SEC Commissioners divided over “new category” for finders

January 25, 2021
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Where does this leave businesses in need of capital?

By Dave Thayer.

The trouble with finders continues and much of it is self-imposed by the Securities and Exchange Commission (SEC), which has proposed exemptive relief for unregistered finders.[1] The proposed rule, released on Oct. 7 , 2020, would provide a new limited, conditional exemption from broker registration requirements for a “finder” who assists small business issuers in private offerings to “accredited investors.”

A “finder” refers potential investors to a company issuing its own securities to raise capital, typically in connection with private offerings. The primary issue facing finders is whether they should be registered as broker-dealers under federal and state securities laws. Section 15(a)(1) of the Securities Exchange Act of 1934 provides that it is unlawful for any broker or dealer to induce or attempt to induce the purchase or sale of any security unless the broker or dealer is registered with the SEC. Given the broad nature of the broker-dealer definition, many finders do not realize when their activities trigger a registration requirement.

Current Law

The federal securities laws have no formal statutory definition of a finder and currently do not have a broad-based exemption, which is why the SEC has proposed a rule. Determining whether a finder is an unregistered broker-dealer under the Exchange Act can be difficult. The SEC and courts have developed several criteria as guidance when determining if a person should be registered as a broker-dealer.

  • Receives compensation contingent on the success of a securities transaction or based on the amount or value of a securities transaction (i.e., commissions).
  • Engaging in solicitation of potential investors.
  • Providing advice or engaging in negotiations with investors.
  • Previous history of finder or securities sales experience, activities or a history of related disciplinary problems.

To date, there have not been any hard and fast rules about how many of the above factors must be met to be deemed an unregistered broker-dealer. While no one factor is expressly more important than the others, receiving compensation contingent on the success of a securities transaction or based on the amount or value of a securities transaction is a hallmark factor as to whether a person is acting as a broker-dealer. The SEC staff’s position is that even one instance of transaction-based compensation may be enough for a finding that a person was “engaged in the business” of broker activity, and thus subject to registration.

This puts companies using a finder who is deemed an unregistered broker-dealer at risk and could give rise to several problems, the primary of which is investors may have a recission right in favor of investors under federal securities laws. If investors succeed in asserting their rescission rights, the issuer would be required to return the money it received from the investors for the purchase of its securities. This requirement could devastate a company; by the time the violation is discovered, the company may not have enough funds to return the investors’ money and there may be potential claims against the controlling persons of the company to make up any shortfall.

Likewise, finders who are found to have violated the broker-dealer registration requirement may be subject to several different penalties under federal securities laws. The most typical sanction is a temporary or permanent injunction barring the finder from participating in the purchase or sale of securities. The SEC, however, has the power to impose more severe sanctions, including disgorgement of funds and civil penalties. In addition, these actions by the SEC are generally publicly reported resulting in significant bad publicity for the finder.

The Proposed Rule

It’s been difficult to make a place for finders that provides adequate investor protection and adequate funding for businesses. This proposed rule would expand the number of finders who can engage in capital-raising activities without becoming a registered broker-dealer.

The proposal provides for two classes of “finders”, Tier I Finders and Tier II Finders. Tier I and Tier II Finders would both be permitted to accept transaction-based compensation without federally registering as a broker-dealer. Both Tier I and Tier II Finders who want to comply with the exemption are subject to various general requirements, which include but are not limited to, (i) they must be a natural person, (ii) they cannot engage in general solicitation to the public, (iii) they cannot be a “disqualified” person due to prior bad acts, such as violations of securities laws, fraud, etc., and (iv) their finder activities can only be provided to private companies performing a securities offering pursuant to certain private placement exemptions and then only to accredited investors.

Assuming the person meets the general requirements referenced above, a “Tier I Finder” is limited to providing contact information of potential investors in connection with only one capital raising transaction or offering by a single issuer within a twelve (12) month period. A Tier I Finder cannot not have any direct contact with the potential investors about the issuer.

A “Tier II Finder” who meets the general conditions referenced above and can significantly more engagement with the prospective investor, including (i) identifying, screening and contacting potential investors; (ii) distributing the company’s securities offering materials to investors; (iii) discussing the company’s 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. A Tier II Finder may also participate in more than one capital raising transaction or offering within a 12-month period. But the price for finders who want to rely upon the Tier II exemption is a requirement that  they provide significant disclosures to potential investors.

Competing Interests

The competing interests of companies accessing capital through finders and government regulation of  finders, some of whom may be unscrupulous, has divided the commissions within the SEC. Two of the five SEC commissioners publicly voiced their opposition to the proposed regulation. Commissioner Caroline A. Crenshaw calls the proposal “a radical departure from established registration requirements.”  Her public statement on the issue specifically asks what the basis is for subverting proven broker-dealer registration protocol and demands data in support of the need to expand access to capital before ruling on the proposed exemptive relief on finders.[2]

Equally opposed, Commissioner Allison Herren further sees the new “category of unregistered financial professionals” created by the proposed rule as “circumventing important economic analysis that should accompany a proposed policy shift of this significance.” Herren finds this approach would further obscure what is going on in the private markets by releasing individuals into the system to raise capital without safety protocols.[3]

After a short 30-day public comment period, the SEC is now reviewing the comments. Typically, the public comment period is for 60 days following publication of an SEC proposal. The status of the proposal under a new administration, and likely change in Chairperson of the SEC in 2021, combined with existing commission dissent, raises questions about whether this proposed regulation will be tabled or is doomed.

Unregistered finders

Practically speaking, it is difficult to act as an unregistered finder because contacts who are introduced by the finder invariably ask the finder what he or she thinks of the company, its management and the proposed investment. An explicit or tacit recommendation constitutes advice about the potential investment and triggers SEC registration requirements.

So, is there a middle ground for finders? One where businesses can raise the money they need to start or expand their businesses using networked people who can introduce business owners to investors without violating securities laws and leave investor protections intact? The trouble with finders has been a problem for decades, and it’s a problem that may continue indefinitely if the current proposal is laid to rest.

Dave Thayer, is a corporate and transaction attorney, and former CPA, who focuses on deal making as he helps clients achieve their business dreams. He can be reached at dthayer@joneskeller.com.  

 

[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, Exchange Act Release No. 90112 (Oct. 7, 2020). https://www.federalregister.gov/documents/2020/10/13/2020-22565/notice-of-proposed-exemptive-order-granting-conditional-exemption-from-the-broker-registration.

[2]  Statement on Proposed Exemptive Relief for Finders, Commissioner Caroline A. Crenshaw, Oct. 7, 2020 (https://www.sec.gov/news/public-statement/crenshaw-finders-2020-10-07).

[3]  Regulating in the Dark: What We Don’t Know About Finders Can Hurt Us, Commissioner Allison Herren Lee, Oct. 7, 2020 (https://www.sec.gov/news/public-statement/lee-proposed-finders-exemption-2020-10-07).

 

This information is not intended as legal advice. Readers should seek specific legal advice before acting with regard to the matters addressed above.