Summary of the Proposed Exemption
During the fourth quarter of 2020, the US Securities and Exchange Commission (SEC) proposed a limited, conditional exemption from the broker registration requirements under Section 15(a) of the US Securities Exchange Act of 1934, as amended (Exchange Act), to permit "Finders" to engage in certain limited capital raising activities on behalf of issuers without having to register as brokers. 1 This proposed exemption is intended to supplement current broker-dealer regulation, and to provide clarity with respect to activities that would be permitted outside the current broker-dealer regulatory regime.
The proposed exemption would create two tiers of Finders, Tier I Finders and Tier II Finders. Each tier of Finder would be able to engage in certain limited capital raising activities with accredited investors and receive transaction-based compensation, subject to conditions tailored to the scope of their permitted activities.
A Tier I Finder would be limited to providing contact information for potential investors in connection with a single capital raising transaction by a particular issuer over the course of any 12 month period. A Tier I Finder would not be permitted to have any contact with a potential investor about the issuer.
A Tier II Finder would be permitted to solicit investors on behalf of an issuer, but the solicitation-related activities would be limited to: (i) identifying, screening, and contacting potential investors; (ii) distributing issuer offering materials to investors; (iii) discussing issuer information included in any offering materials, provided that the Tier II Finder 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.
Under the proposed exemption, both Tier I Finders and Tier II Finders must be natural persons and would only be eligible for the proposed exemption if:
- the issuer is not required to file periodic reports under Section 13 or Section 15(d) of the Exchange Act;
- the issuer is seeking to conduct the securities offering in reliance on an applicable exemption from registration under the US Securities Act of 1933, as amended (Securities Act) 2;
- the Finder does not engage in any activities that would be deemed to constitute a 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 any such 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, as that term is defined in Section 3(a)(18) of the Exchange Act; and
- the Finder is not subject to statutory disqualification, as that term is defined in Section 3(a)(39) of the Exchange Act (i.e., the Finder is not a "bad actor" under Securities Act Rule 506(d)), at the time of his or her participation.
A Tier II Finder intending to rely on the proposed exemption would also need to provide investors with appropriate disclosures of the Tier II Finder's role and compensation prior to or at the time of the solicitation, 3 and obtain from the investor a dated, written acknowledgment of receipt of the required disclosures prior to the time of any investment in the issuer's securities.
Under the proposed exemption, a Finder could not (i) be involved in structuring the transaction or negotiating the terms of the offering, 4 (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 purchases, or (vii) provide advice as to the valuation or financial advisability of the prospective investment.
As the proposed exemption is limited in nature, Finders would not be able to rely on the proposed exemption to engage in brokerage activity beyond the scope of the proposed exemption. Prohibited activities would extend to facilitating a registered offering, a resale of securities, or the sale of securities to investors that are not accredited investors or that the Finder does not have a reasonable belief are accredited investors.
The SEC's Office of the Advocate for Small Business Capital Formation prepared a video and a chart showing a comparison of some of the permissible activities, requirements and limitations for Tier I Finders, Tier II Finders, and registered brokers.
The comment period relating to the Notice ended in mid-November. As of the date hereof, it is unclear whether the Biden Administration will support this rulemaking initiative, or will simply table or restart the process.
Background on Finders
Indicators of Broker Status
Whether a person is a broker within the meaning of the Exchange Act turns on the facts and circumstances of the matter. As a result, courts and the SEC have looked to certain factors to determine whether a person is a broker within the meaning of the Exchange Act.
Most notably, courts and the SEC have identified the following activities as indicators of broker status: (i) actively soliciting or recruiting investors; (ii) participating in negotiations between the issuer and the investor; (iii) advising investors as to the merits of an investment or opining on its merits; (iv) handling customer funds and securities; (v) having a history of selling securities of other issuers; and (vi) receiving commissions, transaction-based compensation or payment other than a salary in connection with the purchase or sale of securities.
However, this list of indicative activities is not exhaustive, and no one activity is dispositive.
