported this as the №1 roadblock to their growth and success. Statistics for start-up sources of capital reveal that 64% of startups used personal or family savings as capital, as opposed to only 18% who succeded in obtaining financing from banks or other lending institutions.
Despite repeated pleas from the small business community, the federal government has, until recently, refused to even attempt legitimizing the burgeoning role of unregistered financial intermediaries in the capital-raising process. And the ABA has stated that there is a major disconnect between the various laws and regulations applicable to brokerage activities, and the common practices employed in the vast majority of early-stage business capital raising. Businesses want the cheapest, most efficient means of raising capital, while the aim of the Exchange Act is to provide security for investors. This sets up an inevitable clash between theory and practice. The SEC’s legislative aim was set forth in SEC v. Kramer, where the court stated that:
“The Exchange Act is intended ‘to protect investors.?.?. through regulation of transactions upon securities exchanges and in over-the-counter markets’ against manipulation of share process.?.?. The broker-dealer registration requirement is of the utmost importance in effecting the purpose of the [Exchange] Act ‘because registration facilitates both discipline ‘over those who may engage in the securities business’ and oversight ‘by which necessary standards may be established with respect to training, experience and records’.”
With this protective purpose in mind, the SEC diligently scrutinizes activities that resemble operating a securities business. And the difficulty for finders lies in the fact that their activities often occupy a grey area between brokerage and mere networking.
4. The SEC’s Approach — When is Registration Required?
Reaching a generally agreed definition of “finder” can be elusive. It has been defined in academic literature as “.?.?. a person, be it a company, service or individual, who brings together buyers and sellers for a fee, but who has no active role in negotiations, and may not bind either party to the transaction.” and by the New York Court of Appeals as:
“.?.?. a finder is not a broker, although they perform some related functions. Distinguishing between a broker and finder involves an evaluation of the quality and quantity of services rendered. The finder is required to introduce and bring the parties together without any obligation or power to negotiate the transaction in order to earn the finder’s fee.”
Determining whether a particular participant in the financial markets is a true “finder” who does not need to be registered, rather than a broker who does, is often a question of degree. Merely labelling oneself “Finder” will not always negate the requirement to register. The evolving attitude of the SEC in this area may be discerned from the multitude of no-action letters the SEC has published. Although no-action letters are not legal precedent, they do carry some weight. In a footnote in the 2008 decision of Torsiello Capital Partners LLC v Sunshine State Holding Corporation, judge Herman Cahn stated:
“Securities and Exchange Commission no-action letters are prepared by SEC staff counsel; they are purely advisory and do not constitute binding precedent.?.?. However, they may be found “persuasive” in the interpretation of the federal securities laws and regulations.?.?.”
While each matter is considered on its particular facts, the SEC consistently focuses on several factors in determining whether a person is an unregistered broker-dealer rather than a true “finder.” These include:
The SEC appears to repeatedly take the stance that triggering any of these four elements can be sufficient to require registration.
1. Receipt of Transaction-Based Compensation
Any consideration in the nature of a commission, or otherwise referable to the success or number of introductions, appears to be the single most important factor that the SEC will look at when considering whether a person is a broker-dealer or a finder. In fact, this element is often specifically referred to when the SEC issues no-action letters. The importance of this element was outlined clearly by the SEC in the Partial Denial of No-action Request of 1st Global, Inc (May 7,2001):
“Receipt of transaction-based compensation related to securities transactions is a key factor that may require an entity to register as a broker-dealer.?.?. Persons who receive transaction-based compensation generally have to register as Broker-dealers under the Exchange Act because, among other reasons, registration helps ensure that persons with a “salesman’s stake” in a securities transaction operate in a manner consistent with customer protection standards.?.?.”.
If recipients of commissions are part of a corporate internal sales team, this does not negate the need to register.
It is important to note that the prohibition of receiving transaction-based compensation extends to the sharing of the commissions of a registered broker-dealer with unregistered persons, an arrangement that may be contemplated by professional advisors such as CPAs. The specific circumstances need to be carefully considered, however, as compensation related to assets under management, is unlikely to require registration.
While there are instances in which transaction-based compensation alone was insufficient to require registration, this appears to be the exception rather than the rule, and not something the SEC is likely to accept at the present time.
2. Involvement in the Securities Transaction
Commentary and attempted definitions of finders, while varying in many respects, are generally consistent in that a finder’s role is limited to facilitating introductions, and they do not have a stake in the transaction. Evidence of greater involvement in the transaction process is likely to be seen by the SEC as an indication that the “finder” is actually an unregistered broker or dealer. Such activities can include:
Ordinary tax, legal and business consulting will not usually require registration, provided there is no transaction-based compensation. The usual fixed fee or hourly/time-based charging methods are less likely to attract SEC scrutiny, while more entrepreneurial arrangements come with greater risk attached. Finders working under a variable-fee, equity, or percentage-based arrangement should seriously consider obtaining a no-action letter. t. There are instances in which courts decided that finder involvement was insufficient to require registration. Insofar as a consistent scheme can be inferred from no-action letters, the SEC appears to consider it a qualitative question, to be determined case-by-case in light of the factors discussed above. Therefore, staking one’s enterprise on the hope of getting similar treatment by the SEC — as divined from past no-action letters — is to risk an adverse finding in the individual case, together with all the attendant fallout.
