On October 7, 2020, the U.S. Securities and Exchange Commission (“SEC”) voted 3-2 to propose a conditional exemption (“Exemption”)1 to permit natural persons to engage in limited securities activities as “finders” on behalf of private issuers without registering as brokers under Section 15 of the Securities Exchange Act of 1934, as amended (“Exchange Act”). If adopted, the proposed Exemption would put an end to some of the debate and uncertainty surrounding the permissibility of private issuers using unregistered finders to assist with raising capital. Please refer to our August 2020 client alert, in which we provided background on, and addressed many of the issues and concerns (and even some criticism) surrounding, what has been, to say the least, a murky area of U.S. securities law and regulation. This includes the push and pull of federal and state oversight in this area.
The proposed Exemption will surely be subject to robust comment and criticism, and already has (particularly from SEC Commissioners Lee and Crenshaw who voted against the proposal and issued strongly-worded dissents). While we think the proposed Exemption, if adopted, will provide clarity and certainty with respect to several longstanding questions related to the grey area of finders, we also think the proposed Exemption itself raises significant questions (many of which the Commission identifies in the proposal, and we identify several below).
Background
Federal and state securities laws generally require that persons who engage in securities brokerage activity be registered as brokers. For example, Section 3(a)(4) of the Exchange Act generally defines a broker as any person engaged in the business of effecting securities transactions for the accounts of others.[2] Please read our August 2020 client alert for a discussion of (1) how the broker definition is difficult to square in a private offering (where the notion of “effecting a transaction” does not fit the practical reality of the mechanics of the private sale); (2) SEC staff views and court decisions with respect to finders and broker status (including how the meanings of “engaged in the business” and “solicitation” lack clarity); and (3) how engaging a finder can create regulatory risk for the issuer and the exempt status of the private offering itself (as well as for the finder).
Proposed Exemption
In proposing the Exemption, the Commission itself, rather than SEC staff, has finally provided its views in this area (at least preliminarily). The Commission noted that it “preliminarily believes that there are situations where the need to impose the broker registration requirement may be mitigated by other factors.” It is important to note that the proposed Exemption relates to registration as a broker. However, individuals serving as a finder could still be engaged in broker activity. This is an important distinction, including because the proposed Exemption does not provide relief from the antifraud provisions of the federal securities laws.[3] Here is an overview of the proposed Exemption and the mitigating factors the Commission considered:
- There would be two categories of exempt finders—“Tier I” Finders and “Tier II” Finders—based on the activities in which they engage (with different conditions and limitations applicable to each). The SEC published this chart showing the proposed differences between Tier I and Tier II Finders. Additionally, the SEC’s Office of the Advocate for Small Business Capital Formation published a video giving a brief overview of the proposed Exemption.
- Both Tier I and Tier II Finders would be permitted to accept transaction-based compensation, despite not being registered as brokers. This is a key aspect of the proposed Exemption. Over the years, court decisions have yielded various factors that may be relevant to a broker status analysis, including receiving commissions or other forms of transaction-based compensation.[4] The SEC often cites transaction-based compensation in determining whether activity is that of a broker. According to many SEC staff letters, an individual who receives transaction-based compensation often is considered to have a “salesperson’s stake” in the transaction and is likely to be deemed a broker.[5]
- Both Tier I and Tier II Finders would be subject to all of the following conditions (“General Conditions”):
a. The issuer is not a “reporting company”—i.e., it is not required to file reports under Section 13 or Section 15(d) of the Exchange Act.
b. The issuer is seeking to conduct a “private offering”—i.e., in reliance on an applicable exemption from registration under the Securities Act of 1933 (“Securities Act”).
c. The Finder does not engage in “general solicitation.”[6]
d. The potential investor is an “accredited investor,” as defined in Rule 501 of Regulation D, or the Finder has a reasonable belief that the potential investor is an “accredited investor.”[7]
e. The Finder provides services pursuant to a written agreement with the issuer that includes a description of the services provided and associated compensation.
f. The Finder is not an associated person of a broker-dealer.
g. 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 Tier I Finder would be a Finder who satisfies the General Conditions and limits his/her activity to the following:
a. Providing contact information of potential investors to an issuer. The contact information may include names, telephone numbers, e-mail addresses, and social media information.
