For early-stage companies, the ability to raise money from investors is often critical to success. This can be a difficult and time-consuming process and it’s not uncommon for companies to enlist the help of a “finder” to help them access qualified investors. This practice comes with certain risks, including possible violations of the Securities and Exchange Commission’s broker-dealer registration requirements.
There have, however, been several important developments in recent years in securities laws related to such requirements that emerging companies and investors should be aware of.
To begin, it is important to understand the distinction between a finder and a broker-dealer. Federal securities laws generally consider anyone who effects transactions in securities to be acting as a broker-dealer, requiring that person go through the costly and extensive process of registering with the SEC and the Financial Industry Regulatory Authority, or FINRA. Finders, on the other hand, are exempt from federal registration requirements. Securities laws do not specifically define the term finder, or what they can do. Generally speaking, in order to distinguish themselves from broker-dealers, finders cannot “effect” transactions in securities. Rather, they must limit themselves instead to simply making introductions between issuers and investors. According to case law and SEC no-action letters, regulators have found there are other factors typical of broker activity, which would require the person involved to register as a broker-dealer. These include:
- participating in negotiations between the issuer and potential investors, offering advice in the financing transaction, or handling funds involved in the transaction
- receiving success-based fees (i.e. a commission or fees that vary with the size or type of resulting investment)
- soliciting investors, or locating issuers on behalf of investors
While no one factor by itself will determine whether someone should register as a broker-dealer under Section 15(b) of the Securities Exchange Act of 1934, transaction-based compensation appears to draw close attention from regulators. This sort of fee can signal that the person was more involved than just making introductions.
Companies who use an unregistered broker to help raise capital can face serious consequences, including government enforcement action. Investors may also be able to rescind the deal and require the issuer to return their investment. The individual who acted as the broker could also be subject to fines and penalties, including disgorgement of its fee.
As previously mentioned, there have been some noteworthy developments in recent years relating to broker-dealer requirements.
In April 2012, President Obama signed into law the Jumpstart Our Business Startups Act or JOBS Act. The act created two exemptions from broker-dealer registration under Section 15(b). The first is for intermediaries participating in offerings conducted in compliance with Rule 506 under Regulation D. The exemption is available to someone who:
- maintains a platform (i.e., a website) that permits the offer, sale, purchase, negotiation, general solicitation, advertisements, or similar activities in connection with the offering;
- co-invests in securities being offered; or
- provides ancillary services in connection with the offering.
In order to qualify for this exemption, the intermediary must not receive compensation in connection with the purchase or sale of securities in the offering or be in possession of customer funds in connection with the offering. The person is also subject to disqualification under “bad actor” provisions.
The second exemption from broker-dealer registration is for Funding Portals, commonly known as crowdfunding platforms. Last October, the SEC adopted long-awaited final rules for crowdfunding pursuant to the JOBS Act. Under this exemption, companies can raise up to $1 million in a 12-month period through online crowdfunding portals.
In May 2013, the SEC’s Division of Trading and Markets provided foreign financial advisors who facilitate the sale of a private company, known as M&A Brokers, with some relief from broker-dealer registrations. In a no-action letter, the Division provided guidance that allowed a foreign broker to interact with a U.S. company and develop an M&A transaction without facing registration requirements, so long as certain conditions were met. The relief was somewhat surprising because it provided foreign M&A Brokers with more relief from registration than was available to U.S.-based brokers, who remained subject to registration for the same activities.
The Division addressed those discrepancies in a groundbreaking no-action letter issued in January 2014. In it, the SEC staff took the position that they would not recommend enforcement action against unregistered M&A Brokers who effect securities transactions in connection with the transfer of ownership of a privately held company. This relief, which applies equally to U.S. and foreign brokers, is subject to certain conditions, which include:
- The M&A Broker will not have the ability to bind the principals in the M&A transaction
- The M&A Broker will not provide financing for the transaction
- The M&A Broker may not have possession of customer funds or securities
- The M&A transaction may not involve a public offering
- If the M&A Broker represents both the target and the acquirer, it must get a written consent from both
- The target company may not be sold to a passive buyer
- The securities received by the buyer will be restricted securities
- The no-issue letter did not affect state securities laws, many of which also have broker-dealer registration requirements.
That same year, the Division provided no-action relief from broker-dealer registration to two online funding platforms; an investment platform for venture capital investing, the FundersClub, and a platform for “angel investing,” called AngelList. The letters indicated that running a platform that connects investors with private funds and qualifying investors would not, by itself, require broker-dealer registration, as long as there were not other indications of broker-dealer activity, like transaction-based compensation.
FundersClub posts information on its website about opportunities to invest in private companies. This information is available only to FundersClub members, all of whom have been pre-screened as accredited investors. Members can use the site to express a non-binding indication of interest to invest in a particular company. When a target level of capital is reached and investment interest and investor qualifications are confirmed, an investment fund is created and FundersClub negotiates the final terms of the investment. FundersClub, which oversees the investments and provides consulting services to the companies, is compensated with a percentage of profits from the investment fund.
Angel List employs a similar strategy, helping accredited investors find companies that are seeking capital and in which one or more investors intend to invest. The distinction between the FundersClub and AngelList online matchmaking platforms lies in AngelList’s use of a “lead angel,” who identifies the start-up and structures the terms of the investment. AngelList indicated to the SEC that the lead angel would not receive a management fee. Instead, compensation would be restricted to a percentage of the profits from the investment fund, which would be shared between the lead angel and an AngelList-affiliated investment advisor.
Though the Division’s findings were based on the particular facts of each of theses cases and specific to the entities seeking no-action relief, the guidance it provided indicates some of the activities the SEC finds acceptable for an unregistered broker-dealer.
Not long after the SEC’s no-action letters to AngelList and FundersClub, David Blass, Chief Counsel of the Division of Trading and Markets, commented in a speech on the need to consider whether finders and other intermediaries should register as broker-dealers. He noted that the SEC staff had been focused on granting relief from broker-dealer registration requirements, where appropriate, and was “working collaboratively with FINRA on a more customized approach for regulation of market participants who perform only limited broker functions.”
Blass also mentioned the staff’s work with FINRA to consider the appropriate level of regulation for funding portals, given the limited scope of their activities. He noted that the SEC was considering whether there were “opportunities to extend the approach to other types of brokers whose activities are limited.”
For its part, FINRA implemented Rule 2040 last August, which prohibits member firms from making payments to persons who aren’t registered as broker-dealers. The rule aligns with with Section 15(a) of the Exchange Act and its guidance on whether persons who aren’t registered can receive transaction-related compensation. Rule 2040 does not eliminate what is known as the “foreign finder exemption,” which allows certain payments to unregistered person referring foreign customers to FINRA members. Broker-dealers must look to SEC rules to determine whether their activities will require registration under the Exchange Act Section 15(a). The rule permits FINRA members to support their determination by relying on no-action letters or seeking their own no-action letter. Support can also be derived by obtaining a legal opinion from independent U.S.-licensed counsel.
As evident from the above, there is much to consider when trying to determine whether an intermediary is acting as a finder or as an unregistered broker-dealer. There are steep consequences for using a broker-dealer that is not properly registered, making it important that companies carefully consider the involvement of a finder or broker-dealer when they are looking to raise capital.