Finder's Fees are risky to evade registration

SUMMARY

In general, in California, whenever any person earns compensation based ion a transaction in securities occurring, the person earning the compensation must be properly registered with both the SEC under the

Securities and Exchange Act of 1934⁠

and the State of California Corporations Code section

25210⁠

. Throughout this article registration refers to the applicable requirements at the Federal, State or both levels.

Federal law has a limited exception for M&A brokers, but even under the Federal M&A exemption, California registration may be required. California State has a "Self-Registering" Finder’s Exception, but that does not exempt the person from Federal registration, the finder’s activities use the telephone, internet, mail, fax or federal highways.

Although many entrepreneurs creatively try to legally get paid to find investors, the truth is actually lawfully performing the actions of finding investors for issuers, and getting paid based an investor investing money, and getting paid, without registering is difficult.

Violations can be costly, potentially exposing the finder to being sued by and paying damages to disappointed investors, paying money fines and being banned from the securities industry by the SEC.

Overview

At least 10 times a year, I consult with a person who is acting or wants to act as a finder for another company and get paid if and when that other company sells securities or issues securities. A security is a financial asset in which the seller and purchaser contemplate a division of profit that is generated based on a group effort. Traditionally, securities have been simple securities like stocks and bonds. Modernly, the world is more complex, and securities may encompass other assets including crypto assets, subject to the

Howey Test⁠

But, back to the point, the question is usually, can I enforce a finder’s contract for payment based on successfully introducing one party to another, when the payment is triggered by the sale of a security or the purchase, acquisition or merger of a company, if I am not licensed as an broker dealer or licensed as an agent of a licensed broker dealer?

Surprisingly in law, the answer is generally straightforward and simple.

Generally, No.

Of course, there are some exceptions, but even those exceptions do not seem to help much.

Under section 780 of the Securities and Exchange Act of 1934, “[i]t shall be unlawful for any...[person or company]...to...use...any means or instrumentality of interstate commerce[, meaning mail, email, telephone, fax, or federal highway,] to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security,]...other than an exempted security or commercial paper, bankers’ acceptances, or commercial bills) unless....registered....” [

15 USC section 780⁠

In other words, no person can legally transact in non-exempt securities using the telephone, email, mail, fax, or federal highways, without properly registering with the SEC.

In the face of ever-increasingly creative structuring to avoid registration, the SEC has that“[t]he SEC and SEC staff have long viewed receipt of transaction-based compensation is a hallmark of being a broker....” and therefore requiring registration. [

A Few Observations in the Private Fund Space⁠

, April 5, 2013].

In the distant past, the SEC has issued at least one no action letter regarding so-called "finder's fees." However, more recently, the SEC has subject non-registered persons soliciting transactions on behalf of advisers and broker dealers to much more scrutiny and discipline. For example, In the Matter of Raieri Partners, the SEC issued a

Cease and Desist Order⁠

Federal law has a limited exception for M&A brokers, but California registration may be required. California State has a "Self-Registering" Finder’s Exception, but that does not exempt the person from Federal registration.

DETAILS

When registration is required

Registration if a security.

Broker registration is required only if the broker service involves a "security." If a finder's fee relates to an asset or business interest that is not a security, its likely that no securities broker registration is required.

What is a security?

"Security" is defined broadly as any "note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement... or, in general, any instrument commonly known as a 'security'..." [

15 USC section 780⁠

] (Securities Exchange Act of 1934).

The "Investment Contract" Catch-All

Although the statutory list is expansive, the US Supreme Court case, S.E.C. v. W.J. Howey Co. (1946)

328 U.S. 293⁠

established the Howey Test test for an "investment contract" to determine whether something is a security is as follows:

An investment of money;

In a common enterprise;

With an expectation of profits;

To be derived primarily from the efforts of others.

Act as a broker, must register

Who and what makes is a broker?

The term "broker" means "any person engaged in the business of effecting transactions in securities for the account of others." 15 U.S.C. section 78c(a)(4)(A) and

SEC guidance⁠

To help the entrepreneurial spirited people who are determined to forge ahead with getting paid when their efforts without being registered with the SEC as a broker dealer, the SEC poses some simple questions that may help determine, are you acting as a broker.

Do you participate in securities transactions, including solicitation, negotiation, or execution of the transaction?

Does your compensation either depend upon or related to the outcome or size of the transaction or deal?

Do you receive any other transaction-related compensation?

Evaluating Conduct that May Require Registration

Evaluating Conduct that May Require Registration

Conduct

Authority / Guidance

Participation in Negotiations (Discussing terms, structure, or value of the security).

SEC Staff Guidance (Repeatedly cites negotiation as a key factor).

Handling Customer Funds/Securities (Having custody or discretion over investor money/assets).

15 U.S.C. section 78o(c)(8) (Broker/Dealer rules on custody).

Making Valuations or Giving Advice (Performing financial analyses or recommending the security).

SEC Staff Guidance.

Active Solicitation of Investors (Seeking out investors/purchasers, rather than simply introducing existing parties).

