Cameron Miranda
The payment of finder's fees is a complex topic that requires careful legal analysis on a case-by-case and state-by-state basis. While finder's fees can be an effective way to incentivize individuals to introduce potential investors, they can also violate securities laws if not handled properly. The Securities and Exchange Commission (SEC) has taken action against unregistered finders, confirming that the activity of unregistered persons and entities participating in capital raising is subject to scrutiny. State and federal securities laws generally prohibit the payment of referral fees to non-broker-dealers, and the SEC considers such payments as violations of the Exchange Act. However, there are exceptions, such as California's new law, which permits the payment of finder's fees in certain transactions involving California-based issuers, finders, and purchasers of securities. To ensure compliance, it is crucial to seek legal advice and be aware of the potential risks and liabilities associated with finder's fees.
| Characteristics | Values |
|---|---|
| State and federal securities laws | Prohibit the payment of referral fees to non-broker-dealers in securities transactions |
| SEC | Prosecutes issuing companies under Section 20(e) for aiding and abetting violations |
| SEC | Has indicated that the total amount finders can introduce in a 12-month period should be limited |
| SEC | Requires the disclosure of compensation and fees paid in connection with a capital raise |
| FINRA Rule 2040 | Allows the payment of finders' fees to unregistered foreign finders where the finder's sole involvement is the initial referral |
| California law | Permits the payment of finders' fees in transactions involving California-based issuers, finders, and purchasers of securities |
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What You'll Learn
Unregistered finders and broker-dealer registration requirements
The Securities and Exchange Commission (SEC) has strict requirements for broker-dealer registration. The SEC's rules and regulations are interpreted broadly, and the same goes for courts and state regulators. The SEC now prosecutes issuers under Section 20(e) for aiding and abetting violations.
Broker-dealers must register before selling unregistered securities, including private placements. They must also comply with Regulation S-P. Registered broker-dealers are the ones who usually help companies find and connect with potential investors. However, there are unregistered "finders" who perform these services.
The SEC has stated that "the federal securities laws require that an individual who solicits investments in return for transaction-based compensation be registered as a broker." The existence of transaction-based compensation is a significant factor in determining whether a finder should register as a broker-dealer. This is because it often indicates that the individual is more involved in the transaction than simply making introductions.
The two most commonly claimed exemptions from broker-dealer registration are the statutory exemption included in Section 15(b)(13) of the Exchange Act (the M&A Exemption) and the position taken by SEC Staff in a 1991 no-action letter (the Finders Exemption). The M&A Exemption offers flexibility for certain activities, but it is limited to a narrow group of unregistered broker-dealers. To qualify for the exemption, the broker or its affiliates cannot have been barred or suspended from association with a broker or dealer. The Finders Exemption is not a statutory exemption from registration included in the Exchange Act but comes from exemptive relief granted by the SEC. It states that the SEC will not recommend enforcement action where an unregistered broker-dealer provided a company with a list of potential investors in exchange for a transaction-related commission.
FINRA Rule 2040(c) allows broker-dealers to pay transaction-related compensation to non-registered foreign finders if the finder's sole involvement is the initial referral of non-U.S. customers. FINRA Rule 2040 specifically allows the payment of finders' fees to unregistered foreign finders if certain conditions are met, including that the person is not required to be registered as a broker-dealer in the U.S., the compensation does not violate foreign law, the finder and customers are foreign nationals domiciled abroad, the payment of the finder's fee is disclosed to the customer, and proper records regarding the payments are maintained.
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Referral fee issues and securities fraud
Referral fees, also known as finders' fees, are commonly paid by companies to individuals who introduce them to investors or potential acquirers. However, this practice raises complex legal issues, particularly regarding securities laws and fraud.
State and federal securities laws generally prohibit the payment of referral fees to non-broker-dealers in securities transactions. This includes payments characterised as finders' fees, referral fees, consulting fees, or success fees. The reason for this prohibition is that registered broker-dealers play a crucial gatekeeping role between sellers and purchasers of securities, helping to prevent fraud and other predatory behaviours. The US Securities and Exchange Commission (SEC) and state regulators interpret "broker-dealer" activity expansively.
Despite the legal risks, companies and their officers often pay questionable finders' fees, sometimes due to a lack of legal sophistication, and sometimes as a calculated risk to get deals done. The payment of finders' fees is a difficult secret to keep, and it can attract regulatory scrutiny in several ways. For example, the SEC now prosecutes issuing companies under Section 20(e) for aiding and abetting violations, and individual officers can be named as aiders and abettors. Additionally, the payment of fees may need to be disclosed under SEC laws requiring the disclosure of compensation and fees paid in connection with a capital raise.
To ensure compliance with securities laws, companies should use registered broker-dealers as finders. However, this may not always be practical or desirable. When using non-broker-dealer finders, companies can minimise legal risks by avoiding compensation arrangements tied to deal success or other deal-related factors, and by limiting the finder's role to making initial introductions.
To further mitigate referral fee issues, members and candidates of professional bodies such as the CFA Institute are advised to encourage their employers to develop clear procedures related to referral fees. This may include completely restricting such fees or outlining steps for requesting approval of a referral fee arrangement. Regular disclosure of the amount and nature of compensation received through referral fee arrangements is also recommended.
