A company raising capital through a private securities offering will often retain a finder to locate investors and possibly help negotiate the terms of the financing. It’s fairly common for the company to agree to pay the finder a transaction-based fee tied to the amount of money raised through the finder’s efforts. Unfortunately, this seemingly simple arrangement can be a trap for the unwary.

Unless the finder is licensed as a broker-dealer under federal and state securities laws, the agreement between the company and the finder is an illegal contract and is likely unenforceable. Failure to disclose the use of an unlicensed broker in the offering may also give investors a right to rescind their investment and may destroy the private offering exemption relied upon by the company to avoid registering the offering with the SEC.

Federal and state securities laws prohibit a person from being engaged in the “business of effecting transactions in securities” unless properly licensed or registered as a broker-dealer. Like many provisions in the securities laws, the interpretation of what constitutes the “business of effecting transactions in securities” is somewhat fuzzy. However, through various no-action letters, the SEC has provided some standards to help determine when the finder must be licensed.

Factors considered by a regulator in determining whether the finder must be licensed include whether the finder:

  • Has been previously involved in the sale of securities
  • Will be compensated with a transaction-based fee
  • Will discuss details of the offering with potential investors or provide recommendations to the potential investors regarding the offering
  • Is involved in the negotiations with the potential investors

The leading SEC no-action letter dealing with finders was issued in 1991 at the request of the Ottawa Senators Hockey Club, which had retained the entertainer Paul Anka to help the Club find investors (Paul Anka, SEC No-Action Letter (July 24, 1991)). Anka agreed to provide the Club a list of the names and telephone numbers of his personal contacts who might be interested in investing, in exchange for which he would receive a commission-like fee based on whether his contacts invested in the Club. He had no other duties or involvement with the offering.

The Paul Anka no-action letter is unusual in that the SEC allowed the company to pay an unlicensed finder a transaction-based fee. However, the SEC made it clear this result was based upon Anka’s very limited involvement in the offering and his agreement not to make the initial contact with potential investors or make any recommendations to them. Although the Paul Anka no-action letter has not been withdrawn by the SEC, there have been recent hints that the SEC staff would not reach the same conclusion today, and that receipt of a transaction-based fee may in itself require licensing as a broker-dealer.

Despite several calls for the SEC to adopt a simplified registration process for finders whose principal function is to introduce small businesses to potential sources of capital, those calls have not been answered. Until the SEC takes more definitive action in this area, companies and finders should exercise great caution.