Nevertheless, the receipt of transaction-based compensation in connection with securities activities, such as solicitation of potential investors, has been considered by courts as a key factor indicating that registration as a broker may be required. As such, Finders receiving transaction-based compensation are at risk of being deemed brokers who must register under the Exchange Act.
The SEC has not previously recognized a "finders" exemption or exception, nor has the SEC broadly addressed whether and under what circumstances a person may "find" or solicit potential investors on behalf of an issuer without being required to register as a broker, or even whether such activity implicates the SEC's regulatory regime for brokers.
Instead, market participants have relied on existing SEC staff no-action letters discussing circumstances under which persons may act as "finders" without registering as brokers.
Existing No-Action Letters
The proposed exemption for Tier I Finders largely tracks a 1991 no-action letter in which the staff stated that it would not recommend enforcement action to the SEC under Section 15(a) of the Exchange Act against Paul Anka if he, without registering with the SEC as a broker-dealer: (i) entered into an agreement with an issuer to provide to the issuer a list of names and telephone numbers of potential investors he reasonably believed to be accredited investors and with whom he had a pre-existing business or personal relationship, (ii) had no further contact with potential investors concerning the issuer, and (iii) received a finder's fee for doing so. 5
The staff in its response noted that Mr. Anka would not: (i) solicit the prospective investors or have any contact with them regarding the proposed investment; (ii) participate in any advertisement, endorsement, or general solicitation; (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 purchases; (vii) provide advice as to the valuation or financial advisability of the investment; or (viii) handle any funds or securities in connection with the investment.
The staff's response also noted that Mr. Anka had not previously engaged in any private or public offering of securities (other than buying and selling securities for his own account through a broker-dealer), had not acted as a broker or finder for other private placements of securities, and did not intend to participate in any distribution of securities after the completion of the proposed private placement, so that the letter only addressed an individual's first participation in a securities offering and not participation in any subsequent offerings by that individual.
More recently, in 2010, the staff refused to issue a no-action letter to a law firm that proposed to introduce an issuer to persons with potential interest in investing in the issuer's securities in exchange for a percentage of the amount raised as a result of the introductions without the law firm registering as a broker under the Exchange Act. 6 In its response letter, the staff noted that a person's receipt of transaction-based compensation for effecting transactions in securities or inducing the purchase of securities is a hallmark of broker-dealer activity. The staff believed that the introduction to the issuer of only those persons with potential interest in investing in the issuer's securities implied that the law firm anticipated both "pre-screening" potential investors to determine their eligibility to purchase the securities and "pre-selling" the securities to gauge the investors' interest. The staff also believed that the receipt of compensation directly tied to successful investments in the issuer's securities by investors introduced by the law firm (i.e., transaction-based compensation) would give the law firm a "salesman's stake" in the proposed transactions and would create heightened incentive for the law firm to engage in sales efforts. Accordingly, the staff believed that the law firm's proposed activities would require registration as a broker-dealer under the Exchange Act and refused to issue the requested no-action letter.
In a 2013 no-action letter, the staff agreed not to recommend enforcement action to the SEC under Section 15(a) of the Exchange Act if an independent strategy consulting firm based in Germany contacted certain US-based entities (or non-US-based entities that have US-based parents involved in investment decisions of the non-US entity) to assess their interest in proposed merger and acquisition transactions with the consulting firm's non-US-based clients without registering as a broker under the Exchange Act. 7 The no-action letter also allowed the non-US-based consulting firm to develop and manage the data room and the information process for the proposed transaction, conduct negotiations on behalf of its non-US client (subject to certain limitations) and advise the non-US client on the terms of the transaction. The no-action letter was expressly conditioned on the fact that the consulting firm would not represent or advise any contacted US-based entity and would not receive, acquire or hold funds or securities.
