INSIGHT: Finders and Private Placement Brokers: The Missing Link and H.R. 6127

The Problem – Need for Finders

Many small businesses that want to raise capital by issuing securities in private placements don’t have access to the services of registered broker-dealers. This is because the funds that the issuers seek to raise are not significant enough to generate interest from a Financial Industry Regulatory Authority (“FINRA”) member or justify the overhead that the broker-dealer would incur in preparing for this kind of private placement. As a result, some small companies have turned to “finders” to help them connect with investors. Although intermediaries are frequently referred to as broker-dealers, the types of finders discussed in this article act solely as brokers or agents. They never take ownership of the securities being sold so we will refer to them as “brokers,” and not broker-dealers.

Sometimes the finders’ services are limited to supplying the names and coordinates of likely investors (“selling the Rolodex”) without any other participation in the offering process. Sometimes the finders help promote the sale of the securities by telling their friends and other contacts why they should be interested in the proposed investment. They may also help to structure the offering, prepare written offering material and provide other assistance. Almost always, the issuers wish to compensate the finders based on the amount of money they help to raise, mainly because these kinds of issuers cannot afford the services of an intermediary unless the offering is successful. Similarly, many finders want to receive this kind of transaction-based compensation.

Historically, the Securities and Exchange Commission (“SEC”) and the states, under their “blue sky” laws regulating and requiring registration of brokers, consider the receipt of transaction-based compensation as a virtually-irrebuttable indication that the intermediary is a broker that is required to be registered. The rationale behind this position is that the receipt of payment only if a sale is made inevitably creates a conflict of interest in which the finder, on one hand, had a duty to be candid with the offeree and, on the other hand, has a normal economic desire to earn a fee. This kind of conflict of interest, in the view of some regulators, should be allowed to exist only within the confines of a regulated entity, a registered broker.

Some Burdens of Being a Registered Broker

However, the cost and some of the logistical burdens of registering as a broker, which bring with it the requirement to become a FINRA member, are frequently prohibitive for finders who may handle only a few small transactions a year. The cost of a FINRA membership application, not to mention state registration fees, can run to thousands of dollars. In addition, all registered brokers are subject to the Net Capital Rule, Rule 15c3-1 under the Securities Exchange Act of 1934 (the “Exchange Act”), which requires the registrant to maintain net capital (net worth minus illiquid assets) of at least $5,000 or, under FINRA policies, $6,000. That alone may not be a tremendous hurdle. However, along with the minimum net capital requirement, SEC rules require at least quarterly financial “FOCUS” report which must be prepared under the supervision of a FINRA-registered Financial and Operations Principal. On top of that, the registered broker is required to obtain an annual audited financial statement prepared by a Public Company Accounting Oversight Board (“PCAOB”)-approved auditor. This alone could cost in excess of $20,000 and provides very little in the way of investor protection.

The result is that small issuers may find it impossible to engage a finder, because many people who are capable of performing this service don’t want to go through the expense and hassle of becoming registered with the SEC and becoming FINRA members. Some issuers may use unregistered finders, which raises not only the risk of SEC and/or state enforcement action but the dreaded “R Word” – rescission. Section 29(b) of the Exchange Act provides that any contract made in violation of that Act is void, which means that an unhappy investor has a right to get back his money, even if there was no fraud or other malfeasance in the management of the company in which he invested. Moreover, an unregistered finder who sues to collect his fee will lose because courts will not enforce the void contract.

Need for Clarity in the Definition of “Broker”

The preceding discussion has been a statement of black-and-white certainties. To make matters worse, there are many grey areas surrounding the question of what, in fact, triggers the need to be registered as a broker. Section 3(a)(4)(A) of the Exchange Act defines a “broker” as “any person engaged in the business of effecting transactions in securities for the account of others” (emphasis added). Over the years, the SEC has issued (and occasionally withdrawn) various no-action letters, and some courts have made findings, as to what constitutes “engaging in the business” and what it means to “effect” a securities transaction. This article will not attempt to summarize the vast literature on this subject, but suffice it to say that there is no de minimis test of what constitutes “engaging in the business;” theoretically a single transaction in which the finder earns transaction-based compensation is enough to subject him to broker registration requirements. Also, the term “effecting” has been interpreted broadly to include almost every step in the process leading up to a securities transaction, so long as the service-provider receives toxic transaction-based compensation.

All of this has had a depressing effect on the ability of many small businesses to raise capital. They are not able to get the attention of a FINRA member and may be reluctant to risk the rescission sword of Damocles resulting from using an unregistered finder.

Compliance with the Securities Act of 1933- Exemptions from Registration of Securities

In recent years, Congress and the SEC have taken some steps to facilitate capital formation by small businesses. Notably the JOBS Act has allowed for crowdfunding, and FINRA has now registered about 47 crowdfunding portals, some of which may not be active. Regulation A+, an extension of the little-used Regulation A, has been adopted. Rule 506 of Regulation D, which provides a safe harbor for private placements in which the securities are exempt from registration, has been expanded to include Rule 506(c) to permit general solicitation of investors, provided sales are made only to “accredited” investors. However, except for the limited use of crowdfunding by the smallest issuers, these changes have affected only the requirement to register the securities being offered. Nothing has been done to make it easier for finders to help small issuers raise capital; they are still the “missing link.”

