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April 29‚ 2011
Using Finders to Assist in Financings Can Impose
Significant Risks on Your Company
By Steve Ganis,
Jeremy D. Glaser,
and Jake Romero
You have a great new idea and you need capital in order to
build your new company. Unfortunately, finding venture capitalists or high
net worth “angels” who may be interested in investing in your business is
not an easy task. Like many entrepreneurs who find themselves in this
predicament, the idea of retaining a “finder” to assist you in locating potential
investors can look promising. However, using a finder who is not a
registered broker/dealer can create significant risks for your company.
In this article, we provide a brief summary of liabilities
and penalties that may result from the use of an unlicensed broker-dealer,
as well as guidelines for companies considering using professionals to
assist in fundraising. We also provide guidance to individuals or entities
attempting to safely operate as finders. It is important to note, however,
that the interpretation of the Securities and Exchange Commission (SEC)
regulations is broad and often difficult to apply. We recommend that you
consult with your legal counsel before retaining any individual or entity
to assist in fundraising or acting as a fundraiser.
Potential Risks
for Your Business
Using an unregistered broker-dealer to assist with the sale
of securities may create a rescission right in favor of the purchasers of
the securities, potentially requiring the issuing company to return the
money it received for its shares, under both federal and California
securities laws. Section 29(b) of the Exchange Act provides that every
contract made in violation of the Exchange Act, including contracts for
which performance under the contract is a violation of any of the Exchange
Act provisions, shall be void as to “any persons who, in violation of any
such provision, rule or regulation, shall have made or engaged in the
performance of any such contract.”
While Section 29(b) creates risk for the individual operating
as the finder, potentially allowing the issuer company to claim its
obligations to the finder under the finder’s engagement agreement to be
void, the language is broad enough that it can also be interpreted to void
the contract for the sale of the securities to investors located through
the use of the finder. If investors successfully assert this claim, they
would have the right to demand that their purchase contract be rescinded
and require the issuer company to return their funds. This potential rescission
right can have a significant negative impact on a company’s ability to
raise funds in the future because under federal law the rescission right
can be exercised until the later of three years from the date of issuance
of the securities or one year from the date of discovery of the violation.
In recent transactions for clients seeking venture capital financing, the
potential of a rescission right in favor of prior angel investors in a
company that used finders who were not registered broker-dealers has raised
serious impediments to the closing of the venture financing.
In addition, many states also regulate the registration of
broker-dealers. For issuers and purchasers located in California, for
example, a rescission right is explicitly available pursuant to California
Corporations Code section 25501.5, enacted by the legislature in 2005,
where securities are sold to or purchased from an unregistered
broker-dealer. Section 25501.5 also provides that the purchaser can seek
damages if he or she no longer owns the security, and gives the court
discretion to award a plaintiff seeking rescission attorney fees and costs.
Even if rescission is not demanded by prior investors, the
use of an unregistered broker-dealer in a prior transaction will create
disclosure requirements in subsequent financings, acquisitions, or
offerings. SEC filings require disclosure of compensation paid to finders
in connection with an offering, as do many state blue sky filings. Such
disclosure may dissuade future investors from investing and may prevent
your legal counsel from being able to issue required legal opinions in
connection with a subsequent financing. In addition, failing to disclose
payments made to unregistered broker-dealers in connection with the sale of
securities can expose a company to potential liability for fraud under
Section 10b-5 of the Securities Act.
In March 2008, for example, the SEC announced the settlement
of fraud charges brought against W.P. Carey & Co., as well as the
company’s chief financial and accounting officers, for failing to disclose,
and later mischaracterizing, compensation paid to a broker-dealer in
connection with issuances of securities.1
The settlement, which included a number of other claims in addition to
the failure to disclose, resulted in millions of dollars in fines,
disgorgement, and interest, as well as a five-year ban preventing the
former Chief Financial Officer (CFO) from serving as an officer or director
of a public company. Given the overlapping nexus of state regulation,
similar claims could potentially be brought by investors seeking
rescission. Further, there is some risk that the failure to disclose the
very fact that a finder is not registered as a broker-dealer might itself
be characterized in regulatory enforcement or private litigation as a
misleading omission that amounts to fraud.2
As the SEC steps up its enforcement of regulations requiring
registration of broker-dealers, it is also worth noting that issuer
companies who engage unregistered broker-dealers and finders may also find
themselves subject to SEC action pursuant to Section 20(e) of the Exchange
Act for aiding and abetting a violation.3
In addition, if a private fund manager is newly required to
register as an investment adviser under the Dodd-Frank Wall Street Reform
and Consumer Protection Act and engages a finder, then strict disclosure
requirements about the solicitation arrangements will apply pursuant to the
Investment Advisers Act of 1940 Rule 206(4)-3.
Finally, by utilizing a finder, an issuer company also runs
the risk of eliminating potential securities registration exemptions under
federal and state law, particularly if the company is not extremely vigilant
in monitoring the activities of the finder. Actions by the finder, such as
approaching unaccredited investors or engaging in general solicitation, can
ultimately prevent the issuer from obtaining an exemption under Federal
Regulation D or Section 25102 of the California Corporations Code.
