The business world is more competitive than ever. That’s especially true for entrepreneurs and privately owned businesses. Success depends on a number of factors, not the least of which is raising money and securing investors. What exactly is the best way to capitalize your business for desired growth and scale? On the subject of fundraising, many entrepreneurs are unaware of the rules that govern private placements in the U.S. It is always critical to proceed with caution as you entertain crucial decisions pertaining to capital generation. In the past year or so, there have been important changes to regulations with the Securities & Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) regarding finders in a capital raise.
Finders payment: what exactly is allowed today?
Many individuals and firms hold themselves out as being able to connect companies seeking capital with investors. And, more often than not, they will charge a commission, or “success fee,” related to the amount of capital raised for the issuer. These finders, as they are known, may refer to themselves as placement agents, business brokers, or consultants. They may also be CPAs, insurance brokers, investment bankers, or other professionals. They often claim that they do not need to be registered as broker-dealers based on the so called “finders exemption.” And this is where you need to be wary. True, SEC regulations do provide for a finders exemption from broker-dealer registration requirements, but it narrowly offers exemption to a person that serves as a director, an officer, or employee of the issuer raising capital—with substantial duties at that company other than capital raising. Additionally, the finder must be compensated by a fee that is not contingent upon the success of the finder’s sales efforts. And the finder’s exemption only applies if the finder’s role is limited to introducing the parties or giving names to the issuer.
Should a finder be registered?
A review of SEC no-action letters suggests that the following factors would require a finder to register as a broker-dealer: 1) conducing or assisting with a sales efforts; 2) participating in negotiations between the issuer and investors; 3) receiving commissions or transaction-based compensation; 4) holding investors’ funds or securities; and 5) previous involvement in the offer/sale of securities for other issuers. Both federal and state securities laws set forth governance rules for what is and isn’t permissible. And they are quite clear: those that take a success fee must be affiliated with a broker-dealer.
How is a broker-dealer defined?
This is where most of the confusion arises for businesses and entrepreneurs, yet in fact, it’s pretty clear-cut. Under the Securities and Exchange Act of 1934 (and current state securities laws), a broker-dealer is “a person engaged in the business of effecting transactions for the account of others.” It is unlawful for any broker-dealer to “effect any transaction in, or induce or attempt to induce the purchase or sale of, any security” without first registering as a broker-dealer with the Securities and Exchange Commission and applicable state regulators. Registered broker-dealers must also be members of a self-regulatory organization known as FINRA, and comply with SEC regulations regarding financial responsibility and market conduct.
What about finders who’ve never registered?
There is actually good news, of late, for finders who have never registered as a broker-dealer. The SEC approved a FINRA rule that allows firms that are not broker-dealers to register in a new category titled Capital Acquisition Broker (CAB). CABs are firms that engage in a limited range of activities. They advise companies and private equity funds on capital raising and corporate restructuring, and act as placement agents for sales of unregistered securities to institutional investors under limited conditions. Firms that elect to be governed under the CAB rule are not permitted to carry or maintain customer accounts, handle customers’ funds or securities, accept customers’ trading orders, or engage in proprietary trading or market making.
When do new CAB rules go into effect?
In early January, FINRA began accepting applications for firms that are not broker-dealers, but wish to register as CABs, and existing member firms requesting to convert from a broker-dealer to a CAB status. The CAB rules become effective on April 14, 2017. So, for anyone seeking to raise capital, it is important to realize that if a finder doesn’t register as either a CAB or the more comprehensive designation of a broker-dealer, they pose a serious risk of being sanctioned under civil administrative penalties, criminal penalties, even possible imprisonment, if they violate SEC and/or state securities laws.
Guilt by association
It’s not just the finders who are at risk. For an issuer that uses an unregistered finder—unwittingly or not—that company and its controlling individuals may also be liable to investors and regulators. Risks include regulatory sanctions for employing an unregistered broker or for aiding and abetting the violation of federal and state law. This could result in administrative fines; inability to rely on certain securities registration exemptions and criminal penalties; 10b-5 securities fraud liability to investors and regulators for failure to disclose use of an unregistered broker; rescission claims by investors demanding return of invested funds; loss of the securities registration exemption; responsibility for the unregistered broker’s actions, such as general solicitation prohibited by Regulation D and fraudulent misrepresentations by the broker and unavailability of legal opinions on legality of the issuer’s stock; loss of institutional investors’ interest in the offering; and tainted financial statements.
It pays to be prudent
When raising capital, it is critical to understand the rules and regulations regarding such activity—especially as they apply to each participating party. Not knowing the dynamics at play can have dire consequences for all. When in doubt, consult the stipulations as laid out by the Securities & Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). And don’t be afraid to ask questions. Clarity is the best way to prevent mishaps and mitigate unforeseen setbacks. After all, raising capital for your company or business venture carries enough risk, without the added hurdles of dealing with finders who fail to comply with strict mandates. A little caution goes a long way.
Sources: FINRA Regulatory Notice 16-37; Paying Unregistered Finders to Raise Capital for Your Company is Generally Illegal” by Richard A. Riley in Business Law.