A legal expert examines the SEC's proposal to carve out an exemption from broker registration requirements on persons raising capital from accredited investors.

The US Securities and Exchange Commission proposes to establish a new limited and conditional exemption from the broker registration requirements for natural persons engaging in certain limited capital-raising activities on behalf of issuers seeking to raise funds from accredited investors. 

If adopted, the proposed exemption will allow natural persons to engage in certain limited activities involving accredited investors without registering with the Commission as brokers. The idea is to help small businesses raise capital and give clarity to investors, issuers, and the finders who assist them. 

To explain the situation is Rimon Law counsel Carl M Sherer. The editors of this news service are pleased to share these comments. The usual editorial disclaimers apply. To get into the conversation, email tom.burroughes@wealthbriefing.com and jackie.bennion@clearviewpublishing.com  (See another article on the same topic here.)

If you’re a start-up company and you have tried to raise investment capital, you may have come across an esoteric set of rules called the broker-dealer rules. The Securities Exchange Act requires that “finders” who receive compensation for raising money that is based on the amount raised must be registered with the Securities and Exchange Commission as a broker-dealer. In general, the rules apply unless both the investor and the agent receiving the compensation are non-US persons, which means that they can and often do affect non-US start-ups and investors, in addition to their impact on the US markets.

The rules have vexed start-up companies, who are prevented from hiring unlicensed private finders to help them raise capital. In a 2014 no-action letter, the SEC permitted a limited exemption for finders in merger transactions, but that had little effect on the literally thousands of small businesses seeking funding. Now, with small businesses across the world suffering because of the coronavirus outbreak, the SEC is proposing an exemption that may make it easier for them to raise money.

On Wednesday, the Securities and Exchange Commission voted to propose a new limited, conditional exemption from broker registration requirements for “finders” who assist issuers with raising capital in private markets from accredited investors. If adopted, the proposed exemption would permit natural persons to engage in certain limited activities involving accredited investors without registering with the Commission as brokers. The proposed exemption seeks to assist small businesses to raise capital and to provide regulatory clarity to investors, issuers, and the finders who assist them.

The proposal would create two classes of finders, Tier I Finders and Tier II Finders, that would be subject to conditions tailored to the scope of their respective activities. The proposed exemption would establish clear lanes for both registered broker activity and limited activity by finders that would be exempt from registration.

A Tier I Finder would be limited to providing contact information 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. In essence this would reinstate what many of us remember as the ‘occasional finder’ exemption – an exemption that the SEC has largely refused to recognize for the last several years. However, the Tier II exemption is potentially much more useful to venture capital companies than Tier I.

A Tier II Finder could solicit investors on behalf of an issuer, but the solicitation-related activities would be limited to: (i) identifying, screening, and contacting potential investors; (ii) distributing issuer offering materials to investors; (iii) 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; and (iv) arranging or participating in meetings with the issuer and investor. This sort of ‘finding’ is already common in the capital markets, although the inability to pay the finder a success fee inhibits the ability of small issuers to use this sort of finder. Issuers mask their use of finders in this manner by assigning them non-fundraising tasks, appointing them to management positions, and finding creative ways to compensate them that are not tied to their success, a system that introduces an element of risk for the issuers.

None of the conditions the SEC proposes to place on the exemption would inhibit its use. Those conditions include:

a. the issuer is not required to file reports under Section 13 or Section 15(d) of the Exchange Act, i.e. the issuer is a private company;
b. the issuer is seeking to conduct the securities offering in reliance on an applicable exemption from registration under the Securities Act;
c. the Finder does not engage in general solicitation;
d. the potential investor is an “accredited investor”;
e. the Finder provides services pursuant to a written agreement with the issuer that includes a description of the services provided and associated compensation;
f. the Finder is not an associated person of a broker-dealer; and
g. 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 his or her participation.

The Finder also could not (i) be involved in structuring the transaction or negotiating the terms of the offering; (ii) handle customer funds or securities or bind the issuer or investor; (iii) participate in the preparation of any sales materials; (iv) perform any independent analysis of the sale; (v) engage in any “due diligence” activities; (vi) assist or provide financing for such purchases; or (vii) provide advice as to the valuation or financial advisability of the investment. Other than item (v), which may prevent lawyers from being compensated for introducing their clients to investors (a common practice among Israeli lawyers and Israeli companies), none of these restrictions are likely to inhibit capital raising.

A Tier II Finder would also be subject to certain disclosure requirements, including providing appropriate disclosures of the Tier II Finder’s role and compensation prior to or at the time of the solicitation. This seems only fair and reasonable.

While a true evaluation of the SEC’s proposal cannot be made without reviewing it in detail, Wednesday’s announcement by the SEC ought to give venture capital companies around the world who aspire to tap into the US capital markets reason for hope.

About the author:
Carl M Sherer is counsel at Rimon PC, where he practices corporate and securities law, helping individuals and corporations in both transactional and regulatory settings in the US and in Israel. He is based in Israel and New York, and may be reached at carl.sherer@rimonlaw.com.