Divided SEC proposes conditional registration exemption for finders assisting with private capital raising

Last week, the Securities and Exchange Commission (SEC) voted 3-2 along party lines to propose a limited exemption from its broker registration requirements for persons acting as “finders” (the Proposal).  The Proposal would permit natural persons to engage in certain activities related to private offerings of securities without registering with the SEC as brokers.  The stated intention of the Proposal is to assist small businesses with raising capital – although it is not limited to such entities – and provide regulatory clarity to investors, issuers and finders by establishing “clear lanes for both registered broker activity and limited activity by finders that would be exempt from registration.”  Commissioners Allison Herren Lee and Caroline A. Crenshaw, however, dissented strongly.  Set forth below are background on the finder’s issue, a summary of the Proposal and the Commissioners’ views, and key takeaways.

Background

The controversy over finders is long standing.  The Proposal notes that a gray market has existed for decades in which finders have sought various ways to assist issuers in private capital raising for compensation without being registered as securities brokers despite significant regulatory uncertainty.  Section 3(a)(4) of the Securities Exchange Act of 1934, as amended (Exchange Act), generally defines a “broker” as “any person engaged in the business of effecting transactions in securities for the account of others” and Exchange Act Section 15(a)(1) generally requires a broker to be registered with the SEC.  Unless one of a limited number of exceptions or exemptions applies, anyone engaged in the business of effecting transactions in securities for the account of others is a broker and is required to register.

In determining whether a person is acting as a broker, the SEC and federal courts have traditionally examined a number of factors such as whether the person participates at key points in the chain of securities distribution, including investor solicitation, negotiation or execution of the transaction; whether the person’s compensation depends on or is related to the outcome or size of the transaction (ie, transaction-based compensation); whether the person is otherwise engaged in the business of effecting or facilitating securities transactions; and whether the person will handle funds or securities of others in connection with securities transactions.  Ultimately, as a general matter, those involved in the offer and sale of securities who perform such functions are brokers and must be registered, especially if they receive any form of transaction-based compensation.

Once registered, brokers are subject to an extensive regulatory structure that is intended to protect investors and ensure that brokers act in a manner consistent with high standards of commercial honor and just and equitable principles of trade.  Since June 30, 2020, the conduct standard applicable to brokers has been even higher, with SEC Regulation Best Interest requiring brokers that make recommendations to act in the best interest of their clients and comply with a host of new regulations.

The SEC has historically viewed the registration requirements very broadly, providing only occasional relief and only for discreet activities under very limited circumstances.  For example, in 1991 the SEC granted relief in the form of a “no-action” letter to entertainer Paul Anka.[1]  This letter is often cited for the proposition that there is a general finders exemption from broker registration; however, the facts behind the letter belie that assertion.  Anka was asked to assist an issuer to find investors and was to be compensated for doing so.  In granting relief, the SEC permitted Anka on a one-time basis to do nothing more than furnish the issuer with names and telephone numbers of persons he thought might be interested in purchasing the issuer’s securities.  He neither personally contacted these persons nor made any recommendations regarding the investment, and the issuer was required to disclose the finder’s fee to investors.

Despite the extremely limited activities in which Anka was permitted to engage, at least some SEC personnel subsequently disavowed the relief or at least attempted to view it as narrowly as possible.  For example, in November 2008, a senior staff member of the SEC Division of Trading and Markets said publicly that “there is no progeny of Paul Anka … and the ways that we look at broker-dealer regulation today, I'm not even sure that we would issue the Paul Anka letter again.  And so, [I] really don't think it's something that people out there doing transactions should be relying on.”[2]  Moreover, the Proposal points out that the SEC staff has responded over the years to other requests similar to the Paul Anka letter and that “[d]ifferences in the facts and circumstances can lead to different results.”  It goes on to reference more recent no-action letters denying relief.

