Wednesday, October 1, 2014

Proposed Finders Exemptions in Capital Raising Deals: If M & A Brokers are Exempt from Registration, Why Aren't Capital Raising Finders Exempt? (Article 10 in a series of 14 articles about Deal-Makers)

By Jim Verdonik

I'm an attorney with Ward and Smith PA. I also write a column about business and law for American Business Journals , have authored multiple books and teach an eLearning course for entrepreneurs. You can reach me at
Or you can check out my eLearning course at
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This article is one of 14 articles in a series of articles about Deal-Makers called:


What if you were in a desert and the only people allowed to sell you something to drink refused to sell less than one thousand gallons?

What if you didn't have enough money to buy one thousand gallons?

What if you only had enough money buy one gallon?

What if you met people who had water and were willing to sell you one gallon, but selling one gallon was against the law?

If you were dying of thirst, would you obey the law and die?

Or would you break the law and live?

If you had one gallon, would you let someone die of thirst, because the law required it?

Even most law abiding people would buy the one gallon and live or save a life.

Then they would probably go home and complain about stupid government laws that stop people from buying a gallon of water when they are thirsty.

Laws that force good people to choose between obeying the law and acting both rationally and ethically are bad public policy.

That sounds crazy - doesn't it?

Why would anyone have a law like that?

But this is the type of law that limits young business' ability to raise the capital they ungently need.

The SEC says that "transaction based compensation" in the form of success fees is illegal, unless the person you hire to raise money for you is a registered broker-dealer.

But most registered broker-dealers don't want to raise money for young businesses: 

·         The liability risks are too high.

·         The transaction sizes are usually too small to compensate the broker for incurring the cost of complying with broker-dealer registration and regulation laws.  They have to sell you at least 1 thousand gallons to make a profit.  So, they search for customers who do deals that are bigger than a thousand gallons and pass up smaller deals.

Many unregistered "finders" are willing to do your small (one gallon deal), but the SEC thinks it's illegal for them to do it. 

  • The unregistered finder can be penalized.
  • You can be penalized for using an unregistered finder, because the government will give your investors the right to get their money back from you if you us an unregistered finder.
Comparison to M & A Brokers

We discuss in article (8) of this series of articles, the M & A broker exemption that the SEC explained in a recent no action letter.  The SEC bowed to the reality that small businesses need unregistered finders to help them sell their businesses.

For many years, people who know about capital raising deals have tried to persuade the SEC to create a similar exception for finders in capital raising transactions.  Prohibiting the use of unregistered finders creates bigger problems in capital raising transaction than in sales of businesses.  The reasons why the problem is bigger in capital raising transactions than in business sales include:

·         When you sell an entire business, the amount of money in the deal is based on the value of the entire business.  If instead you try to sell a 20% interest in the same business, the deal size usually shrinks proportionately.  While commission percentages in private placements are often higher than the percentage commissions are for sales of businesses, the broker usually makes less money in the smaller capital raising deal.

·         Businesses use the capital they raise to grow.  Therefore, valuations are usually much higher when the business is sold than when the business raises capital.  This contributes to an even bigger differential in transaction size and commissions.

·         Liability risks are usually higher for everyone in capital raising transactions than in business sales.  Business buyers are usually more sophisticated than individual investors.  The buyer is often in the same business as the seller so the buyer usually knows more about the industry and its risks than investors know in a capital raising transaction.  Disclosures focus on the individual business being sold, whereas in capital raising transactions you usually have to devote substantial effort to disclosing risks about the industry, including competitors.

·         When businesses are sold, they usually have historical financial statements on which valuations are based.  Businesses often raise capital using projections of future financial performance.  Since the future is more speculative than the past, it often takes much greater effort to sell an investment round than to sell a business.

·         Many capital raising rounds require you to find and sell to multiple investors.  Selling to one buyer is often a simpler task.

