While an SEC proposal to exempt “finders” from broker-dealer registration requirements is promising, potential hazards remain and interpretive questions may persist.
The US Securities and Exchange Commission (SEC) recently proposed for comment an exemption from the broker-dealer registration requirements under the Securities Exchange Act of 1934 (Exchange Act) for natural persons that act as “finders” for certain issuers of securities (Proposed Exemption). While the Proposed Exemption, if adopted, would provide finders and issuers with some legal certainty, interpretive questions may still persist with respect to (1) the type of issuers that this impacts; (2) the impact on persons who work for an affiliate of a broker-dealer; (3) the potential impact to issuer marketing departments; (4) the protections that issuers would be afforded; (5) potential liability for historic fundraising activities; and (6) the applicability of state law.
Comments on the Proposed Exemption are due by November 12, 2020.
Small issuers can often find it difficult to attract interest from venture capitalists, angel investors, or registered broker-dealers, thus creating a funding gap for these issuers as they work toward expanding their businesses. As discussed in the Proposed Exemption, a longstanding issue in the area of broker regulation is the status of persons—so-called finders—who seek to identify investors for such small issuers, but who are not registered as brokers with the SEC.
In brief, Section 15(a) of the Exchange Act makes it unlawful for a broker-dealer to use the mails or other 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-dealer is registered with the SEC under Section 15(b) of the Exchange Act. Absent an exception or exemption from registration, persons acting as brokers must register with the SEC, become members of the Financial Industry Regulatory Authority, Inc. (FINRA), and comply with a host of ongoing regulatory requirements related to recordkeeping, sales practices, and financial responsibility, among others. These regulatory requirements can result in substantial costs, and these costs can serve to deter a finder’s willingness to submit to the regulatory regime.
Although the SEC has not previously provided explicit relief to finders from broker registration, market participants often have looked to SEC staff no-action letters to gauge the extent to which persons can engage in finder activities on behalf of issuers without incurring an obligation to register as a broker. One letter in particular, the so-called Paul Anka Letter, is frequently referenced. In that letter, the SEC staff stated that it would not recommend enforcement action to the SEC under Section 15(a) of the Exchange Act against an individual if that person (1) entered into an agreement with an issuer to provide the issuer with a list of names and telephone numbers of potential investors that the individual reasonably believed were accredited investors and with whom he had a preexisting business or personal relationship; (2) had no further contact with potential investors concerning the issuer; and (3) received a finder’s fee for doing so. Over the years, however, the SEC staff has distanced itself from the Paul Anka Letter, causing uncertainty and risk for issuers and finders regarding the extent of permissible fundraising activities that do not require registration as a broker. The Proposed Exemption is intended to mitigate these risks by providing guardrails through which finders can navigate without incurring a broker-dealer registration obligation.
THE PROPOSED EXEMPTION
The Proposed Exemption would create two classes of finders whose activities would not result in a broker registration requirement: (1) Tier I Finders who would be able to engage in the passive activities permitted under the Paul Anka Letter; and (2) Tier II Finders who could take a more active role in soliciting investors on behalf of issuers.
GENERAL CONDITIONS APPLICABLE TO TIER I AND TIER II FINDERS
The Proposed Exemption would impose the following conditions (General Conditions) with respect to the activities of both Tier I and Tier II Finders:
- Private Issuers – A finder would only be able to engage in activities for an issuer that (a) is not required to file reports under Section 13 or Section 15(d) of the Exchange Act (Reporting Issuer); and (b) is seeking to conduct the securities offering in reliance on an applicable exemption from registration under the Securities Act of 1933 (Securities Act).
- Investor Qualifications – A potential investor under the Proposed Exemption must be an “accredited investor” as defined in Rule 501 of Regulation D; however, a finder may operate under a reasonable belief that the potential investor is an “accredited investor.”
- Written Agreement with Issuer – The finder must have a written agreement with the issuer that includes a description of the services provided and associated compensation.