3. Solicitation of Investors
Any activity that involves the solicitation of third parties is likely to be frowned upon by the SEC, particularly if it involves emailed or written material.
In SEC v. Kramer, the United States District Court in Florida considered the degree of solicitation involved in determining whether the defendant was operating as an unregistered broker. In determining that registration was not required in that instance, the Court noted that the “solicitation” was limited to discussing an investment with close friends and family and directing them to a website. However, the Court did outline a number of elements that, had they been evidenced, might have led to a different result:
All the above elements reflect an active form of solicitation. If any of these elements are present, a finder is likely to have a problem.
4. Evidence of Prior Securities Business Activity
Any evidence that the finder has previously been involved in the securities industry as a broker is closely reviewed by the SEC, under the supposition that this could be evidence of a de facto securities business. The aim of the SEC in such cases is to weed out unregistered brokers who might be “flying under the radar”. It also aims to prevent past offenders from gaining backdoor access to the industry, thereby putting investors at risk.
Risk to Finders
A principal issue for many unregistered brokers is that they have preconceived ideas of what broker-dealers are, and they do not consider themselves as falling within this category. Many do not grasp the breadth of activity that could trigger a registration requirement. Examples of individuals who could unwittingly breach the requirement include transaction lawyers, insurance agents, real estate brokers, private fund advisors, investment bankers, business consultants, investor networks and CPAs. Even some crypto assets can be deemed “securities” depending on their structure, and crypto promoters may be surprised to learn they must register as broker-dealers.
Thus it is critical for promoters large and small to obtain legal advice before they consider raising capital for another business. Failure to comply with registration requirements can trigger severe consequences. Noncompliance can cripple the ability of an entity to raise additional finance, and in some circumstances it can even lead to prison time (see below). Experienced attorneys can be vital to keeping operators and advisors informed of the SEC’s current position, as evidenced by recent no-action letters. The fact that an activity was deemed to fall outside the broker-dealer rubric in the past does not imply that the same activity will escape SEC regulation in the future.
Why Not Just Register?
Businesses who hire finders to raise capital must evaluate whether their relationship with the consultant finder complies with SEC rules in each case. The difficulty is often compounded when consultants also carry on a broader financial advisory practice, dealing with registered broker-dealers or otherwise assisting in deal structuring and receiving success fees. For agents, the question is often, “Why not just register anyway?” and similarly for small businesses, “Why not just use a registered broker-dealer?”
In answer, finders often complain of an onerous and expensive broker-dealer registration process. A 2015 presentation by Gregory Yadley, a member of the SEC Advisory Committee on Small and Emerging Businesses, outlined some of finders’ most common issues. Initial costs related to a finder’s legal, accounting and compliance needs alone often exceed $150,000, with ongoing annual costs of around $100,000. Yadley suggested that an exemption or a separate registration process could be adopted specifically for finders. Yadley noted the exceptional burden for small operators, especially when added to the usual costs of establishing a business: staff, insurance, rent, office equipment and so on.
Finders also face a major disincentive when they consider the monumental compliance obligations that will attach post-registration. These include complying with antifraud provisions to prevent misstatements or misleading omissions, complying with the duty of fair dealing, ensuring “suitability” requirements are met (that is, only recommending specific investments or overall investment strategies that are suitable for their customers), ensuring compliance with the duty of best execution (seeking the most favourable terms available under the circumstances), customer confirmation details at or before the time of completing a transaction, disclosure of credit terms where relevant, maintaining liquidity levels (generally $250,000 or 2% of aggregate debit items for those carrying customer accounts), restrictions on short sales and other trading requirements. Overall, these duties impose a significant burden upon operators who may be limited in operation to finding activities with transaction-based compensation.
Most small businesses seeking investors are looking for investments of less than $5 million. However, many of the larger brokers set floors of $25 million. This is because, in most respects, the time, risk and transaction costs to brokers are similar between smaller and larger deals. Further, an ongoing trend toward broker conglomeration means that many broker dealers who might have once worked with smaller deals have since merged with larger operators. This results in a funding gap for smaller businesses that are denied access to traditional markets, and are therefore funnelled into non-traditional streams.
The 2020 SEC Proposal on Finders
On October 7 2020, the SEC finally proposed a change that would effectively allow for a limited federal exemption for finders, provided that individuals who seek the exemption meet a strict subset of conditions. The proposed change would create two classes of finders — Tier I and Tier II finders — and would finally codify “no-action” relief for finders that fall into one of these two categories. However, given the extensive qualifications required for the exemption, the impact of the proposal in its current form is questionable: most notably, relief is only available to finders that are natural persons, and for investors that are “accredited investors.”
In order for the exemption to apply, finders in either tier must meet the following prerequisite conditions:
The permitted activities of finders that satisfy the requirements outlined in Release 34–90112 will differ depending on whether they qualify as Tier 1 or Tier 2 finders. However, both Tiers may receive transaction-based compensation without being required to register as a broker-dealer.
Tier I Finders would be limited to “…providing contact information of potential investors in connection with only a single capital raising transaction by a single issuer in a 12-month period.” Finders falling into this category may only provide names, telephone numbers, e-mail addresses and social media information regarding potential investors to issuers. Tier 1 Finders would not be permitted to have any further contact with potential investors regarding the issuer.
