We can't tell you how often we are presented with this question. For the most part, the answer is a clear "no," but why is that? The short answer is that—except under certain limited circumstances—it is likely illegal, it may provide investors with a right to their money back with interest and attorney fees, and it may result in, among other things, founders being held personally liable to investors.
Finding investors is one of the biggest challenges facing startups because most founders don't have an established network of investors ready to invest capital. Often, founders who are seeking to expand their network of investors will run into someone who would be happy to make a few introductions … for a fee. RUN AWAY!!
Most often, someone who wants a fee for helping to raise capital (often referred to as a "finder") is not licensed to do so, and generally speaking, use of a finder who is not a licensed broker-dealer is a violation of federal and state securities laws. Below we summarize how to identify a broker-dealer and then look at the potential negative consequences of using an unlicensed broker-dealer.
What Is an Unlicensed Broker-Dealer?
The answer is somewhat complicated, but the starting point is the definition of "broker-dealer," which is a person who is "engaged in the business of effecting transactions in securities for the account of others."1
For decades, the SEC has articulated a four-factor test to determine when a "finder" is required to register as a broker-dealer. The SEC's position is that that these four factors will be analyzed in determining when someone is acting as a broker-dealer, with no one factor being dispositive:
- Whether the person receives commissions or other transaction-based compensation;
- Whether the person makes buy/sell recommendations and provides investment details;
- Whether the person has a history of selling securities (regular activity); and
- Whether the person takes an active role in negotiations between the investor and the issuer.
You are likely thinking—"what if a finder receives a percentage of the money raised through finder introductions, but does not make recommendations, does not have a history of selling securities, and does not take an active role in negotiations between the investor and the issuer?" Despite its emphasis on four factors, the SEC has stated in several no-action letters that transaction-based compensation represents a hallmark of being a broker-dealer, even absent the other three factors. Consequently, an individual or company that receives a commission substantially increases the risk that the party receiving the commission will be considered a broker-dealer. For decades, the best advice has been that in view of the risks involved, issuers should typically not engage finders on a percentage-based compensation basis.
On several occasions, we have come across finders who refer to a no-action letter issued by the SEC in 2014 as evidence they can receive a commission despite not being a licensed broker-dealer. The problem with that position is that the letter has several conditions, including that the buyer of the securities being sold has, following the sale of the securities, (i) control of the company, and (ii) must actively operate the company. Nearly all startup financings do not fit into this scenario, so the no-action letter does not apply.2
Finders will also often attempt to find (and share with the startup's leaders) comfort by relying on the 1991 SEC No Action Letter involving the singer Paul Anka. While often cited by finders, the SEC staff's decision to not recommend enforcement against Mr. Anka—if, without registering as a broker-dealer, he provided the company a list of potential investors in exchange for a commission—is of limited relevance and utility.
The SEC staff noted its no-action decision was conditioned on several factors, including that Mr. Anka was not engaging in the following activities: soliciting the prospective investors, participating in any general solicitation, assisting in the preparation of sales materials, performing independent analysis, engaging in "due diligence," assisting or providing financing, providing valuation or investment advice, and handling any funds or securities.
There may be changes to these rules. In October 2020, the SEC proposed new rules that would provide an exception for certain finders who engage in certain limited activities on behalf of small companies engaged in private offerings to accredited investors. However, at this point the rules are not final and their fate is unknown, so stay tuned!3
What Possible Liability Is There for Using an Unlicensed Broker-Dealer to Raise Capital?
Using a finder may create liability under federal and state law. Agreements for the sale of securities made in violation of federal law may be held void.4 This would certainly apply to the agreement with the unregistered broker who attempts to collect a fee for assisting in the sale of the securities.
While the startup may feel that this is not such a bad thing, a violation of federal securities laws also may void (or make voidable) the agreement between the startup and investors under which the startup raised the funds. If the agreements are held void by a court, then all parties to those agreements would have a right of rescission that would last for the later of three years from the transaction or one year from the date the violation is discovered.
A right of rescission is simply a right to cancel the agreement and return each party to its original position, which means returning investments back to investors. In other words, the use of a finder who is not but should be a registered broker-dealer in effect gives the investors a multi-year redemption right.
Many states have similar rules. For example, violations of Washington's securities laws provides a private right of rescission that includes 8 percent interest and reasonable attorneys' fees.5 Similarly, Oregon investors can seek rescission of the transaction plus 9 percent interest (or greater) plus attorneys' fees.6
A violation of Oregon's and Washington's securities laws is made even more scary by the fact that Oregon and Washington investors can hold personally responsible for the violation any person who directly or indirectly controls the startup.7 In other words, investors in an offering that violates Oregon or Washington securities laws can sue founders personally to recover their investment plus interest plus attorneys' fees.
Are There Other Potential Consequences of Engaging an Unlicensed Broker-Dealer to Raise Capital?
Yes, otherwise we would not have posed the question. Founders who engage unregistered broker-dealers to raise capital may:
- Face enforcement actions from the SEC as an aider and abettor;8
- Face enforcement actions from state securities regulators; and
- Be labeled a "bad boy" and prohibited from participating in or being involved with companies that do a securities offerings made under commonly used securities exemptions.9
Additionally, the startup itself may be prohibited from doing a Rule 506 securities offering, which is the most commonly relied-upon securities exemption for startups and emerging growth companies. And, just because the list goes on, the use of an unlicensed broker-dealer could impact the ability to close future rounds of financing because of the contingent liability associated with the initial violation, which is likely to come up in investor due diligence.
Hopefully we have your attention!
1 See Section 3(a)(4) of the Securities Exchange Act of 1934.
2 It is worth noting that a no-action letter is not a finding that there has not been a violation of federal securities laws. It is only that the SEC staff will not recommend enforcement based on the facts presented in the request for the no-action letter. The SEC staff's position is not binding on (a) investors, (b) judges or (c) state securities regulators.
3 It is also worth noting that even "employees" of the startup can get caught up in the finders net. An employee whose principal duties include fundraising, e.g., the CFO, AND who receives a bonus or other compensation based on the successful raising of funds from investors, e.g., a bonus paid solely upon the successful close of the financing, may be deemed to be a broker-dealer.
4 See Section 29(b) of the Exchange Act.
5 See RCW 21.20.430
6 See ORS 59.115 and 82.010
7 See RCW 21.20.430 and ORS 59.15
8 See Section 20(e) of the Securities Exchange Act of 1934.
9 See Rule 506.