Federal law generally requires an individual to register as a broker-dealer before engaging in the business of effecting tra nsactions in securities. There is currently a narrow exemption for an individual who merely introduces a potential purchaser to an issuer in exchange for a finder’s fee. This finder exemption is being eroded by the Securities and Exchange Commission (the “SEC”) while receiving greater deference within the judicial system. The former does not permit transaction-based compensation while the latter provides relief for true finders. We recommend the law be liberalized in order to improve economic efficiency and enforcement consistency.

I. INTRODUCTION

Individuals and businesses typically need to register as brokers or dealers upon “[e]ngaging in, or finding investors for, venture capital or ‘angel’ financings, including private placements.”[1] Young businesses that need to raise small amounts of capital, however, typically do not attract the interest of registered brokers-dealers because the liability risks are too high and the transaction sizes are too small to justify the cost of SEC compliance. Instead, entrepreneurs seeking to employ the services of a private placement broker often rely on the use of an unregistered finder to raise early stage capital.

If an unregistered finder accepts a fee based on the amount of a successful transaction, the SEC is likely to find a violation of Section 15 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). The current broker-dealer registration system, however, is too costly for most finders of early stage capital. For example, the initial registration costs can exceed $150,000, and ongoing compliance costs may range from $75,000-$100,000,[2] while start-up financing is often sought in amounts of $100,000 or less (and rarely more than $5,000,000).[3] This heavy-handed approach by the SEC simultaneously creates an underground market for bad actors and causes finders operating in good faith to get caught in the fray with no realistic alternatives. This dilemma has resulted in several SEC initiatives over the years to liberalize or adopt new exemptions for market participants who perform only limited broker-dealer functions from federal registration.

The ABA Private Placement Broker Task Force, in response to the SEC’s request for comment on this topic, proposed a federal finder exemption.[4] In its proposal, the Task Force referred to “finders” synonymously with private placement brokers and securities intermediaries. Accordingly, its finder exemption would include two categories of activities, both of which would permit the receipt of transaction-based compensation: The first category of permissible activities includes “arranging for the purchase and sale of securities in private placements, and related due diligence, structuring, valuation, negotiation, and assistance in obtaining financing.”[5] The second category includes mere introductions between an issuer and an SEC-registered broker-dealer for ANY type of transaction, including private placements, in exchange for a finder’s fee.[6]

In this white paper, we adopt the finder exemption proposal of the ABA Task Force, in addition to supporting the codification of this finder exemption under federal law. To begin, we review the SEC’s no-action letter that created the finder exemption. Next, we examine how the SEC’s no-action position has been eroded over the years. Afterwards, we compare the SEC’s erosion of the exemption to the deference provided within the judicial system. Finally, we propose an explicit carve-out from federal registration for finders that will include the full scope of their activities.

II. ORIGIN OF THE FINDER EXEMPTION

Section 15(a) of the Exchange Act requires brokers and dealers to register with the SEC pursuant to Section 15(b) of the Exchange Act unless an applicable exemption is available. A broker is defined as “any person engaged in the business of effecting transactions in securities for the accounts of others.”[7] A dealer is defined as a person that is “engaged in the business of buying and selling securities” as part of a regular business for such person’s own account.[8] While the Exchange Act does not define a “finder,” the Practising Law Institute defines a finder as “a person who places potential buyers and sellers of securities in contact with one another for a fee.”[9] Despite the lack of a statutory definition, finders are prevalent in the world of start-up financing where they operate on the edge of legality by introducing entrepreneurs to angel investors.

An individual who is not certain whether a particular action would constitute a violation of the federal securities law may request a no-action letter from the SEC staff. These letters limit relief to the specific facts and circumstances described by the requester. The SEC’s prevailing finder exemption originated in the early 1990s from a no-action letter granting relief to Paul Anka.[10] In this letter, the facts establish that Mr. Anka agreed to furnish a limited partnership with the names and telephone numbers of prospective purchasers of limited partnership units. In return, the limited partnership agreed to pay Mr. Anka a finder’s fee equal to 10 percent of the sales price of certain partnership units sold to the purchasers he had identified. Mr. Anka did not otherwise participate in any solicitation, negotiation, sales, or due diligence activities. Under these facts, enforcement action was not recommended. While not legally binding, this no-action letter is frequently cited as the narrow set of facts under which a finder is not required to register as a broker-dealer.