In a 2014 no-action letter, the staff agreed not to recommend enforcement action to the SEC under Section 15(a) of the Exchange Act for persons effecting securities transactions in connection with the transfer of ownership of a controlling interest in a privately-held operating company (M&A Brokers) under certain facts and circumstances without registering as brokers under the Exchange Act. 8 The facts and circumstances included the following: (i) the M&A Broker not having the ability to bind a party to the transaction, (ii) the M&A Broker not providing financing for the transaction, either directly or indirectly, (iii) the M&A Broker not having custody, control or possession of funds or securities in connection with the transaction for the accounts of others, (iv) the transaction not involving a public offering and being conducted in compliance with an applicable exemption under the Securities Act, (v) if the M&A Broker represents both buyers and sellers, providing written disclosure as to the parties it represents and obtaining written consent from both parties to the joint representation, (vi) the M&A Broker not assisting in forming any buyer group, (vii) the buyers actively operating the company or the business conducted with the assets of the company and the transaction not resulting in the transfer of interests to a passive buyer or group of buyers and (vii) the M&A Broker not being barred from association with a broker-dealer and not being suspended from association with a broker-dealer.
This proposed exemption is limited to the regulatory status of individuals who identify and solicit potential investors for an issuer as discussed above, and does not address the M&A Broker Letter.
As part of its request for comment on the Notice, which is described in more detail below, the SEC requested comment on which staff letters, if any, should or should not be withdrawn. The SEC also specifically requested comment on whether the M&A Broker Letter should be codified.
FINRA Rule 2040
The Notice does not address how the proposed exemption may interact with Financial Industry Regulatory Authority (FINRA) Rule 2040, which generally prohibits FINRA members (i.e., registered broker-dealers) or associated persons from, directly or indirectly, paying any compensation, fees, concessions, discounts, commissions or other allowances to: (i) any person that is not registered as a broker-dealer under the Exchange Act but, by reason of receipt of any such payments and the activities related thereto, is required to be so registered under applicable federal securities laws and Exchange Act rules and regulations; or (ii) any appropriately registered associated person unless such payment complies with all applicable federal securities laws, FINRA rules and Exchange Act rules and regulations. 9 FINRA Rule 2040, however, does allow FINRA members to pay unregistered foreign finders transaction-based compensation based upon the business of non-US customers that the finder directs to the member, subject to certain conditions.
In FINRA's supplementary material on Rule 2040, FINRA notes that members that are uncertain as to whether an unregistered person may be required to be registered under Section 15(a) of the Exchange Act by reason of receiving payments from the member can derive support for their determination by, among other things, (i) reasonably relying on previously published releases, no-action letters or interpretations from the SEC or SEC staff that apply to their facts and circumstances; (ii) seeking a no-action letter from the SEC staff; or (iii) obtaining a legal opinion from independent, reputable US-licensed counsel knowledgeable in the area. FINRA notes that the member's determination must be reasonable under the circumstances and should be reviewed periodically if payments to the unregistered person are ongoing in nature and that the member must maintain books and records that reflect the member's determination.
We expect that if the proposed exemption becomes a final exemption, FINRA Rule 2040 would not restrict FINRA members and associated persons from being able to pay transaction-based compensation to a Finder who is able to avail itself of such final exemption from registration as a broker under the Exchange Act, although we expect that FINRA may amend Rule 2040 or provide clarification on its application and requirements in light of the final exemption.
Effect of Not Registering as a Broker
It is important to briefly note the risks that a finder currently takes if he or she engages in the activities of a broker without being registered under the Exchange Act.
As an initial matter, the finder could potentially be subject to SEC injunctions, enforcement actions and civil penalties. Where the finder has willfully violated the broker registration requirement, the finder could also be subject to criminal prosecution.
Perhaps almost as troubling as criminal prosecution is Section 29(b) of the Exchange Act10 which, inter alia, makes void every contract the performance of which involves the violation of, or the continuance of any relationship or practice in violation of, the Exchange Act or any rule or regulation thereunder. In the case of a finder who engages in unregistered brokerage activities, investors availing themselves of Section 29(b) could potentially bring successful recission actions against the issuer for the return of their investments.
