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In this era of increased regulatory scrutiny and expanded application of investor protection laws, a continually evolving area of broker-dealer law takes on increased importance: whether a so-called finder, who introduces potential investors or merger partners to each other, can avail himself of the exemption from the registration requirements applicable to broker-dealers. A finder might bring interested parties to a transaction, but may threaten the viability of that deal if he or she cannot meet the exemption from registration, and thus improperly performs the functions of a broker-dealer. As the Securities and Exchange Commission (SEC) expands its enforcement activity and continues to consider, for example, whether to bring the hedge fund industry within its purview, it should be expected that the SEC will continue to assess more closely when a finder is in fact effecting transactions like a broker-dealer and thus would be subject to regulation. Securities brokers are required to register with the SEC pursuant to � 15 of the Securities Exchange Act of 1934 (15 U.S.C 78(a)(4)), which broadly defines “any person engaged in the business of effecting transactions in securities for the account of others” to be within the scope of the registration mandate. Enacted to combat abusive sales tactics, the broker registration law aims to protect investors by imposing standards of professional conduct on registered brokers, enforced through disciplinary action. Registered broker activity is supervised by registered national securities associations and exchanges, in which membership is compulsory for all registered brokers. Registered brokers are also governed by the SEC through its enforcement of federal securities law and financial-responsibility rules. A significant exemption to the registration requirement has emerged for “finders,” a term that has been defined mainly by the SEC’s unofficial pronouncements in no-action letters. Sometimes referred to as interpretive letters, no-action letters are written guidance from the SEC staff in response to inquiries concerning the application of the securities laws to a proposed transaction or particular set of facts. These informal opinions may provide assurances that the staff will recommend that the SEC refrain from pursuing any enforcement action in response to the described transaction or conduct. The SEC examines numerous factors to determine the applicability of the finder’s exemption. While the general rule is that the exemption applies when the finder does not “effect securities transactions,” that statement serves merely as the jumping-off point for dozens of very fact-sensitive SEC no-action letters that, in aggregate, yield a somewhat cryptic message. The effect is as if the SEC was saying, “the test is very dependent on the facts but the SEC will look at the level of involvement in negotiating and structuring the deal and valuing and endorsing the securities; the extent to which the compensation is based on the sale of securities; and whether the broker or finder is generally engaged in the business of brokering these transactions, among other aspects of each specific transaction.” See, e.g., IMF Corp., SEC No-Action Letter, 1978 SEC No-Act. Lexis 1246 (May 15, 1978). Whether a finder’s referral services qualify for the registration exemption is determined on a case-by-case basis. Factors for finders When finders facilitate the introduction of buyers and sellers of businesses, the factors most relevant to the SEC’s determination of whether the exemption is met are well described in Int’l Business Exchange Corp., SEC No-Action Letter, 1986 SEC No-Act Lexis 3065 (Dec. 12, 1986). In that matter, the finder provided a listing service to businesses interested in transferring ownership primarily by way of asset sales. While the finder’s listing only publicized the assets to be sold, the company also contemplated selling ownership in the form of equity securities. The finder did not handle funds on behalf of the parties. The structure of the deal was negotiated and agreed upon solely by the buyer and seller, with minimal intervention by the finder. The finder did not advise the parties whether to issue securities or assess the value of the securities to be sold. The SEC took a no-action position, based in part on the nature of the deal as a sale of a business rather than a transfer of securities. The SEC’s analysis in these cases places significant emphasis on the form of the finder’s compensation. When a finder will be paid only if the transaction is completed successfully, the SEC is less likely to apply the exemption. Some of the more common forms of transaction-based compensation (also known as success fees) described in the no-action releases consist of commissions linked to the volumes of securities sold, although success fees can take a variety of forms. Thus, in many no-action letters involving transaction-based compensation-whether in the form of a fee, commission, concession or other compensation that is paid only upon a successfully consummated deal-the SEC would not