Finders And Unregistered Broker-Dealers

In the last few years, we have seen a number of important developments in the securities laws related to finders and broker-dealer registration requirements. Below we provide an overview of the broker-dealer registration requirement as it relates to finders who assist in matching issuers with investors or buyers and the latest developments in this area.

Overview

The distinction between being classified as a finder and a broker-dealer can have significant consequences. An unregistered broker-dealer may face sanctions from the Securities and Exchange Commission (SEC), and it may be unable to enforce payment for its services. In addition, transactions involving an unregistered broker-dealer may create a right of rescission in favor of the investors, allowing the investors the right to require the issuer to return the money invested. One example of the consequences of an unregistered broker-dealer occurred in the Ranieri Partners SEC enforcement action. In that action the SEC brought charges against a private-equity firm, its managing director, and a consultant because of the consultant's failure to register as a broker-dealer. The SEC's order found that the private equity firm paid transaction-based fees to a consultant, who was not registered as a broker-dealer, for soliciting investors for private fund investments.1

The federal securities laws do not specifically define the term "finder" or outline what finders can do. Instead, finders must avoid being deemed a broker or dealer under the federal securities laws unless they register as such with the SEC and the Financial Industry Regulatory Authority (FINRA). A broker is defined as "any person engaged in the business of effecting transactions in securities for the accounts of others."2 A dealer is defined as a person that is "engaged in the business of buying and selling securities ... for such person's own account," but excludes a person that buys and sells securities for its own account, but not as part of a regular business.3 Because the broker definition is the one that finders have the most trouble with, this discussion is focused on what activities may cause a finder to fall within the definition of a broker required to register with the SEC and FINRA.

To help determine whether certain activities bring someone within the definition of a broker, the SEC has revealed, through various no-action letters and other guidance, the various factors it considers when deciding whether a finder has violated the securities laws by failing to register as a broker-dealer. According to case law and SEC no-action letters, the following facts are typical of finders who would not need to register as a broker-dealer:

Introduces investors to issuers or their promoters without further involvement in discussions between the issuer and the investor(s) and without giving advice on the investment's structure or suitability; Receives compensation for making introductions and the compensation is not tied to the success of the raising of capital (i.e., not a commission); Assists in transactions that convey all of a business's equity securities or assets to a single purchaser or group of purchasers; and Does not assist purchasers with obtaining financing, other than providing uncompensated introductions to third-party lenders or help with completing the paperwork associated with loan applications. The following factors are typical of broker activity where the person involved may need to be a registered broker-dealer:

Participates in discussions and negotiations between the issuer and the potential investors; Assists in structuring transactions; Receives transaction-based compensation, i.e., a commission or some form of compensation that varies with the size or type of the resulting investment; Engages in "pre-screening" potential investors to determine their eligibility to purchase securities; Engages in "pre-selling" the issuance to gauge the level of interest; Conducts or assists with the sale of securities; Provides advice regarding the value of securities; Locates issuers on behalf of investors; Solicits new clients; Disseminates quotes for securities or other pricing information; Actively (rather than passively) finds investors; Sends private placement memoranda, subscription documents, and due diligence materials to potential investors; Advises on portfolio allocations to accommodate an investment; Provides analyses of potential investments; and Provides potential investors with confidential information identifying other investors and their capital commitments.4 As these lists demonstrate, there is very little that a finder may do without crossing the line into activities that may trigger the requirement to register as a broker-dealer. No factor alone will determine whether a finder should register as a broker-dealer; all existing factors are considered together in making such a determination.

Nevertheless, some factors may carry more weight than others. One that appears to draw close attention from the SEC is the existence of transaction-based compensation, which often signals that the individual is more involved in the transaction than simply making introductions. The SEC has stated that "the federal securities laws require that an individual who solicits investments in return for transaction-based compensation be registered...