Furthermore, Section 20(a) of the Exchange Act11 provides that any person who directly or indirectly controls a finder who has engaged in brokerage activities without being registered is jointly and severally liable with and to the same extent as such finder to any person to whom such finder is liable (including the SEC) unless the controlling person acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action. This rule means that entities and supervisors who control finders who are engaged in brokerage activities without being registered could potentially be liable to the same extent as the finders themselves, including for purposes of SEC injunctions, enforcement actions and civil penalties.
Calls for SEC Action
Given the legal uncertainty surrounding finders who have not registered as brokers under the Exchange Act, there have been several calls for SEC action in this area.
In 2005, the American Bar Association Business Law Section Task Force on Private Placement Broker-Dealers (ABA Task Force) recommended that the SEC, the National Association of Securities Dealers (NASD, now FINRA) and state regulators work to establish a simplified system for the registration for finders. 12 The ABA Task Force stated that any such simplified registration system should recognize that finders will be permitted to engage in only very limited activities and that rules and procedures relating to membership in the NASD, record keeping and reporting, net capital, testing and continuing education should be modified to address only requirements which are logically applicable to the activities of the finder.
The ABA Task Force also recommended that finders be required to file an annual Statement of Activity with the NASD and applicable states which summarizes the transactions in which it has participated during the past calendar year and provides sufficient statistical information for regulators to analyze the effectiveness of the finder program or to conduct appropriate inspections.
In 2017, the US Department of the Treasury recommended that the SEC, FINRA, and the states propose a new regulatory structure for finders and other intermediaries in capital-forming transactions, noting that the possibility of a "broker-dealer lite" rule that applies an appropriately scaled regulatory scheme on finders could promote capital formation by expanding the number of intermediaries who are able to assist smaller companies with capital raising. 13
Until this proposed exemption, neither the recommendations of the ABA Task Force or the Department of the Treasury have resulted in any meaningful SEC action to clear up the uncertainty surrounding finders who have not registered as brokers under the Exchange Act.
Effect of Proposed Exemption
The proposed exemption would provide a non-exclusive safe harbor from broker registration. The safe harbor is intended to provide clarity with respect to the ability of a Finder to engage in certain activities without being required to register as a broker under the Exchange Act.
However, the Notice makes clear that no presumption shall arise that a person has violated Section 15(a) of the Exchange Act if such person is not within the terms of the proposed exemption; rather—consistent with how questions under Section 15(a) have been evaluated—it would depend on the facts and circumstances of the situation.
For the same reason, the Notice also states that engaging in some of the limited activities falling within the terms of the proposed exemption should not be considered per se to require registration as a broker in the absence of the exemption.
Notably, nothing in the proposed exemption excuses compliance with all other applicable laws, including the antifraud provisions of the Securities Act or the Exchange Act, or state law.
The exemption was proposed by a divided 3-2 vote of the SEC's five commissioners. Commissioner Allison Herren Lee and Commissioner Caroline A. Crenshaw, both of whom were appointed to Democratic seats on the SEC, dissented from the proposed exemption, focusing on a number of perceived procedural and substantive issues with the proposal.
The partisan nature of commissioner support for the exemption suggests that the prospects of its adoption have become significantly more challenging since the November election.
Commissioners Lee and Crenshaw both took issue with the fact that the Notice proposes to make a significant change to the SEC's regulatory framework without the benefit of notice-and-comment rulemaking. 14
Commissioners Lee and Crenshaw noted that because the relief is proposed as an exemption, it does not include the cost-benefit analysis that would be required if the relief was proposed as a formal rule change. Commissioner Crenshaw observed that the Notice provides no meaningful description of the current state of the finders market and does not include any data supporting the need for the proposed exemption.
Commissioner Lee observed that because the proposed exemption does not require Finders to report or notify the SEC when they rely on the proposed exemption, the exemption could serve to exacerbate the SEC's lack of insight into the private markets, leaving the SEC with no basis to evaluate the exemption's use or abuse. Commissioner Crenshaw also noted that the proposed exemption does not reflect any consideration of potential market competition consequences to registered broker-dealers.
Commissioner Lee also pointed out that an exemptive order would be contrary to the conclusions reached by the ABA Task Force in 2005 and the Department of the Treasury in 2017, both of which recommended a limited registration regime applicable to finders.