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SEC's stance on finders' fees and state laws
The Securities and Exchange Commission (SEC) considers the payment of finder's fees to persons not registered as securities broker-dealers as violations of Section 15(a) of the Securities Exchange Act of 1934. The SEC has the authority to investigate and take enforcement actions against unlicensed broker-dealers, which can result in civil monetary penalties, injunctions, disgorgement of fees or profits, prohibition from working in the securities industry, and reputational damage.
The SEC interprets its rules and regulations very broadly, and courts and state regulators do the same. The SEC now prosecutes issuers under Section 20(e) for aiding and abetting violations. The SEC has found it more effective to prosecute the issuing company than an unlicensed person. The SEC also requires the disclosure of compensation and fees paid in connection with a capital raise.
State and federal securities laws prohibit the payment of referral fees to non-broker-dealers in securities transactions. However, the new California law, which came into effect on January 1, 2016, legalizes the payment of finder's fees by an issuer of securities to a person who introduces one or more accredited investors who purchase securities of the issuer and who complies with the requirements of new Section 25206.1 of the California Corporations Code. This law was proposed by the Business Law Section of the California State Bar in 2012, acknowledging that the payment of finder's fees by businesses seeking to raise capital was already a widespread practice in California and nationwide. The proposal noted that the penalties for paying finder's fees to unregistered persons included rescission of sales of securities, which potentially harmed both issuers and investors.
To ensure compliance with Section 15, issuers are generally advised to use registered broker-dealers as finders. When non-broker-dealer finders are used, the risks may be somewhat mitigated by avoiding compensation arrangements tied to the success of the deal, investment amounts, or other transaction-related factors. Additionally, finders should strictly limit their activities to making initial introductions without attending meetings, discussing terms, or handling customer funds and securities.
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Enforcement priorities and regulatory attention
The SEC interprets its rules and regulations broadly, and courts and state regulators follow suit. This means that the potential consequences of violating securities laws by engaging in unregistered broker-dealer activity can be severe and far-reaching. These consequences can include regulatory proceedings, civil liabilities, and even criminal liability in extreme cases.
While the mere payment of success-based compensation can trigger claims of securities law violations, the direct involvement of an unregistered finder in solicitations, presentations, or transaction administration is more likely to do so. This is an important distinction to make, as it highlights the specific actions that could trigger regulatory attention and enforcement.
To ensure compliance with securities laws, it is advisable to use registered broker-dealers as finders. However, this may not always be practical or desirable. In such cases, it is crucial to avoid compensation arrangements tied to deal success or other deal-related factors and to limit the role of the finder to making initial introductions.
Additionally, the regulatory landscape can vary across different states. For example, California has legalised the payment of finder's fees to unregistered persons for securities offerings within the state, recognising the widespread practice of such payments. However, this is in direct conflict with the current policy of the SEC, which considers these payments as violations of the Exchange Act for transactions conducted outside of California.
Given the complexities and potential risks associated with finder's fees, it is imperative to seek competent legal counsel before entering into any agreements or arrangements.
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Rights of rescission and contract voidance
According to Section 15(a) of the Exchange Act, the direct involvement of an unregistered finder in solicitations, presentations, or transaction administration may trigger claims of Section 15 violations. Section 29(b) of the Exchange Act further emphasizes that any contract made in violation of the Act is void. This includes contracts where performance would violate the Exchange Act. As a result, purchasers of securities may have the right to require the rescission of the sale, receiving the purchase price plus interest.
The interpretation of SEC rules and regulations is broad, and rescission rights can be exercised within a specific timeframe. Federal law allows for the exercise of rescission rights until three years from the date of securities issuance or one year from the discovery of the violation. This timeframe is important as it creates a contingent liability for issuers who utilize unlicensed finders, potentially deterring investors and underwriters.
To avoid issues related to finder's fees and rescission rights, companies should ensure compliance with Section 15 by using registered broker-dealers as finders. When this is not practical, companies can avoid compensation arrangements tied to deal success and ensure that finders only make initial introductions. Additionally, specific exemptions, such as FINRA Rule 2040, permit the payment of finder's fees to unregistered foreign finders under certain conditions, including disclosure, written acknowledgment, and proper record-keeping.
In summary, rights of rescission and contract voidance are crucial aspects of securities law. They provide purchasers with the ability to unwind transactions and protect themselves from violations of the Exchange Act or issues with unregistered securities. By understanding these rights, companies can navigate the complex topic of finder's fees and avoid potential liabilities.
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Frequently asked questions
A finder's fee is a payment made to an individual or entity for introducing two parties to a transaction.
Yes, a finder's fee can violate securities law if the person receiving the fee is deemed a broker who is inducing the purchase or sale of a security without being licensed under the Securities Exchange Act of 1934. The SEC has taken action against unregistered finders, confirming that the activity of unregistered persons participating in capital raising is under scrutiny.
The consequences can be severe, including regulatory proceedings, civil liabilities, and even criminal liability in extreme cases. The agreement to pay the fee might also be deemed unenforceable, and the company and its officers may face substantial personal and professional liabilities.
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