Identifying
Unregistered Broker-Dealers
Determining whether a finder is considered a broker-dealer
under the Exchange Act can be difficult, but a number of factors provide
guidance. The Exchange Act defines a “broker” as “any person engaged in the
business of effecting transactions in securities for the account of
others.” 4 This
definition is typically interpreted broadly, and includes such activities as
providing advice regarding the value of securities, locating issuers,
soliciting new clients, assisting in the structuring and negotiation of
securities transactions, and disseminating quotes for securities.5 Section 15(a)(1)
of the Exchange Act provides that “[i]t shall be unlawful for any broker or
dealer … to induce or attempt to induce the purchase or sale of, any
security … unless such broker or dealer is registered” with the SEC. Given
the broad nature of the of the broker-dealer definition, some finders may
not realize that their activities have triggered a registration
requirement. Below is a list of questions you should ask in assessing your
risks if you are considering retaining a finder:
·
Does the finder receive transaction-based compensation?
Often finders will prefer to receive compensation based on a
percentage of funds raised by the company. In addition, companies prefer to
pay finders only if they are successful in helping to raise capital.
However, this type of transaction-based compensation creates a substantial
likelihood that the finder would be viewed as a broker-dealer and would be
required to register because the SEC considers transaction-based
compensation to be a key factor in determining if someone is acting as a
broker-dealer.6
It is important to note that the amount of compensation,
either objectively or in relative comparison to the finder’s total income,
is irrelevant for purposes of determining whether registration is required.
Therefore the finder can be considered to be “in the business” of effecting
transactions (as used in the definition of “broker” above) even if the
transaction-based compensation is a small part of the finder’s total
income.7
The SEC has elected not to take action against the
presumptive broker-dealers under circumstances where transaction-based
compensation is not present.8
In addition, the SEC has recently indicated that the use of finders may
be allowed, even where such finder’s compensation is transaction-based,
where the party acquiring securities is purchasing 100% of the outstanding
securities of a business as a going concern. The SEC staff issued a
no-action letter to indicate that the staff would not recommend to the
commission that the SEC undertake enforcement action with regard to Country
Business, Inc. (CBI), where CBI represented (among other factors) that (1)
it will have a limited role in negotiations between the seller and
purchaser, will not advise either party, and will not assist the purchasers
in obtaining financing; (2) the sale in question will be structured as a
sale of 100% of either the assets or security interests of the business to
a single purchaser, but only the sale of assets would be advertised; and
(3) CBI’s compensation will be “determined prior to the decision on how to
effect the sale of the business, will be a fixed fee, hourly fee, a
commission, or a combination thereof, that is based upon the consideration
received by the seller, regardless of the means used to effect the
transaction and will not vary according to the form of conveyance (i.e.,
securities rather than assets).”9
While transaction-based compensation would typically trigger a
registration requirement (as discussed above), the CBI no-action letter
suggests that transaction-based compensation by unregistered finders is
still permissible in limited circumstances in connection with an
acquisition or merger, where the terms of such compensation are pre-set and
not dependent upon the manner in which the transaction is effected and the
finder is advertising a target company as a going concern, rather than
securities.
·
Does the finder engage in solicitation of potential investors?
The solicitation of potential investors weighs in favor of
requiring registration. However, whether an intermediary is engaged in
“solicitation” can be a difficult determination because solicitation can
take any number of forms. Generally, a solicitation can be any action that
is designed to incentivize or persuade another person to purchase the
security. Activities as general as newspaper advertisements or as targeted
as individually-addressed e-mails may constitute solicitation.10
The SEC has recently indicated in a denial of a no-action
relief that the introduction of investors “who may have an interest” in a
securities investment implies “both ‘pre-screening’ potential investors to
determine their eligibility to purchase the securities, and ‘pre-selling’
[the] securities to gauge the investors’ interest.”11 Both the pre-screening and
pre-selling are apparently broker-dealer functions requiring registration
in the SEC’s view.
·
Does the finder provide advice or engage in negotiation?
Providing advice, particularly with regard to the value of
the securities involved, or assisting the investor in negotiating the terms
of the sale of the securities will bring the finder within the definition
of a broker-dealer. This may also be the case even if the intermediary is
performing a “due diligence” function of providing detailed information on
the issuer to the investor. For an intermediary’s participation to fall
reliably outside the definition of a broker-dealer, the intermediary’s
involvement should not go beyond the “ministerial function of facilitating
the exchange of documents or information.”12
·
Does the finder have previous securities sales experience or
have a history of disciplinary action?
