One issue that comes up regularly in capital raises and M&A transactions, and which can put otherwise promising deals at risk, is the unintentional and improper use of unregistered brokers.
Companies often need outside help when raising capital or preparing for a sale, but do not always understand the legal and regulatory framework dictating who can legally provide such help. When capital is tight or timing is critical, businesses may lean on someone who promises results without fully understanding the legal risks involved until it is too late.
Sometimes this happens due to confusion or a lack of awareness of the legal and regulatory framework, and other times it's a calculated risk by the company. Either way, using an unregistered broker or structuring the engagement incorrectly can put the entire transaction, and in some cases the company, in legal and financial jeopardy.
The Risks of Using an Unregistered Broker
Engaging an unregistered broker can create unintended and serious problems for the company. Payments to unregistered brokers are generally unlawful. Meaning, if any such payment to an unregistered broker is determined to be unlawful, then such "finder" may be barred from receiving compensation, and its investors may be entitled to rescission rights, thereby allowing such investors to unwind a transaction and demand their money back, often with interest.
In some cases, these actions may need to be disclosed in future financings or exits, leading investors to question the judgment of a business's management team and potentially impairing the transaction.
The Two Riskiest Areas: Investor Fundraising and M&A Transactions
These risks typically show up in two places:
- M&A Transactions – There is a statutory exemption for M&A brokers under Section 15(b)(13) of the Exchange Act, which provides a workable path forward, but only if the transaction meets certain requirements. That may require ensuring the transaction is an asset sale or confirming the intermediary is a registered broker-dealer using their license for the transaction.
- Finding Investors – Paying someone transaction-based compensation is also high risk if they are not a registered broker-dealer. Although the SEC has discussed potential "finder" exemptions, no broad exemption has been formally adopted, and the existing exemptions are nuanced and narrow. As a result, these arrangements require careful structuring and legal review.
It is also not enough that a person is registered or affiliated with a brokerage. The transaction must run through the sponsoring broker-dealer and be subject to that firm's internal approval processes. Sometimes, a broker will fail to channel the deal through their sponsoring broker-dealer to avoid sharing the commission, which can invalidate an exemption. It is important to ensure the broker is individually registered and is funneling the transaction through their sponsoring broker-dealer.
Guidelines for Engaging a Broker-Dealer
If you're considering engaging an outside third-party person to help your company with a capital raise or M&A transaction, consider these guidelines:
- Talk to an experienced securities attorney at the outset and prior to engaging such a person to raise capital on a commission basis. Once an engagement agreement is in place, unwinding it later can be challenging and potentially expensive.
- For M&A transactions, confirm the deal structure qualifies for the M&A broker exemption available through Section 15(b)(13) of the Exchange Act or that the intermediary is a registered broker-dealer and that the transaction is being run through their sponsoring firm.
- Capital raises require caution. Until the SEC formally adopts a finder exemption, structuring a legally compliant "finder" arrangement with an unregistered intermediary is challenging. Work with your attorneys to determine whether a legally compliant structure is available for your situation.
- Document roles, compensation, and limitations clearly and ensure compliance with the agreement. The outcome of an enforcement action can turn on these details.
Whether you're preparing to sell your company or seeking new investors, the urge to move quickly is understandable. Companies should be mindful, however, and exercise caution in selecting third parties to assist with a company sale or fundraising activities and how such persons are compensated. It's important to consult with an attorney regarding the potential use of broker-dealers in connection with a company sale or fundraising activities prior to commencing such transactions, as the costs and expenses of rescission and unwinding would likely have severe or fatal economic consequences for your company.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