For these reasons, the SEC's very expansive views about who is a broker and who needs to register when they are paid to provide services in capital raising transactions cause young businesses bigger problems in finding suitable assistance when they try to raise capital than when they sell their businesses.

Most young businesses are forced to go it alone or suffer the risk of using an unregistered finder.  As we discuss in article (6) in this series of articles, unregistered finders may not always produce perfect disclosures for investors, but they usually improve the quality disclosures compared to when inexperienced business owners try to do it themselves.

We should all be able to agree that unrealistic SEC policies that produce less disclosure to investors and lower quality disclosures cannot be justified on the grounds that if everyone just stopped behaving rationally we might achieve better disclosure.  People will continue to act imperfectly driven by reality.  Pretending that will change is bad public policy.

SEC vs the Courts

We discuss in article (3) of this series of articles why some courts disagree with the SEC's broad views about who has to register as a broker. 

Such courts are carving out their own exemptions from registration as a broker based on their view that Section 15 (a) (1) of the Securities Exchange Act of 1934 never intended to regulate all payments to everyone who provides assistance to businesses raising capital.

In SEC v. Kramer No. 8:09 CV-455-T 23 TBM (M. D. Fla. April 1, 2011), the Florida District Court stated: the SEC's" proposed single-factor "transaction-based compensation" test for broker activity… is an inaccurate statement of the law."  

The Kramer court also reminded the SEC that the courts retain the power to interpret the Exchange Act's definition of broker and the registration provisions of the Exchange Act by reminding the SEC that SEC no-action letters "have no binding legal authority." 

In rejecting the "transaction-based compensation" test the SEC applies, the Kramer court determined that it would rely on the Exchange Act's language: "In the absence of a statutory definition and enunciating otherwise, the test for broker activity must remain cogent, multifaceted, and controlled by the Exchange Act."

The Kramer court put the SEC's rightful role into useful perspective in rejecting the SEC's arguments that the mere existence of "transaction based compensation" determines that someone is required to register as a "broker" under Section 15 (a) (1) of the Exchange Act. 
Other courts have added insights into the tests they think are appropriate taking into account the Exchange Act's primary principles as expressed in the language of the statute.  These courts ask relevant questions without jumping to the conclusion that Section 15 (a) (1) of the Exchange Act requires everyone who receives payment to register as a broker.  The relevant questions we should all be asking are:

  • What does "being in the business" mean?
  • What does "effecting transactions" in securities mean?
In both SEC vs. Hansen 83 Civ. 3692, 1984  WL 2413 (SDNY 1984) and SEC vs. Kramer, 778 F. Supp. 1320 (MD Fla 2011) and Landegger Cohen No. 11-CV-01760-WJM-CBS, 2013 WL 5444052, 6-8 (D. Col. September 30, 2013), courts applied a multi-part test to determine whether the alleged broker was really "engaged in the business" of "effecting transactions" in securities.  The test includes:

  • Whether the alleged broker is an employee of the issuer.
  • Whether the alleged broker receives commissions as opposed to a salary.
  • Whether the alleged broker is selling (or previously sold) securities of other issuers.
  • Whether the alleged broker is involved in negotiations between the issuer and the investor.
  • Whether the alleged broker makes valuations about the merits of the investment or gives advice.
  • Whether the alleged broker is an active rather than a passive finder of investors.
In Landegger, the Colorado District Court indicated that the two primary factors for determining whether someone is "in the business" of "effecting securities transactions" are:

·         How often the alleged broker participated in similar transactions.

·         Whether the alleged broker received transaction-based compensation tied to the success of the transaction.

In SEC V. Bravata, 2009 WL 2245649 (E. D. Mich. 2009), a Michigan District Court indicated: "The most important factor in whether an individual entity is a broker is whether there is a regularity of participation in securities transactions at key points in the chain of distribution." 

This focus on regularity evidences that the court believes that a single transaction does not cause someone to be "in the business" any more than someone who holds an annual yard sale is in the retail business.  The Bravata court also considered other factors, including how aggressively the finder pursues investors, participation in negotiating investment terms and offering advice or valuation information.

