As competition for capital has steadily increased for private companies and private funds, issuers and managers have turned to the services of third party marketers (“TPMs”) to raise capital or sell their funds to prospective investors. In the hedge fund space, TPMs typically demand an exclusive arrangement with the fund and approximately 20% of all fees. But due to the nature of their services and the manner in which they are compensated, TPM’s are required to register as brokers-dealer with both the SEC and FINRA (and in certain cases state regulatory agencies) because under Section 15 of the Securities Exchange Act of 1934 they are regarded as “effecting transactions in securities”.
While the broker-dealer registration requirement for capital introduction is fairly broad, the SEC has carved out a limited exception for certain well connected individuals who make solely introductions or open up their contact lists. This has become known as the “finders” exception. Until recently the use of unregistered finders has received little regulatory scrutiny but the SEC has stepped up enforcement action for violation of the brokers-dealer rules in this area. And the consequences can be sever for violation of these rules. Along with regulatory action an issuer or manager can face private actions by investors for damages or rescission of their investment. As a consequence, companies and hedge funds seeking to raise capital through finders are well advised to very carefully tailor these arrangements or do away with them altogether.
The following factors should be carefully considered when engaging an unregistered finder?
1. Who may the finder introduce?
The finder should only contact individuals and entities to whom he has a bona, fide pre-existing relationship and he reasonably believes are “accredited investors”
2. Is the Finder providing services other than Introductions?
The finder’s involvement in the transaction must stop and start with making introductions. The exception will no longer apply if the intermediary takes on a role, however minor, in the ultimate sale of the security. As such, issuers should ensure that the finder is not involved in any of the following:
- Helping to prepare or distribute the fund’s marketing materials;
- Making presentations to investors, negotiating or structuring deal terms.
- Providing advice or recommendations regarding the merits of the particular transaction
- Providing financing to any investor for the purchase of the securities
- Handling the funds or securities involved in the transaction
3. Does the finder regularly engage in the business of facilitating investments?
The regularity of the finder’s activity on the area is also crucial to a determination of whether the exception applies. Individuals who have been engaged to act or finders or who plan to make introductions for other private placements in the future are unlikely to be eligible for the exemption and are encouraged to register as broker-dealers or become affiliated with a registered broker dealer if they intend to become “professional finders”.
4. Does the Finder’s compensation depend on success in raising capital?
Over the years, the SEC has made it clear that paying a finder a fee based on the amount of capital he or she is responsible for bringing to the fund or company is strictly prohibited. The safest course is to pay the finder a fixed fee regardless of the outcome of his or her efforts.
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