On October 7, 2020, the SEC proposed a new rule that would exempt a “Finder” from the requirement that they register as a securities broker. Finders are the people who introduce companies to potential investors and vice versa but who are not registered with the SEC as broker-dealers. Finders play an important role in the process of raising capital because they are often the ones who introduce investors to new opportunities and help companies find investors that are a good fit.
Finders are especially important in the world of social finance, where mission alignment, patience, and a desire to generate a positive impact on society are considered extremely important to issuers (the “issuer” is the entity that is raising funds, and will issue securities to the investors in exchange for their investments).
Do Finders have to register with the SEC?
One big question is whether or not a person who acts as a Finder should be registered as a broker-dealer. The Exchange Act does not answer this question directly, but simply provides that it is unlawful for any broker or dealer to induce or attempt to induce the purchase or sale of any security unless such broker or dealer is registered with the SEC.
There is no broad-based exemption for Finders in the broker-dealer registration rules, the federal securities laws, or SEC guidance. As a result, Finders are in a kind of legal limbo. If a Finder engages in any of the many activities that require registration as a broker-dealer, they are violating federal securities laws. If they don’t register, the permissible scope of their activities is strictly limited.
Finder vs. Broker
Under federal securities law, a broker is defined as “any person engaged in the business of effecting transactions in securities for the accounts of others.” That’s pretty broad. By contrast, a Finder is only loosely defined as a “natural person who assists issuers with raising capital in private markets from accredited investors.” That’s also pretty broad. Since the two definitions overlap, the distinction between Finder and broker can be difficult to make. In a transaction that has been facilitated by a Finder, this uncertainty creates risk.
SEC guidance over the years indicates the factors which point to registration:
Receiving 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 the solicitation of potential investors.
Providing advice or engaging in negotiations.
Having a previous history of broker or securities sales experience or a history of disciplinary action relating to the same.
The Proposed Safe Harbor Rule
The proposed rule would partially resolve the uncertainty by creating a “safe harbor” for Finders to operate legally within certain parameters. It would have the effect of clarifying Finders' status under securities law, making it easier (and less risky) for social investors to use unregistered intermediaries to identify good investment opportunities.
The proposed safe harbor for Finders would only be available where:
The issuer is conducting the securities offering pursuant to an 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 issuer is not required to file reports under Section 13 or Section 15(d) 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, at the time of his or her participation.
Two Tiers of Finders
The proposed rule would create two tiers of finders:
Tier 1 Finders would be limited to providing contact information of potential investors in connection with only a single capital raising transaction by a single issuer in 12 months. A Tier I Finder could not have any contact with potential investors about the issuer.
Tier II Finders would be permitted more active involvement in fundraising. They would be allowed to solicit investors on behalf of an issuer, so long as their solicitation-related activities are limited to (i) identifying, screening, and contacting potential investors; (ii) distributing offering materials to investors; (iii) discussing information included in any offering materials (provided 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.
However, Tier II Funders are subject to additional restrictions. A Tier II Finder needs to satisfy certain disclosure requirements and other conditions. These disclosure requirements, which include a requirement that the Tier II Finder disclose its role and compensation to the issuer, must be made in writing before or at the time of the solicitation. Further, the Tier II Finder must obtain from the investor, before or at the time of any investment in the issuer’s securities, a dated written acknowledgment of receipt of the required disclosures. This certification will certainly become a standard part of any deal where a Finder is involved.
There are a number of conditions that apply to both tiers of Finders. For example, a Finder cannot:
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; (vi) assist or provide financing for such purchases; or (vii) provide advice as to the valuation or financial advisability of the investment.
Facilitate 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 reasonably believe to be accredited investors.
To avoid misinterpretation, the proposed rules are explicit in saying that the proposed safe harbor does not permit Finders to engage in activities that require registration as a broker-dealer. In other words, registration is still preferable for people who regularly facilitate fundraising.
Safe Harbor Take-Aways
For social entrepreneurs, who often depend on networks and “introducers” to find investors, the safe harbor created by this rule would ease their path by removing some uncertainly about whether these matchmaking arrangements are proper. It would also make it easier for social investors to find good investment opportunities using a wide range of contacts without concern. The self-certification requirement will mean slightly higher compliance costs for Finders and their clients to offset the reduction in business risk.
The SEC notice announcing the new proposal is available to read. Please note that this is only a proposed rule and it may change before being finalized – if it is ever finalized.
For more information, contact Bromberger Law to discuss and learn more about how to use this new rule for your capital-raising advantage.
© 2020 Allen R. Bromberger