Press Releases

Articles

Announcements

Speakers Bureau

Glossary

By THOMAS L. HANLEY & ROBERT L. McKAY Jr.*

The trick for growing companies these days, in spite of  record amounts being invested in private equity funds, is finding a venture capitalist that is actually willing to write a check.  Lately, more and more early-stage companies  are turning to outside sources, such as finders, to help them identify willing  investors.  (Very few of these service  providers refer to themselves as finders -- ”they commonly style themselves as consultants, financial advisors, or specialized investment bankers.)  The characteristic that these finders, consultants, financial advisors, or specialized investment bankers all share is their preferred method of being compensated:  in return for their services, finders receive a fee that usually consists of a percentage of the money found.  Many companies do not realize, however, that their use of finders may, under some circumstances, have adverse consequences for them, and, as a recent Massachusetts decision illustrates, finders may find themselves without an  enforceable legal claim to be paid for their services.

Potential Liability for Start-Ups
The potential problem with using a finder is that the finder actually may be operating as an unregistered broker-dealer.  The activities of brokers and dealers are highly regulated by federal and state law and the rules of the National  Association of Securities Dealers (NASD), and unless finders restrict themselves to a rather narrow set of activities, they risk being characterized as unregistered broker-dealers.[1]  This could subject them to regulatory action by the Securities and Exchange Commission (SEC) and state securities regulators.  What’s worse, using a finder  that is actually an unregistered broker-dealer could affect a company’s current  and future capital-raising activities.  In particular, the use of an unregistered broker- dealer could call into question the validity of the securities law private placement exemptions[2] relied on by the company when it completes an investment arranged by the finder or could  void the stock purchase or subscription agreement covering the purchase.[3]  This could result in a potential rescission  of the investment (effectively requiring the company to offer to refund all the investment proceeds) and/or could subject the company to additional regulation,  adverse regulatory action, filing fees, and penalties.[4]

Certain regulators have informally suggested that companies  using finders that are unregistered broker-dealers may be potentially liable for  aiding and abetting the securities law violations of those finders.[5]  In addition, if the capital-raising  transaction involving the unregistered broker- dealer took place near in time to the company’s Initial Public Offering (IPO), the SEC might require some very negative disclosure in the IPO prospectus.[6]  Imagine delivering a prospectus for your IPO that includes a warning that part of the securities you issued in the past may need to be recalled and previous investments refunded, or that the company and its management have been accused of aiding and abetting securities law violations.  Although the authors are unaware of any cases testing the aiding-and-abetting theory, and while the  potential rescission risk might be mitigated substantially by an increase in the value of the company’s stock, dealing with the regulators on these issues during the IPO process certainly won’t help the marketing of your IPO.

Questions to Ask
The following questions are relevant to the issue of whether the finder may actually be operating as an unregistered broker-dealer, and it is  advisable for any company contemplating a relation- ship with a finder to get answers to these questions and discuss them with counsel in order to assess the potential risks and rewards that may result from hiring the finder.  Note that no one of these factors is  dispositive of the question of whether a finder would be deemed to be a broker-dealer.

Is the finder going to do anything beyond merely introducing you to potential investors?

Although the SEC has indicated that finders are not considered broker-dealers for purposes of the federal securities laws, it  considers a finder to be someone who merely introduces parties to each other and  has very little or no further role in or effect on the sale of securities.[7]  The states and the NASD have similarly broad interpretations of the definition of “broker” and similar views regarding the  characteristics of finders versus brokers.[8]  In light of these views, the risk of a finder  being deemed an unregistered broker-dealer is significantly increased if the finder is involved in activities on behalf of the company such as presentations to investors, negotiation and structuring of the investment terms, and similar activities.  The problem for growing  companies, of course, is that they often want and need the finder to provide advice and services that go beyond simple introductions.

Is the compensation for the finder success-based or transaction-based?

Regulators also focus on the payment to the finder of  success-based and/or transaction-based fees.  As noted above, most finders are compensated based on a percentage of the money raised through their efforts, and little, if any, of their compensation is fixed and payable regardless of their success.  Success-based and transaction-based fees are considered to be  characteristics of a broker-dealer, so the safest course is to pay a fixed retainer regardless of the outcome of the finder’s work.  The practical challenge facing most growing companies is that finders are usually most needed at a time when the companies are least likely to have the resources to pay a substantial fixed fee,  particularly for introductions that may not actually lead to an investment.  In view of these issues, the fixed-fee approach is likely to work better if the finder is providing additional  financial or similar consulting services to the company.

Does the finder  regularly engage in the business of finding investors for companies or does the finder hold itself out as a broker-dealer?

Most finders are in the business of being finders, and most companies looking to use finders likely would prefer a finder with an established track record and long list of potential investors.  Unfortunately, it is the regularity of a finder’s activity that catches the eye of regulators and increases the likelihood that a finder will be deemed to be acting as an unregistered broker-dealer.

Did the finder discuss the details of the nature of the securities or make recommendations regarding the securities to the investors?

The more information a finder provides to a potential investor, the more likely the finder will be deemed to be engaged in marketing or selling company securities.  Active sales efforts usually fall within the domain of registered broker-dealers, and finders that engage in advising potential investors regarding an investment  significantly increase their risk of being deemed unregistered broker-dealers.

Potential Liability for Finders
There is also a risk to finders that their service agreements  may not be legally enforceable and, further, that they may be subject to civil and criminal penalties.  In a recent Massachusetts case, Novelos Therapeutics, Inc. v. Kenmore Capital Partners, Ltd.,[9] an early-stage pharmaceutical company (Novelos) sought funding to begin clinical  trials on a new drug it had developed.  Novelos entered into a contract with Kenmore, where Kenmore would serve as an “adviser” to assist Novelos in raising the much needed capital.  Although Kenmore was not able to assist in  the sale of the expected amount of private equity, Kenmore regularly forwarded  invoices for the services it rendered (possibly in an attempt to create a paper  trail that the fees charged by Kenmore were not “success-based,” as discussed above).

Novelos filed suit claiming, among other things, that Kenmore acted fraudulently and that Novelos did not owe any compensation to Kenmore.  Kenmore responded with a counterclaim for breach of contract.  The court ruled that Novelos was not required to compensate Kenmore because Kenmore was acting as an unlawful broker-dealer under Massachusetts law.  The court reasoned that, despite the explicit  language of the contract characterizing Kenmore’s services as “advisory” in  nature, the “essential purpose” of the contract was to provide unlawful broker- dealer services, and the contact was therefore void in its entirety.  Being found to be an unregistered broker-dealer left Kenmore without the ability to be compensated for its services, and the court noted that Kenmore may still be subject to civil and criminal penalties under Massachusetts and federal law.

Conclusion
Entering into a relationship with a finder may pose risks for  both parties to the contract.  The  early-stage company may find itself saddled with regulatory action by the SEC and state securities regulators, may have to refund the proceeds derived from  any securities placed with the assistance of a finder, and may find itself subject to additional filing fees and penalties.  Finders face the risk of not having a legally enforceable contract or claim to be paid for their services and also may be subject to civil and criminal penalties by regulatory authorities.  Both companies using finders and finders themselves would be well-advised to seek legal counsel to ensure that their relationship is consistent with federal and state law and the views of the SEC and other regulators.