United States: New California Law Increases the Risks for Private Placements Made under the So-Called "Finder’s Exemption"

On September 18, 2004, California Governor Arnold Schwarzenegger signed into law Assembly Bill 2167, a new law implementing changes to various California statutes and aimed at deterring individuals and entities from operating as unlicensed broker-dealers. The new law, effective January 1, 2005, does the following:

Provides an express right of rescission to any investor who purchases a security from a person or entity that is required to be licensed in California as a registered broker-dealer that is not so registered against the unregistered seller.

Provides that the purchaser can also sue the unregistered seller for monetary damages, and may recover treble damages (limited to $10,000 above the purchase price), and may also be awarded attorneys’ fees and costs.

Extends the statute of limitation for a purchaser to bring an action to five years after the transaction is completed, or two years from the purchaser’s discovery of the facts, whichever occurs first.

In a tight financial market, many privately-held companies are likely to consider the use of so-called "finders" -- persons or entities who hold themselves out as having the ability to introduce companies to interested investors in exchange for money and, often, equity compensation. Such finders are usually the only option for companies that are interested in raising less than five million dollars, as traditional investment banks and other professional financial firms are rarely interested in transactions of this scale. The practice of using finders can be problematic, however, as finders that engage "in the business of effecting transactions in securities for the business of others" must be registered as broker-dealers under both California and federal law -- a licensing requirement that few finders actually meet.

Under California law, which prior to the passage of AB 2167 was very similar to federal law, issuers and finders have operated in somewhat of a gray area. A person or entity that is truly a "finder" -- doing nothing more than providing the issuer with names of potential purchasers and receiving no sales-related compensation -- may not be required to register as a broker-dealer. But in practice it is likely that many if not most such finders engage in selling activities and are required to register and be licensed as broker-dealers.¹ Despite this uncertainty, many issuers in need of capital have historically been willing to engage finders, as the likely consequences associated with failing to meet the exemption usually were relatively mild. Importantly, the risk was mitigated by the fact that in most cases investors could not claim a private right of action against either the issuer or the finder, and mitigated further by the fact that the issue was not thought to be a priority of either the SEC or the California Department of Corporations. Instead, the primary risk was only that contractual arrangements between issuers and finders were unenforceable in court.

As drafted, AB 2167 applies in the relatively uncommon instance where a finder sells securities to California residents or on behalf of California issuers. While no cases have yet been decided, the consequences of this new law for finders that sell securities in connection with private placements seem relatively straightforward. Investors, armed with a private right of rescission, now essentially have an insurance policy to unwind their purchase of securities in the event that the value of their securities declines. Although an individual investor may not recover more than $10,000 in damages (excluding attorneys’ fees), the liability finders may face for a given transaction may be much more, as private placements typically involve more than one investor. Faced with this threat, it is unlikely that any unlicensed finder will find it worthwhile to engage in such transactions in California.

The consequences for issuers are less certain, as AB 2167 on its face only applies to unlicensed broker-dealers. However, given the stated goals of the amendment, which are to deter private placements that improperly involve unlicensed finders and, in the case of rescission, to return the parties to their original positions, it is foreseeable that a right of rescission might be implied against issuers. This is in part due to the fact that in most private placements finders do not actually buy or sell securities, thus making an implied right against issuers seem necessary to give this new law "teeth." Further, it is possible that existing California Corporations Code Section 25403, which provides for vicarious liability where a person "who with knowledge directly or indirectly controls and induces any person to violate [California securities laws]," could be construed to extend the rescission right that lies against the unregistered seller to also lie against the issuer. Thus, until California courts indicate otherwise, it may be prudent to interpret this law as giving investors a private right of rescission against issuers of securities, as well.

Such a right would threaten the financial position of an issuer engaging a finder in a private placement for at least two years after the date of the transaction. In addition to the monetary damages issuers may face (as described above), the uncertainty associated with such a transaction may also jeopardize the issuer’s ability to raise capital in the future, including its ability to undertake an initial public offering. Issuers may also face unexpected accounting problems in trying to book as cash funds raised in transactions involving finders. Having to live with such uncertainty for up to five years could cause many issuers to refrain altogether from the practice of using a finder.

As suggested above, given the risks associated with this new law, and until we receive guidance from California courts to the contrary, we would generally advise issuers and finders against working together in private placements involving California issuers or California investors. Should an issuer or finder nonetheless determine to participate in such a transaction in the face of these risks, however, at an absolute minimum the finder must not: (1) provide advice about the merits of particular opportunities or ventures; (2) receive compensation from users other than non-contingent fees and nominal flat fees to cover administrative costs; (3) participate in any negotiations between entrepreneurs and investors; (4) directly assist entrepreneurs or investors with the completion of any transaction; (5) handle funds or securities involved in completing a transaction; or (6) hold itself out as providing any securities-related services other than a listing or matching service.

Footnotes:

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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