Since the 19th century companies have used third parties, whether individuals or companies, in their fund raising efforts. Today, companies ranging in size from start-ups to private equity funds rely on finders to help them raise money. Overall, this has been positive for capital formation, especially on the lower end of things. Nevertheless, a minority of finders promise their clients access to capital only to disappear after receiving the first or second retention payment. So what is the problem? Besides the loss of scarce funds, companies that use finders carelessly face the threat of Securities and Exchange Commission and state securities commission enforcement actions. This is so because the SEC will seek enforcement against everyone involved in the “problem” financing transaction, including finder, company, and broker-dealer, as applicable.
SEC View on Finders and Capital Raising
The SEC takes the view that anyone, person or entity, that engages in the business of effecting securities transactions (in English read capital raising) must be a registered broker-dealer or a registered representative of a broker-dealer per Section 15(a) of the Securities Exchange Act. The only exception is the so-called finder exemption. The problem is that this exemption is not clear. It appears that the SEC believes that a finder is someone who solely provides a list of names to a company/broker-dealer who can then solicit investments from them.
The first problem is that any activity beyond providing a list to a company/broker-dealer may, in the view of the SEC, mean that the person is acting as an unregistered broker-dealer. So, for example, forwarding on company information to a potential investor, screening client lists for investors, making positive comments about the target company, hosting dinners and seminars, holding investor funds, and assisting with the negotiation of the terms of investment between the parties are all factors that the SEC may use to determine that the person is acting as an unregistered broker-dealer. Anyone who has spent time capital raising knows that all of the aforementioned activities are commonplace and are not, in the vast majority of situations, entered into with an intent to violate securities laws.
The second problem is that simply paying a commission to a finder may subject the finder and the company to enforcement action. For example, in a transaction where an individual only provides a list of names to a company seeking financing and is paid a percentage of the total investment made by such introduced investors is cause for concern. Why? Because the SEC believes that only broker-dealers and their registered representatives may be paid commissions for raising capital. The fact that this is a relatively common practice in the financing world and that a vast majority of those persons really are finders does not seem to bother the SEC.
Case Law on Finders
The seminal case on this issue is SEC v. Kramer from 2011. The SEC alleged that Kramer: (1) received transaction-based compensation, (2) actively solicited investors (by distributing promotional material and directing people to a company web site), (3) advised investors about the company (by telling people that it was a good company and suggesting that people read it’s press releases), (4) used a “network” of associates to promote the company, (5) demonstrated a regularity of participation (through the money that Kramer earned and the two-years over which the conduct occurred), (6) promoted the shares of other companies, and (7) earned commissions rather than a salary as a company employee.
The court held that Kramer’s conduct consisted of nothing more than bringing together the parties to a transaction. It also found that the SEC presented no evidence that Kramer either participated in the negotiation, discussed the detail of the transaction, analyzed the financial status of the company, or promoted an investment in the company to a certain third party or his investors. The court explained that neither previous case law nor the language of the Securities Exchange Act allowed a conclusion, based on the facts presented at trial, that Kramer acted as an unregistered broker-dealer.
The court, in effect, dismissed the positions that the SEC put forth at trial (based on no-action letters and staff positions) and instead relied on previous cases and the statute in making its determination. This conclusion revealed a troubling split between the courts and the SEC which continues to this day. In practice, this means that companies of all sizes are at risk of enforcement action if the finders they use do not squarely fit into the finder exemption.
Current State of Things
While the SEC recognizes the need for some action, administrative action by the SEC is not likely any time soon. On a recent conference call, SEC staff indicated that the SEC believes it does not have the regulatory authority to act. Translated into English this means that the SEC is going to wait for Congress to pass legislation creating a finder exemption or safe-harbor. On the state level, there is legislation pending in California that would provide an in-state exemption for finders.
The consequences for violating the registration requirement in Section 15(a) are significant. They include monetary penalties into the millions, cease and desist orders, industry bars, rescission rights to investors who may ask for return of capital plus interest, loss of securities exemptions, and so forth. SEC action may provoke state securities commissions to act as well resulting in additional penalties, bars from seeking investment in that state, and placement of the company and its executives on a bad-boy list distributed to other states. For a start-up or early stage company, these penalties could be death blows.
Companies of all sizes engaged in capital raising should consult securities counsel before engaging a finder. In addition, it is helpful for management and individuals to understand the scope of risk of using finders in financing transactions generally.