III. EROSION OF THE FINDER EXEMPTION

The SEC has subsequently indicated its disapproval of the position taken in its no-action letter granting relief to Mr. Anka.[11] The SEC’s current no-action position finds one instance of transaction-based compensation may be enough to show a person was “engaged in the business” of broker-dealer activity.[12] This broad definition of broker-dealer activity has all but eliminated the finder exemption within the enforcement division of the SEC. In response, individuals have placed increasing reliance on judicial decisions in favor of “true” finders where the SEC fails to meet its burden of proof that the finder was acting as an unregistered broker-dealer. Regardless, most finders conclude the reputational and financial costs of litigation outweigh the reassurances of favorable case law in the absence of a codified exemption.

While the Jumpstart Our Business Startups Act (the “JOBS Act”) codified a limited exception for private placement brokers, Section 201(c) only exempts covered persons from registration so long as there is no “compensation in connection with the purchase or sale” of securities. Other statutory exemptions, such as the Rule 3a4-1 safe harbor, also prohibit the payment of commissions. These statutory exemptions are therefore too narrow to protect finders that receive transaction-based compensation during capital-raising activities. Similarly, the JOBS Act mandated exemptions for crowdfunding platforms that are registered as funding portals, but prohibit them from compensating employees “based on the sale of securities.” Thus, the SEC’s no-action position in the 1990s limited the finder exemption to a narrow set of facts, and subsequent carve-outs failed to liberalize the SEC’s treatment of transaction-based compensation. The question remains whether Congress intends to eliminate or expand the judicial view regarding the ability of true finders to accept transaction-based compensation.

IV. JUDICIAL LENIANCY FOR TRUE FINDERS

A series of cases describe the finder exemption as the ability for a person or entity to “perform a narrow scope of activities” that includes “bringing together the parties to transactions, even those involving the purchase and sale of securities” without meeting the threshold of broker-dealer activity that requires federal registration.[13] Therefore, in an enforcement action, the SEC must prove by a preponderance of the evidence that a person or entity was engaged in the business of broker-dealer activity at key points in the chain of distribution in order to prevail. Under this analysis, the courts generally hold that something more than just transaction-based compensation is necessary to require federal registration.[14]

V. CONCLUSION

The SEC regularly brings enforcement actions against finders for receiving transaction-based compensation where failure to register as a broker-dealer constitutes a violation of Section 15(a) of the Exchange Act. The SEC has the power to make findings, issue orders, and impose remedial sanctions with regard to Section 15(a) violations.[15] As a result, unregistered finders are not only vulnerable to defending expensive enforcement actions if they receive transaction-based fees, but also face claims for the rescission of past securities offerings based on “voidness” under Section 29(b) of the Exchange Act. While there is no private cause of action under Section 15(a) of the Exchange Act, a purchaser may likewise seek rescission of a contract where the complaint alleges the finder acted as an unregistered broker-dealer.[16] This lack of finality is harmful to the entire industry of small business capital formation.

The goal of SEC registration and compliance is to protect investors, but the looming threat of enforcement actions are increasing transaction costs and putting investors at risk of employing “bad actors” due to the de facto unregulated nature of the industry. Codifying a federal finder exemption will actually increase transparency and aid state regulation by enabling finders to operate lawfully, thereby providing the proper and predictable legal channels to address fraud, larceny, and other prohibited conduct under state securities law and contract law.

In addition to aiding state regulation, a federal carve-out can go a long way towards facilitating innovation and economic growth. As the leading enforcement agency, other regulators will mimic the SEC’s policy goals. An explicit exemption will therefore liberalize the regulation of finders in many states to the extent that Congress so permits. At a minimum, there should be a federal carve-out for mere introductions in exchange for a transaction-based fee. As a practical matter, however, the law should be sufficiently liberalized to facilitate capital-raising by small issuers who are otherwise denied access to registered broker-dealers.

