Finders, Keepers: SEC Proposes New Exemptive Order for Finders

Wilson Sonsini Goodrich & Rosati
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Wilson Sonsini Goodrich & Rosati

Key Takeaways

  • The Securities and Exchange Commission (SEC) currently requires finders who receive fees based on the size or successful completion of securities transactions to register as broker-dealers.
  • To help startups that need assistance in fundraising, the SEC has proposed an exemptive order that would allow finders to receive transaction-based fees without broker-dealer registration, under certain circumstances.
  • The proposed order could help facilitate capital-raising efforts by startup and early stage companies.

Introduction

Raising capital is one of the central challenges for many start-up and early-stage companies, and when they outgrow initial investment from friends and family, they often face difficulty securing capital. Few registered brokers are willing to raise capital for finding investors in the smaller financings most startups engage in.

Unsurprisingly, many companies in this position turn to "finders," who can open doors and connect emerging companies to investors, typically in exchange for a payment payable upon the closing of a round, and often based on the value of securities sold. Any payment dependent on the size or successful completion of a transaction is known as "transaction-based compensation."

The SEC takes the position that a finder who receives transaction-based compensation must take a securities exam and be supervised by a registered broker-dealer that is regulated by the Financial Industry Regulatory Association (FINRA)i. Anecdotally, a number of finders that are not appropriately licensed insist on receiving transaction-based compensation, and many cash-starved early-stage companies find they have no choice but to accept the finder's terms or risk going out of business for lack of cash. Moreover, in part because the SEC rarely sues finders who receive transaction-based compensation but do not engage in fraudulent activities,ii and in part because paying for performance is such a well-established practice in other parts of the American economy,iii many sponsors of early-stage companies and many finders are simply unaware of the SEC's position.

In recognition of the difficulties in this space, the SEC has proposed an exemptive order (the Proposed Order) that would allow a finder to operate without registration, subject to certain conditions.

SEC Regulation of Finders

For several decades, the SEC has stated that a "hallmark" of broker-dealer activity is the acceptance of transaction-based compensation, which according to the SEC creates the type of "salesman's stake" that it believes the broker-dealer registration requirements were designed to regulate.iv Nonetheless, prior to 2000, the SEC Staff (Staff) had recognized an exemption for "finders" who engage in limited solicitation activities. For example, a 1985 Staff no-action letter to Dominion Resources, Inc. granted a finder relief from broker registration requirements, despite the finder's receipt of transaction-based compensation for introducing investors, based on the limited role the finder would play—the finder would not (among other things) prepare any offering materials, handle money or securities, or actively participate in the negotiation of the price or transaction terms.v

In 2000, however, the SEC rescinded the Dominion Resources no-action letter, and since then it has taken a hardline position (at least in its public statements, although often not in its enforcement actions) that because transaction-based compensation creates a "salesman's stake" in a securities transaction, a finder that receives transaction-based compensation should register as, or become licensed and act under the supervision of, a broker-dealer.vi

As discussed below, the Proposed Order would (among other things) effectively rescind the 2000 Dominion resources no-action letter, and largely reinstate the terms of the 1985 Dominion Resources no-action letter.

The Proposed Order

The Proposed Order would provide a safe harbor from broker registration to certain finders who engage in limited solicitation activities on behalf of small companies engaged in private offerings, where the finding activity is conducted pursuant to a written agreement with the issuer that describes the services provided and associated compensation.vii Under the Proposed Order, finders may not i) be involved in structuring the transaction or negotiating the terms of the offering; ii) handle customer funds or securities or bind the issuer or investor; iii) participate in the preparation of any sales materials; iv) perform any independent analysis of the sale; v) engage in any "due diligence" activities; vi) assist or provide financing for such purchase; or vii) provide advice as to the valuation or financial advisability of the investment. The finder may, however, engage in the activities described below subject to certain other conditions, with two paths of potential relief.

The first track—for "Tier I Finders"—is available to finders whose activity involves only providing a list of potential investors in connection with a single capital raising activity by a single issuer once every 12 months. Tier I Finders cannot have any contact with a potential investor about the issuer or the offering.

