By Robert Loesch and Glenn Morrical

In 2012 when we last addressed the question of “finders” in our Client Advisory, “Finders’ Fees: Forklore and Fact on Regulation,” we said:

In the course of advising clients and reviewing proposed “finder” engagement agreements, we often hear folklore, or possibly wishful thinking, about the laws that apply to using agents to raise capital. This folklore typically takes the form of “finders” (i.e., persons who raise capital for a fee) and issuers (i.e., companies raising money), and assumes that the regulation of securities broker-dealers does not apply where a party seeking debt or equity funds hires a finder to introduce investors to the issuer. … As is almost always the case, this folklore is incorrect. Confusion as to the law in these situations is dangerous for all parties to the transaction, including the issuer, the finder, and in certain instances, the investor.

Good news: The SEC now proposes to bring some clarity to the issue. In early October 2020, the SEC voted 3-2 to propose a conditional exemption in certain situations to address the question of who can act as a “finder” not required to register as a broker-dealer under Section 15 of the Securities Exchange Act of 1934. The SEC’s 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 can be found here.

The proposed exemption is designed to help small businesses that face difficulties raising the capital they need to grow and thrive, especially when they are located in places that lack established, robust capital-raising networks. These smaller companies primarily use the exempt offering rules to access capital needed to create jobs and scale their businesses. For many smaller businesses, the private placement market is their only viable alternative to raise growth capital. SEC Chairman Clayton explained, “[i]n these areas, ‘finders’ can play an important and discrete role in bridging the gap between small businesses that need capital and investors who are interested in supporting emerging enterprises. … The current patchwork of staff guidance and no-action letters in this area has not provided needed clarity, and the time for Commission action is overdue.”

The proposed conditional exemption would allow a natural person to act as a “finder” for non-reporting issuers in an exempt private offering made to accredited investors without registering as a broker-dealer under the Exchange Act. In addition, if the conditions of the exemption are met, in contrast to current and previous interpretations, finders would be permitted to receive transaction-based compensation.

Historically, practitioners have relied on a combination of SEC staff no-action letters and court decisions in advising clients on the question of whether a person helping an issuer raise funds was required to register as a broker-dealer. One of the key determinative factors in the required facts and circumstance analysis was the question of whether the finder’s compensation was tied to a successful capital raise. The SEC staff had taken the position that “the receipt of compensation directly tied to successful investments in [the issuer’s] securities by investors introduced to [it] by [the finder] (i.e., transaction-based compensation) would give [the finder] a ‘salesman’s stake’ in the proposed transactions and would create heightened incentive for [the finder] to engage in sales efforts” requiring broker-dealer registration.

The statute, on its face, is relatively simple. A “broker” means any person in the business of effecting transactions in securities for the accounts of others. If a person is compensated, either directly or indirectly, in connection with his or her participation in a securities transaction, that person is likely a broker and subject to the filing requirements and regulations under the Exchange Act and, potentially, state laws regulating securities brokers. Section 15(a) of the Exchange Act provides that it is unlawful for any unregistered broker or dealer to effect any transaction in, or to induce or attempt to induce the purchase or sale of, any security.

The proposed exemption provides welcome regulatory clarity to the question of whether a “finder” is required to register as a broker. It creates two types of finders – Tier I and Tier II. Tier I finders would be limited to providing issuers with the contact information of potential investors for a single capital raise in a 12-month period. Tier II finders also would be permitted to engage in the following solicitation-related activities on behalf of issuers:

• identifying, screening, and contacting potential investors
• distributing issuer offering materials to investors
• 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
• arranging or participating in meetings with the issuer and investor

Both Tier I and Tier II finders would be subject to conditions:

• the issuer is not required to file 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 Securities Act
• the finder does not engage in general solicitation
• the potential investor is an “accredited investor” as defined in Rule 501 of Regulation D (or the finder has a reasonable belief that the 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
• the finder is not subject to certain statutory disqualifications

Under the proposed exemption a finder could not:

• be involved in structuring the transaction or negotiating the terms of the offering
• handle customer funds or securities or bind the issuer or investor
• participate in the preparation of any sales materials
• perform any independent analysis of the sale
• engage in any “due diligence” activities
• assist or provide financing for such purchases
• provide advice as to the valuation or financial advisability of the investment

In addition, Tier II finders would be required to provide a potential investor, prior to or at the time of the solicitation, disclosures that include: (1) the name of the Tier II finder; (2) the name of the issuer; (3) the description of the relationship between the Tier II finder and the issuer, including any affiliation; (4) 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; (5) any material conflicts of interest resulting from the arrangement or relationship between the Tier II finder and the issuer; and (6) 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. A 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 required disclosures.

We welcome the SEC’s evolution on the “finder” question, albeit limited as described above. Other federal securities laws continue to apply to provide investor protection, such as the general anti-fraud rule (Rule 10b-5) and the Investment Advisers Act of 1940 should a finder’s activities trigger it. Also, issuers and potential finders may be subject to state securities law. Given that two Commissioners dissented from the proposed exemption and the likelihood that it will draw many comments, both pro and con, the final exemption, if adopted, may be different from the proposal in material ways.

In the release, the SEC asked 45 questions for which it seeks input. The breadth and depth of those questions show how many issues may be in play. The comment period ends on November 7, 2020.

Unless and until a safe harbor exemption is adopted, the release serves, ironically, as a cautionary source about just what a morass this subject is today.

The SEC has provided a chart on the permitted activities of Tier I and Tier II finders. The chart can be found here.