SC Lawyer, July 2012, #4. Main Street Goes Wall Street.

Author:By John Jennings and Katherine Gutierrez

South Carolina BAR Journal


SC Lawyer, July 2012, #4.

Main Street Goes Wall Street

South Carolina LawyerJuly 2012Main Street Goes Wall StreetThe Risks of Unregistered Sales Agents in Small Business Capital RaisingBy John Jennings and Katherine GutierrezEdward Entrepreneur calls you with exciting news.

For months, Edward has tried to raise money for his young company from family and friends, banks and even venture capital funds. But in a post-crash world, Edward has had no luck. His company is now a little late on some of its bills.

Edward tells you that he just had lunch with Charlie Connected, a local business person that once built and sold a company very similar to Edward's. Mr. Connected has lots of money and can introduce Edward to potential customers. He wants to invest in Edward's company and will introduce Edward to other potential wealthy investors with the understanding, of course, that Mr. Connected will receive a little fee or maybe some extra stock in exchange. Edward is ecstatic and asks, "How long will it take you to paper this?"

Before digging into exactly what the "this" is that you need to document, you pause as you remember that paying people who are not registered brokers to raise money can be a problem, but you don't recall if the recent JOBS Act has changed that.

Edward never likes it when you pause. Edward implores you not to be the "sales prevention department." As Edward then begins describing exactly how much money his company will take in and how much stock Mr. Connected and his friends will acquire, you think to yourself, "Can the company legitimately do this?"

This article will navigate through the securities laws related to capital "finders" and explore ways that Edward might legally raise money with Mr. Connected's help, without Mr. Connected registering as a broker.

Why worry?

There is a significant disconnect between the laws applicable to broker activity and the methods by which, according to an ABA task force, most of the capital for early stage businesses is actually raised.

Many smaller companies use so-called "finders"-people and entities that are not registered brokers, but who are paid to locate investors and, at least in theory, have no other meaningful role in the securities transaction. In the merger and acquisition context, finders are sometimes called "business brokers." Finders can often be the only option for smaller companies, as most investment banks and other registered brokers are not interested in small transactions.

Unfortunately, in practice, finders and business brokers are often involved in securities transactions to an extent that they are in fact acting as brokers and are violating federal and state securities laws by not registering as such. Using an unregistered broker to assist with a capital raise creates potential business, regulatory and litigation risks for the company raising the money (the "issuer" of the securities).

The Securities and Exchange Commission (SEC) has shown increased interest in preventing unregistered broker activity in recent years, and states, including the S.C. Attorney General, have brought numerous actions against people acting as unregistered brokers. Moreover, in 2008, the SEC amended Form D, a notice filing made by issuers in connection with commonly used Regulation D private placement and small offering exemptions, to include an item that requires disclosure of finders' fees paid in connection with an offering. The current Form D puts a spotlight on unregistered finder activity for the SEC.

For the finder that should have registered as a broker, the consequences can be severe. The finder's fee agreement with the issuer will be unenforceable in court because section 29(b) of the Securities Exchange Act of 1934 (Exchange Act) generally provides that contracts made in violation of the Exchange Act are voidable. In addition, non-exempt finders that engage in broker activity may face civil and criminal penalties under both federal and state law.

For the securities issuer that utilizes an unregistered finder whose activities rise to a level of broker activities, there are multiple risks, including, among others: (a) investors may seek damages or rescission of their investments under federal or state law; (b) the validity of the issuer's exemption from federal and state registration for the offering that involved the finder may be lost; (c) the SEC or state authorities may pursue the issuer as an aider and abettor of securities law violations by the finder; (d) the issuer may face fraud liability under section 10(b) of the Exchange Act for failing to disclose to investors the finder's fee arrangement in connection with the sale of securities; and (e) future capital raising efforts by the issuer may be delayed or fail due to investor concerns over prior sales involving unregistered brokers.

The broad, but uncertain, definition of a "broker"

Section 3(a)(4) of the Exchange Act defines a broker as "any person engaged in the business of effecting transactions in securities for the account of others." Section 102(4) of the South Carolina Uniform Securities Act of 2005 has a similar definition of broker.

At the federal level, Section 15 of the Exchange Act generally makes it unlawful...

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