Regulating Unregistered Finders: New York Dips its Toe in the Murky Waters

This alert provides a brief discussion of the practice of using unregistered “finders” in the context of a private securities offering. We provide background on the process, discuss various risks and considerations, and address how recent developments in New York may change private issuers’ approaches in this murky area of the regulatory landscape.

Background

Raising capital can be a significant challenge for private companies, especially issuers that typically would not draw the attention of investment banks such as early stage or emerging growth companies. One of the highest hurdles these companies face is simply identifying prospective sources of capital. Registered securities brokers can assist in this task. Unfortunately, issuers often find it difficult to pay the fees charged by brokers or even to find a broker with prospective investor contacts likely to bear fruit for the offering. It may be permissible for an issuer’s personnel to assist it with its securities offering or for unregistered “M&A brokers” to assist in the purchase and sale of a company, but available exemptions or relief from broker status are limited in scope.^[1]

Instead of using a registered broker or in-house personnel, private companies often consider using a so-called “finder.” Typically, a finder will help private companies identify prospective investors in return for compensation. Ideally, finders simply provide an issuer with the names and contact information for prospective investors and perhaps an introduction, though finders often try to do more. Typically, the compensation paid to a finder is less than what the issuer would pay a registered broker. Often, all the issuer really needs or wants is the introduction — the other services provided by a broker might not be necessary.

At first glance, this sounds like a great alternative for a private company seeking to raise capital. However, the regulatory status of finders is a longstanding murky area under the U.S. federal securities laws. This stems from the possibility that the U.S. Securities and Exchange Commission (SEC) or the courts may view these finders as unregistered securities brokers. Various states also treat finders differently from a regulatory standpoint. As a result, these arrangements can be problematic for the issuer and the exempt status of the private offering.

The SEC has not formally addressed this issue, despite decades of prodding from private issuers, industry practitioners,^[2] and more recently the SEC’s own Small Business Capital Formation Advisory Committee.^[3] Rather than publish clear guidance, rules, or exemptions (or related requirements and limitations), the SEC has left issuers and the legal community to interpret a patchwork of SEC staff letters and various court decisions, many of which present similar but different facts and circumstances and that, at times, have resulted in incongruent conclusions. SEC staff also maintains a “Guide to Broker-Dealer Registration” that briefly mentions finders, but neither forms a view on regulatory status nor provides any practical guidance in this area.^[4] This creates uncertainty for issuers, and with uncertainty comes risk.

In the midst of the SEC’s inaction on this issue (and, not to mention, a global pandemic) the New York State Attorney General (NYSAG) unveiled a package of related reform proposals intended to protect the public from fraudulent exploitation in the offering and sale of securities.^[5] Among other things, if adopted, the proposals would define “Finder” and would impose registration and exam requirements on these individuals.^[6] If adopted, the proposals could significantly affect capital raising in and from New York.

What is a broker?

Section 3(a)(4) of the Exchange Act generally defines a broker as any person engaged in the business of effecting securities transactions for the accounts of others.^[7] On its face, the definition seems straightforward enough, especially in the context of a retail securities transaction (e.g., through an online broker). But the definition is difficult to square in a private offering, where the notion of “effecting a transaction” does not fit the practical reality of the mechanics of the private sale and the meaning of “engaged in the business” also lacks clarity.

The SEC has long taken the position that broker status depends on the specific facts and circumstances in question. Court decisions have noted that activities of a broker are characterized by “a certain regularity of participation in securities transactions at key points in the chain of distribution.”^[8]  Other court decisions have yielded various factors that may be relevant, including handling or possessing investor funds or securities, actively (rather than passively) soliciting prospective investors (including advertising), negotiating on behalf of a buyer or seller, and receiving commissions or other forms of transaction-based compensation.^[9] It is this last factor that the SEC often cites in determining whether activity is that of a broker. According to many SEC staff letters, an individual who receives transaction-based compensation often is considered to have a “salesperson’s stake” in the transaction and is likely to be deemed a broker.^[10] However, one recent court decision focused on a plain reading of the statutory elements of Section 3(a)(4), determining that the finder in that case was merely facilitating securities transactions rather than performing the functions of a broker.^[11] And before that, another court ruled against the SEC’s allegations of unregistered broker activity, finding that the individual’s receipt of transaction-based compensation, without evidence that (among other things) he participated in purchases and sales or provided advice or other information about the investment, did not cause him to be a broker.^[12]