- Prohibitions – A finder may not (a) engage in general solicitation; (b) be an associated person of a broker-dealer; and (c) be 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.
TIER I FINDERS
Under the Proposed Exemption, a Tier I Finder who satisfies the General Conditions may receive compensation for providing contact information of potential investors. A Tier I Finder may receive this compensation in connection with only one capital-raising transaction by a single issuer within a 12-month period. The contact information that the Tier I Finder may provide includes, among other things, name, telephone number, email address, and social media information. Importantly, a Tier I Finder would not be able to have any contact with the potential investors about the issuer.
TIER II FINDERS
Unlike a Tier I Finder whose activities are limited to providing contact information about potential investors, a Tier II Finder would be able to take a more active role in soliciting investors on behalf on an issuer. In particular, a Tier II Finder would be able to (1) identify, screen, and contact potential investors; (2) distribute issuer offering materials to investors; (3) discuss issuer information included in any offering materials, but not provide advice as to the valuation or advisability of the investment; and (4) arrange or participate in meetings with the issuer and investor.
While Tier II Finders can be more active in their solicitation efforts, they also are subject to the following additional conditions:
- Disclosures – The Tier II Finder would need to provide a potential investor, prior to or at the time of the solicitation, disclosures that include (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 or 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.
- Investor Acknowledgment – 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 of receipt of the Tier II Finder’s required disclosures.
- Additional Prohibitions – The Tier II Finder cannot (a) be involved in structuring the transaction or negotiating the terms of the offering; (b) handle customer funds or securities or bind the issuer or investor; (c) participate in the preparation of any sales materials; (d) perform any independent analysis of the sale; (e) engage in any “due diligence” activities; (f) assist or provide financing for such purchases; or (g) provide advice as to the valuation or financial advisability of the investment.
Scope of Issuers Under the Proposed Exemption
While the SEC presents the Proposed Exemption as a boon for small issuers seeking funding, the SEC does not propose to define a “small issuer” for purposes of the exemption. Rather, the SEC’s only criteria is that issuers for whom a finder could act are limited to non–Reporting Issuers. In this respect, the Proposed Exemption would seemingly permit a finder to engage in activities for issuers of all sizes and lines of business as long as they are not Reporting Issuers. While the Proposed Exemption should be read to include private funds that are excluded from the definition of an investment company under Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940 and other pooled investment vehicles, the SEC does not discuss such types of issuers in the context of this proposal. Given the likelihood that these funds would greatly benefit if able to engage Tier I and Tier II Finders for their fundraising activities, it will be important to get clarity that finders for such funds will be afforded the same status as they would for services provided to other non–Reporting Issuers.
Associated Persons of a Broker-Dealer
One of the General Conditions is that a finder not be an associated person of a broker-dealer. While this condition makes sense when it comes to persons who are licensed with and under the supervision of a registered broker-dealer, the definition of an associated person of a broker-dealer under Exchange Act Section 3(a)(18) is incredibly broad and might effectively serve to prohibit a person from relying on the Proposed Exemption to the extent they are affiliated with a company that has a broker-dealer within its organizational umbrella. To this end, the SEC may consider an approach the SEC staff took under a 1987 no-action letter under which it appeared to permit bank employees to rely on Exchange Act Rule 3a4-1 (the so-called issuer’s exemption) even though the bank had an affiliated broker-dealer, thus making the bank employees associated persons of a broker-dealer that might not be able to otherwise rely on Rule 3a4-1. Such an approach would make sense given that, in the Rule 3a4-1 Adopting Release, the SEC seemed focused on the potential for investor confusion and sales practice abuses by licensed personnel of a broker-dealer, rather than with persons who are employed by a company that is affiliated with a broker-dealer but who otherwise do not engage in brokerage activities.
