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Nov 11, 2020

SEC Proposes Order to Exempt Certain Finders from Broker-Dealer Registration

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SEC PROPOSES ORDER TO EXEMPT CERTAIN FINDERS FROM BROKER-DEALER REGISTRATION

Background

On October 7, 2020, the U.S. Securities and Exchange Commission (SEC) proposed an order (the “Proposed Order”)[1] that would allow natural persons to engage in limited activities assisting issuers in raising capital without registering as a broker-dealer. Currently, a person who identifies and solicits potential investors and receives transaction-based compensation in connection with such activity may be viewed as engaging in broker-dealer activity, and accordingly, would need to register as a broker-dealer with the SEC.[2]

In the Proposed Order, the SEC notes that small businesses often seek capital through securities offerings in reliance on an exemption from registration. Finders, who identify and solicit potential investors for these offerings, often operate in a regulatory gray area. The Proposed Order seeks to clarify that finders can, under certain circumstances, solicit investors without registration as a broker-dealer.

The Proposed Order creates two classes of finders: Tier I Finders and Tier II Finders. Each class of finders would be permitted to engage in solicitation of investors without registration as a broker-dealer, subject to certain conditions.[3] These tiers are discussed in turn below.

The exemptive relief of the Proposed Order would apply solely in connection with primary offerings of non-reporting companies which offerings are exempt from U.S. securities registration requirements.[4]

There is a 30-day comment period on the Proposed Order, ending on November 12, 2020.

Tier I Finders

Under the Proposed Order, a natural person may act as a Tier I Finder by providing investor contact information to an issuer in connection with one capital raising transaction within a 12-month period, if the following seven conditions are met:

  • The issuer is not required to file reports under Section 13 or Section 15(d) of the U.S. Securities Exchange Act of 1934, as amended (“Exchange Act”);
  • The issuer seeks to conduct the offering in reliance on an exemption from registration;
  • The finder does not generally solicit investors;
  • The investors are accredited investors, as that term is defined in Rule 501 of Regulation D[5], or the finder reasonably believes that the investors are accredited investors;
  • The finder provides services pursuant to a written agreement with the issuer, where such an agreement sets forth the description of services provided by the finder and associated compensation the finder will receive;
  • The finder is not an associated person[6] 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.[7]

The Proposed Order would limit the activities of a Tier I Finder to providing the issuer with contact information of potential investors in connection with one capital raising transaction for that issuer within a 12-month period. The Proposed Order provides that a Tier I Finder who meets the above-described conditions may receive transaction-based compensation in connection with providing this contact information to the issuer.

Tier II Finders

The Proposed Order would also create a category of Tier II Finders who would be permitted to engage in a wider range of activity than Tier I Finders. The Proposed Order would permit a Tier II Finder to engage in a broader scope of solicitation-related activities, as set forth in the chart below, including contacting potential investors, distributing offering materials and discussing the issuer information contained in the same with potential investors, and arranging or participating in meetings with the investor. The Tier II Finder may not have a role in preparing the offering materials.

However, in addition to meeting the seven criteria applicable to Tier I Finders, Tier II Finders would need to satisfy certain disclosure requirements and other conditions. For example, a Tier II Finder would be required to provide the potential investor with disclosure that describes the relationship between the Tier II Finder and the issuer, any compensation the Tier II Finder will receive, and any material conflicts of interest arising from the relationship. The Tier II Finder must also provide disclosure that it is not undertaking a role that requires it to act in the investor’s best interest.[8] The disclosure must be provided prior to or at the time of the solicitation, and the investor must provide a written acknowledgement of receipt of these disclosures.[9]

The SEC warns that neither Tier I nor Tier II Finders may provide advice as to the advisability of the investment. Further, the SEC also emphasizes that Tier I and Tier II Finders are not permitted to be involved in structuring the transaction or negotiating its terms, performing any independent analysis of the offering, engaging in due diligence or handling customer funds or securities. Tier I and Tier II Finders may not rely on the exemption set forth in the Proposed Order to engage in broker-dealer activity beyond the scope of the Proposed Order, such as facilitating a registered offering, resale of securities or an offering to unaccredited investors.[10]

Scope of Permitted Activities for Finders Under the Proposed Order

The following chart sets forth a summary of the activities in which Tier I and Tier II Finders would be permitted to engage under the Proposed Order.

 

ACTIVITY

TIER I FINDER

TIER II FINDER

Providing investor contact information to an issuer

Yes

Yes

Participating in more than one capital raising transaction within a 12-month period

No

Yes

Contacting potential investors

No

Yes

Distributing offering materials and discussing those materials with investors

No

Yes

Participating in meetings with both potential investors and the issuer

No

Yes

Structuring the transaction or negotiating its terms

No

No

Performing independent analysis of the transaction

No

No

Performing due diligence

No

No

Handling customer funds and securities

No

No

Providing financing

No

No

Facilitating a registered offering

No

No

Facilitating a resale of securities

No

No

Contacting non-accredited investors

No

No

Providing advice as to the valuation or advisability of the investment

No

No

 

Conclusion

The SEC notes that the Proposed Order would provide issuers with greater access to capital and potential investors. There is a 30-day comment period on the Proposed Order, ending on November 12, 2020. Shearman & Sterling LLP will closely monitor these developments.

