Can a Cannabis Company Pay a Commission to Someone Who Helps Raise Capital?

NEW YORK––There are some horrible stories of people getting ripped-off by so-called cannabis capital raise experts. Cannabis companies cannot, and in almost all cases, should not, pay any kind of fees to an unlicensed broker. 

The reason is because it’s almost certainly illegal, and may give investors a claim to their money back plus interest and attorney fees, not to mention that it may lead to founders being held personally accountable to investors, among other legal problems.

Generally speaking, it’s not easy to raise capital in any industry. The limiting federal legislation makes it even harder to raise capital in the cannabis industry.

Because most founders do not have an established network of investors willing to invest funds, finding investors is one of the most difficult difficulties facing companies. 

Cannabis C-suite folks looking to extend their network of investors will frequently come across someone who’s willing to make a few introductions for a fee. If you come across this person in cannabis, RUN THE OTHER WAY!

Most people who seek a charge for assisting with capital raising (commonly referred to as a “finder”) aren’t licensed to do so, and using a finder who isn’t a qualified broker-dealer is, in most cases, a violation of federal and state securities laws. In this article, we cover how to spot a broker-dealer and the risks of dealing with an unauthorized broker-dealer in the sections below.

What Is a Broker-Dealer Who Isn’t Licensed?

The general rule is that anyone who “affects transactions in securities or attempts to induce the purchase or sale of securities” must be registered.

The SEC has used a simple four-step test to decide when a “finder” must register as a broker-dealer for decades. According to the SEC, these four considerations will be considered when deciding whether or not someone is working as a broker-dealer:

1. Is the person is compensated through commissions or other transaction-based methods?;
2. Is the individual giving buy/sell advice and providing investment information?
3. Does the individual have a history of selling securities on a regular basis (regular activity);
4. Is the person participating actively in investor-issuer negotiations?

Even if a finder receives a share of the money earned through finder introductions but does not: provide recommendations, has no experience of selling securities, and does not take an active position in talks, even then, the SEC has maintained in multiple no-action letters that transaction-based compensation is a hallmark of being a broker-dealer.

Hence, getting or giving a commission greatly raises the possibility of the party receiving the commission being labeled a ”broker-dealer.” For decades, the best advice has been that issuers should not normally hire finders on a percentage-based compensation basis due to the liabilities involved.

We’ve encountered finders who cite a 2014 SEC no-action letter as proof that they can get a commission despite not being a licensed broker-dealer on multiple occasions.

The problem is the letter contains numerous conditions, including that the buyer of the stocks being sold has (i) control of the firm and (ii) must actively operate the company following the sale of the securities. The no-action letter is not applicable to nearly all cannabis company financings because they do not fit into this situation.

In summary, under federal and state law, using a finder may result in liability. Securities sales agreements that are made in contravention of federal law may be declared void.  This would undoubtedly apply to the arrangement with the unregistered broker who tries to charge a fee for assisting in the sale of the securities.

While the business may believe that this is not such a bad thing, a violation of federal securities laws may also void the agreement between the cannabis company and the investors through which the cannabis company raised the funds. If the agreements are declared void by a court, all parties to the agreements will have a right of rescission for three years from the date of the transaction or one year from the date the violation is found, whichever comes first.

A right of rescission is simply the ability to cancel a contract and return each party to their former position, which means that investments are returned to investors. In other words, using a finder who is not a licensed broker-dealer, but should be, effectively offers investors a multi-year redemption right.

Founders who use unregistered broker-dealers to raise finance may be subject to the following penalties:

1. As an aider and abettor, you could face SEC enforcement action.
2. State securities regulators may take action against you;
3. Can be barred from engaging in or assisting enterprises that conduct securities offerings using regularly used securities exemptions.
4. The firm may be barred from doing a Rule 506 securities offering, which is the most popular securities exemption for cannabis companies and rising growth enterprises.

There are remedies on the horizon. For example, SAFE Banking Act solves this issue by enabling cannabis companies to access capital through traditional capital markets.

Meanwhile, because of the contingent liability connected with the initial breach, which is likely to come up in investor due diligence, using an unlicensed broker-dealer could have an impact on your ability to close future rounds of financing.

So think twice about hiring an unlicensed agent. It could come back to haunt you.