"If Susan introduces us to investors, can we pay her a fee based on how much they put in?"
The short answer is "wouldn't be prudent...."
In general, state and federal securities laws prohibit the payment of referral fees to non-broker-dealers in securities transactions. It doesn't matter if those payments are called finders fees, referral fees, consulting fees or success fees.
This is because registered broker-dealers play highly regulated gatekeeping functions between sellers of securities and purchasers of securities.
These statutory gatekeeping functions are in place to prevent fraud and other predatory behaviors, and they apply to all transactions involving securities, including financings and even mergers or acquisitions.
Section 15
At the federal level, Section 15(a) of the Securities Exchange Act of 1934 ("Exchange Act") requires persons engaged in broker or dealer activity to register with the SEC pursuant to Section 15(b) of the Exchange Act.
The SEC and other state regulators take an "expansive" view of what constitutes "broker-dealer" activity. It certainly encompasses:
soliciting investors,
assisting in structuring securities transactions,
helping identify potential investors,
participating in deal negotiations,
handling investment funds or securities.
Transaction-Based Compensation
The SEC and state regulators are particularly focused on the nature of any compensation paid to "non-registered" persons.
A concept etched into my mind from years as an SEC Enforcement lawyer is that "transaction-based compensation is a hallmark of broker-dealer activity."
What the frequent use of this phrase by the SEC means is that, regardless of the degree to which a person engages in the bulleted activities above or not, payment of either "transaction-based" or "success-based" compensation alone can trigger a violation of Section 15.
Common examples of transaction-based or success-based compensation include payments based on amounts invested or on closing above a certain amount.
SEC Guidance and the Myth of a "Finders Exemption"
Guidance from the SEC on these issues is limited and not encouraging, despite efforts over the years by the American Bar Association and numerous law firms to push the SEC for greater clarity.
In 1991, the SEC issued what's known as the Paul Anka No Action Letter, which permitted a person to simply introduce prospective investors to an issuer, and nothing more, and receive success-based or transaction-based compensation without triggering broker registration under the Exchange Act.
The Paul Anka No Action Letter was relied on by finders for many years and appears to be the source of the widely held but erroneous belief in a "finders exemption" from the broker-dealer registration requirements.
Years after issuing it, the SEC distanced itself from even the Paul Anka No Action Letter's restrictive guidance and doubled down with a series of no action relief denials.
Perhaps most importantly, in 2010, the SEC denied a no-action request from law firm Brumberg, Mackey & Wall, P.L.C., which wanted to introduce prospective investors to issuers for success-based fees. The SEC responded that “the Staff believes that the receipt of compensation directly tied to successful investments in [issuer’s] securities by investors introduced” thereto by a person “would require broker-dealer registration.”
The only positive no action relief to date is strictly limited to the M&A realm and only covers finders who help identify potential buyers of companies who intend to be actively involved in running the acquired companies. See M&A Brokers No Action Letter, January 31, 2014.
Potential Legal and Regulatory Risks
Violations of Section 15 can result in direct liability for finders in form of injunctive actions, fines, and even criminal prosecution in the case of willful violations.
Companies paying finders can also find themselves in hot water, both in the form of aiding and abetting liability under Section 21 of the Exchange Act and also for directly causing violations of Section 15(a), as Ranieri Partners LLC learned in 2013.
In that SEC enforcement action, Rainieri Partners paid a fine of $375,000 based on SEC findings that "...Ranieri Partners caused [finder] Stephens’ violations of Section 15(a) of the Exchange Act, which requires persons engaged in the business of effecting transactions in securities to be registered as a broker or dealer or associated with a registered broker or dealer."
Ranieri also highlights that individual officers of issuers can be named as aiders and abetters. The SEC's Order found that Ranieri's Senior Managing Partner, William Phillips, "...willfully aided and abetted and caused Stephens’ violations of Section 15(a) of the Exchange Act." Philips was fined $75,000.
Lastly, Section 15 violations also create rights of rescission in favor of the purchasers of securities. This is because Section 29(b) of the Exchange Act says every contract made in violation of the Exchange Act, including contracts where performance violates the Exchange Act, are void as to “any persons who, in violation of any such provision, rule or regulation, shall have made or engaged in the performance of any such contract.”
The payment of finders fees is a tough secret to keep and they can receive regulatory attention in several ways.
Companies that raise capital under Reg D and/or that file a registration statement with the SEC for an IPO must disclose payments to third parties in connection with financings. See Item 15 on SEC Form D, "Sales Commissions and Finders' Fees Expenses" and Item 15 in Part II of SEC Form S-1, "Recent Sales of Unregistered Securities."
During my time as a staff attorney in the SEC's Division of Corporation Finance I reviewed Item 15 of Part II of every IPO filing for prior sales of securities that looked problematic. I raised rescission issues in comment letters to companies on several occasions.
On those rare occasions when SEC staff comments about rescission concerns stick (usually because of an earlier "blown offering exemption"), the complexities of addressing the rescission offer in the IPO registration statement can become an insurmountable challenge for the issuing company and its IPO.
Unfortunately for a once-promising startup called Neogenix Oncology, Inc., finders fee disclosures from its IPO registration statement later became its undoing. Interestingly, this happened years later when SEC staffers dug into the earlier filings and forced the issue at a time when the company was struggling financially. The financial implications of the rescission issue prevented the company from being able to attract new capital.
The following disclosures from page 9 of Neogenix's 2011 Form 10-K spelled the beginning of the end.
"Certain shares of our common stock were sold through finders who were paid fees in spite of not being licensed as broker dealers.
