With few exceptions, it has long been the case that people who are not registered broker/dealers are generally prohibited from facilitating investments in private companies. And, for as long as I can recall, there are people who have, often unwittingly, done so anyway. A typical example is as follows: Startup Co. is seeking to raise funds in a private offering and connects with John Doe. John is a connector type and a member of a local country club, but not a registered broker/dealer. Startup Co. and John agree that John will receive a commission of 5% of the amount of investments John is able to bring to the company. John introduces high net worth acquaintances at his country club to the company, delivers private placement memorandums and other offering documents to prospective investors, chats up the opportunity at least a bit to the investors, attends a few investor pitches, and is paid his commission upon completion of the investments. John has done this for a few companies on occasion, but it is not how he makes his living. John has almost certainly violated various federal and state securities laws.
This type of activity became a bit more on the radar back in 2005 when California added section 25501.5 to the California Corporations Code, which added an express rescission right as to transactions purchased from an unregistered broker-dealer. Notwithstanding certain drafting issues in this section, its enactment communicated an increased interest in the area on the part of the California legislature. Then, in 2009, the Securities and Exchange Commission modified its Form D, a disclosure form widely used in private offerings under federal Regulation D offerings and filed both federally and with states. One of the modifications was to require disclosure of recipients of sales commissions in connection with the offering. Issuers unaware of the prohibition and not using qualified legal counsel might disclose their unregistered finder making enforcement easier. Those using unregistered finders and aware of its prohibited nature would be faced with either disclosure or filing a false Form D by omitting the commission.
More recently, California has seemed to reverse course. Effective January 1, 2016, Section 25206.1 was added to the California Corporations Code creating a means by which non-broker/dealer finders could legally accept compensation in connection with a securities offering. However, as these things often go, the legislature included requirements that have likely rendered the effort a somewhat pointless exercise. Under 25206.1 and related regulations (See 10 CCR §§ 260.211.4, 260.211.5, 260.211.6 and 260.211.7), there are a host of requirements, including filing an initial statement of information and annual renewals, paying annual fees, collecting informed disclosures and consents from the prospective investors and the issuer and maintaining records for five years. At the same time, the finder’s exemption is only useful for offerings where all parties and transactions occur in California, since the finder would run afoul of Section 15(a) of the Securities Exchange Act and other federal securities laws if not acting entirely intra-state. Moreover, the exemption seeks to contain activity to that of a true finder by prohibiting the finder from any material participation in the offering such as negotiating, advising, or making any disclosures to the potential purchaser other than very limited information.
With these requirements, the California finder exemption fundamentally conflicts with the typical nature and practices cited in my example above. John, in assisting one or two companies in raising capital on occasion, has no desire to comply with the administrative and other formalities required (assuming John even knows of the legal issues and the exemption). Also, while John is generally not making a hard sell to prospective investors or being intensely involved in the transaction, John is a facilitator and intermediary who is, at some level, making an endorsement of Startup Co. In other words, there are reasons that John personally delivers offering documents to prospective investors, makes certain positive statements about the company and attends an initial pitch meeting. These activities give the investor a certain sense of confidence and help get the deal done. Even if John intends to act strictly as a finder as required, he risks inadvertently crossing the line and acting as a broker/dealer outside the exemption. At the same time, it is hard to imagine that anyone willing to closely comply with the requirements would be interested in building a formal business around this narrow exemption. Anyone with a network of investors they can introduce to investment opportunities on a full time and repeated basis, would be more likely to become an investment banker or otherwise take a more formal role in the industry.
There are very good reasons for the caution that the California finder exemption requirements reflect and it is not clear that finders of the type in my example should be permitted to act as I’ve described. Small private offerings can be an area particularly prone to fraud and abuse. However, the California finder exemption fails to align with the practical realities of how such finders operate and their tolerance for compliance burdens, thereby significantly reducing the usefulness of this exemption.