October 19, 2020 | By Patrick T. McCloskey
On October 7, 2020 the Securities and Exchange Commission (“SEC”) proposed an exemptive order that, if adopted, will allow so-called “finders” to engage in specified limited capital raising activities without registering as brokers under Section 15(a) of the Securities Exchange Act of 1934, as amended (the “1934 Act”).
Clarifying a grey area
The question of whether intermediaries need to register as brokers under the 1934 Act when compensated by securities issuers in exchange for investor introductions has long been a grey area. Unregistered finders who engage in activities that require broker registration run the risk of SEC enforcement remedies and issuers who engage and use the services of such finders risk aiding and abetting liability exposure as well as triggering a right of rescission for investors in the applicable offering. At the urging of various securities market constituents, the SEC has finally proposed a conditional exemption that is intended to provide clarity on this thorny issue. There is a 30-day comment period on the proposed exemption that expires on November 12, 2020.
As proposed, the finder exemption would only apply to primary offerings by issuers not required to file periodic reports under Section 13 or Section 15(d) under the 1934 Act, and such offerings would need to be exempt from registration under the Securities Act of 1933, as amended (the “1933 Act”). The exempt finder activities would only apply to prospective investors that are accredited investors (as defined in Rule 501 under the 1933 Act) or prospective investors the finder reasonably believes to be accredited investors. Coincidentally, on August 26, 2020 the SEC adopted amendments that modernize and expand the definition of accredited investor under Rule 501, and these amendments will become effective on December 8, 2020.
The proposed finder exemption would not be available to an associated person of a broker-dealer or anyone who is subject to a statutory disqualification as defined in Section 3(a)(39) of the 1934 Act. The proposal would also require that the issuer and the finder enter into a written agreement describing the finder’s services and the compensation to be received from the issuer, which may be transaction-based compensation (e.g., a commission structure).
From a technical standpoint, the SEC’s proposing release seems to limit the exemption to finders who are natural persons (SEC parlance for human beings), thereby excluding business entities. The SEC did not explain the rationale for the natural person limitation, but specifically requested input on whether it should apply.
The proposed exemption would contain certain restrictions on finders, including prohibitions on: (i) any general solicitation; (ii) handling of customer funds or securities; (iii) binding the issuer or any investor; (iv) participating in the preparation of any sales materials; (v) performing any independent analysis of the sale; (vi) engaging in any due diligence activities; (vii) assisting with or providing financing for a purchase; or (viii) providing advice as to the valuation or the financial advisability of the investment.
The SEC has proposed to bifurcate exempt finders into two categories, each with its own specific restrictions and obligations.
Tier I Finders
Tier I Finders would only be allowed to provide the applicable issuer with the contact information of potential investors (including the potential investor’s name, telephone number, e-mail address and social media information), but would not be permitted to contact prospective investors about the applicable issuer. Tier I Finders would also be limited to a single capital raising transaction by a single issuer during each 12-month period.
Tier II Finders
Tier II Finders would be permitted to engage in certain solicitation-related activities with investors (but no general solicitation), subject to specific disclosure requirements. As proposed, the solicitation-related activities would be limited to: (i) identifying, screening, and contacting potential investors; (ii) distributing issuer offering materials to investors; (iii) discussing issuer information included in any offering materials, subject to a critical prohibition on providing advice as to the valuation or the financial advisability of the investment; and (iv) arranging or participating in meetings with the issuer and the investor.
Tier II Finders would be required to disclose to potential investors, prior to or at the time of solicitation: (1) the name of the Tier II Finder; (2) the name of the issuer; (3) a description of the relationship between the Tier II Finder and the issuer, including any affiliation; (4) a statement that the Tier II Finder will be compensated by the issuer for the solicitation-related activities and a description of the terms of the compensation arrangement; (5) any material conflicts of interest resulting from the arrangement or relationship between the Tier II Finder and the issuer; and (6) an affirmative statement that the Tier II Finder is acting as an agent of the issuer, is not acting as an associated person of a broker-dealer, and is not undertaking a role to act in the investor’s best interest. The SEC has proposed to allow Tier II Finders to make these disclosures orally prior to or at the time of solicitation, subject to a requirement that the disclosures be made in writing no later than the time of the applicable investment. Importantly, a Tier II Finder would be required to obtain from each investor, prior to or at the time of the investment, a dated written acknowledgement of receipt of the Tier II Finder’s required disclosures.