b. Serving in the Finder role in connection with no more than one capital raising transaction by a single issuer within a 12-month period.
c. The Tier I Finder must not have any contact with the potential investors about the issuer. - A Tier II Finder would be a Finder who must meet the General Conditions and is permitted to engage in any or all of the following limited solicitation-related activities on behalf of an issuer:
a. Identifying, screening, and contacting potential investors.
b. Distributing issuer offering materials to investors.
c. Discussing issuer information included in any offering materials, provided that the Tier II Finder does not provide advice as to the valuation or advisability of the investment.
d. Arranging or participating in meetings with the issuer and investor. - A Tier II Finder would not be limited to participation in only one capital raising transaction by a single issuer in a 12-month period, as would be a Tier I Finder.
- A Tier II Finder would need to provide a potential investor, prior to or at the time of the solicitation, disclosures that include:[8]
a. The name of the Tier II Finder;
b. The name of the issuer;
c. The description of the relationship between the Tier II Finder and the issuer, including any affiliation;
d. A statement that the Tier II Finder will be compensated for his/her solicitation activities by the issuer and a description of the terms of such compensation arrangement;
e. Any material conflicts of interest resulting from the arrangement or relationship between the Tier II Finder and the issuer; and
f. 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 Tier II Finder must also obtain from the investor, prior to or at the time of any investment in the issuer’s securities, a dated written acknowledgment of receipt of the Tier II Finder’s required disclosures.[9]
- Neither Tier I nor Tier II Finders could engage in any of the following activity:
a. Structuring the transaction.
b. Negotiating the terms of the offering.
c. Handling customer funds or securities.
d. Binding the issuer or investor.
e. Participating in the preparation of any sales materials.
f. Performing any independent analysis of the sale.
g. Engaging in any “due diligence” activities.
h. Assisting or providing financing for such purchases.
i. Providing advice as to the valuation or financial advisability of the investment.
Observations, Questions, and Concerns
- The exemption for Tier I Finders is a positive step. However, we think the SEC is inherently saying that providing the contact information of prospects to the issuer, and receiving transaction-based compensation in return, is broker activity. That stance is debatable, to say the least. Courts have considered those circumstances and determined that such a finder was not acting as a broker.[10] We think many will view this as an overreach by the SEC. That said, the SEC does include a footnote where it states that “whether a person is acting as a ‘broker’ and in particular, whether he or she is ‘engaged in the business’ of effecting securities transactions for the account of others will depend on the facts and circumstances of the particular matter. Accordingly, engaging in some of the limited activities falling within the terms of the proposed exemption should not be considered per se to require registration as a broker-dealer in the absence of the exemption.” Surely, this must be directed at Tier II Finders, given that there are multiple, permissible activities under the Exemption for Tier II Finders. For Tier I Finders, their only “activity” is providing contact information of prospective investors to the issuer (and, of course, receiving compensation). If the SEC does not consider this activity “per se” to require broker registration, then they should have provided guidance that Tier I activity is not brokerage activity (absent other facts), rather than dealing with this as an exemption.
- The proposed Exemption would only be available to natural persons. Therefore, a corporation, LLC, or some other entity could not serve in the finder role. The Commission does not provide insight as to why they have limited the proposed Exemption in this manner. Our sense is that it is to discourage Tier II Finders from establishing businesses, with employees or agents, to engage in this activity. Issuers may find this limitation helpful, given that it eliminates the potential liability shields that LLCs and other entities can offer the personnel through which they operate. Prospective Finders may find this problematic for the same reason, as well as for other reasons, such as income tax treatment.
- The proposal continually refers to small businesses when discussing the type of issuers that stand to benefit from the proposed Exemption, but the term “issuer” is not defined. In fact, when discussing the terms of the proposed Exemption, only the term “issuer” is used. It is clear that private, non-reporting operating companies are within the scope of the proposed Exemption. We certainly hope that private funds (equity and venture capital) also are within the scope of “issuer.” Unfortunately, the proposed Exemption lacks clarity in this respect. The SEC poses a few related questions that tangentially touch on this issue, but none do so directly. The SEC should be urged to clarify its views in this area – and in particular to include funds as well as operating companies in the types of issuers that may use exempt finders.
