Startup companies need funding, and entrepreneurs are rarely eager to turn away potential sources of investment.

Companies and entrepreneurs often see the initial appeal in using so-called “finders” to help them sell shares in their company to raise cash.  Though not formally defined, a “finder” is typically an individual or company that receives compensation in exchange for their raising money for your company (typically, a percentage of the amount raised, also known as a “finder’s fee”).

However, finders must be registered as broker-dealers with the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA), with very few exceptions; otherwise, both the finder and the company can face serious penalties.

What are “Broker-Dealers”? 

The Securities Exchange Act of 1934 (the “Exchange Act”) defines “brokers” and “dealers.”  A broker is defined broadly as “any person engaged in the business of effecting transactions in securities for the accounts of others…”  A dealer is defined as “any person engaged in the business of buying and selling securities … for such person’s own account,” but excludes a person that buys and sells securities for its own account, but not as part of a regular business.  Individuals who buy and sell securities for themselves generally are considered traders and not “dealers.”

Under federal securities laws, it is unlawful for any “broker” or “dealer” to induce or attempt to induce the purchase or sale of any security unless such broker or dealer is registered with the SEC.  Most state laws have similar regulatory schemes.

 The justification behind the broker-dealer registration rules is the protection of investors.

FINRA members are required to determine if an investment is suitable for potential investors.  On the other hand, unregistered “finders” seek transaction-based compensation for themselves, and will not necessarily conduct themselves with the interests of investors in mind as a FINRA member would be required.

Companies and finders face risks if broker-dealer licensing requirements are not satisfied. 

Among other penalties such as wide-ranging SEC enforcement actions, companies using an unregistered broker-dealer to assist with the sale of securities may be forced to return the money raised (the legal term is a “right of rescission”) to the company’s investors.  This is a serious penalty, which obviously creates even more challenges if the money has already been spent or is unavailable.

Additionally, the Exchange Act provides for aiding and abetting liability if the company knowingly or recklessly helped an unregistered broker-dealer (“finder”) to violate the Exchange Act.  Even if the company is able to survive after all this, it could nonetheless make subsequent rounds of financing more difficult.

Among other penalties such as SEC sanctions, finders acting as unregistered broker-dealers could be forced to forfeit their fee.  A “finder” who fails to disclose the fact that it is not registered as a broker-dealer could also be liable for a misleading omission that amounts to fraud.  The “finder” could also be barred from ever registering in the future.

This is by no means an exhaustive list of things to be aware of, and although there are exceptions to the registration requirements, they are very narrow.  It’s important that finders and companies alike keep abreast of all the rules to avoid “finding” trouble.

Please also see more information straight from the SEC’s website available at:

https://www.sec.gov/fast-answers/answersbdregishtm.html

https://www.sec.gov/reportspubs/investor-publications/divisionsmarketregbdguidehtm.html

Samuel P. Madden

Associate Attorney

(212) 865-9848

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