Distinguishing “Finders” and “Brokers”

In Plain English

A publication of THE SECURITIES LAW GROUP | James E. Grand | May 2024

A question we are frequently asked is whether a fund manager may hire a person to solicit investors for his fund. The question arises when the fund manager wants to hire an unregistered person to introduce investors, and that person seeks to obtain payment based on the successful introductions.

The general rule is that a person who introduces investors to private fund managers must be registered as “brokers” or otherwise associated with a broker-dealer. In legal speak, this newsletter addresses whether and when a fund manager may utilize the services of an unregistered “finder.”

The “Issuer’s Exemption”

Before turning to the factors that generally go into the question of whether a particular person is a finder, you need to understand the scope of another safe harbor known as the “issuer exemption.” This is the exemption that allows you, as your fund’s general partner, to participate in the sale of the fund’s securities without being registered as a broker. In order to qualify for the exemption, you (or a person employed by you) must consider one primary requirement and three alternative sets of conditions.

The primary requirement relating to the general partner is it must not be subject to a statutory disqualification under Regulation D. In addition to this primary requirement, your marketing employee must: (i) have substantial duties other than marketing securities; (2) have not been associated with a broker-dealer in the prior 12 months; and (3) have not participated in securities offerings more than once every 12 months. As the fund’s general partner, you generally will qualify for this exemption, but a full-time employee who continuously marketing fund interests is not likely to do so.

The Finder’s Exemption

The issue of “finders” is currently a hot topic for securities regulators, which remains unresolved today. Each case turns on the specific facts. The federal securities laws do not distinguish between “brokers” and “finders.” Nor do they specifically define the term “finder” or detail what a finder can or cannot do. Based on a handful of SEC staff no-action letters, it is generally thought that persons who do nothing more than introduce prospective investors to the issuer are “finders,” not “brokers,” and are not required to register. However, the SEC has cautioned that persons who find investors for issuers, even

in a “consultant” capacity, may still need to register as a broker depending on a number of factors, including whether: (i) the finder participates in the solicitation, negotiation or execution of the transaction; (ii) the finder’s compensation is related to the outcome or size of the transaction; (iii) the finder is otherwise engaged in the business of effecting securities transactions, or (iv) the finder handles securities or funds of others.

The compensation factor is highlighted because, in practice, it seems to be the key factor in determining the registration requirement. When the finder’s compensation depends on the outcome or size of the transaction rather than a flat fee or retainer, these activities weigh even more heavily toward the need to register. If there is a bright-line rule, it would be if the finder receives commissions, bonuses, or other types of compensation linked to successful fundraising, then registration is probably required. In the words of the SEC: “A person’s receipt of transaction-based compensation in connection with [marketing] activities is a hallmark of broker-dealer activity.”

Potential Penalties Sanctions

Violating the broker-dealer registration requirement has even broader consequences for fund managers than it does for unregistered finders. Thus, it should be of even greater concern to you. Among others, a fund manager may incur fines, sanctions, and reputational damage for aiding and abetting the solicitor’s underlying violation. In addition, the fund manager may be restricted from using any and all future registration exemptions under the Securities Act and it may be subject to liability for fraud under Section 20(e) of the Exchange Act.

This newsletter is published as a source of information only for clients and friends of The Securities Law Group and should not be construed as legal advice or opinion on any specific facts or circumstances. The receipt of this publication is not intended to create, and receipt of it does not constitute an attorney-client relationship.

The Securities Law Group

James Grand

jgrand@tslg-law.com

760-773-4700