/>iA significant part of our corporate practice is advising clients who want to raise capital.
For larger, institutional clients who attract the attention of reputable investment bankers, the process is straightforward. Depending upon the client's industry, phase of development, and the amount and type of capital desired, a quality investment banking firm will recommend and help execute an appropriately structured securities offering—for a fee, of course. And that it is perfectly fine, as long as the investment bank is a registered "broker-dealer." However, often our smaller, more entrepreneurial clients lack experience raising capital and are not yet at the stage of development that will attract a reputable investment banking firm that is, almost by definition, a registered broker-dealer. These clients sometimes arrive at the proverbial table with a "consultant" in tow who has promised to help our client find and connect with potential investors. But the consultant does not plan to do it for free, and often expects our client to pay them a fee tied to the success of the capital raise. Our first question for the consultant is—Are you registered? If the answer is "yes," we have plenty to discuss. If the answer is "no, but," we advise our clients to be wary. The legal path forward is very narrow at best, and may not exist at all.
A Brief Overview of Securities Laws and Broker-Dealer Registration
The two primary federal securities laws are the: (1) Securities Act of 1933 (the "Securities Act") and (2) Securities Exchange Act of 1934 (the "Exchange Act"). These laws were passed by Congress during the Great Depression with the goal of restoring confidence and stability in the securities markets following the stock market crash of October 1929.
The Securities Act focuses primarily on companies issuing securities (frequently "issuers"). Under the Securities Act, an offering and sale of securities must either be registered with the U.S. Securities and Exchange Commission (the "SEC"), or satisfy the requirement of one or more exemptions from these registration requirements. Registration is time consuming and expensive, so the vast majority of capital gets raised by issuers relying upon one or more exemptions from registration requirements, typically the exemption for private offerings. The individual states have laws comparable in many respects to the Securities Act, so the laws and enforcement priorities of states where the issuer's potential investors reside also must be addressed.
The Exchange Act focuses on the integrity of securities markets. It requires companies with securities that are widely held and traded on the primary stock exchanges to file quarterly and annual financial reports, prohibits "insiders" from trading on material, inside information, and, most relevant to this discussion, regulates the firms and individuals who facilitate transactions in securities. The Act requires any individual or entity that meets the definition of "broker" or "dealer" to be registered and defines a broker as "any person engaged in the business of effecting transactions in securities for the account of others." A "dealer" means any person who buys or sells securities for their own account through a broker or otherwise. Since most firms do both, in practice, these terms are usually combined into "broker-dealer." As discussed in more detail below, an entity that is compensated for facilitating an issuer's sale of securities is acting as a broker-dealer and must be registered under the Exchange Act. Thus, our first question for the client's consultant: "Is your firm a registered broker-dealer?"
From "Consultants" to "Finder" to "Unregistered Broker"
If the answer to our first question is "no, but," what usually follows is a discussion of how the consultant is just advising the client on raising capital, but not to the extent necessary to trigger registration requirements. Typically, the consultant will explain how he or she will be substantively involved in preparing the issuer's offering materials, help the issuer's management review customer, vendor, and other relationships to assemble a list of potential investors, and set up a system for tracking who on that list is contacted by management and the level and extent of their indications of interest in investing. The consultant argues that these limitations allow the services to be classified as "consulting" services that do not require the person performing them to be affiliated with a registered broker-dealer. Almost inevitably, however, the conversation proceeds to the point where the consultant also says he or she will introduce our client to prospective investors in the consultant's own network. Such an introduction, if nothing more, probably makes the consultant a "finder." And if the consultant/finder does nothing more than make an introduction, and is not actively involved in soliciting the prospective investor and negotiating the terms of the investment, an argument can be made that the consultant/finder can legally be paid a fee per introduction to each prospective investor, or perhaps a fixed fee for each actual investor but not based on the investment amount. The hypothetical we often use is that a true "finder" can introduce everyone at the beginning of the meeting and even take a seat at the table, but must remain absolutely silent from that point forward as the issuer's management and the prospective investor hammer out the terms of the deal. We have rarely met such a highly disciplined consultant/finder, typically because the consultant's agreement with the issuer contemplates the payment of a commission or "success fee" based on the amount invested by potential investors he or she introduces to the issuer. That financial stake in the transaction closing, combined with familiarity with the issuer, its prospects, and knowledge of the priorities of the prospective investor, typically makes it very difficult for the consultant/finder to remain silent. The definition of "broker" is "any person engaged in the business of effecting transactions in securities for the account of others." Active participation in the negotiation of a securities transaction, combined with the prospect of a commission or "success fee," is viewed by almost all securities regulators as crossing the line from finder to "broker," and requiring registration.
