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New Finder Rules in Texas: What a Tangled Web We Weave
Finders “find” prospective investors to invest in companies in need of capital. In addition, finders “find” ventures for investors to back. Recently, finders have been the subject of increasing scrutiny by state securities regulators. On the forefront is the Texas State Securities Board. In an unprecedented move, the Texas State Securities Board has created a registration category just for “finders.” In addition, the Board now requires finders to make certain disclosures to their clients. If called upon to counsel clients about these new rules, you must be familiar with them and how they interact with the federal securities laws. Finders are akin to securities brokers. However, finders can only provide a very limited service to their clients. Generally, all that a finder can do is make introductions between investors and companies.1 After introducing the company and the investor to each other, the finder must walk away from the transaction. Negotiation of the ultimate investment must be left to the parties without any input from the finder.2 Despite their limitations, finders are relatively widespread and often facilitate investments, especially in small and emerging companies. Historically, finders have been largely unregulated, presumably because of the restricted role that finders play in leading up to securities transactions. The federal government, which extensively regulates securities brokers, does not even directly address finders in its statutes or rules. In fact, before the adoption of these rules, the only state that had adopted rules requiring the registration of those commonly known as finders was Michigan.3 But, Michigan does not have a designated registration category just for finders as Texas does. Instead, Michigan requires a person operating as a finder to register as an investment adviser, a much broader category that includes other investment professionals besides those commonly known as finders.4 At about the same time that Texas adopted its new finder rule, South Dakota enacted a rule addressing finders.5 Now, California is considering the adoption of rules to address finders. No question about it, states are in a rush to regulate this area. The Texas State Securities Board’s adoption of the new finder rules was well intentioned. But, the new rules will be difficult for finders to reconcile with the federal securities laws. The Securities and Exchange Commission and a number of courts have not only recognized finders, but they have also carefully identified the distinctions between finders and brokers.6 In sum, as long as a finder does not perform any of the hallmarks of a broker,7 the finder does not have to register as a broker, or for that matter, in any capacity. However, if a finder crosses the line between a finder and a broker, the finder may be prosecuted as an unlicensed broker.8 In addition, the finder may forfeit any fee that it has contracted to receive.9 The problem for finders in Texas is that the state finder rules are not in harmony with the distinction that the SEC has made between finders and brokers. As a consequence, even though a finder may be exempt from broker registration in Texas, he may be required to register as a broker at the federal level. Conversely, even though a finder may not have to register as a broker under federal law, he may have to register as a broker under Texas law.It all depends upon the circumstances under which the finder is operating. Needless to say, this will cause problems for finders in Texas that are unaware of the nuances between the federal and state laws.
Different Definitions of Finder For starters, the activities of a finder are more limited in scope in Texas than under federal law. The definition of a finder under the Texas rules provides in part that a finder is “[a]n individual who receives compensation for introducing an accredited investor to an issuer or an issuer to an accredited investor.”10 “Accredited investor” is a defined term under the state and federal securities laws. The term “accredited investor” generally includes investors with a significant net worth or high income.11 SEC interpretative announcements do not restrict a finder’s activities to dealing only with accredited investors. Instead, finders under federal law may engage in business with any and all investors regardless of their net worth or income. As a consequence of this distinction, a finder may be complying with the federal laws, but not with Texas’s new finder rules. In this situation, the finder would have to register as a broker with the Texas State Securities Board, but not have to register as such at the federal level.
The Problem with Commissions If a person is registered as a finder under the Texas Securities Act, that person is entitled to receive compensation in the form of a commission.12 The SEC, however, has stated that it may prosecute a finder for acting as an unlicensed broker if he accepts a transaction based compensation such as a commission.13 Consequently, even though a finder may be in compliance with the Texas finder rules, he could nevertheless be prosecuted by the SEC as an unlicensed broker for accepting a commission. Theoretically, there is one circumstance under which a finder may receive a commission in Texas without registering as a broker at the federal level. If the finder’s business is entirely intrastate, the federal requirement to register as a broker would not apply.14 But this intrastate exemption has been so narrowly interpreted that at least one authority has referred to it as “illusory.”15 Consequently, to be on the safe side, finders in Texas should ordinarily refrain from accepting any transaction based compensation, including commissions. In sum, if a finder in Texas accepts a commission, that finder may be in compliance with the new Texas rules regarding finders, but is probably not in compliance with the federal securities laws. In this situation, the finder would have to register as a broker at the federal level. But, the finder would not have to register with the Texas State Securities Board as a broker.
