A highlight of our family trip to Russia three years ago was the Hermitage Museum in St. Petersburg. Comprised of several buildings, including the former main residence of Russian tsars, it is the second largest art museum in the word. Catherine the Great founded the museum and ordered the construction of the Hermitage Theatre in the late 18th century on the site of one of Peter the Great’s winter palaces.
The first Hermitage Theatre performance, in 1785, was a comic opera: The Miller who was a Wizard, a Cheat and a Matchmaker, with music by M.M. Sokolovsky. Premiered in Moscow in 1779, the opera told a convoluted story about the miller Fadei to a background of Russian folk music.
The opera starts as Fadei laments the lack of wind to run his mill. Enter farmer Filimon, who, believing Fadei to be a wizard, enlists him to find a lost horse. After Fadei locates the horse, Filimon seeks Fadei’s assistance with a larger, magical task–winning the hand of Anyuta in marriage.
Since Fadei’s mill is failing, he can’t turn down the opportunity to make money, so he agrees to become a matchmaker. The problem is that Anyuta’s mother wants her to marry a nobleman, while her father seeks a farmer as Anyuta’s husband.
Pretending to be a fortune teller, Fadei sends Anyuta’s mother on a path where she will meet her future nobleman son-in-law, who happens to be Filimon. Anyuta’s parents, Fadei convinces them that Filimon, as both a landowner and a farmer, is a suitable husband for Anyuta. And everyone lives happily ever after.
Selling securities can be like matchmaking. Although investors can invest in multiple products, the investment must match the investor’s needs and risk tolerance – much as Anyuta’s parents had certain requirements for her husband. In the securities field, that’s called suitability.
However, unlike 18th-century Russian matchmaking, today’s investors don’t expect the person who sells them securities to be a magician. And they don’t want to buy securities from a cheat. That’s why someone must have a license and be associated with a broker-dealer to be paid for selling securities.
Now, the Securities and Exchange Commission (SEC) has proposed a rule that would, under limited circumstances, allow unlicensed individuals to be compensated finders in securities transactions. If adopted, this rule would clarify an area of securities law where securities attorneys must comb through No-Action letters to provide reasoned advice.
What is a Finder?
For decades, individuals called “finders,” who aren’t associated with broker-dealers, have sought compensation for procuring investors. Other finders are real estate brokers, business consultants, or other professionals whose ordinary business draws them unaware into the sale of securities. For instance, a business consultant may facilitate a stock sale to multiple buyers, or a real estate broker may have clients who want to invest in tenant-in-common real estate.
Starting in the 1990s, the SEC issued several no-action letters approving finders. The most famous of these letters was a July 24, 1991, No-Action Letter (Paul Anka Letter) that allowed singer Paul Anka to receive compensation for referring investors to a securities issuer. The Paul Anka Letter allowed Anka to receive a finder’s fee for giving an issuer a list of names and contact information of accredited investors with whom Anka had a relationship.
What Activities Are Prohibited Now?
Since the “law” regarding finders has evolved via No-Action letters, there has been confusion regarding what activities are legal. Because the SEC hasn’t adopted rulemaking about finders, Courts, lacking clear guidance, have issued fact-specific decisions, some of which appear inconsistent.
Some have considered whether the finder is “regularly engaged in the business” of effecting securities transaction. Others have looked to whether the finder gives investment advice, explains the securities’ merits, or handles investor funds.
One thing, however, has been clear. “Transaction-based compensation” or compensation based upon a successful investment has become an important consideration when determining whether a finder must be licensed as a broker-dealer.
Sometimes, an issuer possibly can pay a finder for a contact list or for making an introduction. But then, the finder’s compensation must be paid whether or not the prospective investor(s) purchase securities. And a licensed broker-dealer (or individual who qualifies under the issuer agent exemption) must complete (and be compensated for) the sale, making use of a finder impractical and costly.
These limitations don’t allow for significant compensation to finders. If the issuer is paying for leads that don’t pan out, the information is less valuable to the issuer. And there is less incentive for finders to procure solid investors if the finder receives the same compensation whether or not the prospective investor buys securities. Without a success fee or other transaction-based compensation, it makes little sense for most issuers to use finders.
