Written by Mark Hiraide and Travis Jeffries
Ever since the enactment of the Securities Exchange Act of 1934 (the “Exchange Act”), the practice of compensating a so-called “finder” of investors has been risky – it exposed both the finder and the company to whom the finder introduced investors to draconian rescission liability, unless the finder was registered as a broker with the U.S. Securities and Exchange Commission (the “SEC”). However, earlier this month the SEC proposed an order which would, if adopted, exempt a finder from registering as a broker in order to be paid a commission when assisting private companies and private funds raise capital from accredited investors. The proposal is intended to assist small businesses, particularly for businesses located in places that lack established, robust capital raising networks, by increasing their access to capital (through finders) while preserving appropriate investor protections.
Two Types of Exempt-Eligible Finders and Conditions They Must Satisfy.
The proposal would create two classes of finders that would be exempt from registering as brokers in order to be paid a commission, but such finders are subject to conditions tailored to the scope of their respective activities.
- Tier I Finders. A Tier I finder would only be permitted to provide a list of potential investors and their contact information in connection with only one capital raising transaction by a single issuer in a 12 month period. The Tier I finder cannot have contact or communicate with any of those potential investors about the issuer or the investment opportunities.
- Tier II Finders. A Tier II finder would be permitted to engage in a wide range of activity that the SEC has long held constitutes broker activity. The 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.
Further, a Tier II finder would need to provide a potential investor, prior to or at the time of the solicitation, detailed disclosures about the finder arrangement. These disclosure requirements include: (i) the name of the finder and issuer; (ii) a description of the relationship between the finder and issuer, including any affiliation; (iii) a statement that the finder will be compensated for his or her solicitation activities by the issuer and a description of the terms of the compensation arrangement; (iv) any material conflicts of interest resulting from the arrangement or relationship between the finder and the issuer; and (v) the fact that the 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. Under the proposed order, the finder could provide these disclosures orally as long as it is supplemented with written disclosure, through paper or electronic means, prior to the investment itself. A Tier II finder must also obtain from the investor a dated written acknowledgement of disclosure prior to the investment.
Narrowly-Tailored Conditions In Order To Qualify for Exemption.
Both Tier I and Tier II finders would be exempted only where:
- The issuer is not a public company, i.e., 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 of 1933 (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; 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.
Activities that are Not Exempted.
The proposed order does not permit a finder to perform the following activities (i.e., a finder would need to register with the SEC as a broker in order to perform the following activities):
- Solicit investors on behalf of an issuer;
- Structure the transaction or negotiate 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; or
- Provide advice as to the valuation or financial advisability of the investment.
What About State Law?
It is important to note that nothing in the proposed exemption excuses compliance with all other applicable laws, including the antifraud provisions of the Securities Act and the Exchange Act and state law. If a state law does not provide an exemption and requires a broker-dealer to register with the state in order to conduct a securities business, then the broker-dealer must still comply with that state requirement and the SEC’s proposed exemption does not provide relief at the state level. Fortunately for finders and issuers located in California, Section 25206.1 of the California Corporations Code exempts individual finders from the broker-dealer registration requirements of California’s Corporate Securities Law of 1968 under certain circumstances, including, among others, that the finder must be an individual (not an entity), the transaction must involve a sale of securities by a California issuer, the size of the offering (not just the amount raised by the finder) must be less than $15 million; and the finder must file a Statement of Information for Finder with the Department of Financial Protection and Innovation (formerly, the Department of Business Oversight). In addition, an exemption from the obligation to register as a broker-dealer does not insulate a person from the registration requirements of the Investment Advisers Act of 1940 or state law if such person is acting as an investment adviser.
Implications and Take-Aways for Finders and Issuers.
The SEC’s stated intention is to address concerns that have been raised over the years regarding the perceived inability of smaller companies to engage the services of a broker-dealer to assist with opportunities to raise capital in exempt offerings. Accordingly, a Tier I or Tier II finder that complies with all of their respective conditions of the proposed exemption may receive transaction-based compensation for the services provided in connection with the activities described herein without being required to register as a broker under Section 15(a) of the Exchange Act. Notwithstanding the foregoing, issuers and finders should keep in mind that restrictions at the state level and all other applicable laws will continue to apply.
 The contact information may include, among other things, name, telephone number, e-mail address, and social media information.