With good reason, many securities lawyers, myself included, cringe when they hear that a business client has engaged a “consultant” or “finder” to help raise capital rather than a registered broker. Under Section 15(a) of the Securities Exchange Act of 1934, as amended, with some limited exceptions, it is unlawful for any person to effect any transactions in, or induce or attempt to induce the purchase or sale of, any securities unless the person is registered as a broker or dealer under the Exchange Act or associated with a registered broker or dealer. What activities will require a person to register? Even the SEC admits in its guidance on registering as a broker or dealer that it is not always easy tell. However, one clear indicator that a person is probably acting as a broker or dealer is the person’s receipt of transaction-based compensation, such as a percentage of invested capital.
The SEC recently announced that it had charged William M. Stephens with soliciting investments for two related investment funds while not registered as a broker under the Exchange Act. As described in the Cease-and-Desist Order, with respect to investors introduced by Mr. Stephens, Mr. Stephens was to be paid one percent of amounts investors committed to invest. In addition, Mr. Stephens provided various investment materials to prospective investors, such as private placement memoranda and subscription documents.
Why should a company raising capital care if a consultant or finder is acting as an unregistered broker? The involvement of an unregistered broker could give investors a right of rescission, that is, the right to require the company to buy back the securities the investor purchased at the original purchase price. Obviously, the consequences of having to repurchase a large number of securities could be catastrophic as they were for Neogenix Oncology, Inc. As detailed in a surprisingly frank series of letters from Neogenix’s management to shareholders and Neogenix’s SEC filings, Neogenix’s use of unregistered finders to secure investments gave rise to up to $31 million of potential rescission liabilities. These potential liabilities, and their impact on Neogenix’s ability to raise additional capital, ultimately contributed to Neogenix’s decision to file for bankruptcy.