Over the years I have written many times about exemptions to the broker-dealer registration requirements for entities and individuals that assist companies in fundraising and related services (see, for example: HERE). Finally, after years of advocating for SEC guidance on the topic, the SEC has proposed a conditional exemption for finders assisting small businesses in capital raising. The proposed exemption will allow for the use of finders to assist small businesses in raising capital from accredited investors.
In its press release announcing the proposal, SEC Chair Clayton acknowledged the need for guidance, stating, “[T]here has been significant uncertainty for years, however, about finders’ regulatory status, leading to many calls for Commission action, including from small business advocates, SEC advisory committees and the Department of the Treasury. If adopted, the proposed relief will bring clarity to finders’ regulatory status in a tailored manner that addresses the capital formation needs of certain smaller issuers while preserving investor protections.”
Separately, New York has recently proposed a new finder’s exemption, joining California and Texas, who were early in creating exemptions for intra-state offerings. Also, I have received several inquiries lately on the topic of non-U.S. finders in the Regulation S context. This seems a good time to address it all. In Part I of this blog, I will review the new SEC proposal and in Part II the state law exemptions and Regulation S framework.
Introduction
Most if not all small and emerging companies are in need of capital but are often too small or premature in their business development to attract the assistance of a banker or broker-dealer. In addition to regulatory and liability concerns, the amount of a capital raise by small and emerging companies is often small (less than $5 million) and accordingly, the potential commission for a broker-dealer is limited as compared to the time and risk associated with the transaction. Most small and middle market bankers have base-level criteria for acting as a placement agent in a deal, which includes the minimum amount of commission they would need to collect to become engaged. In addition, placement agents have liability for the representations of the issuing company and fiduciary obligations to investors.
As a result of the need for capital and need for assistance in raising the capital, together with the inability to attract licensed broker-dealer assistance, a sort of black market industry has developed, and it is a large industry. Despite numerous enforcement actions against finders in recent years, neither the SEC, FINRA nor state regulators have the resources to adequately police this prevalent industry of finders.
In its proposal the SEC recognizes this cottage industry, stating finders “often 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 SEC goes further recognizing that the lack of regulation makes it very difficult, noting that “companies that want to play by the rules struggle to know in what circumstances they can engage a ‘finder’ or a platform that is not registered as a broker-dealer.” The SEC gives a nod to the numerous calls for action over the years, including the ABA’s 2005 report, the SEC Advisory Committee on Small and Emerging Companies and the U.S. Treasury report (see links to discussions under Additional Reading on Finders).
I have advocated in the past for a regulatory framework that includes (i) limits on the total amount finders can introduce in a 12-month period; (ii) antifraud and basic disclosure requirements that match issuer responsibilities under registration exemptions; and (iii) bad-actor prohibitions and disclosures which also match issuer requirements under registration exemptions. Although the exemptive order does have bad actor prohibitions it does not have a cap on the amount of the raise, and other than as related to the finder and his/her compensation, does not require specific disclosures.
Although I think the proposal is a much needed step towards regulating finders, there are two aspects of the exemption that I have trouble with. The first is limiting the exemption to natural persons. Many natural persons operate through personal business entities such as an LLC or S corporation for valid business reasons including tax and estate planning.
The second is making the exemption unavailable for companies that are subject to the Exchange Act reporting requirements. The SEC reasons that once a company is able to file reports under the Exchange Act it is more likely able to attract a licensed broker dealer and would not need an unlicensed finder. The SEC indicates that non-reporting companies are more likely to experience difficulty obtaining the assistance of a broker-dealer, and are therefore most likely to need the assistance of a finder. I completely disagree with this reasoning as a basis for limiting the exemption.
Certainly the SEC reasoning may be true in some cases, but many broker-dealers will not work with small public companies, and many are simply prohibited from doing so. For instance Bank of America, and their brokerage, Merrill Lynch, will not transact business in the securities of companies with less than a $300 million market cap and less than a $5.00-per-share stock price (see HERE). Even many of the smaller tier brokerage firms that I deal with on a daily basis will not assist with a capital raise for an OTC Markets traded security unless the raise is a public offering in conjunction with an up-listing to a national exchange. Many of these brokerage firms clear through a clearing firm who in turn will not allow them to transact business with an OTC Markets issuer. Even those that will work with these smaller public companies, generally will not do so for a private capital raise, but rather will only work on public registered offerings.
If the SEC’s argument is based on need, then there is a large group of small public companies that have a palpable need for assistance with exempt offering capital raising efforts that will be left unfulfilled. Exempt offerings are smaller than registered offerings. Even if a small company can attract a broker-dealer for a private capital raise, the commissions, expense reimbursement and fees are generally extremely high and the agreements generally include strong rights of first refusal (ROFR rights) and other provisions that can make the cost of capital unfeasible. Further, knowing that by becoming subject to the SEC reporting requirements, the ability to use finder’s will be foreclosed, many of these companies may delay a going public transaction, which in and of itself is contrary to the SEC’s stated policies of encouraging public offerings and access to U.S. capital markets (see for example HERE).