Tier II Finders would be able to provide certain solicitation activities on behalf of issuers. Because Tier II Finders would be subject to less restrictions than Tier I Finders, it is expected that most finders would likely seek to qualify for the Tier II exemption. However, a number of key limitations would be imposed upon their activities. Tier II Finders would only be able to: (1) identify, screen, and contact potential investors; (2) distribute issuer offering materials to investors; (3) discuss issuer information included in any offering materials, as long as the finder does not provide advice regarding the valuation or advisability of the investment; and (5) arrange or participate in meetings with the issuer and the investor.
Because Tier II finders would be able to engage in a broader range of activities, the Commission has proposed that these finders must also satisfy specific disclosure requirements. The finders must provide disclosure of:
The Tier 2 finder would also need to obtain a dated written acknowledgement of receipt of the required disclosures from the investor.
Both categories of finders would still be subject to the anti-fraud provisions of the securities laws. Also, as with other provisions of the Exchange Act, the proposal would not affect state registration requirements, and accordingly finders would still need to be conscious of applicable state laws.
The new proposal received swift criticism, with only three out of the five Commissioners then serving in support, and two dissenting Commissioners issuing public statements outlining their concerns on the same day Release №34–90112 was published. SEC commissioner Caroline A. Crenshaw argued that the proposed exemption would allow finders to engage in activities that the Commission has traditionally classified as brokerage activities, and that it would water down the significant investor protections contained in the current regime. Commissioner Crenshaw described this as a “radical departure” from established requirements. Under the proposal, for example, Tier II Finders would be allowed to directly contact investors on behalf of issuers, and even discuss offering materials with investors. These activities are typically regarded as “core” broker activities. The only limitation that the proposal provides is that the finders cannot “provide advice as to the valuation or advisability of the investment.” Critics argue that finders would have virtually no limits regarding the amount of praise and hype they could offer promoting an investment in respect of an investment, provided they do not conclude their sales pitch with a recommendation to invest.”
Commentators outside the SEC voiced similar concerns. William F. Galvin, Secretary of the Commonwealth of Massachusetts, the top securities regulator in the state, wrote in a letter to the SEC that the proposed exemption would enrich sellers seeking to skirt regulation, and would lead to inevitable conflicts of interest if and when finders are tempted to cross the line between networking and promotional activities. “While some may argue that finders are different from broker-dealers or agents of brokerage firms based on claims that they are not in the business of effecting transactions in securities, both the nature of their activities and sound policy under the securities laws call for them to be registered.” And the North American Securities Administrators Association, an industry group, summed up much of the investment community’s concern: “This is another instance in which the Commission seeks to expand the private markets with no commensurate effort either to protect investors from the evident risks of fraud, or to understand how an exemption could be abused.”
Those in favor of the proposal have argued that because it would only allow finders to solicit accredited investors, the activities permitted would not pose a threat to the investors involved. However, opponents argue that although accredited investors are presumed to require less protection than typical investors, recent studies have indicated that this is not the case and significant protection is still required. The rationale for “stripping” the protections for accredited investors while retaining them for others runs contrary to the policy evident in recent SEC publications.
Acting SEC chair Allison Herren Lee voiced another concern which many share: while supporters of Release №34–90112 have argued the proposal would benefit businesses owned by women and minorities, Lee called these arguments speculative. “The release,” Lee stated, “contains no empirical evidence supporting that supposition, and nothing in the proposed order is tailored to that purpose. It simply asserts that this change broadly applies to all businesses, large and small.” Commentators have noted that, given the sharp divergence of views by SEC commissioners on the current Release №34–90112 and the likelihood of significant comment from interested parties, the final form of any relief adopted by the SEC could be significantly different from that outlined in the current proposal.
5. What are the Consequences of a Breach?
So, why does this even matter? Why should finders follow internal debate at SEC rather than seek profit with an ask-forgiveness-not-permission attitude?
This is a question many small players in the market face: cash-strapped, mid-sized enterprises, advisors trying to expand their client base, investment firms with in-house sales teams or a range of other participants in the financial sector might wonder if the consequences of failing to register could outweigh the considerable costs. The answer often comes as a shock to issuers and finders alike: fines, disgorgement, bad actor disqualification, rescission of investment arrangements and, consequently, potential bankruptcy. The fact that the issuer or finder may not even be aware that their conduct is in violation of a law or act is largely irrelevant. The SEC requires issuers and finders to conduct “reasonable inquiry” as to whether their activities trigger the registration requirement. Failing to do so can suffice for a finding of “willfulness.”
Issuers can have a particularly tough time when it comes to deciding whether to use a registered broker or a cheaper unregistered operator to help them find capital. The fact that many unregistered finders operate openly — even advertising their service — and that neither the SEC nor FINRA have the resources to police the finder industry, makes it nearly impossible for attorneys to convince small issuers that they should avoid such entities. But however however spotty, SEC policing and enforcement is real. A review of enforcement cases by the ABA revealed that SEC enforcement of broker registration named both the issuer and the broker-dealer in suits, and often included multiple counts. SEC compliance actions can be triggered by form D disclosures of sales commissions and finder’s fees, tips from disgruntled investors or competitors and routine examinations.
