California has enacted a sweeping change to its securities laws, allowing for the payment of finder’s fees to unregistered persons in connection with securities’ offerings. The law was meant to make it easier for small and mid-sized businesses to obtain investment capital. But it also conflicts with existing policy of the Securities and Exchange Commission, meaning those who want to utilize this new tool need to tread carefully.
In California, the term “finder” is generally understood to mean a person who introduces two parties to one another, without negotiating on behalf of either side. It’s not uncommon for emerging companies, for whom the ability to raise capital is often critical, to engage finders to help them access qualified investors.
Previously, California allowed only registered broker-dealer firms to receive compensation for putting an investor in touch with an investment opportunity. But registering as a broker-dealer is a costly and extensive process and there was a widespread practice, both in California and nationwide, of companies paying finder’s fees to unregistered persons.
The new law, which took effect Jan. 1, adds Section 25206.1 to the California Corporations Code and creates an exemption that allows issuers of securities to provide finder’s fees to unregistered persons for the sale of securities, provided certain conditions are met.
The law was proposed in 2012 by the Business Law Section of the California State Bar, which said that legalizing this common practice was necessary to promote capital formation for small businesses and eliminate the risks for issuers and investors in companies which raised capital with the help of unregistered finders.
The Business Law Section did note, however, that the proposal conflicts with SEC policy, which considers the payment of finder’s fees to unregistered persons who effect transactions in securities a violation of Section 15(a) of the Securities Exchange Act of 1934. There is no statutory guidance that indicates what activities trigger the definition of a broker-dealer, but the business law group said the SEC sees transaction-based compensation as a strong factor in favor of finding that a finder acted as such. Nonetheless, it said percentage-based compensation is often the only type of compensation that an issuer can afford to pay to a finder.
The new Section 25206.1 has a number of requirements that must be met for the exemption to apply. They include:
- The finder must be a person, not an entity.
- The transaction must involve a sale of securities by a California issuer of securities.
- The size of the transaction or series of transactions cannot exceed an aggregate of $15 million.
The finder must limit its activities to introductions and referrals and cannot: participate in negotiations regarding the terms of the transaction, advise parties on the value of the securities or whether to invest, sell securities the finder owns, be in possession of funds involved in the transaction, conduct due diligence for the parties or participate in the transaction unless the transaction itself is permitted or exempt from California qualification. The finder also may not disclose to a buyer anything other than the name and contact information of the issuer, the name, type, price and aggregate amount of the securities offered and the issuer’s industry, location and years in business.
Before receiving any finder’s fees, the finder must also file information with the California Bureau of Business Oversight and pay a $300 filing fee. Every year after, the finder must file renewal statements and pay a $275 fee.
In addition, the finder must procure a written agreement which must be signed by the finder, the issuer and the person introduced by the finder. The agreement must disclose, among other things: the type of compensation the finder will be paid; confirm that the finder is not providing the investor with advice regarding the investment; whether the finder owns any of the securities sold and whether any conflict of interest exists; and a representation that the investor is an accredited investor as defined in SEC Regulation D.
The new law is seen as a mechanism to make it easier for California business to obtain investment capital and legalizes what had been a common practice. But it only allows the payment of finder’s fees in securities transactions that are conducted exclusively within the California, involving state-based issuers, finders and investors. Transactions conducted outside California are still subject to the conflicting SEC regulations, which carry potential fines and disciplinary actions.
