Coronavirus Legal News

New Proposed Rule Would Give Non-Exclusive Safe Harbor from Broker Registration

January 20, 2021

On October 7, 2020, the Securities and Exchange Commission (SEC) published a rule proposal to provide a safe harbor exemption permitting an individual acting as an unregistered broker or dealer, or “finder,” to engage in capital-raising activities on behalf of smaller private companies without registering as a broker-dealer. The SEC’s proposal (Release No. 34-90112; File No. S7-13-20) aims to address concerns that have been raised by small businesses when attempting to identify “finders” to engage potential investors while raising capital. In today’s capital markets, the SEC has not previously recognized a “finders” exemption or exception, nor has the SEC provided general guidance on “finders”, other than interpretive positions taken by the SEC staff in no-action letters, prompting some to observers to refer to the use of finders as the “gray market.”

The proposed exemption provides a non-exclusive safe harbor from broker registration, consisting of two classes of finders (Tier 1 and Tier 2, as described below), with such finders complying with a number of conditions:

  • the finder may only provide capital-raising services to issuers that are not required to file reports under Section 13 or Section 15(d) of the Exchange Act (or privately-held issuers) which are seeking to conduct offerings in reliance on an applicable exemption from registration under the Securities Act of 1933;
  • the finder shall not engage in general solicitation of potential investors, and each potential investor must be 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 must enter into a written agreement with the issuer that includes a description of the services provided and associated compensation; and
  • the finder cannot be an associated person of a registered broker-dealer, as defined under Section 3(a)(18) of the Securities Exchange Act, and cannot be subject to a statutory “bad actor” industry bar or disqualification, as that term is defined in Section 3(a)(39) of the Securities Exchange Act of 1934.
The SEC’s rule proposal divides finders into two tiers – Tier 1 finder: a finder who identifies a potential investor on a very limited and passive basis; and Tier 2: a finder who is focused on the active solicitation of potential investors for securities offerings on behalf of smaller private companies.

Tier 1 Finders:
A tier 1 finder who meets the above conditions, is limited to providing contact information of potential investors in connection with only one capital-raising transaction by a single issuer within a 12-month period, provided the finder does not have any contact with the potential investors about the issuer. The contact information may include, among other things, name, telephone number, e-mail address and social media information. A tier 1 finder that complies with this limitation and the basic conditions of the proposed finders exemption may receive transaction-based compensation without being required to register as a broker-dealer.

The SEC views commissions and other success-based compensation on sales traceable to a finder’s efforts to be a significant factor in requiring broker-dealer registration. However, where a tier 1 finder’s activities are limited such that there is no opportunity or incentive to engage in the business of effecting securities transactions, the SEC appears to take the position that registration, which is intended to regulate and prevent such conduct, is not necessary.

Tier 2 Finders:
The SEC’s rule proposes a tier 2 finder’s to activities include additional solicitation-related activities beyond those permitted for tier 1 finders. A tier 2 finder, after meeting the above conditions, may: (i) identify, screen and contact potential investors, (ii) distribute issuer offering materials to investors, (iii) discuss issuer information included in the offering materials, but cannot provide advice as to the valuation or advisability of the investment, and (iv) arrange or participate in meetings with an issuer and prospective investor.

A tier 2 finder desiring to rely on the proposed tier 2 finders exemption would need to provide, either prior to or at the time of the solicitation, a potential investor with disclosures that include:
  • the name of the tier 2 finder and name of the issuer;
  • a description of the relationship between the tier 2 finder and the issuer, including any affiliation;
  • a statement that the tier 2 finder will be compensated for his or her solicitation activities by the issuer and a description of the terms of such compensation arrangement;
  • a statement of any material conflicts of interest resulting from the arrangement or relationship between the tier 2 finder and the issuer; and
  • an affirmative statement that the tier 2 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 rule proposal, this disclosure may be provided to the investor orally as long as the oral disclosure is supplemented by written disclosure and satisfies all of the disclosure requirements listed above no later than the time of an investment in the issuer’s securities. Then, the tier 2 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 finder’s required disclosures. The requirement for written disclosures and the acknowledgment can be satisfied either through paper or electronic means.

A tier 2 finder that limits its solicitation-related activities, complies with the investor disclosure obligations and follows the basic conditions of the proposed finders exemption may receive transaction-based compensation for services provided in connection with the tier 2 finders activities without being required to register as a broker-dealer.
Prohibited Activities by Finders:

The SEC’s rule proposal specifically noted a number of capital-raising activities and services in which a finder may not engage. As proposed, a finder may not:

  • structure a transaction or negotiate the terms of an offering;
  • handle customer funds or securities or bind an 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 any purchases; or
  • provide advice as to the valuation or financial advisability of an investment.
In addition, the proposed exemption is limited to activities solely in connection with primary offerings and is not applicable for a registered offering, resales of securities by existing shareholders of an issuer, or the sale of securities to investors that are not accredited investor or that the finder does not have a reasonable belief are accredited investors.

The SEC’s rule proposal concluded by noting other legal matters that apply to finders even if the safe harbor finders exemption is being followed. For example, the exemption does not affect a finder’s obligation to comply with the antifraud provisions of federal and state securities laws, and a finder may need to consider registration if it is acting as another regulated entity, such as an investment adviser.

Robert T. Smith heads the Finance and Commercial Transactions Practice Group.His diverse corporate practice focuses on representing companies and financial institutions in general business, transactional, securities and regulatory matters. 

Matthew D. Mitchell is a partner in the Mergers and Acquisitions Practice Group. Matt concentrates his practice in the areas of banking, corporate and securities, and real estate. Matt represents clients in a wide range of corporate and transactional matters, including entity formation and reorganization, corporate governance, mergers and acquisitions, securities offerings, and commercial contract drafting and negotiation. 

Taylor A. Stockemer is an associate in the firm’s Mergers & Acquisitions Practice Group where he is working with individuals, companies and financial institutions in general business, transactional and regulatory matters. 

Madeline O. McElhanon is an associate in the Finance & Commercial Transactions Practice Group where she advises banking and other corporate clients on transactional, tax, securities and regulatory matters.

Disclaimer: The information included here is provided for general informational purposes only and should not be a substitute for legal advice nor is it intended to be a substitute for legal counsel. For more information or if you have further questions, please contact one of our Attorneys.