Tier I Finders

Under the proposal, a Tier I Finder would be limited to providing contact information (including name, telephone number, e-mail address, and social media information, among other things) of potential investors in connection with only a single capital raising transaction by a single issuer in a 12-month period. A Tier I Finder could not have any contact with a potential investor about the issuer.

Tier II Finders

A Tier II Finder could solicit investors on behalf of an issuer, but the solicitation-related activities would be limited to:

• Identifying, screening, and contacting potential investors.
• Distributing issuer offering materials to investors.
• 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.
• Arranging or participating in meetings with the issuer and investor.

In addition to the above, Tier II Finders would need to satisfy certain disclosure requirements, including:

• The name of the Tier II Finder.
• The name of the issuer.
• A description of the relationship between the Tier II Finder and the issuer.
• A statement that the Tier II Finder will be compensated for their solicitation activities by the issuer and a description of the compensation arrangement.
• Any material conflicts of interest resulting from the arrangement/relationship between the Tier II Finder and the issuer.
• 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.

The above-listed disclosures must be made prior to or at the time of solicitation, so that investors have enough time to consider the information and make an informed investment decision. The Tier II Finder must also obtain a dated written acknowledgement of receipt of the required disclosures prior to or at the time of any investment. The proposal allows Tier II Finders to provide the above disclosures orally, so long as this oral disclosure is supplemented by written disclosure (paper or electronic) which satisfies the above requirements and is provided no later than the time of any related investment.

Conditions Applicable to Both Tier I and Tier II Finders

Both Tier I and Tier II Finders would be eligible for an exemption from broker-dealer registration only when all of the following conditions are also met:

• The issuer is not required to file reports under Section 13 or Section 15(d) of the Securities Exchange Act of 1934, as amended (the Exchange Act).
• The issuer is seeking to conduct the offering in reliance on an applicable exemption from registration under the Securities Act of 1933, as amended (the Securities Act).
• The Finder does not engage in “general solicitation.”
• The potential investor is an “accredited investor” 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.
• The Finder is not subject to statutory disqualification, as defined in Section 3(a)(39) of the Exchange Act, at the time of their participation.

Furthermore, neither tier of Finders would be permitted to:

• Be involved in structuring the transaction or negotiating 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 purchases.
• Provide advice as to the valuation or financial advisability of the investment.

The proposed exemption is limited to activities solely in connection with primary offerings. A Finder could not rely on the proposed exemption to engage in broker activity beyond the scope of the proposed exemption, such as facilitating a registered offering, a resale of securities, or a sale of securities to investors who are not accredited investors. If a Finder fails to comply with any of the enumerated conditions, the Finder cannot rely on the proposed exemption and may need to consider whether they are required to register with the Commission as a broker-dealer under Section 15(A) of the Exchange Act. The exemption does not excuse a Finder from the obligation to continue to comply with other applicable laws, such as the antifraud provisions of the Securities Act and the Exchange Act, and state law.

Dissenting Views of Commissioners Lee and Crenshaw

The proposed exemption does not reflect the unified views of the entire Commission. To the contrary, as the Notice was issued, two commissioners expressed strong dissenting concerns regarding the proposal. One set of these concerns principally addressed procedural matters, whereas the other set of concerns addressed substantive issues.

As to procedural concerns, Commissioner Allison Heron Lee stated that use of an exemptive order approach, as opposed to a formal rulemaking, has the effect of an “end-run around” the rulemaking process, which calls for the Commission to support its decisions with empirical evidence and data. She stated that a policy shift of this significance (one which changes long-standing staff positions regarding when broker dealer registration is required) should be accompanied by the robust data analysis of a formal rulemaking process.

As to substantive concerns, Commissioners Lee and Caroline A. Crenshaw noted that:

(i) An exemptive order mechanism does not impose any affirmative duties on Finders. The proposed order expands the pool of individuals who can engage in core broker conduct, and simultaneously excuses those individuals from basic broker-dealer rules, such as Regulation Best Interest and the requirement to register with the Commission or the Financial Industry Regulatory Authority and notify the Commission of intent to rely on the exemption’s relief. Given that the proposed order is intended to operate only in the private markets (which, in the words of Commissioner Crenshaw, are “less liquid, impose higher transaction costs, are more susceptible to valuation errors and are more prone to fraud”), it would seem that imposition of a notification obligation could provide the Commission meaningful data that could support future rulemaking in the area.

(ii) The proposed exemption will allow a greater number of individuals to engage in “core broker conduct” – receiving commissions for actively soliciting and recruiting investors on behalf of issuers. This action does not appear to be motivated by an analysis of empirical data. As noted by Commissioner Lee, the proposal “points repeatedly to two different sources of support for the action today … [but] neither report actually supports the approach the Commission takes today.” In fact, Commissioner Lee notes that an American Bar Association (ABA) report specifically rejected the approach taken by the proposal. Commissioner Lee quoted the ABA, which stated, “providing a broker-dealer registration national exemption is not going to address all of the current abuses involving unlicensed financial intermediaries” and that “creating an exemption is not currently a better alternative to a more narrowly focused regulatory scheme.” The only protection in the text of the proposed exemption to increasing the pool of individuals engaging in core broker conduct is that Finders may not provide advice as to the advisability of investments. As noted by Commissioner Lee, since this last step in a sales pitch can usually be accomplished by the issuer, or does not need to occur at all, the exemption implicates the “salesman’s stake,” which the Commission has long understood warrants investor protections in the form of regulation. Ultimately, the restriction that Finders not provide advice as to the advisability of investments is no restriction at all and lends credence to the criticism – offered by Commissioner Lee – that a rulemaking, capable of providing additional investor protections, would have been more effective than an exemption, in this instance.

(iii) The proposed exemption suggests that investors will be sufficiently protected because Finders can only solicit accredited investors. Commissioner Lee noted that this reasoning contradicts the Commission’s reasoning made in connection with the adoption of Regulation Best Interest; being that accredited investors are not less in need of the protections afforded by the rule. Furthermore, when the Commission expanded the definition of accredited investor very recently, it cited the protection of Regulation Best Interest in response to concerns about investor protection. As Finders will not be subject to Regulation Best Interest under the proposed exemption, the expanded definition of accredited investor appears to raise legitimate investor protection concerns given the Commission’s past logic.

The comment period for the proposed exemption expires on November 12, 2020.

Please feel free to reach out to the authors with any questions or if you would like to discuss the implications of the proposed exemption further.

Client Alert 2020-566