An obscure section of the California Corporation Code may present unexpected consequences for mergers and acquisitions as well as for early-stage companies seeking initial funding. Section 25501.5, which became effective Jan. 1, 2005, provides rescission rights -- the rights to nullify contracts -- to buyers who purchase securities from or through unregistered broker-dealers or unlicensed intermediaries who are not just deal finders. It also provides the ability to recover monetary damages if purchasers no longer own such securities. If investors no longer hold the securities, they may sue for damages, including attorney's fees, costs and treble damages up to $10,000.

Why is this a problem? Early-stage companies or funds seek capital from investors frequently with the assistance of intermediaries. Similarly, intermediaries are often used in connecting a buyer and seller of a company. In the event these intermediaries are more than finders and are not properly licensed and receive compensation, the code section can trigger a rescission right or a claim for damages. Transactions involving individuals or entities seeking to receive fees who are not finders and are unregistered broker-dealers are seen time and again.

What is a finder? A nonstatutory exemption from the licensing requirements exists for individuals acting as finders. As no bright-line standard exists to determine whether or not an individual is a finder, authorities must weigh several factors. These include the level of services a finder is providing to a company and potential investors, the regularity in which a finder is engaged in the business of facilitating investments between companies and investors, and compensation received by a finder for his or her actions in the investment.

What is a broker-dealer? Under federal securities laws, a broker is any person engaged in effecting transactions in securities for others. California law is very similar and defines a broker-dealer as any person engaged in the business of effecting transactions in securities in California. Under both federal and California law, if deemed a broker, an individual is subject to certain licensing and other regulatory requirements.

In determining whether an individual is a broker-dealer, authorities will consider the level of involvement the individual has in the transaction. To avoid being classified as an unlicensed broker-dealer, a finder should do no more than make introductions between the company and the investors and avoid all involvement in negotiations between the parties.

This factor was stressed in the first no-action letter issued by the Securities and Exchange Commission that recognized the finder exemption. In the Paul Anka no-action letter issued in 1991, which involved the famous entertainer, the SEC found that an individual was merely a finder when he provided his contact list to the company and made introductions to potential investors. In making this finding, the SEC stressed the lack of any involvement in the negotiations of the transaction. Subsequent guidance has followed this initial finding. Therefore, to avoid being deemed an unlicensed broker-dealer, a finder should do no more than make introductions.

The Paul Anka no-action letter also brought to light the fact that an individual regularly acting as a finder is in danger of being deemed an unlicensed broker-dealer. In finding that the individual was not an unlicensed broker-dealer, the SEC focused on the fact that he had not previously arranged investments and that he agreed not to be involved in arranging investments in the future. If he had been involved regularly in these types of transactions, the SEC might have reached a different result. Because of this, companies should be wary of individuals acting as regular finders.

The SEC gives great weight to transaction-based compensation when determining whether someone is acting as an unlicensed broker-dealer. It has gone so far as to state that transaction-based compensation is a hallmark of being a broker-dealer. Although transaction-based compensation does not automatically revoke the finder exemption, it definitely increases the risk of being deemed an unlicensed broker-dealer. Companies must be very careful when paying fees to finders and should try to avoid paying fees based on the amount of capital an individual is responsible for bringing in to the company. One possible option for a company to consider is to pay an up-front fixed fee to the finder, but the SEC has not stated whether such an arrangement would be acceptable.

There are consequences to using an unregistered broker-dealer, including subjecting a company to regulatory and individual actions. Regulatory actions by the states and the SEC may include questioning the reliance on a private placement exemption, prohibiting the company from future Regulation D offerings, company aider and abettor liability, and the unenforceability of the agreement between the company and finder. Rescission rights and individual actions by investors may also arise.

With the passage of Corporation Code Section 25510.5, a fund sponsor who has raised funds, an entity that has raised capital or a seller of a company could all be subject to a rescission right by a buyer if an intermediary is involved who is paid a fee and is not properly licensed in California. Due to its recent passage, very little guidance exists at this time concerning the parameters of the rescission right provided for. Comments to the state Assembly bill indicate that the bill was designed to address the problem of bucket shops or boiler rooms that engage in securities fraud and to specifically target disreputable brokers who victimize consumers by operating illegally, such as unlicensed people who sell mortgage pools, pyramid or Ponzi schemes, and people licensed in a related field, such as insurance, who sell securities to their existing clients without obtaining the proper securities licenses. Except in the case of these unusual securities, most finders do not own the securities they sell and are acting as an agent of the company.

Section 25501.5 provides two alternative remedies if a violation has occurred. First, if the purchaser still owns the security, he or she may bring an action for rescission and tender the security. If a rescission occurs, the statute provides that the purchaser may recover the consideration paid for security plus the legal rate of interest, less the amount of any income received on the investment.

Second, if the purchaser no longer owns the security, the purchaser may sue for damages. Damages recoverable are in an amount equal to the difference between the price at which the security is bought plus the legal rate of interest reduced by the value of the security at the time it was disposed of by the purchaser, plus any income previously received by the purchaser on the security. In addition to the foregoing remedies, a court is empowered in its discretion to award reimbursement of reasonable attorney fees to a prevailing plaintiff under this section.

In conclusion, as a matter of course in connection with any sale of a business or fundraising in which an intermediary is involved who is to receive compensation, an analysis must be made whether such an individual is truly a finder or, if not, whether the person is properly licensed. If such an intermediary is not properly licensed in California, risk exists under Section 25501.5 that a rescission right will exist or that a damage claim may exist if the security in question has been sold.

George Wall is a senior partner in law firm Rutan & Tucker LLP's corporate section.