- Tier 1 Finders would be limited to one instance of finder activity every 12 months. The Commission noted its preliminarily belief that “limiting the exemption to this activity will appropriately narrow the role of the Tier I Finder to preclude the participation in continuous or multiple sales of securities by persons that are not subject to broker-dealer registration or to the heightened requirements of Tier II Finders.” If the goal is to push more active finders into Tier II, this may be a pragmatic place to land, although it may be argued that the other limitations on a Tier I Finder would also have that effect. If a person is truly not engaged in the business of being a finder and is willing to do nothing more than hand over a list of names for a fee, why should he or she not be able to be paid for handing over the list of names in two, or five, or more offerings in a year? The once-per-12-months limitation is consistent with Rule 3a4-1, which imposes the same once-per-12-month cap for issuer personnel involved in a private offering,[11] but SEC staff have conceded that the limitation is not well suited to some issuers, especially private funds.[12]
- The Exemption relates to broker status and registration at the federal level. However, the individual states also regulate the activity of securities brokers. It will be interesting to see how the states respond. If the SEC ultimately adopts the Exemption, some states may follow suit. However we also think it is likely that many states decline to do so, either through intention or inaction. This would create a regulatory and compliance quagmire for issuers who engage Finders. One such scenario is that issuers would need to prohibit Tier II Finders from soliciting in those states that have not adopted the same exemption from broker registration. In that case, the issuer may need to deploy its own personnel to solicit in those states (e.g., pursuant to Rule 3a4-1 under the Exchange Act) or perhaps engage a registered broker for activity in those states. It is also worth noting that New York recently proposed rules related to finders, which would actually include the requirement for finders to register in New York (see Goodwin client alert).
- The SEC noted that “an issuer’s failure to comply with the conditions of an exemption from registration under the Securities Act for an offering would not, in itself, affect the ability of a Finder to rely on the proposed exemptive order provided the Finder can establish that he or she did not know and, in the exercise of reasonable care, could not have known, that the issuer had failed to comply with the conditions of an exemption.” This should give comfort to prospective Finders. Conversely, the SEC noted that “a Finder that, through its activities on behalf of an issuer, causes an issuer’s offering to be ineligible for an exemption from registration, would not be able to rely on the proposed [E]xemption.” This appears, alarmingly, to indicate that an issuer and the exempt status of the offering could be affected by the actions of a Finder. That seems like a problematic policy, absent some element of knowledge, willful disregard, or gross negligence on the part of the issuer that contributes to the loss of the exemption from registration under the Securities Act. Will there be a safe harbor for issuers who engage a Finder, only to discover at a later date that the Finder has engaged in activity that goes beyond the permissible and agreed-to bounds of the proposed Exemption? For example, we might consider advising our issuer clients to seek a representation from a Tier I Finder that it has not engaged in that role within the prior 12 months. If that representation turns out to be inaccurate, would the issuer (and, importantly, the exempt status of the private offering) be in jeopardy? Could the issuer be viewed as having engaged an unregistered broker that is not exempt from registration? Absent a safe harbor for issuers in this respect, they may be unwilling to utilize Finders pursuant to the proposed Exemption, which may eviscerate the usefulness of the proposed Exemption.
Conclusion
The Commission should be commended for proposing the Exemption and, in doing so, balancing (or at least attempting to) (1) the needs of the private issuer community, (2) the need to clarify an area of significant and longstanding regulatory uncertainty, and (3) investor protection concerns. The Commission is seeking feedback on the proposal, both generally and related to specific questions. Comments are due 30 days following the date of publication in the Federal Register (which should be around or prior to November 15). We think the public comments on the proposed Exemption, which will likely be robust, will invoke the usual Goldilocks conundrum. Some will think it does not go far enough. Others will say it goes too far (either from an overreach standpoint or due to investor protection concerns). And a (likely) very small faction will think that it is calibrated perfectly. We will monitor the comments and any other developments in this area.
[1] Notice of Proposed Exemptive Order Granting Conditional Exemption from the Broker Registration Requirements of Section 15(a) of the Securities Exchange Act of 1934 for Certain Activities of Finders, SEC Release No. 34-90112 (Oct. 7, 2020), available at https://www.sec.gov/rules/exorders/2020/34-90112.pdf.
[2] Exchange Act Section 3(a)(4).