Consequences for Issuers
The most common consequences for issuers using an unregistered broker-dealer are:
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Prosecution
There are two principal areas of issuer prosecution in unregistered broker-dealer actions: (1) actions for fraud; and (2) actions for aiding and abetting a breach of the Exchange Act.
Actions for fraud generally arise in the context of failure to disclose commissions paid to unregistered broker-dealers. The SEC requires disclosure of all compensation paid in relation to a capital raising under section 10(b) of the Exchange Act and Rule 10b-5. Rule 10b-5 imposes liability for making a materially false or misleading statement, or omitting material facts, in connection with the purchase or sale of securities.
In most cases, fraud claims will be brought not only against the issuing company, but also against participating officers and directors of the issuer. (For example, refer to SEC v W.P.Carey & Co. LLC et al. where the former CEO and a former Chief Accounting Officer were named as parties to the proceedings.) It is also common for the SEC to prosecute issuers under section 20(e) of the Exchange Act for aiding and abetting violations. Commentators note that it appears to be a more effective deterrent to prosecute the issuing company rather than an unlicensed person, who may be difficult to track down.
Rescission
Section 29(b) of the Exchange Act provides (in part) that contracts made in violation of the substantive provisions of the Act:
“.?.?. shall be void.?.?. as regards the rights of any person who, in violation of any such provision, rule, or regulation, shall have made or engaged in the performance of any such contract.”
In effect, this means that investors can recover their funds if they were materially misled by a broker or finder. This provision could extend to circumstances where the finder did not inform the investor that they were unlicensed, because the legislative protections an investor may have assumed were not in fact available. Section 29(b) requires an action to be brought within the later of one year from the discovery of the violation and within three years of the actual sale of the securities. Accordingly, for at least three years after using an unregistered broker-dealer, the issuer could have a contingent liability on their books and as a disclosure item. [11](12)
The operation of section 29(b) was considered by the United States District Court in the decision of Celsion Corp. v. Stearns Management Corp. In that case, Celsion Corp. sought rescission of a series of common stock purchase warrants that Celsion issued to the Stearns Mgt. Corp. and others without the assistance of a registered broker. Although the Court applied the three year time limit in deciding that rescission was not available, they did observe that rescission was a private cause of action, and that as the Exchange Act was intended to protect investors against the manipulation of stock prices, registration of Broker-dealers was of utmost importance. Celsion Corp. v. Stearns Management Corp makes it clear that but for the three-year technicality, rescission would have been available.
The case of the Neogenix Oncology, Inc. bankruptcy in 2012 is an example of the possible consequences when a party invokes their right of rescission. Following a round of financing for the start-up company, the SEC requested information related to the payment of finder’s fees paid to unregistered third parties. Management at Neogenix was unable to quantify the potential rescission liability, which could include not only investment amounts, but also interest, and it could not complete preparation of the financial statements, which in turn could not be reviewed by the independent auditor. The result of the unsigned accounts, SEC investigation and potential rescission liability, meant that the company could not raise additional funds. Chapter 11 bankruptcy became necessary. While subsequent arrangements allowed the business of Neogenix to be restructured into a clean entity, this will not always be a viable alternative for entities in similar situations. It is a costly, time-consuming activity that may result in disruption or cessation of day-to-day operations.
Disgorgement and Fines
The imposition of fines and court-ordered disgorgement can have a major impact both from a financial and reputational perspective: Who wants to invest in a business that plays fast and loose with the law?
The purpose of disgorgement actions is generally to put the perpetrator back in the position in which they would have been if the breach had not occurred. However, disgorgement can be treated as a penalty for certain legislative purposes. The Supreme Court has also acknowledged that disgorgement that does not exceed a wrongdoer’s net profits can qualify as equitable relief. This quasi-relief is left to the Exchange Act, as the legislation makes allowance for appropriate equitable relief in separate provisions from the imposition of penalties, and the specific powers of accounting and disgorgement in administrative and cease-and-desist proceedings.
The SEC generally pursues disgorgement together with other actions, such as penalties. An example is the SEC proceedings In the Matter of Edwin Shaw LLC. This case involved the sale of limited liability company membership interests in a New York taxi and livery company to foreign investors as part of the EB-5 immigrant investor program. Under the arrangement, a principal of Edwin Shaw LLC, who was not registered as a broker-dealer, marketed the interests and received an administrative fee for each successful investment, which was funded out of the investments themselves. Edwin Shaw was censured, received a cease-and-desist order in respect of future violations of Section 15(a) of the Exchange Act, was ordered to disgorge $400,000, pay prejudgment interest of $54,209.20 and received a civil penalty of $90,535.
“Bad Actor” Determination
Regulation D offerings, especially through rule 506, are a major source of capital raisings for smaller operators due to the limited regulatory burdens when compared with other types of raisings. The popularity of Rule 506(b) is bourne out by the statistics. In 2018, the amount raised by Rule 506(b) offerings was $1.5 trillion, much larger than the $1.4 trillion raised through registered offerings. More than 95% of private offerings rely on Rule 506 of Regulation D.