A "Tier II Finder" is permitted to engage in additional solicitation activities, including i) identifying, screening, and contacting potential investors; ii) distributing offering materials to investors; iii) discussing issuer information included in offering materials, without providing any advice as to the valuation or advisability of the investment; and iv) arranging or participating in meetings with the issuer and investor. A Tier II Finder must, to rely on the proposed relief, disclose information about the finder's role in the offering, including (among other things) the role and compensation of the finder and any material conflicts resulting from the arrangement. These disclosures must be provided to potential investors prior to or at the time of the solicitation, and the finder must obtain dated written acknowledgment of them.

If and when the SEC adopts the Proposed Order, the increased flexibility available to finders may allow startup and early-stage companies to access investors they would not have previously identified and could therefore generally support their financing efforts.

Importantly, though, it is not clear whether the SEC will adopt the proposed order before the current SEC chairman leaves office at the end of this year, and whether the SEC under a new chairman would adopt the proposed order if it had not previously been adopted, or would rescind the order if it had previously been adopted. One of the weaknesses of the SEC addressing the finders issue through an exemptive order (which is a highly unusual approach), rather than by adopting a rule that is subject to notice and comment requirements, is that the commission can more easily change or rescind an exemptive order than it can a rule.

California's Finder's Exemption

An alternative source of compliance for finders in California is registration as a finder under state law. Under this set of provisions, finders may take compensation without full broker-dealer registration if (among other things) they register with the state and pay an initial and annual fee, execute a written agreement with and make certain disclosures to customers, and limit the size of the transaction to $15 million.viii The exemption is only available with respect to transactions that involve only accredited investors and have an aggregate purchase price of $15 million or less. California registered finders may only engage in limited activities and cannot (among other things) participate in negotiations, take custody of investor funds, conduct due diligence, sell their own shares in the transaction, or disclose more than limited issuer information. Importantly, this exemption does not preempt federal law regulating broker-dealers, and the exemption would therefore not apply unless all the transaction and solicitation activities, the issuer, the finder, and the investors are within state lines. It is unclear whether, even in that case, the SEC would have (or claim) jurisdiction over finders acting as unregistered brokers.

For more information regarding the finder's exemption or any other questions, please contact Rob Rosenblum (202-973-8808; rrosenblum@wsgr.com), Amy Caiazza (202-973-8887; acaiazza@wsgr.com), or any other attorney in the Securities Regulatory and Complex Transactions practice at Wilson Sonsini Goodrich & Rosati.


i See e.g. Brumberg, Mackey &Wall, PLC, SEC Staff Denial of No-Action Request (May 17, 2010) (rejecting a request for relief from an attorney finder that would be paid transaction-based compensation); Nemzoff & Co., LLC, SEC Staff Denial of No-Action Request (Nov. 30, 2010) (denying the same relief for a consulting company); Putnam Investor Services, Inc., SEC Staff No-Action Letter (Dec. 31, 2009) (providing relief from broker-dealer registration to a non-bank transfer agent in part because there was no transaction-based compensation); John W. Loofbourrow Associates, Inc., SEC Staff Denial of No-Action Request (Jun. 29, 2006) (denying relief from broker-dealer registration to a finder who would only structure and place privately offered securities and would receive a finders or referral fee). See also Dominion Resources, Inc., SEC Staff No-Action Letter (Aug. 22, 1985) (providing relief for a finder who would receive transaction-based compensation); Dominion Resources, Inc., SEC Staff Revocation of Prior No-Action Relief (Mar. 7, 2000) (revoking previous guidance). Under Section 3(a)(4) of the Securities Exchange Act of 1934 (the Exchange Act), a "broker" is defined as "any person engaged in the business of effecting transactions in securities for the account of others…" Section 15(a) of the Exchange Act requires that "brokers" register in the SEC unless they fall into an available exemption. Additional support for the position that the SEC views transaction-based compensation as generally requiring registration is provided by Exchange Act Rule 3a4-1, which provides a safe harbor from broker registration for certain employees of a company who engage in fundraising for it. Among other requirements, Rule 3a4-1, which was adopted in 1977, requires that the employee does not receive transaction-based compensation. It is also significant that (as discussed in more detail in endnote (vi)) in 2017, FINRA adopted a more limited registration category for certain finders who receive transaction-based compensation.

