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Bar News - September 6, 2002

Doing Deals the Right Way: Beware of Strangers Finding Investors

By: Tim Platt, Peter G. Ness, Richard A. Samuels & Cordell A. Johnston
Doing Deals the Right Way Beware of Strangers Finding Investors

Issues in Business Law

JOHN SMITH, A budding entrepreneur, founds his new software company. John's family provides the initial "seed capital" in the company, but he needs more money to fund product development. John meets a representative of the ACME Finance Company, which promises to raise $1 million for his company in 30 days in a private placement from ACME's undisclosed "investor group." ACME undertakes the private placement and closes the deal. John's business moves forward, but he's not meeting his business plan due to unforeseen market conditions. The investors are unhappy and hire a lawyer. The lawyer learns that ACME isn't a registered broker-dealer and sues John and his company for rescission. John comes to your firm for representation, what do you do?

The issuance of securities provides valuable capital to businesses, whether through the sale of stock to angel investors or to new owners in a merger or acquisition. An intermediary, e.g., an investment banker, financial advisor, business broker or the so-called "finder," often implements these transactions. These transactions are also subject to federal and state securities laws. Whereas the legal requirements of the issuer of the security, i.e., the company, or the regulations governing the security itself may be well understood, the registration as a broker-dealer of an intermediary hired to advise or assist in the sale of the security is not as well understood.¹ A lawyer who represents business owners should understand three concepts if his or her client is approached to raise money or buy or sell a company by or with the assistance of an investment banker, financial advisor or finder: What is a broker-dealer? Should the broker-dealer be licensed? And what are the consequences of using an unlicensed broker-dealer?

What is a broker-dealer?

The answer to this question can be found in the law itself. A broker-dealer is defined as any person "engaged in the business of effecting transactions in securities for the account of others or for his own account," subject to certain exclusions.² This language includes individuals and firms that help businesses raise capital, as well as investment bankers, business brokers, financial advisors and other similar firms that represent a client in the purchase or sale of a business where stock or securities are issued or sold. Regardless of the intermediary's title, a business lawyer should understand that if the intermediary offers services involving the purchase or sale of securities, the intermediary most likely meets the definition of a broker-dealer under the securities laws.

When should a broker-dealer be licensed?

This question is more difficult to answer, considering some popular notions by the general business community.

One common misperception is that the licensing requirements do not apply to an intermediary who does not take a commission on a sale. A broker-dealer is legally defined not by the form of compensation the individual or firm receives, but instead, by the activity it undertakes.³ Accordingly, there is no general exemption in the securities laws excluding a broker-dealer from registration simply because the broker-dealer is paid a flat fee or by the hour.

A second misperception is that the intermediary is not "effecting transactions in securities" if it limits its role to "advising" the client. This begs the question of whether these advisory activities meet the law's definition of a broker-dealer.⁴ The business lawyer should note that common "advisory" activities such as preparing the sales or marketing "book" or calling potential securities purchasers (whether for investment or a business purchase or sale) involve direct forms of communication regarding the offer or sale of a security. These communications are made for the purpose of soliciting a purchase or sale of securities and therefore require a broker-dealer license.

Finally, some believe that an exemption exists for de minimis activity where the intermediary is not regularly engaged in the business of placing securities.⁵ Whereas the existence and scope of such an exemption is unclear, the following analysis is helpful. The term broker-dealer applies to one who "holds oneself out" as an investment banker or who provides "corporate finance" transactional services, as well as to the "finder," advisor or consultant who offers services that solicit, negotiate or close a securities transaction.

This analysis indicates that a colleague's suggestion to call a rich relative to invest in your company may not require broker-dealer registration, but an intermediary that offers investment banking, "M & A" or similar services to businesses or owners involving the sale of securities to the public is a broker-dealer requiring registration.

How does involvement of an unlicensed broker-dealer affect you as a lawyer?

This question is the most important for the business lawyer, his or her client, and perhaps the unlicensed broker-dealer or its lawyer.

Regarding the unlicensed broker-dealer, the answer is simple. An individual or firm conducting business as an unlicensed broker-dealer is subject to civil and criminal penalties under federal and state securities laws.⁶ To the extent an unlicensed broker-dealer balks at this conclusion, the issuer's lawyer may question the intermediary's judgment if it does not understand, acknowledge or comply with its obligations under the securities laws.

More significantly regarding your client, the hiring of an unlicensed broker-dealer presents two significant risks. The first is the statutory or common law cause of action for rescission.⁷ The risk of unwinding a transaction after the money has changed hands is obviously unsatisfactory to all, especially the issuer and its counsel. If an unlicensed broker-dealer participates in a transaction, related risks include potential loss of the private placement exemption from registration (e.g., for lack of strict compliance with Regulation D requirements); a claim against the broker and others for aiding and abetting an unlawful activity; and the voiding of one or more transaction contracts.

The second material risk is in whether you, the issuer's legal counsel, can issue a valid securities opinion if an unregistered broker-dealer is involved. Any opinion as to "validly issued" would need to be qualified for securities sold subject to a rescission right or without a clear private placement exemption. Given the legitimate commercial expectations of the parties, a lawyer's qualification of his or her legal opinion might render the opinion unmarketable and either delay or prevent the deal from closing.

How to Protect Your Client's Deal

For you and your client, the rescission risk and unmarketable opinion risk are undesirable and require proactive measures. The simplest measure is to work with licensed broker-dealers, just as you would require with other professionals. Prudence suggests that if your client hires an unlicensed finder or intermediary, the finder or intermediary should provide proof of an exemption from broker-dealer registration and you or another lawyer with relevant securities experience should review the exemption on behalf of your client. Ultimately, if your client is going to hire someone to raise money or to buy or sell his or her business, which is difficult work, you and your client should reasonably expect they have the credentials and licenses necessary to deliver those services. Otherwise, you and your client will end up taking on such challenging tasks yourselves.

Attorneys Tim Platt and Peter G. Ness are principals in AreteCaptial Group^sm, an investment banking firm offering mergers and acquisitions and private placement services to emerging stage and middle market private and public companies. Richard A. Samuels is a director at the law firm of McLane, Graf, Raulerson & Middleton in Manchester, where he concentrates his practice in corporate and securities law. Cordell Johnston is an attorney at Orr & Reno in Concord, where he represents clients in the offer and sale of securities, mergers and acquisitions, and corporate governance.

1.	See e.g., the New Hampshire Securities Act, N.H. RSA 421-B, the Securities Act of 1933, 15 U.S.C. § 77, and the Securities Exchange Act of 1934, 15 U.S.C. § 78.
2.	N.H. RSA 421-B:2, III; see also Securities Exchange Act of 1934, § 3(a)(4)(A), 15 U.S.C. § 78c(a)(4).
3.	Id.; see also Securities Exchange Act of 1934, Section 15(a)(1), 15 U.S.C. § 78o(a)(1) (definition of unlawful activity by a broker-dealer is due to failure to register under statute, not form of compensation).
4.	See Henry C. Goppelt, SEC No-Action Letter, June 2, 1974, 1974 SEC No-Act. LEXIS 2415.
5.	See Novelos Therapeutics, Inc. v. Kenmare Capital Partners, Ltd. et. al., 2001 Mass. Super. LEXIS 307.
6.	Securities Exchange Act § 32(a), 15 U.S.C. § 78ff(a) (failure to register as a broker-dealer is unlawful under § 15, penalties set forth in § 32).
7.	See Doherty v. Bartlett et. al., 81 F.2d 920, 1936 U.S. App. LEXIS 3582 (1^st Cir, 1936); see also Novelos Therapeutics, Inc., at n. 5 supra.

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