[3] However, the Commission noted that “[a] Tier I Finder or Tier II Finder that complies with the requirements of the proposed exemption would not be subject to broker-dealer sales practice rules, including Regulation Best Interest.”
[4] See, e.g., S.E.C. v. Margolin, No. 92-civ-06307, 1992 WL 279735 (S.D.N.Y. Sept. 30, 1992); S.E.C. v. Hansen, No. 83-3692,1984 WL 2413, (S.D.N.Y. Apr. 6, 1984); S.E.C. v. M & A West, Inc., No. 01-3376 VRW, 2005 WL 1514101 (N.D. Cal. Jun. 20, 2005).
[5] See 1st Global, Inc., SEC No-Action Letter (May 7, 2001); see also Herbruck, Alder & Co., SEC No-Action Letter (May 3, 2002); Brumberg, Mackey & Wall, P.L.C., SEC No-Action Letter (May 17, 2010).
[6] The Commission noted that it has previously indicated, “[w]hether there has been a general solicitation is a fact-specific determination.” The Commission elaborated by explaining that “[o]ne way, though not the exclusive way, to demonstrate the absence of general solicitation is by establishing the existence of a pre-existing substantive relationship.” The Commission generally views a pre-existing relationship as “one that the issuer has formed with an offeree prior to the commencement of the securities offering or, alternatively, that was established through another person (for example a registered broker-dealer or investment adviser) prior to that person’s participation in the offering.” The Commission views a substantive relationship as “one in which the issuer (or a person acting on its behalf, such as a registered broker-dealer or investment adviser) has sufficient information to evaluate, and does, in fact, evaluate, an offeree’s financial circumstances and sophistication, in determining his or her status as an accredited or sophisticated investor.” See the SEC “Harmonization Proposal,” Facilitating Capital Formation and Expanding Investment Opportunities by Improving Access to Capital in Private Markets, Release No. 33-10763 (Mar. 4, 2020), 85 FR 17956 (Mar. 31, 2020).
[7] The Commission noted that it “recently reiterated that the steps necessary to establish a reasonable belief as to investor status will depend on the facts and circumstances of the contemplated offering and each potential issuer.” See Solicitations of Interest Prior to a Registered Public Offering, Release No. 33-10699 (Sept. 25, 2019), 84 FR 53011 (Oct. 4, 2019) at 53018. The Commission indicated that “Finders can look to the methods that other market participants currently use to establish a reasonable belief regarding an accredited investor’s status in other contexts.”
[8] The Commission noted that “[t]he conditions of this proposed exemptive order for Finders differ from the requirements for solicitors under the Commission’s proposed amendments to Rule 206(4)-3 under the Investment Advisers Act of 1940.” See Investment Adviser Advertisements; Compensation for Solicitations, Release No. IA-5407 (Nov. 4, 2019), 84 FR 67518 (Dec. 20, 2019) (“Cash Solicitation Rule Proposed Amendments”). The Commission elaborated by indicating that “[t]hese differences reflect the particular facts and circumstances surrounding the proposed permitted activities for Finders and solicitors, and the characteristics of the applicable regulatory regimes, notably that a solicitor would solicit for an investment adviser and would be subject to oversight by such investment adviser, while a Finder would solicit for an issuer and therefore would not be subject to such oversight.” See Cash Solicitation Rule Proposed Amendments at 67580.
[9] The Commission noted that while it “is requiring that the acknowledgment be written, we believe this can be satisfied either through paper or electronic means, similar to the disclosure condition discussed above. The Commission believes this acknowledgment is important as it helps ensure that the investor received the required disclosures.”
[10] See, e.g., S.E.C. v. Kramer, 778 F.Supp.2d 1320 (M.D. Fla. 2011); S.E.C. v. Mapp, 240 F.Supp.3d 569 (E.D. Tex. 2017); S.E.C. v. M & A West, Inc., No. 01-3376 VRW, 2005 WL 1514101 (N.D. Cal. Jun. 20, 2005).
[11] See Rule 3a4-1(a)(4)(ii)(C).
[12] David Blass, Chief Counsel to the SEC Division of Trading and Markets at a meeting of the American Bar Association (Apr. 5, 2013).
Contacts
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Nicholas J. Losurdo
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Peter W. LaVigne
Of Counsel