Conclusion There are significant differences between Texas’ new finder rules and the federal government’s approach towards finders. When it adopted the new rules, the Texas State Securities Board anticipated that they would be a model for other states to follow. It will be interesting to see if other states do so. In the meantime, however, finders in Texas have the difficult task of reconciling the new finder rules with the federal securities laws.
Nelson S. Ebaugh earned his LL.M. in Securities and Financial Regulation from Georgetown University Law Center. He has his own firm, Nelson S. Ebaugh, P.C.
Endnotes 1. 7 Tex. Admin. Code § 115.1(a)(9) (2006); John Polanin, Jr., The “Finder’s” Exception from Federal Broker-Dealer Registration, 40 Cath. U. L. Rev. 787 (1991). 2. 7 Tex. Admin. Code § 115.11(a) (2006); Cornhusker Energy Lexington, LLC v. Prospect Street Ventures, 2006 WL 2620985, Fed. Sec. L. Rep. P 93,974 (D. Neb. 2006) (“A finder . . . will be performing the functions of a broker-dealer, triggering registration requirements, if activities include: analyzing the financial needs of an issuer, recommending or designing financing methods, involvement in negotiations, discussion of details of securities transactions, making investment recommendations, and prior involvement in the sale of securities.”) 3. Mich. Comp. Laws Ann. 451.801(i) (“‘Finder’ means a person who, for consideration, participates in the offer to sell, sale, or purchase of securities or commodities by locating, introducing, or referring potential purchasers or sellers.”); Mich. Comp. Laws Ann. 451.704 & 451.802. 4. Mich. Comp. Laws Ann. 451.801(l)(c) (“‘Investment adviser’ means any person who, for consideration, engages in the business of advising others, either directly or through publications or writings, as to the value of securities, or as to the advisability of investing in, purchasing, or selling securities, who, for consideration and as a part of a regular business, issues or promulgates analyses or reports concerning securities, or who acts as a finder in conjunction with the offer, sale, or purchase of a security.”) 5. S.D. Admin. R. 20:08:03:17. 6.See generally Polanin, supra note 1, at 789-790. 7. Courts have identified several factors that should be considered in evaluating whether an individual is acting as a broker, including: (1) regular participation in securities transactions, (2) employment with the issuer of the securities, (3) payment by commission as opposed to salary, (4) history of selling the securities of other issuers, (5) involvement in negotiations between the issuer and the investor, (6) preparation of valuations as to the merits of the investment or gives advice, (7) involvement in advice to investors, and (8) active rather than passive finder of investors. S.E.C. v. George, 426 F.3d 786, 787 (6h Cir. 2005); S.E.C. v. Martino, 255 F.Supp.2d 268, 283 (S.D.N.Y. 2003); Securities and Exchange Com’n v. Zubkis, 2000 WL 218393, *9, Fed. Sec. L. Rep. P 90,769 (S.D.N.Y. 2000); SEC v. Hansen, 1984 WL 2413, *10, Fed. Sec. L. Rep. P 91,426 (S.D.N.Y. 1984). 8. 15 U.S.C. § 78o(a)(1). 9.Eastside Church of Christ v. National Plan, Inc., 391 F.2d 357, 354 (5th Cir. 1968); Tex. Rev. Civ. Stat. Ann. art. 581-34. 10. 7 Tex. Admin. Code § 115.1(a)(9) (2006). 11. 7 Tex. Admin. Code § 109.13(l)(11)(A)-(H); 17 C.F.R. § 230.501(a). 12. John R. Fahy, The New Texas “Finder” Securities Broker Registration, 41-WTR Tex. J. Bus. L. 341, 342 (2006) (“The finder registration protects finders against unenforceable commission contracts and penalties for non-registration, including criminal penalties.”) 13.BondGlobe, Inc., SEC No-Action Letter, 2001 WL 103418 (February 6, 2001); Dominion Resources, Inc., SEC No-Action Letter, 2000 WL 669838 (Mar. 7, 2000). 14. 15 U.S.C. § 78o(a)(1). 15. Robert J. Haft, Analysis of Key SEC No-Action Letters § 9:11 (2006); see also David A. Lipton, A Primer on Broker-Dealer Registration, 36 Cath. U. L. Rev. 899, 943 (1987) (observing the intrastate exemption “is restrictively applied.”)
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