The Company has concluded that finders’ fees were paid to certain individuals who were not registered as broker-dealers or otherwise licensed under applicable state law. Accordingly, it is possible that at least some investors who purchased shares of common stock in transactions in which finders’ fees were paid may have the right to rescind their purchases of shares, depending on applicable federal and state laws and subject to applicable defenses, if any. In addition, the Company may be subject to additional liability under state and/or federal laws in connection with the use of unlicensed broker-dealers. If the Company is forced to rescind a significant number of share purchases and/or pay substantial damages, it will impact the ability of the Company to continue operations; therefore management believes that there is substantial doubt about the Company’s ability to continue as a going concern."
Well before SEC staffers or state regulators start asking questions, however, potential rescission rights could be a powerful incentive for investors to raise "finders" issues if an investment looks like it's going south.
Again, finders fees are a tough secret to keep.
Common Practices
Despite these many risks to finders, companies and company officers, the payment of questionable finders fees seems common.
In most cases, this is due to lack of sophistication - particularly where the violation is simply due to the type of compensation involved and not the nature of the finder's involvement, which might be completely insignificant. As noted above, the myth of a "finders exemption" is widespread.
In many other cases, calculated risks are taken to get deals done. Finders with networks of rich investors naturally want to make money referring those investors. And companies paying for referrals naturally only want to pay for ones that are "successful." The more difficult a deal is to complete, the greater the risks a company might be willing to take to get it done, particularly where a company's very existence depends on bringing in funds.
Deal dynamics, including financial desperation, simply drive some companies and individuals to gamble on the relatively safe assumption that finder fee enforcement actions or litigation are unlikely.
More often than not, this seems to be a somewhat safe, albeit inappropriate, gamble. Referral fee issues are probably most often "add-on" issues where the primary claims involve allegations of securities fraud or unregistered securities offerings. Pursuing actions based solely on finders fee violations does not seem to be an enforcement priority for either state or federal regulators.
How to Use Finders without Violating Section 15
Again, the best way to ensure compliance with Section 15 is to use registered as broker-dealers as finders. But relying on registered broker-dealers isn't always practical or desirable.
When non-broker-dealer finders are used, Section 15 issues can be largely eliminated by doing two things:
Avoiding any compensation arrangements tied to deal success, investment amounts or other deal-related factors.
Ensuring that finders do nothing more than make initial introductions.
By way of example, Susan can receive $3,000 per month as a "consultant" for introducing her wealthy friends to a company raising funds, provided she does not:
attend meetings with the company and investors,
attempt to explain or discuss the company, investment opportunity or deal terms with the investors,
aid in preparation or dissemination of deal materials, or
handle securities, cash or any other aspects of securities transactions.
Risky Activities
The "anecdotal evidence" seems to indicate that many companies and finders are not content to work within these strict confines.
Based on finder proposals I have personally rejected, it seems some finders are accustomed to receiving success-based fees, and hence some companies must be paying them.
Whenever success based compensation is involved, it becomes even more important to not trip over the above bulleted no-no's. Participants in such arrangements are running afoul of the regulatory guidance. Preserving arguments that the compensation was a one-time arrangement and/or didn't involve any other aggravating circumstances might help limit, but not eliminate, overall risk exposure.
In other cases, many finders receiving flat fee compensation not tied to deal success metrics are doing much more than they should - sitting in on meetings with investors, helping structure the deal, trafficking in deal materials, or cajoling investors to get in.
These types of finder activities, depending on the facts, probably raise the greatest risks. When deals go bad and investors are aggrieved, an overly active finder is more likely to be identified and caught up in any legal or regulatory aftermath than a finder who merely made a simple introduction and bowed out of the process.
Proposed SEC Finders Fee Rule
Article Update: On October 7, 2020, the SEC issued a proposed rule that would create "a new limited, conditional exemption from broker registration requirements for “finders” who assist issuers with raising capital in private markets from accredited investors." The SEC's press release provides the following general overview:
The proposal would create two classes of finders, Tier I Finders and Tier II Finders, that would be subject to conditions tailored to the scope of their respective activities. The proposed exemption would establish clear lanes for both registered broker activity and limited activity by finders that would be exempt from registration.
As of April 27, 2021, the status of this finders rule proposal remains uncertain, particularly given changes in the U.S. presidency and given SEC Chair Jay Clayton's resignation in December of 2020, but hopefully the SEC will issue follow-up guidance in the coming months.
Summary
While the mere payment of success-based compensation can trigger claims of Section 15 violations, an unregistered finder's direct involvement in solicitations, presentations or transaction administration is probably more likely to trigger such claims. In such situations, problematic compensation would just be another bad fact.
Many companies and finders seem willing to take calculated risks in this area in order to get deals done, but company officers, counsel, and other advisers need to be aware that these risks could easily result in substantial personal and professional liabilities.
On a final note, fellow securities law enthusiast Mark Beatty was kind enough to review this post before publication and made the following policy observation:
"The ABA has been trying to work with the SEC on finders issues for years without success. Given everything that's been done under the JOBS Act with crowdfunding and other provisions to help small businesses raise capital, this should be a priority for the SEC. Allowing for reasonable regulation of finders activities could probably do more for capital formation than anything that's been accomplished under the JOBS Act."
Perhaps the SEC's October 2020 proposed rule release is a sign of greater clarity and flexibility to come. Stay tuned.
Paul Swegle has served as general counsel to numerous tech companies and advises a dozen others as outside counsel. He has completed $12+ billion of financings and M&A deals, including growing and selling startups to public companies ING, Capital One, Nortek, and Abbott.
Paul has authored two authoritative and practical business law books, available for preview and purchase here:
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