The exemption is specific to serving as a finder in defined transactions; a finder cannot rely on the exemption to perform any other brokerage functions.
On October 7, 2020, the Securities and Exchange Commission (SEC) announced it would propose for public comment an exemption from broker-dealer registration for persons functioning as intermediaries in raising capital for nonreporting companies. This controversial proposal addresses an unclear area of the law where securities regulators historically have thwarted so-called finders from introducing investors to emerging or expanding businesses when not registered as brokers under the Securities Exchange Act of 1934 (’34 Act).
Background
The ’34 Act and the blue sky laws of most states require registration as brokers of persons engaged in the business of effecting securities transactions for the account of others. Registered retail brokers and investment bankers clearly fit this definition. Finders (both individuals and small entities), although a fixture of the capital formation ecosystem in facilitating financings of emerging and growing privately owned companies, also literally fit this definition. According to the SEC, finders who are not registered violate the law, tainting the legality of the entire investment and creating a basis for disgruntled investors later to seek rescission.
The SEC, although generally requiring registration of finders, has periodically authorized unregistered finders to be compensated for introducing investors. Several prior efforts to promulgate a new rule addressing the functions of finders have been recommended by various bar and business groups and considered by the SEC, but the commission has been reticent either to offer a finder’s exemption or to simplify the sometimes daunting process of broker registration for the finder community.
In January 2014, the SEC relented in its position of generally demanding registration for finders, but only in transaction involving an acquisition, by issuing a “no action letter” upon request of several leading law firms. That letter stated that no federal action would be taken against finders if they adhered to specific, defined practices.
But until this October 7 proposal, the SEC has never formally entertained an exemption for finder activity in pure capital formation.
The Proposal
The SEC’s proposal is to exempt from registration two varieties of finders.
Tier I finders are one-time finders with no other involvement. They could give the names of potential investors to one issuer in connection with one single financing, once in any 12-month period. Having turned over the name(s), the finder could not have any contact with the parties or transaction. Although such a function is not typical of how finders have functioned, the situation arises on occasion. Seemingly, the finder could be compensated for turning over the names, and presumably that compensation could be keyed to the making of an actual investment.
Tier II finders are those fulfilling a more typical role in introducing one or more investors, including on a more than occasional situation. In effect, a person could establish an ongoing business as an unregistered finder. Such finders could identify and contact investors to measure interest, distribute to investors the offering materials provided by the issuer, discuss those materials with investors and set up and participate in meetings with the issuer and investors. This list of services is more typical of current finder practice.
Both Tier I and Tier II finders would share certain restrictions on their activities:
The issuer must be nonreporting with the SEC and seeking to effect the offering under an applicable exemption from registration under the Securities Act of 1933. The finder could not undertake general solicitation, although issuers themselves under certain rules can in some instances solicit. Potential investors must be accredited or believed to be accredited under Regulation D; although Regulation D is not the sole method of exempting an offering from securities registration. The finder must operate under a written agreement describing services and compensation. The finder cannot be affiliated with a registered broker, preventing associated persons from doing a transaction “away from the firm.” The finder cannot be subject to statutory disqualification under a section of the ’34 Act that generally bars securities activities to persons with a history of certain legal or regulatory violations.
The exemption is specific to serving as a finder in defined transactions; a finder cannot rely on the exemption to perform any other brokerage functions. The SEC press release makes it clear that the finder cannot facilitate a registered transaction, a resale of securities or sales to investors who are not accredited and not believed to be accredited.
Even Tier II finders would be prohibited from certain functions which often are performed under current finder practice (which practice may in fact be noncompliant under current law): The finder cannot structure or negotiate the offering, handle funds, bind any party to a transaction, prepare sales materials, perform independent analysis of the sale, engage in due diligence, arrange financing for investors or provide advice as to valuation or investment advisability.
At time of solicitation, a Tier II finder must advise proposed investors of his or her role and compensation arrangement, and if an introduced investor actually participates, the investor must provide a dated written acknowledgment of receipt of such disclosures.
In a separate statement, SEC Chair Jay Clayton made clear that the proposed exemption is from federal law only and related only to finder registration; disclosure standards as to information accuracy and completeness under federal law remain in effect. Even if an SEC exemption is promulgated, at present it does not appear that state regulatory requirements, which typically echo federal broker-dealer law, will be relaxed automatically, and state exemption would require specific state action. (Certain states already have specific exemptions for particular types of transactions, and local law must be separately reviewed before reliance on any federal exemption.)
The release does not address the potential impact of other broker-dealer regulations. Financial Industry Regulatory Authority (FINRA) Rule 2020 prohibits its members (including all registered broker dealers) from paying any fees or other compensation to anyone that is not (1) registered with the SEC as a broker dealer and (2) a member organization of FINRA. Accordingly, absent additional regulatory relief by the SEC or FINRA, if an issuer engaged a broker to assist it in an offering, that broker could not pay anything to a finder.
Next Steps and Anticipated Debate
Once the formal proposal is published in the Federal Register, there will be a 30-day period of public comment. Substantial comment sent to the commission is likely. Comments generally are available to interested persons on the SEC website. After the comment period, the SEC will consider the comments and may issue the exemption as proposed or in modified form, or even withdraw the proposal. Nor is there a set timeline for this process.
The proposal was issued by a 3-2 vote of the commissioners, divided on party lines. Chairman Clayton stated that the goal of the proposal was to facilitate capital raises by entrepreneurial and small businesses by making clear the permissible role of unregistered finders. Clayton’s written statement noted that capital markets today were much changed from the times when more stringent controls were appropriate, but he also requested comment as to whether there should be added to the exemption a limit on the amount of funds that could be raised in finder-facilitated transactions.
Historically, the North American Securities Administrators Association, representing state securities regulators, has sometimes opposed relaxation of the federal regulatory scheme, although at the date of this Alert we are not aware of any such action.
The two Democratic commissioners immediately issued their own statements in opposition to the proposal. Among criticisms: The exemptions gives further vitality to the “opaque private markets at the expense of better-lit public markets”; the exemptions reduce investor protection; finder-related transactions create illiquid investments often based on valuation errors, in situations with higher transaction costs more prone to fraud; unregistered finders are not held to the same performance standards imposed on registered brokers; although framed as a benefit to minority and women-headed enterprises, there is no evidence that this proposal would address those companies; and the proposal is a procedural end-run around what should be the subject of a full rule-making process, with more data and deliberation, given the radical break with past policy.
For More Information
If you have any questions about this Alert, please contact Stephen M. Honig, Robert P. Bramnik, any of the attorneys in our Capital Markets Group, any of the attorneys in our Broker-Dealer and Securities Regulation Group or the attorney in the firm with whom you are in regular contact.
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