Courts in the Southern District of New York have focused on a more basic distinction between finders and brokers: 

"A finder locates potential buyers and sellers, stimulates their interest and brings the parties together, while a broker brings the parties to an agreement on specific terms."  Jones v. Whalen (S. D. N. Y. March 29, 2002) and Antares Management v Galt Global Capital 12-CV-6076 S. D. N. Y. March 22, 2013). 

This distinction seems to place greater weight on whether the alleged broker helped to negotiate an investment on specific investment terms than on how many transactions the finder did or how the finder is compensated.  In this scenario, it is not important that the finder:

  • Is "in the business" of introducing people, because introducing people is not the same as "effecting transactions" in securities any more than introducing two people who later decide to marry one another is the same as performing a marriage.
  • Is compensated with a success fee.
These New York decisions focus on what the finder did to help close the deal.  By doing this, the courts are implicitly saying that the Exchange Act's use of the term "effecting transactions" in securities requires greater involvement in the specific deal than simply introducing people.  If the finder does not actually "effect transactions," it does not matter that the finder is "in the business," or the nature of the compensation or the number of introduced transactions. 

The SEC's position is strongest where a finder is continually interacting with investors about deal terms or the value of the securities.  Where the finder is advising only the issuer and does not interact with investors about deal terms, the SEC's position that the finder is selling the deal or "effecting the transaction" is weaker.  Issuers have many advisers who are not required to register as brokers.  It is difficult to justify treating an adviser to the issuer who also introduced an investor differently than other advisers to the issuer.

Certainly, to the extent the SEC worries about success fees creating the temptation to engage in high pressure sales tactics with investors, that factor is not present where the finder communicates advice about deal terms solely to the issuer.

Finders have an economic incentive to have deals close, but they no real economic incentive to establish the deal terms, because they are paid the same amount regardless of the deal terms.  Finders are usually neutral on deal terms.  Consequently, we should not assume that finders always participate in establishing deal terms or always do anything else beyond introducing people and encouraging them to do a deal of some kind. 

What is the primary value of finders?  Usually, the primary value a finder brings is to cause potential investors to spend the time to evaluate whether to invest in a particular issuer.  Investors are busy people.  They can't evaluate all deals in the market.  Usually, the finder is someone whose judgment the investor respects enough to spend time to read a business plan or talk to a management team.  In some cases, finders affect the decision to make an investment, but in most transactions they simply get the investor's attention and the investor makes its own decision.

What finders actually do varies from one deal to the next.  That's why it is difficult to say that finders always have to register as brokers or never have to register as brokers.  Different finders simply do different things in different deals. 

Although there is no safe harbor, situations where finders have the best defenses against being required to register as brokers under Section 15 (a) (1) of the Securities Exchange Act of 1934 include the following circumstances:

  • The finder is not doing more than introducing the issuer of securities to investors.  That means not advising the investor to invest and not participating in negotiations between the investor and the issuer, including not circulating or commenting on term sheets and not collecting investor signatures and checks.
  • If the finder does participate in establishing deal terms, it is as a consultant to the issuer and the finder communicates only with the issuer and not with investors.
  • The finder only infrequently accepting finder's fees.
  • The finder is not playing a part in any of the key points in the chain of distribution of securities.
  • The finder does not hold itself out to the public that it is in the business of raising capital.
  • The finder issues disclaimers to investors that the finder is not providing investment advice and is not making any recommendation to purchase securities.  These disclaimers should specifically indicate that the finder's role ended with the introduction to the business that is raising capital.
  • The finder does not hold money or securities of either investors or the issuer.
With respect to compensation, finders are in a better position if they charge for introductions without regard to whether the people being introduced actually make investments, but businesses that are trying to raise capital rarely agree to that, because they cannot afford to pay fees until they raise money.

