Good for raising capital in California, but contrary to current SEC policy for transactions outside California
On October 10, 2015, the Governor of the State of California approved California Assembly Bill 667, which will legalize the payment of finder’s fees by an issuer of securities to a person who introduces one or more accredited investors who purchase securities of the issuer and who complies with the requirements of new Section 25206.1 of the California Corporations Code, as described below. This new law will take effect on January 1, 2016, and will create a fundamental change in California securities law. However, it will also create a conflict between California law and the current policy of the Securities and Exchange Commission (“SEC”), which considers payments of finder’s fees to persons not registered as securities broker-dealers as violations of Section 15(a) of the Securities Exchange Act of 1934 (“Exchange Act”).
The new California law recognizes the widespread practice of payment of finder’s fees to unregistered persons and acknowledges the need to legalize this practice to promote capital formation in small business.
The new California law was proposed by the Business Law Section of the California State Bar in 2012, for the purpose of legalizing what the Business Law Section acknowledged was already a widespread practice of payment of finder’s fees by businesses seeking to raise capital, both in California and nationwide. In recommending the change in California law, the proposal commented that percentage-based compensation is often the only type of compensation that an issuer can afford to pay to a finder. The proposal noted that the penalties for payment of finder’s fees to unregistered persons included rescission of sales of securities, which potentially harmed both issuers and investors in companies which raised capital using unregistered finders. The proposal concluded that legalizing finder’s fees was a necessary action to promote capital formation for small businesses and eliminate the risks caused to issuers and investors resulting from the treatment of this common practice as illegal under California securities laws.
The SEC continues to take a contrary position that finder’s fees cannot be paid to unregistered persons.
The California State Bar Business Law Section noted in its proposal that the SEC’s position is contrary to that recommended in the new California law, and contrary to the recommendations of the SEC’s own 2004 Government Business-Forum on Small Business Capital Formation. In fact, the SEC 2004 Forum whitepaper acknowledged that, “the vast majority of finders are unregistered broker-dealers under federal and state securities laws, and accordingly transactions in which they are involved jeopardize the issuer, its officers and directors, and other investors because of the use of the unregistered/non-exempt person.”
The SEC has nevertheless continued to treat the payment of finder’s fees to persons not registered as broker-dealers as violations of the Exchange Act. For example, the SEC denied any exemption for payment of finder’s fees in response to a No-Action Request Letter from Brumberg, Mackey & Wall, P.L.C., dated May 17, 2010. In that No-Action Response, the staff of the Division of Trading Markets of the SEC stated that, “[a] person’s receipt of transaction-based compensation in connection with these activities is a hallmark of broker-dealer activity,” and the SEC therefore stated that it could not assure the requesting party that it would not take enforcement action against persons who received finder’s fees in connection with the sale of securities.
The California exemption requires numerous conditions to be met by the finder and the issuer.
New Section 25206.1 of the California Corporations Code will require the following conditions to be satisfied in order to for the exemption from registration to apply to persons who receive finder’s fees for the sale of securities:
- the finder must be a natural person, not an entity;
- the transaction must be a sale of securities by an issuer of the securities in California;
- the size of the transactions for which the finder is engaged must not exceed a purchase price of $15 million in the aggregate;
- the finder must not: (a) participate in negotiating any of the terms of the transaction, (b) advise any party regarding the value of the securities or the advisability of purchasing or selling in the securities; (c) conduct any due diligence for any party to the transaction; (d) sell any securities that are owned directly or indirectly by the finder; (e) receive possession or custody of any funds in the transaction; (f) participate in the transaction unless it is qualified by permit or exempt from qualification under California law; (g) make any disclosure to any potential purchaser of securities other than: (i) the name, address and contact information of the issuer; (ii) the name, type, price and aggregate amount of the securities offered; (iii) the issuer’s industry, location and years in business.
- the finder must file, in advance of taking any finder’s fees, a statement of information with the finder’s name and address, together with a $300 filing fee, with the California Bureau of Business Oversight, and thereafter file annual renewal statements with a $275 filing fee and representations that the finder has complied with the exemption conditions.
- the finder must obtain a written agreement signed by the finder, the issuer and the person introduced by the finder, disclosing: (a) the type and amount of compensation that has been or will be paid to the finder; (b) that the finder is not providing advice to the issuer or any person introduced to the issuer as to the value of the securities or advisability of purchasing or selling them; (c) whether the finder is also an owner of the securities being sold; (d) any conflict of interest in connection with the finder’s activities; (e) that the parties have the right to pursue any available remedies for breach of the agreement; and (f) a representation by the investor that the investor is an “accredited investor” as defined in SEC Regulation D and consents to the payment of the finder’s fee.
- the finder must preserve copies of the notice, the written agreement and all other records relating to the transactions for a period of five years.
The disparity between California law and the SEC’s current policy requires caution in utilizing the exemption.
The new California law will permit payment of finder’s fees in transactions involving California based issuers, finders and purchasers of securities, in transactions conducted in California. However, any transaction conducted outside of California will also be subject to federal law, and the SEC’s current policy is to treat such transactions as violations of Section 15(a) of the Exchange Act, which could result in penalties and potential disciplinary action to the issuer and/or the finder. Therefore, until the SEC changes its policy on finder’s fees, issuers and finders will be at risk of SEC enforcement action for any transaction that takes place outside of California. We note that the courts have not always agreed with the SEC regarding its position on the legality of payment of finder’s fees. For example, in 2011, a Florida federal trial court in SEC vs. Kramer ruled against the SEC on this issue, holding that the “finder” question requires analysis of at least six factors, not merely whether there was transaction-based compensation paid to the finder. The SEC appealed that decision, but the appeal was dismissed on procedural grounds. The SEC has subsequently taken enforcement against several other finders and issuers on grounds that include the payment of finders fees, among other issues, indicating that the SEC continues to take a hard line position on this issue, despite court rulings and recommendations to the contrary.
It is interesting to note that in January 2014, the SEC issued a no-action letter to a group of law firms, in which the SEC stated that it would no longer require persons who received fees in merger and acquisition transactions to register as broker-dealers. However, the SEC specifically excluded any capital-raising from the exemption effectively granted in this no-action letter. If the SEC would adopt a policy similar to that adopted by the State of California on the payment of finder’s fees, it could help many small businesses to raise capital in a way that still allow the SEC to monitor the payment of finder’s fees and perform its primary duties of protecting investors and preserving the integrity of the U.S. securities markets. In our view, this would be a welcome development.
Catherine DeBono Holmes is the chair of JMBM’s Investment Capital Law Group, and has practiced law at JMBM for over 30 years. She specializes in EB-5 immigrant investment offerings and hotel and real estate transactions made by Chinese investors in the U.S. Within the Investment Capital Law Group, Cathy focuses on business formations for entrepreneurs, private securities offerings, structuring and offering of private investment funds, and business and regulatory matters for investment bankers, investment advisers, securities broker-dealers and real estate/mortgage brokers. Contact Cathy at CHolmes@jmbm.com or 310.201.3553.