Furthermore, one of the SEC’s core missions is the protection of investors. Companies that are subject to the Exchange Act reporting requirements are audited by independent auditors and required to comply with Sarbanes Oxley Act Rule 404(a) requiring the company to establish and maintain internal controls over financial reporting and disclosure control and procedures and have their management assess the effectiveness of each. These companies are subject to robust disclosure requirements delineated by Regulation S-K and financial disclosure requirements under Regulation S-X. Clearly, investors have much greater protections with the use of finders on behalf of a reporting company than a small private company.
Proposed Federal Finder’s Exemption
Background
Registered broker-dealers are subject to comprehensive regulation under the Exchange Act and under the rules of each self-regulatory organization (“SRO”) of which the broker-dealer is a member, such as FINRA, the NYSE and Nasdaq. Section 3(a)(4) of the Exchange Act defines a “broker” as “any person engaged in the business of effecting transactions in securities for the account of others.” Section 15(a)(1) of the Exchange Act, in turn, makes it unlawful for any broker to use the mails or any 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 that broker is registered with the SEC. Accordingly, absent an available exception or exemption, a person engaged in the business of effecting transactions in securities is a broker required to register with the SEC.
Periodically the SEC updates its Guide to Broker-Dealer Registration explaining in detail the rules and regulations regarding the requirement that individuals and entities that engage in raising money for companies must be licensed by the SEC as broker-dealers. The Guide clearly includes “finders” and in particular:
Each of the following individuals and businesses is required to be registered as a broker if they are receiving transaction-based compensation (i.e., a commission):
- “finders,” “business brokers,” and other individuals or entities that engage in the following activities:
- Finding investors or customers for, making referrals to, or splitting commissions with registered broker-dealers, investment companies (or mutual funds, including hedge funds) or other securities intermediaries;
- Finding investment banking clients for registered broker-dealers;
- Finding investors for “issuers” (entities issuing securities), even in a “consultant” capacity;
- Engaging in, or finding investors for, venture capital or “angel” financings, including private placements;
- Finding buyers and sellers of businesses (i.e., activities relating to mergers and acquisitions where securities are involved);
From a legal perspective, determining whether a person must be registered requires an analysis of what it means to “effect any transactions in” and to “induce or attempt to induce the purchase or sale of any security.” It is precisely these two phrases that courts and commentators have attempted to flesh out, with inconsistent and uncertain results. Despite the inconsistent results, key considerations have included: (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 for selling the investments.
The SEC has now proposed to issue an exemptive order, not a rule change, which would provide exemptive relief to allow a natural person to engage in certain defined activities without registration as a broker dealer. The exemption is in the form of a non-exclusive safe harbor and accordingly even if the parameters of the safe-harbor are not met, the traditional facts and circumstances analysis could still support that a person did not need to register as a broker dealer for specific activities.
Proposed Exemption
The SEC proposal creates two classes of finders, both of which would allow a natural person (not an entity) to accept transaction-based fees for assisting with capital raising. A Tier I finder would be limited to providing contact information for potential investors and, as such, would not be able to have any direct contact with the investor. A Tier I finder could only assist a single company in a 12-month period.
A Tier II finder may (i) identify, screen and contact potential investors; (ii) distribute offering materials to investors; (iii) discuss company information including about the offering but may not provide advice on valuation or the advisability of making an investment; and (iv) arrange or participate in meetings with the company and investor. A Tier II finder is subject to certain disclosure requirements, including as to their role and compensation, and must obtain a written dated disclosure acknowledgement from the investor prior to any investment solicitation.
Regardless of the Tier, a finder could not (i) be involved in structuring the transaction or negotiating the terms of the offering; (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 investment.
Further, both Tiers of the proposed finder’s exemption are subject to the following conditions:
(i) the issuer cannot be required to file reports under the Exchange Act;
(ii) the issuer must be relying on a valid Securities Act registration exemption (such as Regulation D or Regulation A);
(iii) the finder cannot engage in general solicitation (the exemptive order does not specify if the issuer itself can engage in general solicitation but the finder cannot and in practice it may be difficult to maintain a clear line evidencing that the investors introduced by the finder did not learn of the offering through general solicitation if the issuer is doing so);
(iv) the investor must be accredited;
(v) the finder must have a written agreement with the issuer, including scope of services and compensation;
(vi) the finder cannot be associated with a broker-dealer;
(vii) the finder could not engage in other broker-dealer activities such as facilitating a registered offering or the resale of securities; and
(vii) the finder cannot be a “disqualified person” as defined in Section 3(a)(39) of the Exchange Act.