Risks in Using a Finder

Using a finder can create risk for the issuer and the offering itself. For example, Exchange Act Section 15(a)(1) makes it unlawful for a person to “effect a transaction in securities” or “attempt to induce the purchase or sale of, any security” unless registered as a broker or dealer. Exchange Act Section 29(b) provides that any contract in violation of broker-dealer registration requirements “shall be void.” This means that investors could have the right to rescind their purchase – essentially, a put right to the investor as a voidable transaction. However, investors are not typically parties to the contract between the issuer and finder, so it is not clear whether a subscription agreement is voidable based on the involvement of a finder. Exchange Act Section 20(e) also allows the SEC to impose aiding-and-abetting liability on any person who knowingly or recklessly provides substantial assistance in a violation of the Exchange Act – in other words, if the issuer knew or should have known that it was utilizing an unregistered broker.^[13] Additionally, an issuer may not be able to rely on a securities registration exemption, or it could unknowingly result in the issuance of unregistered securities in violation of Section 5 of the Securities Act of 1933. In this scenario, the issuer could be responsible for reimbursing investors for the investment, interest, costs and attorney fees. Importantly, the SEC has continued to pursue enforcement action against unregistered brokers.^[14]

What Say the SEC?

SEC staff has addressed the finder issue from time to time in the form of staff “No-Action Letters.”^[15] However, the Commission itself has not, nor have most states. Below we discuss the New York proposals and certain other states’ existing requirements. We were somewhat encouraged by a statement in the June 2019 SEC Concept Release on the Harmonization of Securities Offerings, in which the SEC noted that “[t]he Division of Trading and Markets is reviewing the status of finders.”^[16] Our proclivity for optimism led us to speculate that, after so many years, we might formally hear the SEC’s views on finders – perhaps SEC rulemaking after a recommendation from Trading and Markets.^[17] But that was over a year ago and, as our optimism waned, so too perhaps has the runway for rulemaking under the current administration.^[18]

That leaves us with the staff No-Action Letters. Likely the most oft-cited letter is Paul Anka way back in (wait for it) 1991.^[19] In Paul Anka, SEC staff essentially blessed an arrangement whereby the named pop singer would provide an issuer with names and contact information for prospective investors in the Ottawa Senators hockey team in return for a finder’s fee calculated as a percentage of funds raised from his investors. That blessing was based on several conditions and representations, including that Anka (1) had a pre-existing, substantive relationship with the investor prospects, (2) reasonably believed the prospects were accredited investors, and (3) would not solicit prospective investors, make any investment recommendations to them, or have any contact with them concerning the prospective investment, either before or after the issuer contacts them.^[20] It was, no doubt, an important additional factor that Anka was involved in the music business rather than a securities, financial, or adjacent business, and, according to the facts on which the SEC staff relied, that Anka had not previously acted as a broker.

However, without formal guidance or rulemaking from the SEC, issuers and practitioners are left to wonder, interpret, and speculate as to the permissibility of using finders in a private offering. Contributing to the uncertainty surrounding finders is that SEC staff views change over time – as do the views of the SEC itself. A prime example is the less-nuanced views of SEC staff in other letters, which instead focused simply on whether the finder receives transaction-based compensation. In Brumberg, Mackey & Wall, P.L.C. (“BMW”), for example, SEC staff was not convinced that broker-dealer registration was not required when BMW (a law firm) sought to introduce a company to a limited number of BMW’s contacts as a source of financing for the company’s operations, in return for compensation to BMW based on a percentage of the amounts raised from those contacts.^[21] The staff focused on its belief “that the receipt of compensation directly tied to successful investments in [the company’s] securities by investors introduced to [the company] by BMW (i.e., transaction-based compensation) would give BMW a ‘salesman's stake’ in the proposed transactions and would create heightened incentive for BMW to engage in sales efforts.”

New York Proposal

The NYSAG proposal is interesting for several reasons. First, it seeks to address a regulatory gap that the SEC has been reluctant to address. Second, it may pave the path for what to expect in state securities regulation on the issue going forward. Third, if adopted, it would likely create dilemmas for issuers, not the least of which being whether issuers will need to consider excluding prospective investors in New York. Finally, it builds on related requirements in other states, including California and Texas. Below, we discuss (i) the proposed definition of a Finder, and (ii) key considerations going forward.