It is vital for smaller operators to keep the Reg 506(d) avenue open for raising funds as they grow. While several requirements must be met in order to rely on Rule 506, for current purposes there has been no “bad actor” disqualification. But one important requirement detailed in Rule 506(d) has broad application: no exemption is available if, among other things, the issuer, its predecessors, directors, general partners, managing members, certain executives and participating officers, or any beneficial owners of 20% or more of the voting equities has been convicted of offenses (or received certain specified orders from the SEC) in connections with the sale or purchase of a security, arising out of a business as a broker or dealer, or a breach of anti-fraud provisions. This means that an earlier adverse finding arising from the use of an unregistered broker may well result in losing the Rule 506 advantage. The time limit for prior convictions stretches back ten years, and given the extension of the requirement to any beneficial owner of 20% or more of the company, a prior conviction can spell disaster for a growing business which relied upon the benefit.
Consequences for Finders
Many of the consequences faced by issuers are also faced by finders, albeit in a slightly different way. Consequences include:
Prosecution and Fines
The most common prosecution is for breach of Sec 15(a) and any attendant breaches (often including fraud under section 10(b)). Case law has shown that when a prosecution is initiated against an unregistered finder, the SEC will generally pursue a range of remedies including interest, disgorgement (where appropriate — see below) and other actions.
The SEC also uses “follow on” administrative proceedings which include “administrative bars” to acting in certain capacities, such as a promoter or finder engaging in activities with brokers related to the issuing or sale of securities.
One recent example of a range of penalties imposed by the SEC can be found in the 2020 complaint SEC v. Biongiorno. The case involved defendants acting as unregistered brokers soliciting investors to buy shares in microcap issuers. The complaint alleges the defendants used aliases in soliciting purchasers, received transaction-based compensation, issued false receipts to obfuscate commissions compensation and (at least in one case) misappropriated client funds. Penalties sought by the SEC included permanent restraining orders for breaching sections including 15 and 10 of the Exchange Act, a prohibition from directly or indirectly soliciting for the sale or purchase of securities (or owning a company that does the same), disgorgement of funds on the basis of unjust enrichment, and civil penalties.
A key takeaway from recent cases is that while monetary penalties can be significant, the real sting comes in the form of the administrative actions: an administrative bar can effectively end a finder’s business, and any further involvement in the securities industry.
Disgorgement
As discussed in the “issuer” section above, disgorgement of gains obtained through unlawful or unjust means is a common remedy pursued by the SEC, particularly where a matter involves fraud (specifically Section 10(b) of the Exchange Act and Rule 10b-5). There are numerous examples of such penalties, and it is worth noting that even persons not directly involved in fraudulent activities can still be required to disgorge funds. The following matters involve a number of significantly different factual scenarios where disgorgement was considered appropriate.
The 2013 Administrative Decision of In the Matter of Ranieri Partners, LLC. et al involved charges against a New York based private equity firm (Ranieri Partners), a former senior executive and an associate who was operating as an unregistered broker-dealer (actively soliciting investors, receiving transaction-based compensation, sending documentation to potential investors and providing confidential information related to other investors). There was no allegation of fraud. The consequences for the “finder” (unregistered broker-dealer) were several administrative measures including a cease-and-desist order, and bars on association with certain financial industry participants. The court also ordered disgorgement of more than $2.4 million and prejudgement interest. The disgorgement amount was referable to the amount of transaction-based compensation received by the unregistered broker-dealer.
A very different arrangement was involved in the case of In the Matter of Retirement Surety LLC et al. In that case, approximately $11 million in nine-month promissory notes were issued by a number of non-registered persons, for which they were paid 5% commission. When the issuer failed to pay investors under the promissory notes, it engaged the unregistered brokers to contact investors and procure forbearance agreements for which the brokers received an additional 4% commission. While the forbearance agreements were not securities per se, the profits from extending the terms of the notes were viewed as derivative of the original unregistered sales, and accordingly the additional commission was included in the disgorgement amount.
In the matter of SEC v. Hidalgo Mining Corp., et al, Hidalgo sold investment contracts through a sales team and two principals to investors, raising approximately $10.35 million. The contracts were unregistered securities. Neither the company officers nor any of the sales staff were registered as broker-dealers. The staff generally received 10% commission on sales, however there was no disclosure to investors regarding any commissions. The matter was settled with permanent injunctions, civil penalties, prejudgment interest and disgorgement of the commissions by both the company and the principals.
Rescission and Return of Fees
As detailed above, section 29(b) of the Exchange Act makes contracts voidable at the option of the innocent party, provided the innocent party adheres to the strict timelines prescribed by the act (three years from the offense or one year from the date of discovery of the violation). Courts have applied section 29(b) not only to contracts that violate the terms of the Exchange Act directly, but also to cases where the means of performing the contract involve a violation, such as the use of an unregistered broker.
The consequences of rescission for an unregistered broker-dealer could include a requirement to return commissions, fees and expenses, or, where payment has not yet been made by the issuer, a refusal to pay in accordance with the agreement.
The consequences of a rescission under section 29(b) come into focus in the unreported decision of Torsiello Capital Partners LLC v Sunshine State Holding Corporation, where the Supreme Court of New York considered Section 29 of the Exchange Act, and the return of a retainer fee on the basis of “unjust enrichment”. Sunshine engaged an advisory firm, First International, to provide advice and banking services for a private placement of Sunshine’s securities. First International prepared documents to assist with the security sale, made calls to potential investors and held meetings. These efforts were not successful, nor were the finders registered brokers. When the shares were later sold, First International and Torsiello, as affiliates and successors in interest, sought to enforce the original contract, which carried a retainer of $50,000 and a fee of 3.5% of the purchase price. The Supreme Court found in favour of Sunshine on the basis that the contract was voidable pursuant to Section 29(b), and the retention of the retainer would comprise unjust enrichment. The Court stated at (18):
“As discussed at length above, the contract is void ab initio by virtue of the plaintiff’s lack of registration as a securities broker with the SEC and, therefore, the contract has been rescinded. Therefore, Sunshine is entitled to the return of the $50,000 retainer fee.?.?.”
