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Making Finders Keepers:  Unregistered Broker-Dealers and the Need for Reform

March 18, 2024

Identifying potential investors is one of the most difficult challenges facing early-stage companies.  The range of amounts sought at this stage is typically greater than what could be provided by the founders and friends and family, but below what would attract a VC or a registered broker-dealer.  The problem is even more acute in geographic regions with weak investor networks. 

Finders play an important role in filling this gap.  But many finders choose to operate without being licensed because the existing securities broker regulatory regime, appropriate for full-service broker-dealers, is disproportionately complex for those merely acting as finders.  The resulting uncertainty is a problem for companies, unregistered finders, lawyers and regulators. 

A few states have adopted their own exemptions or limited registration regimes for finders, but the vast majority have not.  The SEC in 2020 proposed a new exemption for finders who comply with certain conditions, but ultimately never acted on the proposal.

In its 2023 Annual Report, the SEC’s Office of the Advocate for Small Business Capital Formation included in its official policy recommendations that the SEC provide regulatory clarity for finders.

It’s time for the SEC to adopt common sense rules to create a realistic regulatory framework for finders.

Regulatory Background

Federal and state law prohibit any person from engaging in the business of effecting transactions in securities unless the person is registered as a broker-dealer with the SEC and is a member of FINRA. Any person who accepts a commission or other form of transaction-based compensation for raising capital is deemed to “engage in the business” and thus required to register. There’s a limited exception for introducing a potential investor to an issuer and accepting a “finder’s fee” irrespective of whether an investment occurs, but it’s the position of the SEC and most state securities administrators that anyone accepting a fee for investor introductions more than once is probably “engaged in the business of selling securities for compensation” and thus required to register as a broker-dealer. The JOBS Act of 2012 also included a limited exemption for persons brokering Rule 506 transactions provided they don’t receive transaction-based compensation.

Risks to Issuers

Using an unregistered broker to help raise capital could result in investors having a right of rescission under federal securities law, which if successfully exercised would require the company to return funds to investors.   Section 29(b) of the Securities Exchange Act provides that any contract made in violation of the Exchange Act is void as to the rights of any person in violation of the relevant provision.  Section 29(b) is broad enough that it can be interpreted to void a purchase agreement with any investor located through a finder that was acting in violation of the Exchange Act’s broker-dealer registration requirement.  The right of rescission may be exercised until the later of three years following the date of issuance of the securities and one year from the date of discovery of the violation.

For companies that have used unregistered finders in the past, the risk of potential rescission rights often raises significant risks in future rounds because of the uncertainty as to how long rescission rights may be exercised.  Companies that use unregistered broker-dealers could also be hit with SEC enforcement actions for aiding and abetting an Exchange Act violation.

Risks to Finders

Issuers may have rescission rights against unregistered finders.  Issuers could claim their obligations to a finder under a finder’s engagement letter are void if the finder acted in violation of the Exchange Act’s broker-dealer registration requirements.  A finder acting as an unregistered broker-dealer may also be at risk of an SEC enforcement action, the most common of which is a temporary or permanent injunction barring the finder from participating in the purchase or sale of securities. The SEC has the power to impose more severe sanctions, including disgorgement of funds, which are no longer limited to cases just involving fraud.

Finder Issues Unique to Early-Stage Companies

So why don’t finders just register as broker-dealers and become members of FINRA?  The problem is that broker-dealer registration and the FINRA membership application process are disproportionately complex for someone acting only as a finder. The ongoing regulatory requirements – appropriate for a full-service broker-dealer, i.e., one that engages in market making, over-the-counter trading for customers, proprietary trading, holding customer funds or securities, making margin loans, etc. – are similarly overwhelming for a finder.

Most startups raise early-stage rounds from angel investors in the range of $100,000 to a few million dollars.  Connecting with angels, particularly outside of the major investment hubs is particularly challenging for entrepreneurs, so finders could theoretically serve a critical role in bridging this gap.  But registered broker-dealer placement agents are generally not interested in these deals because the success fees, which are a function of deal size, are too low.  Also, the risks associated with small deals are similar to those of larger ones, but without the upside.  Early-stage companies usually lack internal recordkeeping and controls, and their financials are rarely audited, which means more work and risk for the intermediary in preparing offering materials.

2020 Proposed Exemption

In October 2020, the SEC issued a proposal that would have allowed individuals to engage in certain limited finder activities without registering with the SEC. I blogged about it at the time here.

The exemption would have applied to natural persons and only be applicable with respect to accredited investors. The finder would not be allowed to engage in general solicitation, help structure a deal, negotiate terms, handle customer funds or securities, have authority to bind the issuer, participate in preparing offering materials, engage in due diligence, provide or arrange for financing or render valuation advice. Any finder satisfying the applicable requirements would be permitted to receive transaction-based compensation.

The proposal would have created two classes of finders, Tier I and Tier II, based on the type of finder activities, with exemption conditions tailored to the scope of activities.

The activity of Tier I finders would have been limited to providing contact information of potential investors for only one capital raise by a single issuer within a 12-month period, but no contact with the potential investor about the issuer, i.e., no solicitation.

A Tier II finder satisfying the above conditions would have been allowed to engage in certain solicitation activities on behalf of an issuer. Those activities would have been limited to identifying and contacting potential investors, distributing offering materials, discussing information in the materials (but no investment advice) and arranging or participating in meetings between the issuer and investor.  Tier II finders would have been required to make certain disclosures, including the compensation arrangement and any conflicts of interest.

The SEC has not acted on the proposal and, consequently, it may not be relied upon.

Need for Reform

The absence of regulatory clarity on the role of finders in facilitating introductions between companies and investors harms both investors and issuers. The lack of a clear framework makes it easier for unscrupulous intermediaries to solicit investors without disclosing hidden conflicts of interest. Unregistered broker-dealer activity could expose a company to rescission rights, which could require the company to return to investors their investment plus interest. Market participants deserve clarity here.

The 2020 SEC proposal promoted a meaningful dialogue regarding the proper role of finders in the startup ecosystem and offered a good starting point for addressing the problem of unregistered finders.  I would expand the exemption beyond natural persons to include entities as well.  The SEC should also consider allowing Tier II finders some leeway for making recommendations, which is what is at least implicitly happening when they are allowed to contact prospective investors and participate in meetings between issuers and investors.  The SEC should also allow finders to solicit non-accredited investors, perhaps with an investment cap to address the investor protection concern.  Finally, finders within the exemption should be allowed to engage in due diligence, inasmuch as a finder should be encouraged to be reasonably well-informed about the terms of the investment and the suitability of prospective investors. 

A finder exemption in the form of the SEC’s 2020 proposal, especially with the foregoing modifications, would result in a more realistic regulatory framework for finders.

Takeaway:

Early-stage companies often struggle to identify potential investors, with ‘finders’ playing a key role in bridging this gap. However, the current regulatory framework for finders is complex and unclear, causing uncertainty and potential legal risks for companies, finders, and investors. It’s crucial for the SEC to adopt clear, common-sense rules to regulate finders and facilitate startup investment.