What is a “Finder” in New York?

As proposed, a “Finder” would be a person, firm, association, or corporation who as part of a regular business, engages in the business of effecting transactions in securities for the account of others within or from New York, to the limited extent that such person, firm association, or corporation, receives compensation for introducing a prospective investor or investors to any broker, dealer or salesperson.

What Would New York Require of Finders?

Finders would be subject to all of the filing and exam requirements applicable to brokers, dealers, and salespersons in New York.^[22]

Key Considerations

The comment period for the NYSAG proposals has closed. As we await any updates or movement, it is important for issuers and those who could be considered Finders to consider how the proposals may affect their future capital raising efforts (and efforts that might be ongoing).

1. More than ever, issuers will need to be aware of the status of those they engage as finders. One potential outcome to consider is whether the issuer can engage a registered New York Finder and also reasonably conclude that the Finder is not engaged in broker activity. This could call into question the Finder’s role for the offering more broadly. This relates to the risks we discussed above.
   
   
2. The proposal is not clear regarding how New York could view potential Finders as engaged in the covered activity “in or from” New York. We suspect that a Finder who is physically present in the state would satisfy the definition, but beyond that we cannot be certain. For example, if a Finder’s permanent residence or principal place of business is in New York, but the Finder operates from outside the state, will that satisfy the “in or from” element of the definition? This nuance is particularly relevant in the COVID-19 era, during which many individuals are working remotely and often have travelled outside of their resident state for significant periods of time.
   
   
3. A related question is whether someone who serves in a Finder role from outside of New York, but calls or emails an individual present in New York, would satisfy the “within or from” element, although it seems likely that the NYSAG will consider a person who directs communications to issuers, brokers or investors located in New York to be acting within the state.
   
   
4. The proposal references the “regular business” engaged in by a Finder, but makes no mention of the frequency on which this standard will be based. Would one instance of this activity trigger the requirements? What about two or three times in a calendar year? Monthly?
   
   
5. The proposal references a Finder introducing prospective investors “to any broker, dealer or salesperson” However, as we noted above, in a typical finder relationship, the finder introduces investors to issuers – not to a broker-dealer or its personnel. Does this mean that an individual who introduces prospective investors directly to issuers falls outside of the proposed Finder definition and requirements in New York?
   
   
6. And finally, the scope of the proposed Finder definition includes any “person, firm, association, or corporation.” This seems to indicate that a Finder could function as such through an entity established to carry out the role, rather than simply in an individual capacity. Finders may find this helpful, including to shield themselves from personal liability. Yet, issuers may find this problematic for the same reason.

Other States’ Requirements

New York is not the first state to take its own approach to regulating this corner of the market. For example, California enacted rules governing “finders” in 2015. California permits (subject to numerous limitations and affirmative obligations) issuers to pay a finder’s fees in transactions involving California-based issuers, finders, and purchasers of securities, in transactions conducted in California.^[23] The relevant statute exempts finders, as defined, from the requirement to register as securities brokers in California. However, California law also provides for rescission rights or damages for investors who purchase or sell a security through an unregistered broker.^[24]

Texas takes yet a different approach by allowing finders to legally receive compensation if they register as a finder, which is less onerous than broker-dealer registration.^[25] But under Texas law, unregistered persons cannot enforce commission contracts relating to the sale of securities. The Texas State Securities Board limits the activities of finders by prohibiting them from providing investment advice or receiving a percentage based on the securities purchased or the investor’s profits. However, a finder who connects investors and securities issuers is allowed to receive a fee solely for the finding process.

Conclusion

Goodwin will monitor the status of the NYSAG proposal for any developments. We will also keep our fingers firmly crossed (as we have for many years) in hope that the SEC itself (rather than the staff) takes action to clarify its views and expectations regarding finders. With this being such a longstanding murky area, one can only ask whether the lack of action by the SEC has encouraged continued utilization of finders by the private issuer community and, as a result, a cottage industry of individuals serving in the finder role. With several states now implementing their own requirements, issuers are faced with potential disparate regulatory results based on the same, basic action of using a finder.