The SEC is concerned that persons who have been barred from
engaging in the purchase or sale of securities will attempt to operate as
“finders” in order to evade registration requirements. As such, a finder’s
prior experience in dealing securities and, in particular, any prior
disciplinary action by the SEC, can trigger registration requirements even
when other factors listed above are not present.13
Risk and
Guidelines for Intermediaries Acting as Finders
Finders operating as unregistered broker-dealers may be
subject to a number of penalties, the most typical of which is a permanent
injunction barring such finder from participating in the purchase or sale
of securities. However, the SEC has the power to impose more severe
sanctions, such as disgorgement of funds and civil penalties. While
historically such harsher penalties have generally been associated only
with those cases in which fraud is also present, this is no longer the
case. In April 2008, the SEC sanctioned Robert MacGregor, an employee of
Duncan Capital who specialized in arranging private investments in public
entities, for acting as a broker-dealer without proper registration.14 The action against
MacGregor was brought specifically in response to MacGregor’s failure to
register as a broker-dealer. The final judgment against MacGregor, absent a
finding of fraud, not only barred MacGregor from associating with any
broker or dealer for one year, it also required that MacGregor disgorge any
“ill-gotten gains” that resulted from the transactions.
Furthermore, as noted above, finders may be unable to collect
fees under their engagement agreements with issuers. In 2008, the Supreme
Court of New York County in New York denied relief for an unregistered
broker dealer who sued to collect fees owed under a contract with an issuer
for brokerage services.15
The fees owed under the contract were calculated as a percentage of the
investment dollars raised with the finder’s assistance. The court held that
the agreement was void and rescindable because the finder was providing
services associated with a broker-dealer, but was not a registered broker.
Summary
Particularly in a tight capital market, finding willing
investors can be difficult and time- consuming. It is important to
remember, however, that the long-term success of your business may be at
stake if you choose to engage an unregistered broker-dealer. Transactions
in which compensation is provided to an unregistered broker-dealer can make
raising subsequent rounds of financing more difficult, make your business a
less desirable target for acquisition, and potentially expose you and your
company to penalties. If you are considering working with a finder,
consultant, or other type of intermediary to assist in your fundraising
activities, we suggest that you first seek the advice of corporate counsel.
* * *
Mintz Levin attorney Daniel I. DeWolf also contributed to this alert.
Click here to view Mintz Levin’s Corporate &
Securities professionals.
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& Emerging Companies professionals.
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professionals.
1 See,
SEC Litigation Release No. 20501, also available at http://www.sec.gov/news/press/2008/2008-45.htm.
2 Torsiello Capital Partners v.
Sunshine State Holding Corp., 2008 NY Slip Op. 30979, April 7, 2008.
3 As noted by the ABA, in most
typical cases the SEC will urge registration and take no further action,
provided that such request is complied with. However, where fraud or
misrepresentation are present, the SEC generally brings multiple counts,
“including violations of the registration provisions for the securities
themselves as well as violating the requirement that a broker-dealer be
registered.” Id. at 36.
4 Securities Exchange Act of
1934 § 3(a)(4)(A).
5 See, SEC No-Action Letter
re: InTouch Global, LLC, November 14, 1995.
6 Supra note 1, at 17, citing
SEC No-Action Letter re: Mike Bantuveris, October 23, 1975 (“The staff
noted that its opinion was ‘based primarily on the fact that the consulting
firm would . . . receive fees for its services that would be proportional
to the money or property obtained by its clients and would be contingent
upon such transactions in securities.”). See also, SEC No-Action
Letters re: Nemzoff & Co., LLC, November 30, 2010; Brumberg, Mackey
& Wall, P.L.C., May 17, 2010; John w. Loofburrow Associates, Inc., June
29, 2006; Wolff Juall Investments, LLC, May 17, 2005
7 Supra note 1, at 17. See
also, SEC No-Action Letters re: Herbruck, Alder & Co., June 4,
2002; Mike Bantuveris, October 23, 1975); John M. McGivney Securities,
Inc., May 20, 1985; Richard S. Appel, February 14, 1983.
8 See, SEC No-Action
Letters re: Putnam Investor Services, Inc., December 31, 2009; Goldman,
Sachs & Co., January 17, 2007; TriNet Group, Inc., February 17, 2006;
CommandTRADE, LP, December 28, 2005.
9 SEC No-Action Letter re:
Country Business, Inc., November 8,
2006.
10 Supra
note 1 at 19, citing SEC v. Schmidt, Fed. Sec. L. Rep. 93,202
(S.D.N.Y. 1971). See also, SEC No-Action Letters re: Nemzoff &
Co., LLC, November 30, 2010; Hallmark Capital Corporation, June 11, 2007;
Mike Bantuveris, October 23, 1975; Victoria Bancroft, August 9, 1987; and
F. Willard Griffith, II, October 7, 1974.
11 SEC No-Action Letter re:
Brumberg, Mackey & Wall, P.L.C., May 17, 2010.
12 SEC
No-Action Letter re: Samuel Black, December 20, 1976. Compare, SEC
No-Action Letter re: The Investment Archive, LLC, May 14, 2010 (relief
granted where intermediary represented that it will not participate in
negotiations between parties, assist investors with the closing of the
transaction, or handle, receive or direct funds. See also, Goldman,
Sachs & Co., January 17, 2007.
13 Supra note 1 at 20. See
also, SEC No-Action Letter re: Rodney B. Price and Sharod &
Assocs., November 7, 1982.
14 SEC
Litigation Release No. 20535, April 23, 2008, available at http://www.sec.gov/litigation/litreleases/2008/lr20535.htm.
15 See Supra note
2.
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