Commissioners Lee and Crenshaw also took issue with how the Notice addresses conduct outside the scope of the proposed exemption. Commissioner Crenshaw noted that while the Notice provides a clear statement of the activities Finders would be permitted to undertake, it does not explain what, if any, activities are actually prohibited, meaning that regulatory uncertainty and enforcement challenges in this space are likely to remain. Commissioner Lee also noted that because the scope of conduct permitted by the proposed exemption quite clearly meets the threshold for registration as a broker, the SEC undercuts its goal of providing clarity to finders and issuers by not only failing to emphasize the importance of complying with the terms of the proposed exemption, but also by suggesting that deviation from those terms might not have consequences.
Commissioners Lee and Crenshaw also observed that because the Notice does not impose any limitations on the size of the issuers or the size of the offerings, under the proposed exemption, issuers of any size would be permitted to employ Finders to raise unlimited amounts of capital outside of the broker-dealer regulatory regime, making the proposal overbroad to achieve its purported purposes of attempting to meet the needs of small issuers and women- and minority-owned businesses.
Areas of Continuing Consideration
While the SEC sought comment on all aspects of the Notice, including the potential costs and benefits of the proposed exemption, the SEC posed 45 sets of questions on which it specifically sought comment, including the following significant items:
- whether Finders should be limited to natural persons;
- whether Finders should be limited to natural persons resident in the US;
- whether investors identified by Finders should be subject to investment limitations, regardless of the exemption being relied upon, such as a dollar limit on the size of the investment;
- whether the proposed exemption should be limited to offerings of a specific size threshold;
- whether Finders should be able to "find" or solicit investors only for offerings under certain exemptions from registration;
- whether the proposed exemption should be integrated with Rule 206(4)-3 under the US Investment Advisers Act of 1940, as amended (Advisers Act), and the cash solicitation rule disclosure and acknowledgement, including the proposed amendments thereto; 15
- whether the scope of the proposed exemption should be expanded to include secondary offerings;
- whether the proposed exemption should include limitations on the types of securities for which a Finder can "find" or solicit investors;
- whether the proposed exemption should be conditioned on a Finder filing a notice with the SEC of reliance on the exemption;
- whether there should be any limitations on the amount or form of compensation a Finder can receive;
- whether Finders should be prohibited in certain circumstances from receiving transaction-based compensation, and instead be required to receive compensation that is not tied to the success of the transaction;
- whether Finders should be able to receive a financial interest in an issuer as compensation for its services;
- whether the SEC should provide guidance regarding activities of private fund advisers, M&A Brokers or real estate brokers that may require registration under Section 15(a) of the Exchange Act;
- which staff letters, if any, should or should not be withdrawn and whether the M&A Broker Letter should be codified; and
- whether the proposed exemption has a competitive impact on registered brokers.
Assuming the review process is not suspended or otherwise delayed after the Biden inauguration, new rules could be issued as soon as the first half of 2021. As noted, however, the probability that the exemption will be adopted as proposed has declined significantly since the election.
As should be clear from the above discussion, the limited nature of the proposed exemption means that the proposed exemption, even if adopted, is not likely to constitute a complete solution to the issue of finders who are engaged in brokerage activities without being registered under the Exchange Act.
Of particular importance, Finders would not be able to rely on the proposed exemption to engage in brokerage activity beyond the scope of the proposed exemption. As a result, facilitating a registered offering, secondary offerings such as transactions facilitating the sale of equity by employees holding options or warrants, or the sale of securities to investors that are not accredited investors or that the Finder does not have a reasonable belief are accredited investors would remain outside the scope of permitted Finders' activities.
In addition, the proposed exemption would not affect a Finder's obligation to continue to comply with all other applicable laws, including the antifraud provisions of the Securities Act and the Exchange Act, such as the obligations under Section 10(b) and Rule 10b-5 under the Exchange Act, and state law.
