THE USE OF FINDERS IN INVESTOR FINANCING TRANSACTIONS
By John W. Cones
One of the most common questions asked in relation to raising capital from investors is: “Can I use finders?” There also appears to be a significant number of conflicting answers to that question floating around out there in the marketplace – hence a great deal of confusion exits. Part of that confusion occurs because the answer to the question differs somewhat depending on the following variables:
1. Does the transaction involve the sale of a security or is it a non-securities transaction?
2. If a security, does the transaction involve a public/registered offering, a public/private hybrid offering or an exempt/private offering?
3. Do both the federal and state laws apply to the transaction?
4. If a private/exempt offering, which exemption is being relied on at the federal level and which exemptions are being relied on at the state level?
A few points from a legal perspective with respect to finders:
1. The Rules Vary – The rules relating to the activities and compensation of finders will vary depending on whether you engage in a securities or non-securities transaction, and if a securities transaction, what type. So, if you do not know what sort of investor offering you are proposing to conduct, it is not likely that you will be able to determine what the rules are for your proposed transaction with respect to finders.
2. Non-Securities Transactions -- If you are trying to raise money in a non-securities transaction (i.e., from a few active investors -- people from outside the film industry who have knowledge and experience of the film industry and who are capable of and authorized to help make the project's important decisions on a regular basis – the definition of active investors per federal case law) then the use of finders is not regulated, although they can still commit common law fraud on your behalf if you do not carefully limit what they say to prospective investors. Generally, you just want them to introduce you to such investors. They should not engage in any activity that may be fairly described as “negotiating” on behalf of the issuer, including the delivery of the business plan. You, of course, would want to disclose in the associated business plan what compensation will be paid to such finders.
3. Securities Transactions – If you are seeking to raise funds from passive investors, you are selling a security. And, if a securities offering is being undertaken, the general rule is that no transaction-related remuneration may be paid to persons not trained, licensed and supervised as broker/dealers. That, in effect, is what a finder is and how finders want to be paid (i.e., a percentage of the money raised). Generally speaking, finders are not trained, licensed and supervised as broker/dealers, and that is why securities regulators find it necessary to limit the activities of finders. The idea is to protect investors from untrained, unlicensed and unsupervised sales people who are only or primarily motivated by the desire to make money on the transaction.
Pursuant to the securities laws, finders are limited to merely introducing the producer and the prospective investors. For a public/registered offering (e.g., S-1, SB, Reg. A, SCOR) or the so-called public/private hybrid offerings (e.g., the Model Accredited Investor Exemption), that is not as much of a problem. There is no pre-existing relationship requirement between the issuer of the security (i.e., the film producer for purposes if this article) and the prospective investor in such offerings. However, for a private placement (i.e., exempt offerings like Regulation D Rules 505 or 506), the issuer of the security (or its upper-level management) must have a pre-existing relationship with the prospective investor. Thus, the finder's introduction must occur prior to the start of the offering, so that when the offering actually begins, the upper-level management of the issuer has the required pre-existing relationship. In other words, the issuer of the security cannot rely on the pre-existing relationships of finders in private placements. Reg. D, Rule 504 is not recognized by most state securities laws for use in conjunction with their exempt offerings, thus it is of little use, except if used in conjunction with the MAIE mentioned above, or possibly the Small Corporate Offering Registration (SCOR). In either case, the use of finders is not problematic in those situations since the MAIE allows some limited advertising and SCOR is a small public offering. Also, in a securities offering, the compensation to be paid to finders must be disclosed in the securities disclosure document. In addition, in some instances, the total offering expenses including any selling expenses may be limited by state law.
Note further, that two states: Michigan and Texas, now require that finders be registered with the state's securities regulatory authorities. So, if you plan to raise money in those states, be sure and review their respective finder regulations. Other states may follow.
4. SEC No-Action Letter – The narrow line between “finders”– who locate prospective investors in business ventures – and licensed broker/dealers in the securities world continues to get more difficult to walk safely. In No Action Letter, Brumberg, Mackey & Wall (May 17, 2010), the SEC just denied “No Action” assurance (i.e., that the SEC won’t take enforcement action against the requesting party) for a finder’s exemption from broker-dealer registration under Sec. 15(b) of the Securities Exchange Act. The finder (a law firm) proposed helping a company raise funds to finance its operations and development by introducing the company to individuals and entities that might invest in equity or debt instruments of the company. While the finder in this case apparently was to have played a fairly limited role, arguably consistent with that of a mere finder, what particularly triggered the broker/dealer registration requirement in the SEC’s view was the fact that the finder would receive transaction-based compensation in the form of a cash referral fee equal to a percentage of financing raised through the finder’s introductions, payable upon closing of the financing. The SEC declared that “a person’s receipt of transaction-based compensation in connection with these activities is a hallmark of broker-dealer activity.” The SEC was also concerned that the finder in this case would be pre-screening the investors, as well as conditioning the market by “pre-selling” to some extent, which further induced it to conclude that brokerage registration might be required. Thus, it is important once again to limit the finder’s activities to that of merely introducing the buyer and seller.
5. Further Resources – The finder question in Utah is discussed in an article entitled "Finding a Solution to the Problem with Finders in Utah" by Brad R. Jacobsen and Olympia Z. Fay, Utah Bar Journal, April 24, 2006. An article arguing that a category of finders ought to be regulated ("Legitimizing Private Placement Broker-Dealers Who Deal with Private Investment Funds:A Proposal for a New Regulatory Regime and a Limited Exception to Registration") appears in Volume 40, page 703 of The John Marshall Law Review, 2006 (written by Robert Connolly). Another similar article making the same argument ("Improving the Efficiency of the Angel Finance Market: A Proposal to Expand the Intermediary Role of Finders in the Private Capital Raising Setting") by John L. Orcutt, appears in Volume 37 of the Arizona State Law Journal at page 861 (2005). Also John Polanin, Jr. wrote "The 'Finder's' Exception from Federal Broker-Dealer Registration" and it appears in Volume 40 of the 1990-1991 Catholic University Law Review at page 787. None of this is light reading, so good luck. In the meantime, just review the above brief summary of the contents of these authoritative articles, which the 2010 SEC No Action letter, confirms.
John Cones, Attorney, Author, Lecturer
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