In an effort to address an issue that has frustrated the business community for years, including startups, tech companies, and “finders,” the U.S. Securities and Exchange Commission (SEC) published a proposed conditional exemption for finders on October 7, 2020. Under the proposal, people (i.e., finders) seeking to assist companies or issuers in raising capital – for a fee – will have a non-exclusive safe-harbor from the broker-dealer registration requirement under Section 15(a) of the Securities Exchange Act of 1934, as amended.
Since then, however, a new U.S. president has brought in a new leadership team, and the SEC has received a mix of positive and negative comments with respect to the proposal. How Biden’s recently confirmed SEC Chair Gary Gensler approaches the proposal is a key issue to watch in the coming months.
The question of whether a finder must register as a broker-dealer has been a difficult issue to navigate. As indicated in the new proposal, companies, particularly small businesses, often encounter challenges raising capital. This challenge has provided an opening for finders to help these issuers by introducing them to potential investors. Section 3(a)(4) of the Exchange Act generally defines a broker as “any person engaged in the business of effecting transactions in securities for the account of others.” Section 15(a)(1) of the Exchange Act makes it unlawful, generally, for a broker to use any means of interstate commerce to “effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security,” unless the broker is registered under the Exchange Act.
As such, the Exchange Act, as a general matter, presents a potential roadblock for finders, that are not registered as broker-dealers, to be compensated for introducing issuers to investors that invest in their private offerings. The uncertainty relates to the fact that the Exchange Act does not provide guidance as to what it means to be “engaged in the business” or “effecting transactions.” As such, the SEC has attempted to tackle this issue over the years through a series of no-action letters, which are based on the facts and circumstances associated with each particular letter. The SEC has attempted to provide guidance through these letters by identifying activities and factors, particularly involving the finder’s ability to receive transaction-based compensation, that are deemed to be broker-dealer activities. Although the SEC has, in very limited circumstances, granted relief to finders in these letters, it has not provided a set of rules or guidance that provides a uniform answer to the conundrum of whether the finder must be registered as a broker-dealer under the Exchange Act.
“Gray Market” and Potential Penalties
This resultant “gray market,” where companies consider utilizing finders that are not registered broker-dealers, can lead to potential penalties for both the issuer and the finder. As to finders who are engaged in certain activities but not properly registered as a broker-dealer, they can be subject to both civil and criminal penalties. With respect to the issuer utilizing a finder who is not registered as a broker-dealer, it can potentially lose the exemption it relied upon to conduct the private offering, and it can potentially be required to conduct a rescission offering, which could be disastrous.
The SEC’s Exemption Proposal
Under its new proposal, the SEC proposes to exempt two (2) classes of finders, “Tier I Finders” and “Tier 2 Finders.” The exemptions for Tier I Finders and Tier II Finders would be available only where:
- The finder is a natural person;
- The issuer is not required to file reports under Sections 13 and 15(d) of the Exchange Act;
- The issuer is seeking to conduct a securities offering in reliance upon an applicable exemption from registration under the Securities Act of 1933, as amended;
- The finder does not engage in general solicitation;
- 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”;
- The finder provides services pursuant to a written agreement with the issuer that includes a description of the services provided and associated compensation;
- The finder is not an associated person of a broker-dealer; and
- The finder is not subject to statutory disqualification as defined in Section 3(a)(9) of the Exchange Act, at the time of its participation.
Tier I Finders
Tier I Finders are defined as those finders who meet the general conditions referenced above and whose activity is limited to providing contact information for potential investors in connection with only one capital-raising transaction or offering by a single issuer within a 12-month period. However, the Tier I Finders cannot have any direct contact with the potential investors about the issuer. The proposal would allow Tier I Finders to provide issuers with investor contact information, which may include, among other things, their names, telephone numbers, email addresses, and social media information.
Tier II Finders
Tier II Finders are defined as finders who meet the general conditions referenced above and who engage in additional solicitation-related activities, on behalf of the issuer, that are limited to: (1) identifying, screening and contacting potential investors; (2) distributing issuer offering materials to investors; (3) discussing issuer information included in any offering documents as long as the Tier II Finder does not provide advice as to the valuation or advisability of the investment; and (4) arranging or participating in meetings with the issuer and the investor. Tier II Finders may participate in more than one capital-raising transaction or offering within a 12-month period.
Tier II Finders that seek to rely upon the proposed exemption would need to provide a potential investor, either prior to or at the time of solicitation, disclosure that includes: (1) the Tier II Finder’s name; (2) the issuer’s name; (3) certain information about the relationship between the issuer and the Tier II Finder; (4) a statement that the Tier II Finder will be compensated for the solicitation activities by the issuer and the terms of such 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 written statement acknowledging 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.
Under the proposal, the Tier II Finder may deliver such information orally, provided that the oral disclosure is supplemented by written disclosure satisfying the requirements set forth above. Additionally, the Tier II Finder must obtain from the investor, prior to or at the time of any investment in the issuer’s securities, a dated written acknowledgment that the investor has received such disclosures.
Tier I Finders and Tier II Finders that comply with the exemption’s conditions may receive transaction-based compensation for the limited services described above without registering as a broker under the Exchange Act.
To further limit the scope of the exemption, the proposal prohibits finders (both Tier I Finders and Tier II Finders) from: (1) being involved in structuring the transaction or negotiating the terms of the offering; (2) handling customer funds or securities; (3) binding the issuer or investor, (4) participating in the preparation of any sales materials; (5) performing any independent analysis of the sale; (6) engaging in any “due diligence” activities; (7) assisting or providing financing for such purchases or (8) providing advice as to the valuation or financial advisability of the investment.
What Will the Biden Administration Do?
The SEC received more than 90 comments by the close of the commenting period and, as expected, they reflected a wide variety of opinions. Some commenters praised the proposal for providing regulatory clarity while others criticized it for allowing unregistered finders to conduct broker activities without sufficient investor protection mechanisms.
Given that the proposal was not adopted by the SEC before the end of the Trump administration, it now sits on the Biden administration’s to-do (or not-to-do) list. President Biden’s new SEC Chair Gary Gensler has not expressed a particular view with respect to the proposal. Nevertheless, from a policy perspective, it’s worth noting that during his testimony before the Senate Banking Committee, Mr. Gensler emphasized both the importance of protecting investors and having “clear rules of the road.” Despite this uncertainty, our contacts at the SEC indicate that the proposal is still in play and that they are still looking closely at the issue.
While the outcome of the proposal is uncertain, the fact that the SEC is looking closely at the “finder” issue is definitely a step in the right direction. The practical implications of the proposal are far-reaching as this is not an exercise with respect to some esoteric concept but, instead, it is an issue that companies, finders, and the legal community address on a constant basis.
As is generally the case, the SEC is attempting to determine whether this proposed construct not only enhances an issuer’s ability to raise capital but whether it also provides adequate shareholder protections. These are legitimate considerations the SEC must weigh, but the mere acknowledgment that this issue needs to be addressed is a positive. So, we will continue to keep a close eye on this very important proposal.
Alonzo Llorens and Olivia Daly are attorneys at Parker Poe. Alonzo is based in Atlanta, Georgia, and has substantial experience in corporate law and represents clients ranging from startups to Fortune 500 companies. His legal career started with the federal government, as he worked as an attorney in the U.S. Department of the Treasury’s Honors Program and later with the U.S. Securities and Exchange Commission in its Division of Corporation Finance. Olivia is based in Greenville, South Carolina, where she practices primarily in the areas of mergers and acquisitions, general corporate law, corporate finance, and commercial lending.