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In brief

In a significant regulatory action, the US Securities and Exchange Commission (SEC) recently proposed to issue an order granting certain “finders” a conditional exemption from broker-dealer registration in connection with capital raising activities in private markets (“Finders Proposal“). The Finders Proposal seeks to address the long-standing regulatory uncertainty surrounding the status of intermediaries in the private capital-raising markets and to encourage investment in small businesses, which disproportionally rely on finders to locate capital. The proposed exemption would allow natural persons to engage in certain limited activities involving accredited investors without registering with the SEC as brokers under the Securities Exchange Act of 1934 (“Exchange Act“).


Background

Section 15(a)(1) of the Exchange Act makes it unlawful for any broker or dealer 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 or dealer is registered with the SEC in accordance with Section 15(b) of the Exchange Act. 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 accounts of others.” Persons or firms engaging in broker-dealer activity without registration are subject to SEC enforcement actions, including civil monetary penalties and disgorgement. In addition, each state also oversees its own securities laws, and in the event of failure to register as a broker or dealer at the state level, the parties to a transaction may have a right of rescission under the relevant state securities laws.

The SEC has historically taken an expansive view of the broker-dealer registration requirement. SEC guidance (virtually all of which is reflected in the grant or denial of “no action” requests or in enforcement cases) suggests that broker registration of “finders” has been required where the finder, among other things, (i) was involved in the solicitation, negotiation or execution of an investment transaction, (ii) received transaction-related compensation, or (iii) handled the securities or funds in connection with the transaction. Of the factors considered in determining broker status, the most significant, in the view of the SEC staff, is the receipt of success fees or transaction-related compensation. Receipt of transaction-related compensation suggests to the SEC that the recipient has a “salesman’s stake” in a securities transaction and, therefore, should operate in a manner consistent with customer protection standards governing broker-dealers.[1]

The Finders Proposal is not the first time that the SEC has enabled non-registered persons to act as brokers. In 2014, the SEC liberalized the treatment of non-registered persons in the context of an M&A transaction involving the sale of a business. In a staff no-action letter, relief was granted from broker-dealer registration requirements in the limited context of an M&A Broker that facilitates the purchase or sale of a complete or controlling interest in a privately held company (“M&A Letter“).[2]

According to the M&A Letter, enforcement action would not be recommended under Section 15(a) of the Exchange Act against an unregistered M&A Broker that effects securities transactions in connection with the transfer of ownership of a privately held company and receives transaction-based compensation, under certain specific circumstances. The SEC staff held that registration would not be required, provided the M&A Broker met several requirements based on representations made by the persons requesting the relief. Notably, the relief afforded in the M&A Letter is limited solely to activity that fits precisely within the narrow facts and circumstances outlined in the letter. As a result, persons engaged in general finder activity continued to be at risk of being deemed unregistered broker-dealers subject to enforcement action and rescission claims.

In another example of relaxing registration requirements, Title II of the JOBS Act of 2012 provides an exemption from broker-dealer registration for “Regulation D Portals.” Under Section 4(b) of the Securities Act, a person can offer and sell securities in compliance with Rule 506 of Regulation D under the Securities Act without becoming subject to registration as a broker or dealer where certain conditions are met. However, in contrast to the Finders Proposal, the person acting as a Regulation D Portal, and each person associated with that person, may not receive compensation in connection with the purchase or sale of securities effected through the portal.

The proposed exemption, if adopted, would result in a significant expansion of the situations in which finders would be permitted to receive success or transaction-related fees in connection with private investments.

Takeaways

  • While a variety of “business brokers” already appear comfortable that they can rely on the existing M&A no-action relief, particularly when they are working with small private companies in connection with a potential sale of the business, the new Finders Proposal could benefit additional types of intermediaries in capital-raising transactions. Indeed, the proposal appears to allow unregistered intermediaries to engage in more general private placement activity (e.g., sales of private funds or sales of shares). As a result, although the proposal is ostensibly designed to help small businesses raise capital, it would seemingly pave the way for more unregistered placement agents to engage in capital raises for private equity funds and similar alternative investments (at least in Tier II).
  • While the proposal would permit greater unregistered finder activity, it does not address state registration requirements, which Chair Jay Clayton acknowledged in his statement at the open meeting on the proposal. In this regard, in addition to federal broker-dealer registration requirements, US states have their own regulatory regimes (commonly known as state “blue sky laws”) that separately contemplate broker-dealer registration at the state level and diverge in certain respects from the federal scheme. Tier I and Tier II Finders would still need to be mindful of state-level broker-dealer registration requirements. As noted above, if such an intermediary fails to register as a broker-dealer at the state level, the parties to a transaction involving a sale of securities may have a right of rescission under the relevant state blue sky law.
  • There is a short 30-day comment period, not 60 days as would be expected for a significant SEC regulatory action. This could be due to both the uncertain political environment and Chair Clayton’s likely departure from the SEC at the end of the year. Moreover, given the fact that the proposal was approved in a 3 to 2 SEC vote, it is unclear how the proposal would fare in the event that there is a change in administration resulting from the November 2020 election.
  • The proposal comes on the heels of the SEC expanding the definition of “accredited investor” in August 2020. The SEC designed these complementary actions to create more access to private capital.
  • Under the proposal, exempt finder activity would not be subject to Regulation Best Interest (“Reg BI“). This is noteworthy, as accredited investors that are natural persons can be “retail customers” under Reg BI and be entitled to its protections if the activity involved a recommendation made by a registered broker-dealer.