Some finders may be able to limit their activities as described above.  But that is not a viable solution for all finders.  Many finders go beyond what the courts have indicated they are allowed to do without registering, because:

  • Even most small deal makers have to do at least several transactions per year to pay their bills. 
  • Securities laws are often preoccupied with whether investors are "sophisticated."  But in many transaction issuers are unsophisticated.  This may be their first time trying to raise capital.  Therefore, finders also often advise unsophisticated issuers about how to interact with investors, structure deals and communicate with both the issuer and investors during the course of the transaction. 
  • And, of course, some finders actively try to sell deals to investors, which places them squarely in the middle of activity that requires registration as a broker.
All these activities that are common practice put finders in jeopardy of having to register as a broker even under the court decisions discussed above.

Because the SEC disagrees with these court decisions, however, unregistered finders and the businesses that use them to raise capital place themselves at risk of spending both time and money defending against SEC and investor legal actions with no guaranty of success.

Proposals for Formal Exemptions for Unregistered Finders

This conundrum has cause many people and organizations who are familiar with private placements by young businesses to advocate that the SEC and Congress create reliable exemptions from registration for the capital raising activities of finders.

As we discuss in articles (4), (5) and (6) of this series of articles, Section 201 (c) of the JOBS Act created a specific exemption from the broker-dealer registration requirements of Section 15 (a) (1) of the Securities Exchange Act of 1934 in Rule 506 offerings for people who operate technology devices that permit others to offer and sell securities, people who co-invest in securities offerings, people who provide due diligence services and people who provide standard forms for issuers or investors to use in securities transactions.  The SEC is, however, trying to neuter this statutory exemption by claiming that Section 201 (c) does not permit you to charge fees for any of these services.

If the courts strike down the SEC's fee assertions, Section 201 (c) will certainly help young businesses in their capital raising efforts.  But Section 201 (c) by itself will not solve the capital raising problems caused by broker-dealer registration requirements. 

As we discuss in article (9) of this series of articles, technology platforms may be useful tools for introducing people, but most transactions require in person interaction by people who know how to get deals done.  That's the valuable role finders often play.

For these reasons, Section 201 (c) is not an adequate substitute for a broader finders exemption from the broker-dealer registration requirements of Section 15 (a) (1) of the Securities Exchange Act of 1934.

Generally, exemption proposals for finders who help businesses raise capital fall into two categories:

·         Proposals to totally exempt certain finders.  The exemption criteria often involve transaction size or the number of transactions a finder does in a year.
·         Proposals to provide a limited form of registration and exemption from some of the most burdensome rules registered brokers have to comply with.

The problem of how small to medium size businesses can raise capital through informal middlemen isn't a new one.

Many groups have suggested solutions to the SEC. 

The development of the online single purpose venture capital fund industry (which we discuss in article (13) of this series of articles) may cause the SEC to reevaluate past proposals to create a finders exemption from broker-dealer registration requirements.

·         Changes to the Investment Advisers Act of 1940 that were made by the Dodd-Frank Act of 2010 may provide a model. 
·         Smaller advisers are totally exempt from Federal registration. 
·         Larger advisers to certain types of "private funds" must identify themselves to the SEC, but are exempt from most of the requirements of the Investment Advisers Act that do not make sense for fund advisers.

Broker-dealer registration and regulation would make more sense if we adopted rules that Are tailored to both the size of the operation and the nature of the activities.

If Section 201 (c) of the JOBS Act is any example, however, the SEC is unlikely to act absent a new Federal statute that is carefully written to prevent the SEC from limiting the exemption.  In most situations, the SEC has traditionally used the existence of a "success fee" that measures the finder's compensation by how much money the finder helps the company to raise.  But faced with the new exemption from registration as a broker afforded by Section 201 (c) of the JOBS Act, the SEC indicated that any type of compensation for services was enough to disqualify you from using the exemption

ABA Finder's Exemption Proposal

Many finder exemptions have been proposed from time to time, because this has been a long-term and widespread problem for young growth companies and small businesses.