ii Although most SEC enforcement actions against unregistered finders are pursued as a part of cases that involve additional securities violations, such as fraud or misappropriation of investor assets, from time to time the SEC has brought actions against finders based only or primarily on their status as unregistered brokers. In 2013, for example, the SEC brought an action again a private fund adviser, its managing partner, and a consultant who solicited investors for acting as unregistered brokers and, in the case of the managing partner, aiding and abetting the violations by providing offering materials to the consultant and failing to prevent him from having substantive contact with investors in negotiations. SEC, In the Matter of William M. Stephens, No. 3-15233 (Mar. 8, 2013); SEC, In the Matter of Ranieri Partners LLC and Donald W. Philips, No. 3-15234 (Mar. 8, 2013).

iii Among many other examples, sales people often work on commission; officers and employees in many companies receive a substantial part of their compensation in the form of performance bonuses; investment managers frequently receive a portion of the profits they generate for investors; many musicians receive income that is largely dependent upon how often their songs are publicly performed or purchased; and professional athletes may receive compensation depending in whole or in part on how well they perform in competition. None of these individuals typically register with FINRA (or, with some exceptions, any other regulatory agency).

iv Brumberg, Mackey &Wall, PLC, SEC Staff Denial of No-Action Request (May 17, 2010) ("A person's receipt of transaction-based compensation in connection with these activities is a hallmark of broker-dealer activity."); John W. Loofbourrow Associates, Inc., SEC Staff Denial of No-Action Request (Jun. 29, 2006) (denying relief for a broker-dealer who wanted to pay a finders or referral fee on a commission basis to an unregistered intermediary).

v Dominion Resources, Inc., SEC Staff No Action Letter (Aug. 22, 1985).

vi Dominion Resources, Inc., SEC Staff Revocation of Prior No-Action Relief (Mar. 7, 2000); see also Brumberg, Mackey &Wall, PLC, SEC Staff Denial of No-Action Request (May 17, 2010) ("[T]he Staff believes that the receipt of compensation directly tied to successful investments in EMPS's securities by investors introduced to EMPS by BMW [] would give BMW a 'salesman's stake' in the proposed transaction and would create heightened incentive for BMW to engage in sales efforts."); SEC, Order Exempting the Federal Reserve Bank of New York, Maiden Lane LLC and the Maiden Lane Commercial Mortgage Backed Securities Trust 2008-1 from Broker-Dealer Registration, Securities Exchange Act Release No. 61884 (Apr. 9, 2010) ("Indeed, the receipt of transaction-based compensation often indicates that such a person is engaged in the business of effecting transactions in securities.").

The Staff has allowed the receipt of transaction-based compensation to unregistered finders in limited circumstances. For example, in 2013 David Blass, then Chief Counsel of the Division of Trading and Markets of the SEC, stated that although receiving transaction-based compensation could create a broker registration requirement for private fund advisers, in his view the policy concerns related to broker registration were mitigated if the transaction fees were offset against a fund's advisory fee. David W. Blass, Speech to the American Bar Association, Trading and Markets Subcommittee (Apr. 5, 2013). In 2014, the Staff issued a no-action letter to so-called "M&A brokers"—brokers engaged in the business of facilitating merger and acquisition transactions that involve a change in control—if they (among other things) do not handle the securities, form the group of buyers, or have the ability to bind the parties. In 2017, FINRA also adopted new rules applicable to so-called "Capital Acquisition Brokers" (CABs). These rules provide flexibility for firms that advise companies and private equity funds on capital raising and corporate restructuring and act as placement agents for offerings of unregistered securities to institutional investors under certain conditions. Brokers that elect to be governed under the CAB rules cannot carry or maintain customer accounts, handle customer funds or securities, accept trading orders, or engage in proprietary trading or market-making. While these rules reduce the compliance burden from full broker registration, they still bring CABs into FINRA and SEC regulation.

vii SEC, 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 (Oct. 7, 2020), available at https://www.sec.gov/rules/exorders/2020/34-90112.pdf. The relief would only be available to transactions on behalf of issuers not required to report under Section 13 or Section 15(d) of the Exchange Act (not a reporting issuer or public company), and who are seeking to conduct the offering in reliance on an exemption from registration of the offering under the Securities Act of 1933. In addition, investors targeted by a finder must be accredited investors, or the finder must have a reasonable belief that they are, and the finder cannot engage in general solicitation. The finder also cannot be an associated person of a broker-dealer or subject to statutory disqualification under Section 3(a)(39).

viii Cal. Corp. Sec. L. of 1968 § 25210.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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