by Katherine R. Lofft

There are myriad opportunities right now for new businesses and talented entrepreneurs targeting healthcare, particularly in the IT sector.  It’s an exciting time for people and companies looking to harness the promise of innovation and the power of technology to improve health care delivery, empower patients and lower costs.

However, even the best ideas usually require money to get off the ground.  Sometimes they require more capital than the founders or management, or their family and friends, have available. While there are many individuals and institutions around the country with money to invest, it can be hard for the average start-up or emerging business to identify and appeal to them, or to distinguish itself from competing investment opportunities.

In view of existing prohibitions on the use of general solicitation and advertising in private offerings of equity, many entrepreneurs, founders and early-stage business leaders turn to so-called “finders” (sometimes called “brokers” or “promoters”) to access capital.  Finders are typically individuals, often with no other relationship to the company, who commit to leverage their network of contacts and connections to help a company identify investors and/or secure funding.  The consideration under these arrangements often involves payment of a fee or commission based on a percentage of the funds invested.

Now, you might be asking, what’s the problem with this kind of arrangement?  Only this:  If an individual is involved in the purchase or sale or securities and receives or expects to receive a commission (whether payable in cash or other consideration, such as stock) as a result of the transaction, the individual must be properly licensed under federal, and often under state, law.  The use of unlicensed “finders” or brokers can result in serious consequences not only for the individual finder or broker, but also for the company/issuer.

Penalties for the use of unlicensed finders can accrue to companies/issuers (and to finders as well) under both federal and also state law. Under federal law, an investor may be allowed to demand rescission of the purchase contract and, if such demand is successful, the issuer may be required to refund amounts invested by the investor, and possibly others. Rescission rights can be exercised for a period of at least three years from issuance of the securities – longer depending on when the investor discovers the violation.

As noted above, many states also require registration by individuals acting as broker-dealers. Penalties under state law for issuers that use unregistered finders vary, but they may be different – often, they are more onerous – than those imposed under federal law. For instance, in California, an issuer that uses an unlicensed finder may be subject to not only rescission and refund claims, it also may be held liable to reimburse the prevailing investor’s attorney’s fees and/or costs.  Some states (e.g., California, Ohio) allow investors to seek damages even if they no longer hold securities of the issuer.

There are other potential consequences to issuers that use unlicensed finders. These include:

  • Difficulty attracting new investors. The use of unlicensed finder by a company can complicate, if not entirely frustrate, its future fundraising efforts. Many more sophisticated and/or institutional investors will not look favorably on the overhang of liability and uncertainty arising from potential federal and/or state law rescission and/or damage claims as a consequence of the company’s past fundraising activities.
  • Effect on counsel’s ability to issue legal opinions.  Generally, when an investor invests any significant sum of money in a company, the investor(s) will require, as a condition to the investment, a legal opinion from the issuer’s counsel as to a number of legal matters, including the issuer’s compliance with applicable law. The use of unlicensed finders by an issuer can prevent counsel from being able to issue a legal opinion at all or, at minimum, one that would be acceptable to the investor(s).
  • Loss of exemptions.  An issuer found to have used an unlicensed broker may lose the right to claim an exemption from the securities registration requirements under federal and/or state law based on the actions of the unlicensed broker, and thus be prohibited from raising additional capital through future private offerings.

Some of these serious consequences are illustrated by the experience of Neogenix Oncology, a Maryland company that recently filed for Chapter 11 protection in an apparent effort to move beyond claims, potential liabilities and other fallout associated with its prior use of unlicensed finders.  [Editor’s note:  Neogenix Oncology is not a client of Epstein Becker & Green.]

RiskMany companies (and many finders themselves) still do not fully understand the risks involved in this practice. Issuers often believe that if a finder only makes introductions to potential investors, and does not, for instance, also pass along offering materials, or negotiate deal terms, then the finder need not be licensed.  These ideas are often reinforced, if not also propagated, by attorneys or by non-attorneys who profess knowledge or expertise in fundraising.

The problem, among other things, is that it is not always clear what types of activities trigger a registration requirement under the law. For example, it is hard to predict what specific actions constitute (or may be deemed to constitute) “solicitation” for purposes of determining whether a finder must be registered. For instance, activities that may seem to be merely “introductory” – such as sending individually addressed emails – may constitute solicitation. Pre-screening of potential investors – including to confirm their qualification to participate in a private offering – may also constitute solicitation. Issuers should remember that the question of which state law(s) apply in this context will depend on where the investor(s) reside, not where the company or the finder is located.

Issuers should also bear in mind that federal law requires that issuers disclose any commissions paid or payable in connection with a private offering of equity. A copy of the form that is required to be filed with the Securities and Exchange Commission (SEC) for this purpose (a “Form D”) is also generally required to be filed in each state in which any investor resides.  The SEC and the states do review Form D filings, and may take actions to confirm the registration status of any finders or brokers identified therein. Failing to file a Form D when required, or providing misleading information in any Form D filing, would constitute an independent violation of law that could lead to additional, adverse consequences, in addition to those that would accrue relating to the issuer’s use of an unlicensed finder(s).

From the perspective of a new or emerging company whose business priority is developing and/or marketing a new product or service, the idea of outsourcing at least certain fundraising activities on a commission basis may be quite appealing.  However, companies should know that there are real risks associated with using unlicensed finders for such purposes, and that these risks can accrue not only to the finder, but also to the company itself. A company in this position may want to consider whether it is worth potentially mortgaging its future, in order to fund its present.

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