SEC Staff Guidance (Cites "finding investors" or "making referrals" as potential broker activity).

There are no rows in this table

⁠

Why is registration required?

It is unlawful for any broker or dealer to "effect any transactions in, or induce or attempt to induce the purchase or sale of, any security... unless such broker or dealer is registered in accordance with subsection (b) of this section." [

15 U.S.C. section 780⁠

(a)(1)].

What is entailed in registration?

Registration is complex, time consuming, and subjects the person registered to numerous reporting requirements and oversight. That’s why this is such a popular subject; how do people legally avoid registration?

Although this author’s opinion is that if the reader is so good at finding people and makes so much money, why doesn’t the reader just register, the focus of this article is how do people legally avoid registration?

Nevertheless, for completeness a full SEC explanation of how to register follows.

The formation steps include: 1. Form BD; 2. Self-Regulatory Organization (SRO) Membership, like FINRA; 3. Securities Investment Protection Act Membership; 4. California State Registration; 5. Associated Person[s]. The financial responsibility requirements include: 1. Net Capital Rule 15c3-1, greater of $250,000 or 2% of debits, although less for those who do not clear of carry customer accounts; 2. Use of Customer Balances under Rule 15c3-2, not likely an issue for finders; 3. Customer Protection; 4. Required Books, Records and Reports; and 5. Risk Assessment Requirements.

You can learn more at the SEC Guide to

Broker Dealer Registration⁠

and

Get More Information⁠

on SEC Broker Dealer Registration

Penalties for not registering

Depends if you get paid and then get caught by the investor and/or the SEC.

However, the potential negative consequences of acting as a broker include any and all of the following: (1) inability to enforce a contract to get paid; (2) being sued by an investor if the investment loses money; (3) being required to pay fines to the SEC; and/or (5) being temporarily or permanently banned by the SEC from the securities industry.

Possible Exceptions to Registration

List of potential exceptions

Not a security, see Howey test

M&A Broker as exception for Federal, but not California registration

California Finder, but still subject to Federal Registration

M&A Broker Exemption (Section 15(b)(13).

A specific federal exemption from broker-dealer registration was codified in 15 USC 780(b)(13) of the Exchange Act for certain Mergers and Acquisitions (M&A) Brokers involving the sale of eligible privately held companies.

Key Conditions (among others):

The transaction is solely for the transfer of ownership of an eligible privately held company (which generally means it does not have public reporting requirements and has gross revenue of less than $250 million and/or EBITDA of less than $25 million in the fiscal year prior).

The M&A broker reasonably believes the buyer will retain control of the company and be active in its management.

The M&A broker cannot facilitate a public offering, raise capital, or otherwise facilitate a securities offering.

Important Note: This exemption only applies to federal registration requirements. It does not preempt state law, meaning state-level registration or an exemption may still be required (like in California).

SEC Finder Exception Not a Rule, Yet

In the past, the SEC staff had proposed a conditional exemption for "finders." However that proposed SEC rule has be formally adopted. Currently, the SEC views most activities of a "finder" who receives transaction-based compensation for soliciting investors as requiring broker-dealer registration. Exceptions are limited, relying on the specific facts and circumstances. The aforementioned M&A Broker exemption specifically does not permit general "finder" activities such as identifying new sources of capital.

California State “Finder’s” Exception, Does not Excuse Federal Registration

California Corporations Code section 25206.1 creates a statutory exemption from California State, but not an exemption from Federal registration, for a "Finder" who introduces or refers accredited investors to an issuer. This exemption is commonly referred to as the "Self-Registering" Finder’s Exception because it requires an initial filing, a filing fee, maintenance of records, and an annual information filing.

Key Conditions (among others):

The finder must be a natural person.

The finder must introduce or refer one or more accredited investors to an issuer for a potential offer or sale of securities in an issuer transaction.

The finder must not participate in negotiating terms, advise on the value/advisability of the investment, or conduct due diligence.

The finder must file an initial statement of information (Form DFPI-25206.1) with the DFPI and pay a fee, and file annual renewals.

The finder must obtain the informed, written consent of the introduced person and the issuer, which includes a representation that the introduced person is an accredited investor.

The finder must maintain records for five years.

Risky & uncertain, getting paid for administrative services, not findind

It is unclear if the following situation requires registration.

The person seeking to get paid could have an agreement with the issue to physically deliver the share certificates that the issuer issues to the investors who have purchased those shares. That contract could in general, be non-exclusive, meaning the issuer could pay any person to deliver the share certificates. However, the agreement between the issuer and the delivery person could create a mechanism, whereunder the issuer grants the exclusive right to deliver shares to certain specifically named investors. Furthermore, the amount of compensation could be based on the number of shares delivered.

Note, any regulator has the power to “see through” the form of any transaction and make a determination that the transaction required registration. The SEC could consider that this hypothetical scenario requires registration.

Conclusion

Securities and Exchange Act of 1934⁠

and the State of California Corporations Code section

25210⁠

Violations can be costly, potentially exposing the finder to being sued by and paying damages to disappointed investors, paying money fines and being banned from the securities industry by the SEC.