State law in particular poses a substantial impediment to the relief intended from the proposed exemption as several states, including California, New York and Texas, have implemented or proposed state-level registration requirements on finders. However, such tension is nothing new in the area of finders, as there has been resistance at the state level to some of the staff no-action letters in the area of finders, including the M&A Broker Letter.
The Notice also made it clear that the proposed exemption would not exempt a Finder from having to consider whether it is acting in another regulated capacity, such as a person subject to regulation as an investment adviser or a municipal advisor. Further, the proposed exemption would not relieve a prospective Finder from its obligations, if any, under the Advisers Act if such person is acting as, or on behalf of, an investment adviser. Note that the Notice was agnostic as to whether the requirements of the proposed exemption should be integrated with the requirements of Advisers Act Rule 206(4)-3. As a practical matter, it would appear that even if not formally integrated, the notice and acknowledgment requirements of the proposed exemption are sufficiently similar to those established by Rule 206(4)-3 that it should not be hard to construct integrated disclosure and acknowledgement documentation where doing so would be helpful.
Notably, the conditions of the proposed exemption for Finders differ from the requirements for solicitors under the SEC's proposed amendments to Rule 206(4)-3 under the Advisers Act. The Notice stated that these differences reflect the particular facts and circumstances surrounding the proposed permitted activities for Finders and solicitors, and the characteristics of the applicable regulatory regimes, including that established by the Advisers Act. The Notice observed that a solicitor would solicit business for an investment adviser and would be subject to oversight by such investment adviser, while a Finder would solicit for an issuer of securities and would not be subject to such oversight.
While it remains to be seen whether the proposed exemption will become a final exemption, in the form proposed or otherwise, the Notice nevertheless represents a significant moment in the SEC's consideration of the treatment of finders under the Exchange Act.
1 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, Release No. 34-90112 (Oct. 7, 2020), 85 FR 64542 (Oct. 13, 2020).
2 An issuer's failure to comply with the conditions of an exemption from registration under the Securities Act for an offering would not, in itself, affect the ability of a Finder to rely on the proposed exemption provided the Finder can establish that he or she did not know and, in the exercise of reasonable care, could not have known, that the issuer had failed to comply with the conditions of an exemption. However, a Finder that, through its activities on behalf of an issuer, causes an issuer's offering to be ineligible for an exemption from registration, would not be able to rely on the proposed exemption.
3 Such disclosures would need to include (i) the name of the Tier II Finder, (ii) the name of the issuer, (iii) the description of the relationship between the Tier II Finder and the issuer, including any affiliation, (iv) 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, (v) any material conflicts of interest resulting from the arrangement or relationship between the Tier II Finder and the issuer and (vi) 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. The Notice proposes to allow a Tier II Finder to provide such disclosure orally, provided that the oral disclosure is supplemented by written disclosure and satisfies all of the disclosure requirements listed above no later than the time of any related investment in the issuer's securities.
4 The Notice defines "terms of the offering" as the amount of securities offered, the nature of the securities, the price of the securities and the closing date of the offering period.
5 See Paul Anka, SEC Staff No-Action Letter (Jul. 24, 1991).
6 See Brumberg, Mackey & Wall, P.L.C., SEC Staff No-Action Letter (May 17, 2010).
7 See Roland Berger Strategy Consultants, SEC Staff No-Action Letter (May 28, 2013).
8 See M&A Brokers, SEC Staff No-Action Letter (Jan. 31, 2014) (M&A Broker Letter).
9 FINRA Rule 2040, Payments to Unregistered Persons.
10 15 U.S.C. § 78cc(b).
11 Id. at § 78t(a).
13 U.S. Department of Treasury, A Financial System that Creates Economic Opportunities: Capital Markets (Oct. 2017).
14 See Regulating in the Dark: What We Don't Know About Finders Can Hurt Us, Commissioner Allison Herren Lee; Statement on Proposed Exemptive Relief for Finders, Commissioner Caroline A. Crenshaw.
15 SeeInvestment Adviser Advertisements; Compensation for Solicitations, Release No. IA-5407 (Nov. 4, 2019), 84 FR 67518 (Dec. 20, 2019).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.