Footnotes

[1]  See SEC Release No. 34-90112.
[2]  See Shearman & Sterling LLP, SEC Charges Asset Manager for Finder’s Broker-Dealer Registration Failure. See also SEC Denial of No-Action Request re: Brumberg, Mackey & Wall, P.L.C (May 17, 2010) and SEC Denial of No-Action Request re: Hallmark Capital Corporation (June 11, 2007).
[3]  See SEC, SEC Proposes Conditional Exemption for Finders Assisting Small Businesses with Capital Raising.
[4]  See SEC, Finders Proposed Exemptive Order: Overview Chart of Tier I Finders, Tier II Finders and Registered Brokers.
[5]  17 CFR § 230.501. Accredited investor means “any person who comes within any of the following categories, or who the issuer reasonably believes comes within any of the following categories, at the time of the sale of the securities to that person:

(1) Any bank as defined in section 3(a)(2) of the Act, or any savings and loan association or other institution as defined in section 3(a)(5)(A) of the Act whether acting in its individual or fiduciary capacity; any broker or dealer registered pursuant to section 15 of the Securities Exchange Act of 1934; any insurance company as defined in section 2(a)(13) of the Act; any investment company registered under the Investment Company Act of 1940 or a business development company as defined in section 2(a)(48) of that Act; any Small Business Investment Company licensed by the U.S. Small Business Administration under section 301(c) or (d) of the Small Business Investment Act of 1958; any plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5,000,000; any employee benefit plan within the meaning of the Employee Retirement Income Security Act of 1974 if the investment decision is made by a plan fiduciary, as defined in section 3(21) of such act, which is either a bank, savings and loan association, insurance company, or registered investment adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited investors;

(2) Any private business development company as defined in section 202(a)(22) of the Investment Advisers Act of 1940;

(3) Any organization described in section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;

(4) Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer;

(5) Any natural person whose individual net worth, or joint net worth with that person's spouse, exceeds $1,000,000.

(i) Except as provided in paragraph (a)(5)(ii) of this section, for purposes of calculating net worth under this paragraph (a)(5):

(A) The person's primary residence shall not be included as an asset;

(B) Indebtedness that is secured by the person's primary residence, up to the estimated fair market value of the primary residence at the time of the sale of securities, shall not be included as a liability (except that if the amount of such indebtedness outstanding at the time of sale of securities exceeds the amount outstanding 60 days before such time, other than as a result of the acquisition of the primary residence, the amount of such excess shall be included as a liability); and

(C) Indebtedness that is secured by the person's primary residence in excess of the estimated fair market value of the primary residence at the time of the sale of securities shall be included as a liability;

(ii) Paragraph (a)(5)(i) of this section will not apply to any calculation of a person's net worth made in connection with a purchase of securities in accordance with a right to purchase such securities, provided that:

(A) Such right was held by the person on July 20, 2010;

(B) The person qualified as an accredited investor on the basis of net worth at the time the person acquired such right; and

(C) The person held securities of the same issuer, other than such right, on July 20, 2010.

(6) Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;

(7) Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in § 230.506(b)(2)(ii); and

(8) Any entity in which all of the equity owners are accredited investors.”

[6]  Pursuant to FINRA Rule 1011, an “associated person” means: (1) a natural person registered under FINRA rules; or (2) a sole proprietor, or any partner, officer, director, branch manager of the Applicant, or any person occupying a similar status or performing similar functions; (3) any company, government or political subdivision or agency or instrumentality of a government controlled by or controlling the Applicant; (4) any employee of the Applicant, except any person whose functions are solely clerical or ministerial; (5) any person directly or indirectly controlling the Applicant whether or not such person is registered or exempt from registration under the FINRA By-Laws or FINRA rules; (6) any person engaged in investment banking or securities business controlled directly or indirectly by the Applicant whether such person is registered or exempt from registration under the FINRA By-Laws or FINRA rules; or (7) any person who will be or is anticipated to be a person described in (1) through (6) above.

[7]  See SEC Release No. 34-90112.

[8]  Finders that comply with the requirements of the proposed exemption would not be subject to broker-dealer sales practice rules, including Regulation Best Interest. For a discussion of Regulation Best Interest, please see Shearman & Sterling LLP, Raising the Bar: SEC Adopts Broker-Dealer Standard of Care and Guidance on Investment Advisers’ Fiduciary Standard

[9]  See SEC Release No. 34-90112.

[10]  Id.

Authors and Contributors

Russell Sacks

Partner

Financial Institutions Advisory & Financial Regulatory

+1 212 848 7585

+1 212 848 7585

New York

Jennifer D. Morton

Partner

Financial Institutions Advisory & Financial Regulatory

+1 212 848 5187

+1 212 848 5187

New York

Steven Blau

Associate

Financial Institutions Advisory & Financial Regulatory

+1 212 848 8534

+1 212 848 8534

+1 416 360 2154

+1 416 360 2154

New York

Jenny Ding Jordan

Associate

Financial Institutions Advisory & Financial Regulatory

+1 212 848 5095

+1 212 848 5095

New York

P. Sean Kelly

Associate

Financial Institutions Advisory & Financial Regulatory

+1 212 848 7312

+1 212 848 7312

New York

Taylor Pugliese

Associate

Financial Institutions Advisory & Financial Regulatory

+1 212 848 7294

+1 212 848 7294

New York