Proposal overview

The proposed exemptive order, if issued, would create two classes of finders — Tier I Finders and Tier II Finders. Finders that comply with the conditions of the exemption applicable to their tier may receive transaction-based compensation for services associated with their tier without being required to register as a broker under Section 15(a) of the Exchange Act. Tier I Finders would only be allowed to provide contact information for potential investors to issuers for a single capital raising in a 12-month period. Tier II Finders would be permitted to engage in additional solicitation activities on behalf of an issuer as follows:

  1.  identifying, screening and contacting potential investors
  2. distributing issuer offering materials to investors
  3. discussing issuer information included in any offering materials, provided that the Tier II Finder does not provide advice regarding the valuation or advisability of the investment
  4. arranging or participating in meetings with the issuer and investor

The proposal sets several conditions for capital raising scenarios in which the exemption for Tier I and Tier II Finders would be available:

  1. the issuer is not required to file reports under Section 13 or Section 15(d) of the Exchange Act
  2. the issuer is conducting the capital raising in reliance on an applicable exemption from registration under the Securities Act of 1933
  3. the finder does not engage in general solicitation
  4. 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”
  5. the finder provides services pursuant to a written agreement with the issuer that includes a description of the services provided and associated compensation
  6. the finder is not an associated person of a broker-dealer
  7. 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 their participation

Given that they would be allowed to engage in a wider array of activities, the Finders Proposal sets forth additional disclosure requirements on Tier II Finders. The purpose of these disclosures would be to increase investor awareness of the scope of the Finder’s relationship with the issuer and any potential conflicts of interest, and thereby facilitate better-informed investment decisions. Tier II Finders would need to disclose to a potential investor, prior to or at the time of solicitation:

  1. the name of the Tier II Finder;
  2. the name of the issuer;
  3. the description of the relationship between the Tier II Finder and the issuer, including any affiliation;
  4. a statement that the Tier II Finder will be compensated for his or her solicitation activities by the issuer and a description of the terms of such compensation arrangement;
  5. any material conflicts of interest resulting from the arrangement or relationship between the Tier II Finder and the issuer; and
  6. an affirmative statement that the Tier II 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.

[1] See, e.g., 1st Global, SEC No-Action Letter (7 May 2001); Herbruck, Alder & Co., SEC No-Action Letter (4 June 2002).

[2] See, M&A Brokers, SEC No-Action Letter (31 January 2014).

Author

Jennifer Connors is a partner in Baker McKenzie's Financial Regulation and Enforcement Practice Group. She represents broker-dealers, investment advisers, alternative trading systems (ATSs), private fund managers, financial technology (FinTech) companies and other market participants on securities law and market regulation matters.

Author

Mark is a Senior Counsel in Baker and McKenzie's North American Financial Regulation and Enforcement Practice, which provides clients with a full range of regulatory and compliance advice and enforcement counseling. Previously, Mark has served as a Partner in another international law firm and as an Associate Director in the Securities and Exchange Commission's Division of Trading and Markets (formerly Market Regulation) and Office of Compliance Inspections and Examinations, where he was responsible for the inspection and oversight of the nation's stock and options markets and for nationwide coordination of the SEC's broker-dealer and transfer agent examination programs.

Author

Jonathan Hoffman is an associate in Baker McKenzie’s North American Financial Regulation and Enforcement Practice, which provides our clients with a full range of regulatory advice and enforcement counseling. Jonathan is Certified Information Privacy Professional (IAPP-certified CIPP/US) and a Legal Lean Sigma® Yellow Belt recipient.