The ABA Task Force has already proposed an exemption that permits “arranging for the purchase and sale of securities in private placements,” as well as “related due diligence, structuring, valuation, negotiation, and assistance in obtaining financing.”[17] The Task Force stated the goal in drafting its proposal was the same as the JOBS Act, which is to “promote capital raising and job creation for small businesses.”[18] Likewise, we believe a finder exemption is not only necessary to protect investors, but required in order to provide a lawful method for small businesses to raise early stage capital. Thus, we adopt the Task Force’s proposal and support the codification of the federal finder exemption.

[1] SEC Division of Trading and Markets, Guide to Broker-Dealer Registration (Apr. 2008) available at https://www.sec.gov/divisions/marketreg/bdguide.htm.

[2] See Comment Letter dated May 21, 2015, to FINRA regarding FINRA Regulatory Notice 14-09, Request for Comment on Proposed Rules for Limited Corporate Financing Brokers.

[3] See Gregory Yadley, “Notable by Their Absence: Finders and Other Financial Intermediaries in Small Business Capital Formation,” SEC Advisory Committee on Small and Emerging Companies (dated June 3, 2015).

[4] The ABA Private Placement Broker Task Force, “Private Placement Brokers,” PDF Outline, available at https://www.sec.gov/comments/265-27/26527-26.pdf.

[5] Id.

[6] Id.

[7] Section 3(a)(4)(A), Securities Exchange Act of 1934.

[8] Section 3(a)(5)(A)-(B), Securities Exchange Act of 1934.

[9] See Clifford, Kirsch, “Fundamentals of Broker-Dealer Regulation 2016,” Corporate Law and Practice, Course Handbook Series No. B-2262, Practising Law Institute.

[10] See Paul Anka, SEC No-Action Letter (available July 24, 1991).

[11] See, e.g., Comments by Kristina Fausti, Special Counsel, Office of Chief Counsel, SEC Division of Trading and Markets, at the Private Placement Broker and M&A Broker Panel at the SEC’s Forum on Small Business Capital Formation (Nov. 20, 2008).

[12] See Brumberg, Mackey & Wall, SEC No-Action Letter (available May 17, 2010).

[13] SEC v. Kramer, 778 F. Supp. 2nd 1320 (M.D. Fla. 2011).

[14] See SEC v. Kramer, 778 F. Supp. 2nd 1320 (M.D. Fla. 2011); see also SEC v. Benger, in the U.S. District Court for the Northern District of Illinois, No. 09 C 676, Memorandum Opinion and Order (Mar. 28, 2013) (rejecting the SEC’s argument that anyone who facilitates any transaction in securities through conduct in the United States must register as a broker under Section 15(a) of the Exchange Act, even if the transaction did not involve the domestic sale of stock); but cf. In re Ambit Capital Pvt. Ltd., Order Instituting Administrative Proceedings, SEC Release No. 34-68295 (Nov. 27, 2012), In re Motilal Oswal Securities Limited, Order Instituting Administrative Proceedings, SEC Release No. 34-68296 (Nov. 27, 2012), In re JM Financial Institutional Securities Private Limited, Order Instituting Administrative Proceedings, SEC Release No. 34-68297 (Nov. 27, 2012), and In re Edelweiss Financial Services Limited, Order Instituting Administrative Proceedings, SEC Release No. 34-68298 (Nov. 27, 2012) (charging four financial services firms based in India for providing brokerage services to institutional investors in the United States without being registered with the SEC).

[15] See Section 8A of the Securities Act of 1933, Sections 15(b) and 21C of the Securities Exchange Act of 1934, Section 9(b) of the Investment Company Act of 1940, and Sections 203(f) and (k) of the Investment Advisers Act of 1940.

[16] See, e.g., Cornhusker Energy Lexington, LLC v. Prospect Sr. Ventures, 2006 WL 2620985 (D. Neb. Sept. 12 , 2006).

[17] The ABA Private Placement Broker Task Force, “Private Placement Brokers,” PDF Outline, available at https://www.sec.gov/comments/265-27/26527-26.pdf.

[18] Id.

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