Use Caution When Paying Finder's Fees in Securities Transactions

We at Frantz Ward sometimes receive questions about whether a company that is raising money in a private placement—usually a Regulation D Rule 506 offering—can pay a “finder’s” or “referral fee” to someone who refers an investor to the company.  The issue may also arise in the context of an investor in the offering receiving a discounted share, or perhaps a rebate, for referring another investor to the company. [i]

On the surface this sounds innocuous enough; a way for the company to expand its investor base, and beneficial to the recipient through the receipt of 1099 income.  Probably a good idea to put together a one-page agreement providing for the payment terms, but other than that nothing to be concerned about, right?

Well, actually, there is plenty to be concerned about because paying a finder’s fee or referral fee in connection with a capital raise could run afoul of the securities broker licensing requirements of federal and state securities laws.  The consequences of this for both the company and recipient can be horrific:  regulatory proceedings, civil liabilities including rescission claims, and in extreme circumstances criminal liability for the recipient.  On a less severe note, the agreement to pay the fee might be unenforceable. 

One might ask how could the receipt of a mere finder’s/referral fee cause the recipient to be deemed a securities broker?  After all, the recipient is not in the securities brokerage business and is just trying to help—albeit with a financial incentive.  Besides, the fee is characterized as a finder’s or referral fee, not as a securities sales commission, and is typically much lower.

The reason is because Section 15(a)(1) of the Securities Exchange Act of 1934 provides that it is unlawful for a broker or dealer “to effect any transaction in, or to induce or attempt to induce the purchase or sale of any security…unless that broker or dealer is licensed under subsection (b) of this section.”  If, under this provision, the fee recipient is deemed a broker who is inducing the purchase or sale of a security, the recipient would be acting unlawfully as an unlicensed broker.  The substance of the transaction controls, so using the finder’s or referral fee nomenclature is essentially irrelevant.  Nor does it much matter that finder’s fee are generally much lower than the typical fees charged by securities brokers in private placements.

Factors used to determine whether the recipient of a finder’s or referral fee is acting as a broker have been developed through caselaw, SEC No Action letters, SEC Guides, and other commentaries.  The principal ones are:

• Whether the recipient regularly engages in acting as a finder, actively solicits and recruits investors, and/or hold himself, herself, or itself out as providing such services.
• Whether the recipient will have any active involvement in the securities transaction, such as delivering documents, handling funds, participating in the selling activities of the issuer, analyzing or recommending the investment, or otherwise promoting it.
• Whether the recipient has the power to bind a party to a securities transaction.
• Whether the recipient’s compensation depends upon, or is it related to, the completion of a securities transaction, i.e. whether payment is contingent upon a closing of the transaction.
• Whether the fee is calculated as a percentage of the investment.

While all of these factors are part of the mix, we emphasize the last two because the SEC has indicated that it considers them to be the most important, if not determinative.  Many securities lawyers would argue that the SEC’s position is more nuanced than that, and in any event may be loosening.  While there is some support for this, it is perilous to ignore an SEC statement.

So, if you are considering paying a finder’s or referral fee in connection with a securities transaction, or if you are a person who is considering receiving such a fee, consult with securities counsel before doing so.  If you, as legal counsel, are asked to draft, review, or arrange for a finder’s fee agreement but are not experienced in securities law, be sure to get advice from an attorney who is.