The regulatory uncertainty associated with finder versus broker status can have significant legal consequences.  If an issuer and a finder enter into an agreement, the issuer could refuse to pay the finder if the issuer later concludes that the finder’s activity required broker registration.  If an issuer or broker-dealer pay a finder and an investor later complains to a regulator about the transaction, an examination or investigation could be launched in which a regulator concludes that the finder was required to be registered, and the issuer and broker-dealer could face aiding or abetting or similar liability for their role in the finder’s violation.  Depending on how the matter is resolved, the issuer, finder and broker-dealer could become “bad actors” under SEC Rule 506(d), and thereafter be restricted from engaging in certain types of private fundraising for five years.  If a security is sold by an unregistered person, the investor also has a right of rescission such that the issuer will be required to repurchase the security under federal and state law.

The proposed exemption

The Proposal states that finders “may play an important role in facilitating capital formation, particularly for smaller issuers.”  It acknowledges, however, that significant investor protection concerns arise when an intermediary in a securities transaction is not registered and, as a result, not subject to the detailed regulatory oversight that applies to brokers.  Nevertheless, the SEC believes that there are at least some situations where the need for broker registration is mitigated by other factors.  The Proposal is intended to be narrowly tailored to address those situations and the capital formation needs of certain smaller issuers while preserving appropriate investor protections. To that end, the SEC proposed two categories of finders exempt from registration:  Tier I Finders and Tier II Finders.  Under the Proposal, exempt finders could receive transaction-based compensation.

If they meet certain conditions, Tier I Finders could provide contact information of potential investors for a single capital raising transaction by a single issuer in any 12-month period, but would not be permitted to have any contact with potential investors about that issuer – an exemption similar in scope to the relief provided in the Paul Anka letter.

Tier II Finders, after meeting certain conditions in addition to those required of Tier I Finders, would be permitted to solicit investors on behalf of an issuer, limited to (i) identifying, screening and contacting potential investors; (ii) distributing an issuer’s offering materials to investors; (iii) discussing that information provided that the finder does not provide advice with respect to the valuation or advisability of the investment; and (iv) arranging and/or participating in meetings with the issuer and an investor.

Finders will not be permitted to rely on the exemption to engage in broker activity beyond the scope of the Proposal, including facilitation of a registered offering, any resales of securities, or sales to investors who are not accredited investors. The exemption would not affect a finder’s obligation to continue to comply with all other applicable laws, including the antifraud provisions of the Securities Act of 1933, as amended (Securities Act) and the Exchange Act, such as the obligations under Section 10(b) and Rule 10b-5 under the Exchange Act, and state law. In addition, the exemption would not affect the rights of the SEC or any other party to enforce compliance with other laws or the available remedies for violations of them.

Conditions for both Tier I and Tier II Finders

To qualify for the exemption, both Tier I and Tier II Finders must satisfy certain conditions. The exemption for both Tier I and Tier II Finders would be available only where:

• The issuer is not required to file reports under Exchange Act Sections 13 or 15(d)
• The issuer will conduct the offering in reliance on an applicable exemption from the registration requirements of the Securities Act
• The finder does not engage in general solicitation
• A potential investor is an “accredited investor,” as defined in Securities Act Regulation D, Rule 501, or the finder has a reasonable belief that the potential investor is an accredited investor
• The finder has a written agreement with the issuer that includes a description of the services to be provided and the finder’s compensation
• The finder is not an associated person of a broker-dealer and
• The finder is not subject to statutory disqualification, as that term is defined in Section 3(a)(39) of the Exchange Act, at the time of his or her participation.

A finder cannot:

• Be involved in structuring the transaction or negotiating the terms of the offering
• Handle customer funds or securities or bind the issuer or investor
• Participate in preparation of sales materials
• Perform independent analysis of the sale
• Engage in any “due diligence” activities
• Assist or provide financing for any purchases or
• Provide advice as to the valuation or financial advisability of the investment.

Additional Tier II Finder conditions

Additional requirements would apply to Tier II Finders, who would be permitted to participate in a wider range of activities than Tier I Finders.  The additional requirements would mandate disclosure regarding the finder’s compensation, role in the transaction and material conflicts.  The finder must make the required disclosures before or at the time of the solicitation.  Tier II Finders also would be required to obtain from each investor, before or at the time of the investment, a written acknowledgment that the investor received the required disclosures.