agree to forbear from an enforcement action. In contrast, flat-fee compensation arrangements do not depend on the successful outcome of an investment transaction and are appreciably less likely to raise a red flag to the SEC. But this factor alone is not determinative; indeed, the finder in Int’l Business Exchange Corp. was able to comply with the exemption even though it received transaction-based payment. In addition, the SEC’s no-action declaration in Int’l Business Exchange Corp. and related business-broker scenarios reveals the SEC’s more permissive view of the finder’s exemption when the sale in question disposes of an entire business and does not consist of more limited ownership interests in blocks of securities. Moreover, while it may be form over substance, when a sale of the company is structured as an asset sale rather than a sale of securities (and assuming that the seller’s assets consist largely of hard assets and goodwill-not simply the securities of other companies), the transaction does not generally implicate the securities laws and therefore should almost always be exempt from the broker-dealer registration requirements of the 1934 securities act. See Landreth Timber Co. v. Landreth, 471 U.S. 681 (1985). In Victoria Bancroft, SEC No-Action Letter, 1987 SEC No-Act. Lexis 2517 (Aug. 9, 1987), the SEC also recommended no enforcement action in a similar factual scenario. Victoria Bancroft involved a real estate broker assisting in the sales of various commercial banks and savings and loan institutions. In contrast to Int’l Business Exchange Corp., though, the finder received a flat fee as compensation, and the transactions were all arranged as a sale of the entire stock of the financial institutions. The SEC identified the following criteria as influencing its decision in Victoria Bancroft not to recommend enforcement action: The business represented by the finder is a going concern and not a “shell” organization; the sale conveys all of the business’s equity securities to a single purchaser or group of purchasers; and the finder refrains from advising as to whether to issue securities and from assessing the value of any securities sold. Notably, the SEC’s inquiry into the exemption’s applicability to those who seek to facilitate the sales of entire businesses (as opposed to a portion of the securities of a business) requires an even more fact-intensive analysis than other proposed finder’s activities. Stricter over securities The SEC has adopted a much stricter attitude toward the exemption when finders act as intermediaries in the sales of new issues of securities, in which cases the SEC has severely limited the availability of the exception. In particular, when the finder in such a sale stands to earn his or her payment from such introductions by transaction-based compensation, that factor alone can disqualify the finder from the exemption. See Richard S. Appel, SEC No-Action Letter, 1983 SEC No Act. Lexis 2035 (Feb. 14, 1983). However, when the finder does nothing more than merely refer potential investors to an issuer-i.e., the finder is completely isolated from the ensuing negotiations; provides no investment-related advice or input; and is otherwise totally disassociated from the securities sales and transfer of funds-the SEC does not generally take exception with transaction-based compensation. People in the business of serving as finders typically make more of an effort to close a deal because their compensation and the demands of their paying clients so require. This underscores the thrust of the exemption: to permit businesses to pay those who make successful introductions when that is incidental to-and not the sine qua non of-the relationship between the finder and the company, or at least when that is not the means through which the finder generally makes a living. The exemption likely was not created to let brokers repeatedly profit from dwelling in the interstices of the broker-dealer regulations. Thus, in a well-known no-action letter requested by the popular singer Paul Anka, the SEC advised that he could engage in locating investors for the purchase of limited partnership units of a hockey team. Paul Anka, SEC No-Action Letter, 1991 WL 176891 (July 24, 1991). The finder, Anka, who was also a part-owner of the limited partnership, received transaction-based compensation. However, his involvement and participation in the transactions were strictly confined to introducing the respective parties. He supplied the contact information of the prospective investors, after which only company management and employees were permitted to pursue the investment with the prospective partner. The SEC similarly agreed to forbear from enforcement action despite the promise of transaction-based compensation when finders who arranged for real estate brokers to meet condominium unit sponsors with prospective purchasers were not authorized to deliver a copy of the prospectus, offer or solicit offers, participate in any manner in the negotiations or prepare any documentation required by state law in connection with the sale. Moana/Kauai, SEC No-Action Letter, 