Publications

Introduction
Companies rely heavily on third parties for promoting the sale of new issues of securities. These companies, which are typically startups or early stage companies, frequently lack the resources or contacts necessary to locate investors. Brokerage firms also rely on such third parties for finding new customers. These “finders” are intermediaries that are compensated for finding investors and, to a lesser extent, providing consulting and administrative services. Finders are indeed considered by the financial industry to be an integral part of the capital raising process. Moreover, the SEC has – through the issuance of SEC no-action letters – allowed finders to operate without registering as “brokers” under the Securities Exchange Act of 1934 (the “Exchange Act”) despite the fact that finders’ activities generally fit the definition.

Until recently, it was believed that finders could be compensated on a flat-fee basis and, in limited situations, on a transaction basis without triggering broker registration requirements. To be sure, transaction-based compensation arrangements, where a finder receives fees that are paid in proportion to the amount of the sale, have always received heightened scrutiny from the SEC. Nonetheless, such arrangements have in the past been approved by the SEC in limited circumstances. Moreover, the existence of a transaction-based payment arrangement was thought to be only one of several factors that the SEC considered in determining whether a finder was exempt from registering as a broker. However, in the recently released Brumberg, Mackey & Wall no-action letter, it appears that the SEC has limited the use of transaction-based compensation to the point where such arrangements are no longer practical.[1]

Finder’s Exemption
Under Section 3(a)(4) of the Exchange Act, “any person engaged in the business of effecting transactions in securities for the account of others” must registered as a broker under Section 15(b) of the Exchange Act. The distinction between being “in the business of effecting transactions in securities” and in the business of finding investors for securities transactions is in most cases very slight, but the ramifications for finders engaging in brokerage activities is significant. A broker must pass licensing examinations and be associated with a brokerage firm that is registered with the SEC, FINRA, and state securities regulators in states where they conduct business. Once registered, brokers and their firms must comply with extensive regulatory requirements. Simply put, the costs associated with registering as a broker are not financially practicable for most finders.

Based on the foregoing, finders have avoided registration by relying on SEC no-actions letters that, over time, have delineated the various factors the staff considers in determining whether a finder needs to register as a broker. These factors include:

(1) whether the finder was involved in negotiations; (2) whether the finder engaged in solicitation of investors; (3) whether the finder discussed details of the nature of the securities or made recommendations to the prospective buyer or seller; (4) whether the finder was compensated on a transaction-related basis; and (5) whether the finder was previously involved in the sale of securities and/or was disciplined for prior securities activities.

As discussed below, however, it now appears that the existence of transaction-based compensation alone will now trigger the need for finders to register.

Paul Anka No-Action Letter
For years, finders have relied on the guidance set forth in the Paul Anka no-action letter in structuring transaction-based compensation deals.[2] In this letter, the staff granted Mr. Anka’s request for no action relief from broker registration in connection with his proposal to find investors for limited partnership units in the Ottawa Senators hockey team. Mr. Anka’s proposed activities were limited to submitting to the Senators contact information for potential investors with whom he had a pre-existing personal or business relationship and who he thought would be interested in investing. In return, Mr. Anka would receive compensation based on a percentage of the amount invested by his contacts.

The staff’s no-action decision in Anka has been interpreted for years by the brokerage industry and attorneys as, at the very least, allowing for transaction-based compensation where a finder does nothing more than provide contact information for potential investors. Moreover, the staff has approved of other finder arrangements involving transaction-based compensation where the proposed activities went beyond passively providing contact information. See, e.g., Attkinsson, Carter & Akers, SEC No-Action Letter (June 23, 1998); Dana Investment Advisors, Inc., SEC No-Action Letter (Oct. 12. 1994); Ewing Capital, Inc., SEC No-Action Letter (Jan. 22, 1985); Carl L. Feinstock, SEC No-Action Letter (April 1, 1979). While all of these no-action letters involve unique circumstances and the staff has always maintained that their responses are limited to the specific representations made by the requestor, these letters made it clear that transaction-based compensation alone did not necessarily require a finder to register as a broker.

Brumberg, Mackey & Wall No-Action Letter
In its letter dated December 4, 2008, Brumberg, Mackey & Wall, P.L.C. (“BMW”), a Virginia-based law firm with no history of being involved in securities transactions, requested assurance that the staff would not recommend enforcement action if BMW assisted Electronic Magnetic Power Solutions, Inc. (“EMPS”) in finding investors for equity or debt instruments of EMPS. Specifically, BMW proposed to introduce EMPS to individuals and entities who “may have an interest” in providing financing to EMPS and, in return, receive an amount equal to a percentage of the gross amount EMPS raised as a result of BMW’s introductions. In its letter, BMW also stated that it would not: (1) engage in any negotiations, (2) provide any information about EMPS to any contacts which may be used as the basis for any negotiations, (3) make any recommendations to contacts, or (4) provide any assistance to contacts with respect to any transactions with EMPS. Put another way, BMW represented that the only factor that weighed in favor of requiring BMW to register was the proposed transaction-based compensation arrangement.

In denying BMW’s request, the staff pointed out that “a person’s receipt of transaction-based compensation…is a hallmark of broker-dealer activity,” and that the receipt of compensation directly tied to successful investments would give BMW a “saleman’s stake” in the transaction, creating a heightened incentive for BMW to engage in sales efforts. Additionally, the staff noted that BMW’s proposed activity of introducing investors to EMPS “implied” that BMW would be “pre-screening” contacts to determine their eligibility to purchase the securities and “pre-selling” the securities to gauge the contacts’ interest.

The pre-screening and pre-selling activities seem to be the crux of the staff’s position – possibly setting BMW’s request apart from the Paul Anka no-action letter where Mr. Anka had no contact with the investors. Unfortunately, neither BMW’s request nor the Staff’s response addressed the Paul Anka no-action letter, leaving questions regarding an acceptable level of contact unanswered. As BMW’s proposed activities were limited to introducing investors to the issuer, it seems that virtually any contact with an investor, coupled with transaction-based compensation, will now trigger registration requirements.

Liability For Engaging A Finder That Is Violating Registration Requirements
Finders that are deemed to be acting as unregistered brokers may find themselves the target of an enforcement action by SEC or state regulators. The consequences for companies using finders that violate broker registration requirements are also severe. Under Section 29(b) of the Securities Exchange Act of 1934, an investor may have a right to rescind a securities transaction if the issuer uses a finder that is violating the registration provisions of the Exchange Act. Additionally, the use of an unregistered broker in a private securities offering could cause a company to violate a federal or state securities registration exemption that the company relied upon in the offering. Lastly, the SEC and state securities regulators could bring an enforcement action against the company for, among other things, aiding and abetting the finder’s violation or violating anti-fraud provisions by engaging in an illegal offering.

Conclusion
The BMW no-action underscores the staff’s tendency to interpret the finder’s exemption very narrowly. Additionally, other factors may now be immaterial if transaction-based compensation is involved. Issuers that are currently compensating unregistered finders on a transaction basis would be wise to reevaluate these relationships in light of the regulatory and litigation risks involved.

¹ Brumberg, Mackey & Wall PLC, SEC No-Action Letter (May 17, 2010).
² Paul Anka, SEC No-Action Letter (July 24, 1991).