Plus, the current law has left people in legitimate businesses in limbo. For instance, when business brokers arrange for a sale, they may not know whether it will be an asset sale or a stock sale. If a transaction is later structured as a stock sale, the broker could be deemed an unlicensed broker-dealer. The same may be true of a real estate broker who assists in the sale of a fractional interest in real estate, which depending upon the ownership and management structure, can be a security.
Role of Finders Under the Proposed Rule
The current patchwork of No-Action letters and court cases has created confusion on what is allowed. And this confusion has mostly affected smaller issuers, who may rely upon the private placement exemption in Rule 506(b) to procure investors. Those issuers may rely upon word-of-mouth referrals from current investors because they cannot afford to pay broker-dealer commissions.
The proposed rule would provide a non-exclusive safe harbor under which individuals could act as finders under specified circumstances. The proposed rule would create two classes of finders: Tier I and Tier II.
Most finders probably would be Tier I finders, who would need to meet these requirements:
Non-Reporting Issuers–The securities issuer must not be a reporting company under Section 13 or Section 15(d) of the Exchange Act. Most small business issuers can meet this requirement.
Securities Exempt from Registration–Finders may not be used in public offerings.
No General Solicitation–This requirement functionally limits the use of finders in private placements, most of which are made under the exemption in Rule 506(b). Since Rule 506(c) offerings allow general solicitation, those offerings, finders probably will not be able to sell those offerings. However, the proposed rule remains open regarding whether a finder may assist in the sale of Rule 506(c) securities if the finder, themself, doesn’t engage in general solicitation.
Only Accredited Investors–The finder must reasonably believe that the investor is an accredited investor.
Written Finder Agreement–The finder must have a written agreement, which must outline the services to be provided and the compensation the issuer agrees to pay. Although not required of Tier I finders, the finder’s agreement should be disclosed to the investor, so the investor knows before investing what incentive the finder has to place them in the investment.
Finder Cannot Be Licensed–The finder cannot be an associated person with a broker-dealer.
Finder is not a “Bad Actor”–The finder cannot be subject to statutory disqualification under Section 3(a)(39) of the Exchange Act.
Only One Capital Transaction Per 12 Months–A Tier I finder can assist only one issuer in only one capital transaction in any 12-month period.
May Only Provide Contact Information–A Tier I finder can only provide contact information (e.g., name, telephone number, email address, social media information) to the issuer.
Tier II finders would be given more freedom, including:
Investor Contact–Tier II finders could identify, screen, and contact potential investors.
Distributing Materials–Unlike Tier I finders, Tier II finders could distribute offering materials to prospective investors.
Discussing Offering Materials–Tier II finders could discuss information in offering materials with prospective investors.
No Investment Advice–Like Tier I finders, Tier II finders could not advise investors regarding the valuation or the advisability of an investment.
Participating in Meetings–Tier II finders could arrange for and participate in meetings between the issuer and the prospective investor.
Tier II finders would need to provide additional disclosures to investors, including a description of the relationship between the Tier II finder and the issuer, the description of the compensation, and any conflicts of interest. The Tier II finder also would have to provide prospective investors with written notice that the finder is acting on behalf of the issuer and does not have to act in the investor’s best interest. And the Tier II finder would need written acknowledgment of these disclosures from the investor.
Although Tier I finders wouldn’t have to provide these disclosures, issuers may be required (or at least would be well advised) to do so. That’s because the relationship between the finder and the issuer is likely to be material.
In The Miller who was a Wizard, a Cheat and a Matchmaker, Fadei, seeking a way of filling his coffers, engages in a tangled web of trickery and deceit. Although finders wouldn’t be subject to strict regulation like broker-dealers, the proposed rule includes safeguards to prevent some of the tactics Fadei uses to secure the match between Filimon and Anyuta.
Fadei didn’t disclose to Anyuta’s parents that he was working for Filimon and getting paid. But Tier II finders will have to disclose their relationship with the issuer and compensation to investors. Finders wouldn’t be permitted to provide investment advice. But Fadei advocated to both of Anyuta’s parents to secure her marriage to Filimon.
We never learn whether Fadei’s matchmaking efforts for Filimon were a one-time thing (like a Tier I finder) or whether he found matchmaking so lucrative that he engaged in full-time. Likewise, it remains to be seen whether, if adopted, the rule would create an industry of unlicensed individuals in the Tier II finder business operating outside of the broker-dealer regulatory structure.
This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.