Other materials

The SEC Office of the Advocate for Small Business Capital Formation prepared a video and a chart comparing certain permissible activities, requirements and limitations for Tier I Finders, Tier II Finders and registered broker-dealers.

Request for comments

While requesting comment on all aspects of the Proposal, including the potential costs and benefits, the SEC has posed 45 specific questions for which responses with explanations are also requested.  These include:

• Whether the definition of finder is properly limited to natural persons and whether finders should be limited to US residents
• Whether, instead of limiting potential investors to accredited investors, there should be investment limitations such as dollar limits on the size of an investment
• Whether the proposed exemption should be limited to offerings of a specific size and, if so, what that should be
• Whether the proposed exemption should apply to secondary offerings
• Whether issuers should assume liability for a finder’s misstatements and
• Possible alternatives to the Proposal.

There are also several questions relating to whether the SEC should provide additional guidance on various aspects of the Proposal and questions related to whether the scope of the exemption as proposed is appropriate.

Comments are due on November 12, 2020.

Divergent views of the Commissioners

The Commission’s approval of the Proposal was not unanimous.  Commissioners Lee and Crenshaw were highly critical and, while Chairman Clayton and Commissioners Peirce and Roisman supported the Proposal, their comments seemed to indicate that the approach outlined in Proposal may not be the end of the story.

Chairman Clayton and Commissioners Pierce and Roisman focused on the benefit to small businesses that often face challenges when trying to connect with potential investors in the private market.  They noted that antifraud provisions would continue to apply and stated that they would welcome further comment from stakeholders.  While Commissioner Roisman voted in support of the proposal, he pointed out that it “is indeed just that, a proposal.”

Commissioner Lee expressed strong opposition, stating that the Proposal was “flawed in both substance and procedure.”  She noted that exemptive relief rather than a proposed rule circumvents “important economic analysis that should accompany a proposed policy shift of this significance.”  She was particularly concerned with the expanded universe of unregistered conduct for Tier II Finders, stating that the Proposal would undermine longstanding interpretations regarding when broker registration is needed to protect investors.  Commissioner Lee noted, however, that she could support rulemaking involving a scaled registration model for finders.  She explained that, under the Proposal, a finder, who stands to gain proportionately for every dollar invested, could praise an investment to potential investors while avoiding registration even though that scenario “implicates the quintessential ‘salesman’s stake’” in the transaction that the SEC has long held requires registration.  Commissioner Lee pointed out that such activities would not be subject to the SEC’s recently adopted Regulation Best Interest, which is intended to provide greater protections to the same types of investors at risk here.  She also noted that while the Proposal is premised on the need to assist small and emerging companies, there are no suggested limits on issuer or offering size, making it “vastly overbroad to achieve its purported purposes.”

Similarly, Commissioner Crenshaw viewed the Proposal as “a radical departure” from the SEC’s registration requirements that would expand the range of investor solicitation activities provided by unregistered and unsupervised persons.  She also expressed concern that the Proposal would exempt finders from basic broker sales practice rules, would not require them to maintain records of their activities, and would not subject them to periodic inspections or examinations.  Consequently, the SEC will not know whether such finders are complying with any of the conditions in the Proposal.  This is of particular concern because, in her view, finders are often associated with fraudulent activity.

Key takeaways

With comments due the week after the election, whether the Proposal will go forward if there is a change in the administration is an open question.  While there is a shared desire for regulatory clarity around finders, the strong views about the Proposal suggest that there is much more to come with respect to this issue. There is likely to be a wide range of comments from issuers, registered brokers and potential investors, particularly retail investors, who may be at risk in dealing with unregistered finders subject to comparatively little regulatory oversight.

If you have any questions regarding the Proposal or would like assistance in preparing a comment, please contact one of the authors or a member of the DLA Piper Financial Services team.