SEC Proposes Conditional Finders Exemption From Broker Registration

Brownstein Hyatt Farber Schreck

Brownstein Hyatt Farber Schreck

On Oct. 7, 2020, the Securities and Exchange Commission (SEC) proposed a conditional exemption from the broker registration requirements of Section 15(a) of Securities Exchange Act of 1934 to allow “finders” who are natural persons to assist private issuers with raising capital in private placements from accredited investors.

The proposed exemption is intended to facilitate capital-raising efforts of small and private issuers. These issuers may encounter difficulties in raising capital because they do not have access to public markets, their network of potential investors may be small, the amount of money they plan to raise may be too small to attract registered brokers or the fees of registered brokers may be too expensive compared to the amount raised. As a result, these issuers may turn to so-called “finders” to introduce them to potential investors in exchange for a fee.

Under current law, finders are at risk of being deemed unregistered brokers. Generally, brokers are required to register with the SEC under the Exchange Act. Under the Exchange Act, a “broker” is someone “engaged in the business of effecting transactions in securities for the account of others.” The SEC and courts examine the facts and circumstances to determine whether someone is acting as a broker. For example, solicitation of investors and receipt of transaction-based compensation are two strong indicators that someone is acting as a broker. As a result, the interpretation of the term “broker” has developed through case law and SEC no-action letters, resulting in uncertainty for those acting as finders. The consequences for acting as or using an unregistered broker in a securities offering are significant, and may include, among others, civil fines and investor rescission rights. The proposed exemption is intended to provide clarity with respect to the ability of a finder to engage in certain activities and receive transaction-based compensation without being required to register as a broker under federal law. The proposed exemption would not affect finders’ obligations to comply with other applicable laws, including antifraud laws and state laws regulating brokers or finders.

The proposed exemption would create two classes of finders, Tier I and Tier II, and serve as a nonexclusive safe harbor for finders that meet the applicable conditions.

  • Tier I finders would be allowed to provide contact information of potential investors (e.g., name, address, phone number, email and social media information) in connection with one capital transaction by a single issuer in a 12-month period but could not have any contact with potential investors about the issuer.
  • Tier II finders would be allowed to solicit investors but would be limited to “(i) identifying, screening, and contacting potential investors; (ii) distributing issuer offering materials to investors; (iii) discussing [with investors] issuer information included in any offering materials, provided that the Tier II [f]inder does not provide 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 would be required to disclose to prospective investors the finder’s name, the name of the issuer, any arrangement or relationship between the finder and the issuer and any resulting material conflicts of interest, the finder’s compensation, and that the finder is acting as an agent of the issuer, is not acting as an associated person of a broker-dealer and is not undertaking to act in the investors’ best interest. This disclosure must be provided before or at the time of the solicitation and may be provided orally if supplemented by written disclosure no later than the time of investment. Further, Tier II finders would also be required to obtain from investors a dated written acknowledgment of receipt of the required disclosures, before or at the time of investment. The disclosure and acknowledgment may be provided via paper or electronic means.

The proposed exemption would be available only if:

  • the finder is a natural person;
  • the issuer is a private company;
  • the securities offering is conducted in reliance on an exemption from registration under the Securities Act of 1933;
  • the finder does not engage in general solicitation;
  • each potential investor is an “accredited investor” as defined in Rule 501 of Regulation D or the finder has a reasonable belief that each 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 (this requirement may be satisfied by electronic media and communications);
  • the finder is not an associated person of a broker-dealer; and
  • the finder is not subject to statutory disqualification under Section 3(a)(39) of the Exchange Act, for example, as a result of being subject to regulatory expulsion or suspension, a financial services industry bar, or conviction of a felony.

As a result, entities could not rely on the exemption and a finder could not rely on the exemption for (i) securities offerings for SEC reporting issuers, (ii) offerings registered under the Securities Act, (iii) securities offerings involving non-accredited investors, and (iv) resale transactions. Further, a finder could 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) prepare offering or sales materials, (iv) perform any independent analysis of the investment, (v) engage in any “due diligence” activities, (vi) assist or provide financing for purchases, or (vii) provide advice as to the valuation or financial advisability of the investment.

The proposal is a welcome attempt to create clarity for finders and those who rely on them to raise capital. The Tier I finder proposal should not be controversial because it essentially codifies existing SEC no-action positions. The Tier II finder proposal is a significant expansion of the existing law in this area and may be controversial, as illustrated by the SEC commissioners’ 3-2 vote to approve the proposal and public statements released by the two dissenting SEC commissioners expressing concerns with, among other things, investor protection and the lack of economic analysis in the exemptive order process (as opposed to the rulemaking process).

The proposed exemption is subject to a 30-day comment period that begins after publication of the proposal in the Federal Register.

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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