Key Considerations for Issuers and Potential Finders Under the SEC’s Proposed “Finder” Exemption from Broker Registration
January 23, 2021
In our first installment of this two-part “mini-series” on finders, we outlined the Securities and Exchange Commission’s proposed conditional exemption (“Proposed Exemption”) to permit unregistered brokers – or “finders” – to engage in limited activities on behalf of private issuers without being subject to federal broker-dealer registration requirements.
We expect the Commission’s Proposed Exemption would help facilitate private companies’ capital raising efforts by permitting unregistered exempt finders to connect issuers with accredited investors in private markets in exchange for transaction-based compensation. Private investment funds, prospective finders, issuers, and investors should all take notice of this proposed “finders” exemption. Cannabis businesses, in particular, may find that the Proposed Exemption would open doors to previously untapped networks of potential investors through exempted intermediary “finders” that are not explicitly available under current regulations.
However, there are also certain traps for the unwary.
This installment highlights key considerations and concerns that issuers, private funds, potential investors, and prospective finders should be aware of – particularly any cannabis constituents seeking to navigate the proposed safe harbors in light of the federal illegality their industry operates under.
The Proposed Exemption Would Expand Available Capital Sources: Exempt Finders Would be Free to Connect Private Companies with Potential Investors.
Private companies currently have very few options when seeking to engage intermediaries with relevant industry experience and connections to unlock streams of available capital sources. Traditionally, registered broker-dealers have been mostly unwilling to raise capital for smaller, private transactions; instead, typically concentrating their efforts upstream in the market. Further compounding this lack of availability is the macro-level trend as the overall number of registered broker-dealers continues to decline.
The lack of clear alternatives for private companies has created a noticeable void for issuers in need of capital.
Until now, federal securities laws have not explicitly defined the term “finder” or outlined what finders are permitted to do. The regulatory morass faced by unregistered finders and private companies seeking to engage them is challenging under the existing regulatory regime, which is murky, at best, and brimming with uncertainty. Therefore, the Proposed Exemption would bring welcome clarity and certainty to issuers, investors, and the unregistered finder intermediaries engaging in broker activities.
Thus, for private companies seeking to bridge the funding gap, the proposed relief for exempt finders would offer an appealing alternative as a bona fide channel to possible capital sources.
By Providing a Clear Path Forward, the Proposed Exemption Would Reduce Exposure to Significant Legal Risks Faced by Unregistered Brokers and Businesses that Engage Them.
Unregistered brokers and the issuers who engage them are currently forced to operate within the confines of a regulatory quagmire, where one inadvertent misstep can result in severe consequences to each. This risk profile is further heightened when raising capital within an industry already subject to enhanced scrutiny by the Commission and state securities regulators. Aside from perhaps cryptocurrency, the cannabis space appears to find itself at or near the top of the list of industries on the radar of securities regulators.
Penalties for violations of existing broker-dealer regulations are steep. Indeed, transactions involving finders who engage in activities that may trigger broker-dealer registration requirements can result in severe consequences — not only for the finder itself but also the issuer that retained the finder to assist with its capital raising efforts.
At present, an unregistered broker in violation of applicable securities regulations may face potential SEC and state enforcement actions, criminal and civil penalties, disgorgement, industry bars, and may be prevented from collecting its finder fees. Issuers who engage an illicit unregistered broker – even unwittingly — may be subject to SEC or state enforcement actions for causing or aiding and abetting the finder’s violation. Further, an issuer’s sale of securities through an unregistered broker could give rise to investors’ rescission claims, resulting in the investors’ “put” right to mandate a return of their funds invested. In addition to the foregoing, cannabis businesses may risk suspension, revocation, or non-renewal of cannabis licensure from state regulatory authorities.
The SEC has long aggressively enforced violations of these broker registration requirements, although guidance on compliance has been frustratingly inconsistent over the years. The Proposed Exemption, if enacted, would provide issuers and finders alike with certainty as to how to properly comply, thereby removing the regulatory guesswork they currently face.
The Proposed Exemption is Not Available to Corporations, LLCs, and Other Business Entities.
The proposed relief is limited only to natural persons engaging in finder activity. This condition may prove challenging for many finders and issuers seeking to enter into consulting arrangements.
The proposal would prohibit finders from engaging in activities through a corporation, limited liability company, partnership, or other business entity. Accordingly, issuers should be aware that liability protections otherwise offered by operating through an LLC or other business entity would not be available to finders. This constraint would also likely have tax implications that finders would be wise to consider with their legal and tax advisors.
Finders Would Still Need to Comply With Applicable State Broker-Dealer Requirements.
The Proposed Exemption would apply uniformly only to broker status and registration at the federal level. Broker activities are also regulated at the state level. However, the proposed relief does not preempt state law. Therefore, nothing in the Proposed Exemption would impact the patchwork state “blue sky” securities laws and regulations governing the registration of broker-dealers or broker-dealer representatives. Further, cannabis issuers should also be mindful of any state-specific requirements in applicable cannabis regulations, which may be triggered depending on the broker’s level of commissions and involvement in the operator’s business.
It is foreseeable that a finder could be exempt from federal registration with the SEC and FINRA, yet still be subject to compliance with state law registration requirements. Therefore, it is important for unregistered finders to understand both the Proposed Exemption at the federal level and applicable state laws to ensure compliance at both levels.
What to Watch For Next
Now that the SEC’s comment period for the Proposed Exemption has ended, we are closely watching whether the Commission will approve the proposal in its current form or make additional changes in response to the comments it has received from the public.
While we continue to wait for what comes next, this seemed to be the ideal time to identify some of the potential challenges we expect private companies, prospective finders, and investors may face so that pitfalls can be avoided and safeguards can be exercised with appropriate compliance measures.
Businesses, private funds, and potential finders that are interested in accessing any relief that may be provided by the Proposed Exemption are well-advised to seek experienced guidance on these complex issues.
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