A_Ledbetter_LR.jpgCONTRIBUTED BY
Andrew Ledbetter
andrew.ledbetter@dlapiper.com

For a variety of reasons, many emerging companies are not in a position to easily identify venture capital funds, banks, or angel investors from whom to raise money or to identify a potential acquirer for their business.  Publicly soliciting investors in a registered offering might involve prohibitive costs and an uncertain outcome.  The entrepreneur may not have adequate personal wealth to fund the company, not be fortunate enough to have rich relatives or friends, or not be looped in to the right circles to meet financially sophisticated potential investors.  Such small businesses sometimes turn to “finders” to help them locate potential sources of financing or acquirers.

What is a “Finder”?

Defining a “finder” is difficult.  This report of an ABA Task Force on Private Placement Broker-Dealers describes a “finder” as a person who:

  • brings together buyers and sellers for a fee;
  • who has no active role in negotiations;
  • who may not bind either party to the transaction; and
  • who may not offer or sell or buy the security.

Legitimate finders should strictly be intermediaries who merely introduce parties and then step back.  However, giving the finder a fee, which is commonly tied to a successful closing, can often create an incentive for the finder to do more.  This can raise challenging legal issues under the securities laws.

When do “Finder” Activities Cross the Line and Become Illegal?

Under both federal and state law, a securities “broker” or “dealer” (referred to collectively under most state laws as a “broker-dealer”) generally includes any person:

  • “engaged in the business” of
  • “effecting transactions” in securities for compensation. 

These terms are not defined and are usually interpreted broadly.  Whether a person is acting as a broker-dealer can be a difficult legal question that necessarily varies with the facts and circumstances.  It is often said that a hallmark of being a broker is receiving “transaction-based compensation,” such as a success fee paid only at closing or a commission tied to the amount of funds the finder brings to the company.  Being a broker also involves material participation in securities transactions, such as:

  • actively soliciting investors;
  • being involved in negotiations or in structuring the transaction;
  • advising investors about the company; and
  • holding funds or securities or otherwise being involved in the sales/closing process. 

When a finder has crossed the line into conducting brokerage activities, the person is required under federal and state securities law to register as a broker-dealer, unless an exemption is available.  Exemptions are limited in this area, and registration rarely makes sense for a finder given the costs and compliance steps – and sometimes finders are ineligible to register because they have been previously barred from the securities industry due to misconduct, another factor the SEC views as relevant to whether the finder is acting as an unregistered broker.  As a result, often the person simply operates in violation of federal and state law.

What Problems Does an Illegal “Finder” Pose to Companies Selling Securities?

In addition to the finder’s own exposure under federal and state law as an unregistered broker-dealer (which can be significant), a finder who has crossed the line to act as an unregistered broker-dealer can create several potential legal problems for companies using the finder’s services:

  • Void Agreements.  Investors or acquirers brought to the company by the finder may subsequently sue the company for rescission of their purchase (money back plus statutory interest) on the basis that the company agreed to pay a finder for services that were illegal.  While open to debate, there are arguments that the securities laws may render void any agreement (including the investors’ or acquirer’s agreement with the company) with a party located through the use of an illegal finder.
  • Loss of Securities Registration Exemptions.  Certain federal and state securities registration exemptions are not available if a finder is involved in the transaction.  In addition, unlike trained investment bankers and other registered securities professionals, finders may do things that jeopardize a private offering, such as engage in general solicitation, which companies may have little ability to monitor.  Finders also may not understand the private offering requirement that investors have a prior, substantive relationship with the issuer and may not be familiar with the guidance on developing such relationships.
  • Disclosure Problems.  Finders may say things to potential investors that are inaccurate or misleading, which companies may have little ability to monitor and which could give rise to potential investor fraud suits.  In addition, a company raising money through the use of a finder may be required to disclose the existence of, and material facts about, the finder.
  • Limiting Future Options.  Engaging a finder may make it impossible to engage registered broker-dealers until the finder is terminated, in light of FINRA concerns such as fee-splitting.  The existence of a finder in prior transactions may prevent lawyers from rendering necessary legal opinions in a subsequent transaction.  Using a finder may also frighten away sophisticated investors or acquirers, who wish to avoid the risk that they are purchasing the liabilities the use of a finder may create.

Conclusion

While using a finder to help identify investors or an acquirer may be appealing to many emerging companies, finders can act in violation of federal and state law and create potential problems for companies.  If you have questions about whether a finder is acting as an unregistered broker-dealer, what legal issues may arise in your circumstances as a finder or a company using a finder, or what alternative strategies may be available to minimize risks to you, your company or your deal, you should consult with your securities attorney.