Non-exclusive safe harbor
As proposed, the exemptive order would be a non-exclusive safe harbor, meaning a finder who does not comply with the applicable requirements would need to consider whether broker registration under the 1934 Act is required under the applicable circumstances. On this issue, the SEC stated, in a footnote, there would be no presumption of a violation in these situations, but the amorphous “facts and circumstances” analysis currently applied by the SEC and the courts on the finder registration issue would control. Relatedly, the SEC specifically requested input on whether any of its existing no-action letters on the issue of broker registration for finders should be withdrawn if the proposed exemptive order is adopted.
Other applicable laws
The SEC clarified in the proposing release that the exemptive order would not absolve Tier I Finders and Tier II Finders from compliance with other applicable laws and would not limit or restrict enforcement remedies for violations thereof. The SEC specifically referenced the applicability of the securities antifraud provisions, including Section 10(b) of the 1934 Act and Rule 10b-5 thereunder, as well as a curious caveat that any Tier I Finder or Tier II Finder acting as investment adviser may need to register as such. As mentioned above, the proposed exemption would prohibit Tier I Finders from contacting prospective investors about the issuer at all and both Tier I Finders and Tier II Finders would be prohibited from (i) giving advice on the valuation or financial advisability of the applicable investment and (ii) performing any independent analysis of the applicable sale.
The proposed conditional exemption is not only silent as to preemption, it expressly provides that Tier I Finders and Tier II Finders would remain subject to state laws. In April 2020 the New York Attorney General (NYAG) proposed regulatory amendments that, if adopted, would require finders to register as broker-dealers in New York. That proposal is still pending. If the NYAG’s and the SEC’s proposals are both adopted, finders providing services in New York could be exempt from broker registration under Section 15(a) of the 1934 Act, but still required to register as a broker-dealer in New York.1 Ironically, one of the stated reasons for the NYAG’s proposed regulatory amendments was to harmonize New York and federal registration regulations.
The SEC’s proposed finder exemption is a well-intentioned concept that should provide clarity in a grey area. In addition, as noted by the SEC, the proposed exemption should help bridge the gap between startups and underrepresented founders without access to robust venture capital and angel investor networks, on the one hand, and investors who are interested in supporting early stage companies, on the other. However, to assist startups with capital raising in a meaningful fashion, exempt finders will need to proliferate. While the ability to receive transaction-based compensation may be enticing, certain aspects of the proposed exemption could dissuade finders from availing themselves of the safe harbor. The one that jumps off the page is the apparent limitation of the exemption applying to natural persons only. Even with transaction-based compensation, prospective finders may be unwilling to engage in the activities permitted by the safe harbor without the liability protection afforded by the corporate veil of a business entity. As pointed out by the SEC in its proposing release, finders exempt from broker registration by virtue of the safe harbor would remain subject to the antifraud provisions of applicable securities laws and regulations. While one would expect most finders to negotiate with the issuer for indemnification and contribution as customarily provided in a placement agent agreement, putting personal assets on the line in this situation would be risky business. Since the SEC specifically requested comment on the natural person limitation, it is possible this restriction will be lifted if and when the proposed exemptive order is adopted.
This post is for general informational purposes only and does not constitute legal advice. No one should rely on the information in this blog post without seeking appropriate legal, accounting, tax or other appropriate advice from an attorney, accountant or other professional properly licensed in the applicable jurisdiction(s).
1Although Section 15(i) of the 1934 Act preempts states from establishing requirements on certain matters that differ from or are addition to the federal requirements on such matters for brokers registered under the 1934 Act, since the SEC’s proposal is a safe harbor exempting finders from such federal registration, it is unlikely that Section 15(i) would preempt to New York’s proposed finder registration requirement.