Finder or Broker?
The "finder exemption" is not set forth in the Exchange Act, but rather is based upon informal exemptive relief granted by the SEC in a 1991 letter indicating that it would not take enforcement action against an unregistered firm that, among other things, played a "limited role in the negotiations between the purchaser and seller." In the decades that have passed since that letter, the SEC has not adopted rules to formally recognize the finder exemption, some federal courts have ignored it, and many states refuse to recognize it, particularly if transaction-based compensation is paid. Moreover, a practical challenge to claiming the finder exemption arises where the issuer is relying upon the most common private placement exemption—Rule 506(b)—to avoid registration of the offering under the Securities Act. One of the requirements of this exemption is the filing of a Notice of Exempt Offering of Securities (Form D) with the SEC and each state where securities are sold. That form requires the issuer to specifically identify any person who received transaction-based compensation in connection with the offering, whether a registered broker-dealer or not. The inclusion of a non-registered "finder" on that filing often generates a letter of inquiry from the state, and sometimes the SEC, seeking an explanation of why the person receiving transaction-based compensation is not registered as a broker-dealer at the federal level and in that state.
The SEC and most states typically look to three key factors to determine whether a person is acting as a broker, and thus subject to registration requirements. We break them down as follows:
• Participation. Using the example cited above, this means the consultant/finder is not sitting quietly at the table, but rather actively participating in the solicitation, negotiation and/or execution of the offer and sale. This goes to the concept of "effecting transactions" in the definition of "broker."
• Occupation. Is the conduct in question part of the purported consultant's regular trade or business, or is this a one-off effort due to his or her relationship with the issuer. Stated differently, is the purported consultant/finder " regularly engaged in the business" of helping companies raise capital, and actively marketing their expertise in doing so?
• Compensation. Or more precisely stated, the type of compensation. Is the person or his or her firm receiving transaction-related compensation, i.e., a success fee? Receipt of such compensation is not necessarily dispositive, but it comes very close, even if the other factors are not present. Compensation is usually the biggest factor considered by securities regulators.
Consequences of Acting as a Broker Without Registration
Operating as an unregistered broker-dealer carries significant regulatory and legal risk. The SEC and state securities administrators have the statutory authority to investigate and take enforcement action against unlicensed brokers, and can levy civil monetary penalties, ban firms or individuals from participation in the securities industry or working with public companies, require disgorgement of fees, and refer egregious conduct for criminal prosecution.
Consequences to the Issuer
An issuer that engages an unregistered broker can also suffer adverse consequences. Under federal law, engaging an unlicensed broker-dealer can void agreements with new investors, potentially granting investors the right to rescind the transaction and get their money back. The prospect of further liability for recission rights may need to be disclosed in the offering materials for subsequent offerings and restrict the issuer's ability to raise additional capital under federal and state private placement exemptions. As the issuer advances to the point where it can raise capital through higher quality investment banks and/or attract sophisticated institutional investors, previous capital raising efforts under questionable circumstances will surface in a thorough due diligence effort, and may result in irreparable reputational harm.
So, issuers should be wary of unregistered consultants or purported finders who "just want to help."