1974 SEC No-Act. Lexis (April 10, 1974). The SEC affirmed this position more recently in Dana Investment Advisors Inc., SEC No-Action Letter, 1994 WL 718968 (Oct. 12, 1994), in which a for-profit subsidiary of a hospital association proposed to enter into a finder’s agreement with a private investment fund, pursuant to which general information regarding a private placement of the fund would be disseminated to the members of the hospital association by its subsidiary. The finder was strictly prohibited under the agreement from mentioning any of the advantages or disadvantages of any particular investment; providing any recommendation, analysis or advice related to any investment; participating in any negotiations; and receiving or handling any of the investors’ funds. With these clear parameters in place, the finder met the exemption. Even flat-fee compensation may jeopardize the availability of the finder’s exemption when that fee has an adjustable feature that aligns the payment with the outcome of the transaction. In the Colonial Equities Corp. no-action release, SEC No-Action Letter, 1988 WL 234557 (Jan. 29, 1988), a proposed flat-fee arrangement was subject to annual upward and downward adjustments to take into account a “cost-benefit analysis of the services provided” by the finder. The SEC stated that to avoid enforcement action, the finder’s fees could not fluctuate with the outcome of the investment transactions, and could only be modified once annually on a prospective basis. Finders should take great care to ensure that they satisfy the exemption from registration, as they face stiff penalties for failing to do so: Failure to register as a broker authorizes the SEC to seek severe penalties against the violator, including obtaining a civil injunction to enjoin the finder’s activities; civil monetary penalties; issuing a cease-and-desist order following notice and a hearing; and referring the matter to the U.S. Department of Justice for criminal prosecution. The potential for criminal liability appears limited because it requires a willful violation of the registration requirements-and in most instances, it would be difficult to fault a finder for failing to divine clear guidance from the fact-sensitive and broad spectrum of the relevant SEC no-action guidance in this area-but its specter exists nevertheless. Issuers engaging finders who assist in their capital financing but who ultimately fail to meet the exemption may also be subject to an action for rescission by the investors. Sec. 29(b) of the securities act, 15 U.S.C. 78cc(b), may render void any contract made in violation of the securities act or any of the implementing regulations, and has been used by courts to nullify securities transactions with unregistered broker-dealers. See Regional Properties Inc. v. Financial & Real Estate Consulting Co., 678 F.2d 552 (5th Cir. 1982); Eastside Church of Christ v. National Plan Inc., 391 F.2d 357 (5th Cir. 1968); Harris v. Palm Springs Alpine Estates Inc., 329 F.2d 909 (9th Cir. 1964). In addition to avoiding success fees as discussed above, parties needing to avail themselves of the finder’s exemption should impose restrictions on the finders’ activities such as those identified in Colonial Equities Corp., 1988 WL 234557. There, the finders were strictly prohibited by contract from explaining or advising about the investment, expressing any belief about the advisability of the investment or receiving or handling any securities or funds utilized in the investment. The finders were responsible solely for providing marketing data and criteria for identifying interested investors possessing the necessary financial resources, and the finders’ agreement was terminable if the finders were found to have exceeded that limited scope. The agreement also called for the finder to review a synopsis of the statutory and regulatory provisions governing brokerage activities, including the registration requirements and the anti-fraud provisions, and to acknowledge their understanding of such provisions. Such restrictions that narrowly circumscribe the finder’s limited duties better ensure the availability of the exception and promote the laudable goal of protecting investors from receiving broker-type services from an unregistered, unregulated finder. At a time when the SEC has cast a wider net to catch securities violators, would-be finders will do themselves and their clients an important service by ensuring that they stay within the narrow confines of the registration exemption and abstain from going beyond their mere introductory roles. This will protect the viability of the transaction and preserve the integrity of the securities industry. Steven M. Hecht is a director at Roseland, N.J.’s Lowenstein Sandler and a member of the firm’s securities litigation and enforcement practice group. Edward M. Zimmerman is a director at the firm and chairman of its tech group. Jason I. Diener is an associate in the firm’s tech group. The authors can be reached, respectively, at [email protected], [email protected] and [email protected]

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