Some issuers have investor relations and marketing departments whose personnel provide information to existing and potential investors, and who may facilitate subscriptions requests. Over the years, members of the SEC staff have questioned whether these marketing departments are acting as unregistered brokers. While the Proposed Exemption did not address marketing departments per se, it does contemplate that a finder could be affiliated with an issuer (there is a disclosure to that effect). If persons associated with an issuer can rely on the Proposed Exemption, it would alleviate a perennial issue with the ability of fund personnel to rely on Rule 3a4-1 given the prohibitions in that rule regarding compensation, open-ended offerings, and affiliation with registered broker-dealer. That said, the SEC’s request for comment alludes to limiting the Proposed Exemption to persons who are not associated persons of an issuer, which if so limited, would leave marketing departments in their existing state of uncertainty.
Protection for Issuers
Issuers have, over the years, been concerned that if they use finders that are not registered broker-dealers an investor might assert rescission rights if the finder was subsequently deemed to have been a broker and was acting in violation of the registration requirement. Specifically, Section 29(b) of the Exchange Act has long been viewed as providing investors with what is effectively a put to rescind a transaction if the investor can prove that an investment in an issuer was effected by an unregistered broker in violation of the Exchange Act. While the Proposed Exemption provides regulatory certainty to finders, it may not provide full protections for issuers in the event that a purported finder is subsequently found to have been acting as an unregistered broker outside the scope of the exemption. To this end, issuers could benefit from a safe harbor from Section 29(b) of the Exchange Act to the extent that an issuer had a good-faith and reasonable basis to believe that a finder was satisfying the conditions of the Proposed Exemption, assuming such a safe harbor could be adopted through regulatory action.
Paula Anka Letter
The limitation on activities engaged in by Tier I Finders appears to correspond to the activities permitted under the Paul Anka Letter. Indeed, the Proposed Exemption appears to codify that letter with respect to Tier I finders. However, because the Proposed Exemption is an exemption from broker registration, it necessarily presupposes that a person whose previous finder activities came squarely within the confines of the Paul Anka Letter is a broker. Absent clarification or relief from the SEC, finders that operated within the confines of that letter could potentially be viewed as having been operating as unregistered brokers, raising concerns not only for the finder but also the issuers they assisted. To this end, and at least with respect to Tier I Finders, the industry may be better served with an interpretive statement that the activities permitted of persons acting as Tier I Finders do not deem such persons brokers, rather than providing a registration exemption that would deem them brokers in the first instance.
Limited to Individuals
The Proposed Exemption is limited to finders acting in an individual capacity rather than through an entity. In this respect, members of the SEC staff have, through the years, frowned upon nonregistered entities owned by licensed broker-dealer personnel receiving transaction-based compensation, even where such requests were made for administrative convenience purposes, such as for office expenses and to pay non-sales-related support staff. While we understand the reasoning behind limiting the Proposed Exemption to individuals, the SEC may want to consider whether there would be any meaningful adverse impact to investors if finders were permitted to act in concert under an organizational umbrella, provided that the individual finders act in accordance with the requirements of the Proposed Exemption.
The Proposed Exemption would provide relief for Tier I and Tier II Finders from the broker-dealer registration requirements under the federal securities laws. Although the National Securities Markets Improvement Act of 1996 (NSMIA) amended the federal securities laws to, among other things, preempt states from imposing certain additional requirements on SEC registered broker-dealers, NSMIA did not preempt states from imposing registration requirements on broker-dealers and their personnel. As such, absent coordinated or individual state action, Tier I and Tier II Finders would have to assure themselves that their activities would not incur state-level registration requirements. A similar concern might be present for issuers with respect to state rescission rights analogous to those in Section 29(b) of the Exchange Act, if they use finders that are exempt from federal registration requirements but who are not expressly exempt from state registration requirements.
The Proposed Exemption has the potential to expand the ability of small issuers to access the capital markets. However, judging by the SEC requests for comments, there may still be some room for the SEC to pare back the scope of the Proposed Exemption.