Where the question of unjust enrichment arises, it is important for unregistered broker-dealers to understand that family members in receipt of the funds may need to return monies on the basis of unjust enrichment, notwithstanding they were not parties to the securities law violations. An example of this is found in the 1993 case of SEC v. Antar, which involved an action against the wife and children of an offender under circumstances where there had been no securities law violations on their part. Rather, the action against them was for their possession/custody of proceeds from Mr. Antar’s sale of stock, which had been made in violation of the securities laws.
The key principles in cases of this type were outlined by the Court:
“.?.?. the touchstone is whether the non-party’s claim to the property is legitimate, not whether the party is innocent of fraud or wrongdoing.” (at 399), and
“The nominal defendants cannot keep money that is not theirs.?.?. Unjust enrichment is present here. The nominal defendants should not be allowed to retain funds that are the products of Eddie Antar’s securities fraud. Their enrichment came at the expense of defrauded investors.” (at 402)
The key teaching is that rescission carries consequences not only for the unregistered broker-dealer, but potentially for their family as well.
6. What do You Need to do?
These and other cases demonstrate that the consequences of breaching the registration requirements of the Exchange Act can be devastating for both finders and issuers. The following steps outline a process for protecting finders and their clients from inadvertent breaches of the law.
Step 1: Gathering Facts
The single most important step is to ensure a grasp of the relevant facts and circumstances?. The authorities clearly demonstrate that the registration requirement is a fact-driven question: what is done — or proposed to be done — and how will it be carried out?
Preliminary issues:
Step 2: Consider the Specific Facts in Light of s.15
Analysis is necessary after fact-gathering to determine whether the proposed activities will result in a requirement to register, or could be interpreted as such by the SEC. Specifically, the questions of transaction-based compensation, involvement in the transaction and solicitation need to be considered.
Transaction-Based Consideration
This is the principal issue that needs to be addressed. There is likely no breach of this requirement where the finder:
Any form of transaction-based compensation is likely to trigger action by the SEC if they become aware of it.
Involvement in the Transaction
The cases and no-action letters discussed in this paper provide clear guidance that any involvement in the transaction itself is considered to be activity of a broker-dealer and will require registration. Accordingly, a finder should not:
Active Solicitation
The role of the finder is to facilitate introductions rather than convince investors that a particular investment is appropriate for them (the “salesman’s stake” referred to by the SEC). Accordingly, a Finder should:
Step 3: If Uncertainty Remains
After the gathering of facts and analysis in light of Section 15 of the Exchange Act, there may still be uncertainty around registration requirements, especially in more complex arrangements. In such cases, seeking advice from an attorney experienced in securities law is probably necessary.
The consequences of breaching the registration provisions are severe. If there is any doubt, it is worthwhile to register or to reconsider the services on offer (for a finder) or considering using a registered broker or a finder with a limited suite of services (for an issuer).
6. California: A More Rational Regime
The difficulties finders confront are not new. The SEC is well aware that market participants are forced to make a hard choice: either face expensive, laborious registration — and expensive, laborious compliance duties thereafter — or run the risk of harsh penalties in a regulatory system that lacks clear guidelines. It is encouraging that the SEC has finally circulated a proposal, however flawed, for finder exemption. But the fact remains that the exemptive order proposed in 2020 received only limited support from the Commissioners, and it triggered considerable pushback from the investor side of the industry.
Those states which implemented their own legislative fixes seek to remedy the SEC’s vague definition of broker-dealers and silence on the topic of finders. California’s and Texas’ efforts in particular demonstrate the weight of the issue; if they were sovereign nations, California and Texas would be the fifth- and tenth-largest economies in the world, respectively, by gross product, and they represent tens of billions of dollars in venture capital investment each year. These As previously noted, iPassed in 2015, California Corporations Code Section 25206.1 creates a rational regime for distinguishing finders from broker-dealers, registering finders as defined under the law, and regulating finder activities and compliance.The California model is not above critique. Nevertheless, it is more precise than the SEC regime, and it has garnered demonstratively better results since it went into effect.
We argue (1) the SEC must codify a more rational definition of “finder” and finder activities than those proposed in Release №34–90112; (2) thus identified, finders must be exempt from SEC broker-dealer registration so long as they adhere to new SEC guidelines; and (3) the SEC should use California as a model for drafting and implementing these changes. A more rationalized finder regime implemented at the federal level will foster small business growth, and provide small businesses with a wider range of options to raise capital, particularly outside the realm of homogenized, big-deal oriented institutional lenders.
California’s Finders Regime
California was long aware of the difficulty small businesses face in raising capital. The impetus for passing California Corp. Code Section 25206.1 was the longstanding problem of raising capital for small businesses. The provisions seek to solve this issue by allowing unregistered persons to legally act as finders, subject to a clearer set of conditions than the broker-dealer registration requirements imposed by the SEC.
