Bumblebee and flowers

SEC PROPOSES LIMITED EXEMPTIONS FOR “FINDERS”

In theory, only broker-dealers registered under section 15 of the Exchange Act are allowed to receive compensation for connecting issuers with investors. In practice, the world of private securities includes lots of folks we refer to as “finders.” Like bumblebees, these folks should be unable to fly according to the laws of physics but many plants couldn’t survive without them.

Because of the disconnect between theory and reality, industry participants have been urging the SEC for years to develop exemptions for finders.

The SEC just proposed exemptions that would allow some finders to operate legally, i.e., to receive commissions and other transaction-based compensation from issuers.

The SEC proposes two tiers of Finders 

  • Tier 1 Finders would be limited to providing the contact information of potential investors to an issuer in one offering per 12 months. A Tier I Finder couldn’t even speak with potential investors about the issuer or the offering.
  • Tier II Finders could participate in an unlimited number of offerings and solicit investors on behalf of an issuer, but only to the extent of:
    • Identifying, screening, and contacting potential investors;
    • Distributing offering materials;
    • Discussing the information in the offering materials, as long as the Funder doesn’t provide investment advice or advice about the value of the investment; and
    • Arranging or participating in meetings with the issuer and investor.

A Tier II Finder would be required to disclose her compensation to prospective investors up front – before the solicitation – and obtain the investor’s written consent.

The Limits to the Proposed Finders

  • The Finder must be an individual, not an entity.
  • The Finder must have a written agreement with the issuer.
  • The proposed exemptions apply only to offerings by the issuer, not secondary sales.
  • Public companies (companies required to file reports under section 13 or section 15(d) of the Exchange Act) may not use Finders.
  • The offering must be exempt from registration.
  • The Finder may not engage in general solicitation.
  • All investors must be accredited.
  • The Finder may not be an “associated person” of a broker-dealer.
  • The Find may not be subject to statutory disqualification.

The SEC issued an excellent graphic summarizing the proposed exemptions

Because they are entities, the typical Crowdfunding portal can’t qualify as a Finder under the SEC’s proposals. And because the proposals don’t allow general solicitation, a Finder who is an individual can’t create a website posting individual deals.

But the no-action letters to Funders Club and AngelList that kick-started the Crowdfunding industry (no pun intended) will invite many Tier 2 Finders to take their businesses online. Under the proposals and the no-action letters, it seems that a Tier 2 Finder could legally create a website offering access to terrific-but-unnamed offerings, but give investors access to the offerings only after registering and going through a satisfactory KYC process per the CitizenVC no-action letter.

A Step Forward for Crowdfunding

Many finders and issuers will jump for joy at the new proposals, while others will be disappointed that the SEC drew the line at accredited investors. In a Regulation A offering or a Rule 506(b) offering open to non-accredited investors, the law requires very substantial disclosure, especially in Regulation A. The SEC must believe that non-accredited investors are especially vulnerable to the selling pressure that might be applied by a finder.

Nevertheless, like the SEC’s proposals to expand the definition of accredited investor, the proposals about finders are a step forward.

CAUTION:  As of today these proposals are just proposals, not the law.

Using “Finders” To Sell Securities, Including Tokens

Selling securities is hard, and it makes perfect sense that an issuer or a portal would hire someone to help. And once you’ve hired someone, it also makes perfect sense business-wise to pay her a percentage of what she raises, aligning her interests with yours.

It’s perfect, but it might be illegal.

The Legal Issue

The Securities Exchange Act of 1934 generally makes it illegal for any “broker” to sell securities unless she’s registered with the SEC. The Exchange Act defines the term “broker” to mean “any person engaged in the business of effecting transactions in securities for the account of others.” That’s not a very helpful definition, but if you earn a commission from selling securities, like the helper above, you might be a broker.

So what? Well, if someone who’s a “broker” sells securities without registering with the SEC, lots of bad things can happen:

  • All the investors in the offering could have a right of to get their money back, and that right could be enforceable against the principals of the issuer.
  • The issuer could lose its exemption, g., its exemption under Regulation D.
  • By violating the securities laws, the issuer and its principals could become “bad actors,” ineligible to sell securities in the future.
  • The issuer could be liable for “aiding and abetting” a violation of the securities laws.
  • The issuer could be liable under state blue sky laws.
  • The person acting as the unregistered broker could also face serious consequences, including sanctions from the SEC and lawsuits from its customers.

What is a Broker?

Because the Exchange Act does not define what it means to be “engaged in the business of effecting transactions in securities,” the SEC and the courts have typically relied on a variety of factors, including whether the person:

  • Is employed by the issuer
  • Receives a commission rather than a salary
  • Sells securities for others
  • Participates in negotiations between the issuer and an investor, g., helps with sales presentations
  • Provides advice on the merits of the investment
  • Actively (rather than passively) finds investors

More recently, in court cases and in responses to requests for no-action letters, the SEC seems to be moving toward a more aggressive position:  that if a person receives a commission she’s a broker and must be registered as such, end of story.

So far, courts are rejecting the SEC’s hard-line approach. In a 2011 case called SEC v. Kramer, the court stated:

[T]he Commission’s proposed single-factor “transaction-based compensation” test for broker activity (i.e., a person ‘engaged in the business of effecting transactions in securities for the accounts of others’) is an inaccurate statement of the law. . . . . an array of factors determine the presence of broker activity. In the absence of a statutory definition enunciating otherwise, the test for broker activity must remain cogent, multi-faceted, and controlled by the Exchange Act.

As reassuring as that statement sounds, it was made by a District Court, not a Court of Appeals and certainly not the Supreme Court. A District Court in a different part of the country might take the SEC’s side instead.

But I Know Someone Who. . . .

Yes, I know. There are lots of people out there selling securities, including tokens that are securities, and receiving commissions, and nothing bad happens to them.

There are so many of these people we have a name for them:  Finders. The securities industry, at least at the level of private placements, is permeated by Finders. I had a conversation with a guy who offered to raise money for my issuer client in exchange for a commission, and when I mentioned the Exchange Act he said “What are you talking about? I’ve been doing this for 25 years!”

I’m sure he has. The SEC would never say so publicly, but the reality is that where broker-dealer laws are concerned there are two worlds:  one, the world of large or public deals, where the SEC demands strict compliance; and the world of small, private deals, where the SEC looks the other way.

In my opinion, Crowdfunding offerings and ICOs fall in the “large or public deals” category, even though it’s hard to tell a Crowdfunding client they can’t do something the guy down the street is doing.

So What Can I Do?

If you’re selling securities in a Crowdfunding offering or an ICO, don’t hire that person who promises to go out and find investors in exchange for a commission, unless she’s a registered broker.

On the other hand, in an isolated case, if you know someone with five wealthy friends, who promises to introduce you to those friends, without participating in any sales presentations, you might be willing to offer a commission, relying on current law, as long as (1) you understand that a court might hold against you, adopting the SEC’s hard-line approach; and (2) you hire a securities lawyer to draft the contract.

The Future

Several years ago the SEC created an exemption for Finders in the mergers & acquisitions area. I am far from alone in suggesting that we need a similar exemption for Finders in non-public offerings. The current situation, where a substantial part of the securities industry operates in a legal Twilight Zone, is not tenable as online capital raising becomes the norm rather than the exception.

Questions? Let me know.