In any event, should the SEC move forward as proposed, market participants may still be left with interpretive questions and uncertainty regarding the potential exposure that finders and issuers have for past activities.
 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, Exchange Act Release No. 90112 (Oct. 7, 2020), 85 Fed. Reg. 64542 (Oct. 13, 2020).
 Paul Anka, SEC Staff No-Action Letter (July 24, 1991) (Paul Anka Letter).
 See, e.g., Brumberg, Mackey & Wall, PLC, SEC Staff No-Action Letter (May 17, 2010) (denial of no action for a person who would prescreen investors for eligibility to purchase certain privately placed securities and presell securities to those investors); John Loofbourrow Associates, Inc., SEC Staff No-Action Letter (June 29, 2006) (denial of no action for a person who would receive a commission for introducing an investment banking client to a registered broker-dealer).
 Section 3(a)(18) of the Exchange Act defines associated person of a broker or dealer as “any partner, officer, director or branch manager of such broker or dealer (or any person occupying a similar status or performing similar functions), any person directly or indirectly controlling, controlled by, or under common control with such broker or dealer, or any employee of such broker or dealer, except that any person associated with a broker or dealer whose functions are solely clerical or ministerial shall not be included in the meaning of such term for purposes of section 15(b) of this title (other than paragraph 6 thereof).”
 Exchange Act Rule 3a4-1 provides a conditional exemption from broker status when “associated persons” of an issuer engage in certain limited activities on behalf of the issuer. The ability to rely on the rule is subject to a number of conditions, including that (1) the associated person does not receive compensation that is based either directly or indirectly on transactions in securities; (2) the associated person must also perform, or be intended primarily to perform at the end of the offering, substantial duties for or on behalf of the issuer otherwise then in connection with transactions in securities; and (3) the associated person of an issuer cannot participate in selling and offering of securities for any issuer more than once every 12 months. See Persons Deemed Not to Be Brokers, Exchange Act
Release No. 22172, 1985 WL 634795 (June 27, 1985) (Rule 3a4-1 Adopting Release).
 See Chevy Chase Savings Bank, F.S.B., SEC Staff No-Action Letter (Dec. 28, 1987).
 In that release, the SEC discussed two reasons for excluding “associated persons of a broker or dealer” from being able to rely on Rule 3a4-1. The SEC expressed the view that the offering of an issuer’s securities might be integrated with the activities engaged in by broker-dealer personnel in their employment with the broker-dealer. In addition, the SEC expressed concern that the affiliation with a broker-dealer and an issuer would create a potential for abusive tactics or confusion of investors.
 See, e.g., A Few Observations in the Private Fund Space, David Blass, Chief Counsel, Division of Trading and Markets, US Securities and Exchange Commission, Speech to American Bar Association, Trading and Markets Subcommittee, Washington, DC (April 5, 2013).
 See Rule 3a4-1 (stating that as a condition of the rule, subject to limited exceptions, the associated person of an issuer cannot participate in selling and offering of securities for any issuer more than once every 12 months and cannot receive transaction-based compensation).
 Exchange Act Section 29(b) provides in relevant part that “[e]very contract made in violation of any provision of this title or of any rule or regulation thereunder, and every contract (including any contract for listing a security on an exchange) heretofore or hereafter made the performance of which involves the violation of, or the continuance of any relationship or practice in violation of, any provision of this title or any rule or regulation thereunder, shall be void (1) as regards the rights of any person who, in violation of any such provision, rule, or regulation, shall have made or engaged in the performance of any such contract, and (2) as regards the rights of any person who, not being a party to such contract, shall have acquired any right thereunder with actual knowledge of the facts by reason of which the making or performance of such contract was in violation of any such provision, rule, or regulation.”
 See, e.g., Wolff Juall Investments, LLC, SEC Staff No-Action Letter Denial (May 17, 2005).
 Pub. L. No. 104-290, 110 Stat. 3416 (1996).