History of California Corporations Code Section 25206.1
In April 2013, Assemblyman Donald Wagner first proposed a bill that sought to clarify the provisions for “finders” operating within California. The bill would have allowed any person who met specific requirements to be classified as a finder, instead of a broker-dealer. The bill failed at that time. Its failure was largely due to cost concerns, as it imposed lower fees upon finders than the current statute. As a result, the bill died in the Senate Appropriations Committee. Wagner presented a substantially similar bill in 2015. This time the bill passed without opposition. The bill became California’s new finder statute, Section 25206.1.
Prior to the passage of the finder statute, and similar to the federal position, California only permitted registered broker-dealer firms to receive compensation for connecting an investor with an investment opportunity. At that time the only protection an investor had against an unregistered broker-dealer was Corporations Code Section 25501.5, which allows a person who “purchases a security from or sells a security to a broker-dealer that is required to be licensed and has not, at the time of sale of purchase?.?.?. to bring an action for recission of the sale or purchase, if the plaintiff or defendant no longer owns the securities.”
The stated purpose of Section 25206.1 was to eliminate the risks for issuers and investors who raised capital through finders by clearly defining the limits and bounds of a finder. The sponsors of the bill recognized that:
“Under current law?… the scope of permitted activities for a finder is poorly defined, often resulting in inadvertent violations of broker-dealer registration requirements. In fact, there is no statutory definition of finder, nor is there any regulation of finders. This lack of clear guidance puts finders and the businesses that rely upon them for crucial funding in jeopardy. It also impedes the State’s ability to regulate finders and to hold them accountable.”
The bill passed through the Senate Committee on Banking and Financial Institutions with no opposition in June 2015. The committee members unanimously supported imposing regulatory requirements upon finders to “… ensure better market transparency, proper accountability, and additional investor protection while at the same time facilitating capital formation for business entities in California.” The bill also passed through the Senate Rules Committee with no opposition.
However, the Senate did make two amendments. The Senate requested that the bill should expand the commissioner’s authority to make, amend, and rescind rules in order to carry out the provisions. The Senate also amended the bill to ascribe the commissioner the power to “classify securities, persons, and matters within his or her jurisdiction and prescribe different requirements for different classes.” Thus, the following text was added to the bill:
“The commissioner may from time to time make, amend, and rescind such rules, forms, and orders as are necessary to carry out the provisions of this law, including rules and forms governing applications and reports, and defining any terms, whether or not used in this law, insofar as the definitions are not inconsistent with the provisions of this law. For the purpose of rules and forms, the commissioner may classify securities, persons, and matters within his jurisdiction, and may prescribe different requirements for different classes.”
The bill created a regulatory framework to govern the activities and accountability of finders, and to create statutory and regulatory certainty for finders and the businesses that rely upon them.
The California legislature hoped that the bill would encourage persons who act as finders to comply with the bill’s requirements by creating an outline that clearly distinguishes allowable finder activities from those which do not meet the bill’s definition. The proposed value of the bill to those who follow its parameters is the assurance that they will not need to obtain a broker-dealer license. However, those who do not meet the bill’s definition may still require licensing as broker-dealers.
California was not the first state to enact legislation dealing specifically with finders. A number of States, including Texas, Michigan, and Minnesota, have also enacted finder legislation. It is noteworthy that both the Texas and Michigan finder’s legislation are relatively similar to the California law in that they place substantial limits upon the activities in which a finder can engage, and this approach appears to have been adopted in SEC Release №34–90112. The position in Michigan is somewhat different, and requires a person defined as a “finder” under Michigan law to register as an investment advisor and limits the person’s activities to “…locating, introducing, or referring potential purchasers or sellers.” Texas similarly only allows finders to participate in the introduction of accredited investors.
The California finder’s statute got mixed reviews. The new law created a conflict between California law and the current policy of the SEC. Those who supported passage believed that the requirement that all parties must reside in California would ensure that the SEC would turn a blind eye to the exemption. However, critics of the law argue that the new law is just as cumbersome as the SEC rules, making it still less likely to be utilized as intended. The law imposes many conditions, including both reporting and filing obligations, upon finders, and those failing to follow the strict requirements are still subject to the same penalties as unregistered broker-dealers. Additionally, the exemption seeks to prohibit the activities of a true finder. Finders are not allowed to participate in the offering through “negotiating, advising or making any disclosures to the potential purchaser other than very limited information.” Because section 25206.1 is so extensive, many critics doubt that it will help solve the problems that it was enacted to fix.
Goals of Section 25206.1
Section 25206.1 was enacted to create “regulatory certainty for finders and business owners, by codifying a set of activities that will be legal when performed by a person without a broker-dealer’s license, who meet the bill’s definition of a finder.” Prior to the statute, there was much uncertainty at the State level regarding the activities a person without a broker-dealer’s license could legally perform. As with the Federal regime, most of the confusion has stemmed from the fact that the law has not previously defined “finders” as a separate class of persons.
As finders are an “essential component of an efficient capital market,” providing a clear definition of what a finder is and what activities he or she may engage in was thought to ensure: “greater accountability, investor protections, and regulatory oversight.”