The finder exemption the American Bar Association proposed to the SEC is one of the more thoughtful and detailed proposals.

The ABA proposal, which would permit finders to be paid transaction-based success fees that are contingent on the closing of a transaction, covers two types of activities:

·         Activities in which the sole intermediary would be the exempt finder, including arranging for the purchase and sale of securities in private placements, and related due diligence, structuring, valuation, negotiation, and assistance in obtaining financing; and
·         Acting as a finder between an issuer or selling shareholder and a FINRA-member, SEC-registered broker-dealer for any type of transaction, including private placements or public offerings, where the finder's only function is to introduce the investment banking client or other transaction participant to the registered broker-dealer.
The ABA's proposal suggested several alternatives for limiting the size of businesses that can raise capital through such finders –all of which would have included a range of small to mid-sized companies in recognition that large investment banks have virtually abandoned this market.

The ABA's proposal would have exempted the finder from Federal registration and left registration up to the states.  Several states have recognized that their own rules were preventing businesses from raising capital and have created their own finder exemptions from registration.
The ABA's proposal  recommended that states adopt a model law to promote uniformity, discourage forum shopping, and encourage finders to register in each state where such registration is required.  To prevent bad actors from becoming finders, the ABA's proposal recommended that the CRD system (which tracks violations by brokers) be expanded to include exempt finders and their agents, requiring disclosure of any events that would be reportable in response to Item 7 of Form BD or Item 14 of Form U4.  The ABA's proposal indicated there is no need for a minimum net capital requirement for finders, because exempt finders would not be permitted to hold investor or client money or securities and suggested states instead require meaningful fidelity bonding to protect investors.  The ABA's proposal indicated that states could still require periodic reports on Form D and have other examination and licensing requirements for individual sales people that finders hire.
Recognizing that many finders are already operating in the shadows, the ABA's proposal recommended that states adopt an amnesty policy for finders that have previously functioned in this area without registration but only if they have not committed fraud, larceny, or other prohibited conduct.
The SEC's M & A Broker resolves many of the Federal issues related to brokers in M & A transactions.  It's time for Congress to take similar action for finders operating in capital raising transactions for small to medium size businesses.

When this occurs, we'll have given small to medium size business powerful new tools to let them utilize middlemen to implement both their capital raising and their exit strategies at lower cost of both time and money.


As a consumer protection device, the SEC or FINRA could operate a website that allows anyone to post comments about any finder they think violated the anti-fraud rules.  Both the SEC and state regulators could use this website to commence investigations.  Both state and Federal regulators would be mandated to focus on securities fraud issues instead of registration issues.

 A reasonable approach to registration rules for finders that could help young businesses raise capital would be to adopt a two tier approach:

·         First, clarify that anyone who engages in less than a specified amount of transactions is not in the business of effecting securities transactions.  This would incentivize informal finders to use their network of business connections to sporadically assist others to raise capital. 

·         Finders who exceed the volume of transactions to be totally exempt, could be required to identify themselves to the SEC.

To qualify for either exemption from registration, finders would not be allowed to:

·         Advertise themselves as brokers or investment bankers or investment advisers.
·         Render "fairness opinions."
·         In due diligence reports or other documents express an opinion about the value of securities.
·         Hold money or securities for clients.
·         Conduct offerings for publicly traded companies.

Finders would also be required to:

  • Disclose any relationship they may have with the business raising capital.
  • Disclose all compensation they receive in the transaction.
  • Disclose that they are not registered as a broker-dealer with the SEC or any state.
  • Disclose a physical address.
  • Disclose the SEC website for consumer complaints described above.
To work effectively, the exemption should apply to both Federal and state registration laws and all regulations other than anti-fraud rules.  Bad actor rules could exclude people with a past history of fraud from either exemption.

If you would like to learn more, you can reach me at
Or you can check out my eLearning course at
or read my newspaper articles at








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