A “disqualified person” is similar to a bad actor under the exempt offering rules (see HERE) but regulates when a person is disqualified from being a member of FINRA (i.e., a broker-dealer) or associated with a member.
A person is disqualified from being a member or associated with a member of FINRA, and if the proposal is passed, from acting as a finder, if such person:
(a) has been expelled or suspended from membership, association with or participation in FINRA or foreign equivalent (the language is very broad in covering foreign contracts, markets, regulatory organizations and the like);
(b) is subject to an order of the SEC, other appropriate regulatory authority or foreign financial regulator denying, suspending for 12 months or less, revoking or otherwise limiting registration as a broker, dealer, municipal securities dealer, government securities broker, government securities dealer, security-based swap dealer, major security-based swap participant, or foreign equivalent of any of these or being an associated person of same;
(c) is subject to an order of the CFTC denying, suspending or revoking registration;
(d) is subject to an order of a foreign financial regulatory authority denying, suspending, or revoking the ability to engage in commodities, swaps or similar businesses;
(e) by his conduct while associated with a broker, dealer, municipal securities dealer, government securities broker or dealer, security-based swap dealer, or major security-based swap participant, or while associated with an entity or person required to be registered under the Commodity Exchange Act, has been found to be a cause of any effective suspension, expulsion, or order set forth in the above paragraphs, and in entering such a suspension, expulsion, or order, the SEC, an appropriate regulatory agency, or any self-regulatory organization (FINRA) shall have jurisdiction to find whether or not any person was a cause thereof;
(f) has associated (i.e., licensed with) any person that would be disqualified; or
(g) has committed or omitted any act, or is subject to an order or finding, of willful violation of any provision of the Securities Act, the Investment Advisors Act, the Investment Company Act, the Commodity Exchange Act or the rules of the Municipal Securities Rulemaking Board or has willfully aided, abetted, counseled, commanded, induced or procured such violation; is subject to a final order of a state securities or banking commission or similar agency or federal banking agency baring participation in the securities industry or finding a violation of any law or regulation which prohibits fraud, manipulative or deceptive conduct; has been convicted of any offense specified above or any other felony within ten years of the date of the filing of an application for membership or participation in, or to become associated with a member of, a self-regulatory organization; is enjoined from any action, conduct, or practice above; has willfully made or caused to be made in any application for membership or participation in, or to become associated with a member of, a self-regulatory organization, report required to be filed with a self-regulatory organization, proceeding before a self-regulatory organization, or any foreign equivalent any statement which was at the time, and in the light of the circumstances under which it was made, false or misleading with respect to any material fact, or has omitted to state in any such application, report, or proceeding any material fact which is required to be stated therein (this paragraph is very similar to the Regulation D bad actor rules).
Additional Reading on Finders
For a general review on the law surrounding finder’s fees, including my recommendations for changes, see HERE.
For a review of the U.S. Department of the Treasury report recommending a regulatory structure for finder’s fees, see HERE.
For a review of the no-action-letter-based exemption for M&A brokers, see HERE.
For a review of the statutory exemption from the broker-dealer registration requirements found in Securities Exchange Act Rule 3a4-1, including for officers, directors and key employees of an issuer, see HERE.
To read about the American Bar Association’s recommendations for the codification of an exemption from the broker-dealer registration requirements for private placement finders, see HERE.
To learn about the exemption for websites restricted to accredited investors and for crowdfunding portals as part of the JOBS Act, see HERE.
The Author
Laura Anthony, Esq.
Founding Partner
Anthony L.G., PLLC
A Corporate Law Firm
Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker-dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions, securities token offerings and initial coin offerings, Regulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers; applications to and compliance with the corporate governance requirements of securities exchanges including Nasdaq and NYSE American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALG legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the small-cap and middle market’s top source for industry news, and the producer and host of LawCast.com, Corporate Finance in Focus. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
Ms. Anthony is a member of various professional organizations including the Crowdfunding Professional Association (CfPA), Palm Beach County Bar Association, the Florida Bar Association, the American Bar Association and the ABA committees on Federal Securities Regulations and Private Equity and Venture Capital. She is a supporter of several community charities including siting on the board of directors of the American Red Cross for Palm Beach and Martin Counties, and providing financial support to the Susan Komen Foundation, Opportunity, Inc., New Hope Charities, the Society of the Four Arts, the Norton Museum of Art, Palm Beach County Zoo Society, the Kravis Center for the Performing Arts and several others. She is also a financial and hands-on supporter of Palm Beach Day Academy, one of Palm Beach’s oldest and most respected educational institutions. She currently resides in Palm Beach with her husband and daughter.
Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.
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