Greater Accountability
One of the primary purposes of the law was to clear up ambiguities surrounding finders, thus enabling the State to hold finders accountable. In the past, the lack of clear guidance regarding finders had caused businesses to inadvertently put their businesses in jeopardy when seeking capital. The aim of the clarification provided by Section 25206.1 was to increase the accountability of both businesses and finders.
To start, Section 25206.1 defines a “finder” as
“a natural person who, for direct or indirect compensation, introduces or refers one or more accredited investors?.?.?. to an issuer?.?.?. solely for the purpose of a potential offer or sale.”
Section 25206.1 also establishes a framework of requirements for “finders” to legally receive transaction-based compensation in California. First and foremost, in order for the exemption to apply, the issuer, the finder, and the investors must all be located in California. Second, prior to engaging in any activities relating to securities transactions, the finder must file an initial statement of information and pay a $300 fee. The statement of information must include:
In addition, the finder will be required to file a renewal statement with the Department of Business Oversight and pay a $275 fee.
Finally, the finder must act within a very strict subset of rules detailed in the statute. It is important for businesses to understand the legal limits of finders within California because they too can be penalized if the finder chooses to act outside of the permissible bounds. The following restrictions apply to finders in California:
Finders are also required to adhere to strict disclosure rules when providing information to potential investors. Finders are only allowed to disclose the following information:
The finder also has the obligation to keep all records for transactions in which he participated as a finder for a period of five years.
If the finder fails to follow any of these requirements or restrictions, he or she is no longer eligible for the exemption and will be subject to the somewhat harsh penalties imposed by the SEC upon those who are operating as unregistered-broker dealers.
Investor Protection
Providing “clear guidance for finders and the businesses that rely on their services,” is essential to ensuring that businesses are protected. In the past, the lack of clear guidelines has caused businesses and finders alike to become subject to penalties through inadvertent violations. Small businesses often relied on finders engaged in technically illegal broker-dealer conduct, which exposed them to a risk of severe consequences. As noted above, from both an economic and social perspective, finders are often the only option available for small business issuers to attain the capital they need to expand their businesses. Section 25206.1 seeks to provide the investor the assurance and protection necessary for businesses to confidently utilize finders without fear of repercussion.
Regulatory Oversight
The sponsors of the bill hoped that a new regulatory structure would incentivize unregistered persons to register as finders and thus bring previously unregulated activity within California’s control. By creating a specific class of person and defining a subset of regulated activities for “finders,” the Department of Business Oversight (“DBO”) has regulated finders who may previously have avoided oversight.
Federal Preemption and the New California Exemption
Finders operating under the California exemption must be wary of the fact that the SEC still has not changed its stance on unregistered persons receiving transaction-based compensation. Thus, the exemption applies only to transactions in which the issuers, finders, and investors all reside and transact within California. The law does not provide relief from the SEC’s strict policies nor does it exempt finders from adhering to every other state’s broker-dealer requirements.
Furthermore, it is possible that the SEC could take the position that the federal preemption doctrine applies, and they could prosecute a California finder paid lawfully under State law. In addition, there remains the possibility that this state statute could be challenged and overturned in federal court. Outside of California, the finder will still be considered an unregistered broker-dealer in violation of Section 15(a) of the Exchange Act. As a result, both the finder and issuer could be subject to the significant penalties available to Federal regulators.
Until the SEC changes its current policy on finder’s fees, both issuers and finders run the risk of being penalized by the SEC for any transactions that occur outside of California.
A Model for a New Federal Regime
If the federal experience with unregistered finders tells us anything, it is that the current regime is clearly not working. The fact that no statutory definition of “finder” even exists under the Securities Exchange Act reflects an antiquated system which lags behind the rapidly-changing investment market it purports to regulate. The amalgamation of smaller broker-dealers into larger operators means that servicing smaller businesses is less attractive for big-deal investors, while the need for new capital by growing companies remains. This leaves many cash-strapped smaller businesses with a simple, unenviable choice: engage with an unregistered broker-dealer and run the risk of dire consequences, or face bankruptcy. As commentators and the numerous cases referenced in this paper attest, many growing businesses continue to choose the former.
It doesn’t have to be this way. The SEC’s tentative recognition of the finder vs. broker-dealer distinction, and of the need to exempt some finders from broker-dealer registration, could pave the way for a more rational federal model. That model should be California. California’s finder regulation has been operating successfully for half a decade, and the fact that Texas and Michigan finder laws share such similar provisions to California’s demonstrates that a California Corporations Code-based model could have successful nationwide application. Many commentators acknowledge that it is far less onerous and expensive compared to broker-dealer registration with the SEC. The very specificity of California’s finder criteria should be considered a selling point. Their clear guidelines free operators from the cost of residual uncertainty — the “worry cost” — that finders face within the federal regime.
While California’s provisions are not above improvement, they provide a working model which should serve as a template for the SEC. California balances the dual policy objectives of providing investor protection through oversight, and facilitating capital investment in the small businesses and startups that help to make California the economic dynamo it is today: the №1 state for venture capital investment in the nation. Under a rationalized regime, free from broker-dealer restrictions, finders and the small businesses they support can thrive.
In short, finders, keepers.
*Via Bradshaw, Morgan, Smythe et al., NEW YORK UNIVERSITY JOURNAL OF LAW & BUSINESS VOLUME 19 FALL 2022 NUMBER 1.