Toward a Solution

Attempts to address this problem began to take shape in 1999 with the formation of a Task Force by the American Bar Association. The Task Force was initially made up of lawyers representing issuers; the lawyers were concerned that their clients, which were generally small companies developing technology, with very little assets, earnings, sales, or track record, were using finders to raise capital. They were quickly joined by other lawyers with experience representing brokers and would-be brokers. In 2005 the Task Force published a Report that identified the problems, including the lack of clear guidance from the SEC on the boundaries of who is a “broker” and the need for a more tailored form of regulation for finders. This Report has been widely praised, including by the SEC’s Advisory Committee on Small Business, which in 2006 urged the SEC to “spearhead a multi-agency effort to create a streamlined NASD registration process for finders, M&A advisors and institutional private placement practitioners.” See Recommendation IV on page 6.

The SEC hosts an annual Small Business Forum. At each of these events, for the past several years, one of the recommendations of the Forum was to implement the recommendations of the Task Force Report. However, whenever this concept seemed to be gaining some traction with regulators, it was brushed aside by more pressing matters: the 2008 market meltdown, Bernie Madoff, Dodd-Frank rulemaking responsibilities, the “flash crash,” you-name-it. To date the only significant action by the SEC to mitigate the burdens on finders has been to issue the M&A Brokers No-Action Letter in 2014. It is limited to intermediaries in M&A transactions, where an entire company is changing ownership. There has been no significant, tangible action by the SEC since then to address the need for more appropriate regulation of finders involved in raising capital for small business.

Representative Budd Introduces H.R. 6127

In the face of this deafening silence, on June 15, 2018, Congressman Ted Budd introduced Unlocking Capital for Small Businesses Act of 2018, H.R. 6127. It would go a very long way to remedy the situation. Briefly, this bill would do the following:

● Define “Finders,” who would be limited in the dollar amount they could raise in a year, the amount they could raise for a single issuer in a year, and the number of private placements they could perform in a year. They would be excluded from the Exchange Act definition of “broker.”
● Define “Private Placement Brokers” (PPBs) who would not be subject to the numerical limits for Finders, but who could work only on private placements and could not have custody of investor assets.
● Require the SEC to adopt rules to create a new regulatory framework for PPBs, which could not be more onerous than what is required for crowdfunding platforms. This would mean that PPBs would not be subject to the Net Capital Rule. This is sometimes referred to as “Broker-Dealer Lite.”
● Require the SEC to adopt rules binding on FINRA to allow PPBs to become FINRA members on terms that are consistent with the objectives of H.R. 6127 and the SEC Broker-Dealer Lite rules.
● Leave to the states the right to require registration of PPBs, provided that the conditions of such registration would not be more onerous than what is required under the new SEC Broker-Dealer Lite rules.
● Preserve all anti-fraud statutes and rules of the SEC and the states, including the ability to require appropriate disclosure of conflicts of interest of PPBs. Although Finders would not be considered “brokers,” the SEC, under its anti-fraud powers, could require conflict-of-interest disclosures by Finders as well as by PPBs.
● Be unavailable to “bad actors” who have been barred from the securities business or otherwise been found guilty of serious violations.

The above list is not a complete description of all the terms of H.R. 6127, but it identifies the key operative provisions. It is expected that a companion bill will be introduced in the Senate. It is too soon to predict what will eventually emerge from Congress, or if the SEC will take this opportunity to act without legislation, as it did in the case of the M&A Broker No-Action letter. The less burdensome it becomes to act legally as a Finder or a PPB, the more competition can be expected in the provision of these services, which should lead to better services, at lower cost, and reduce issuers’ temptation to work with those outside the protection of the law. Most importantly from an investor-protection perspective, it would bring many people, who are now working covertly, into the sunshine, visible to the SEC and state regulators.

What Lies Ahead?

One can hope that this is the inflection point toward which some of us have been working for almost two decades. The Bill represents a reasonable balancing of two of the core objectives of the SEC – promoting capital formation and investor protection. Although some may fear that allowing more room for participation of finders could open the floodgates to rampant fraud, the reverse should be the result: more capable finders, greater transparency in what is now largely an opaque market, and lower financing costs. It would also be consistent with the “fourth pillar” of the SEC’s mission, namely, enhancing competition, which was recently advocated by Commissioner Robert J. Jackson, Jr.

Faith Colish is Counsel to Carter Ledyard & Milburn LLP in New York City. She specializes in financial services regulation and has been a leader in the efforts to improve the regulatory framework for finders since the inception of the ABA Private Placement Broker Task Force in 1999, on which she served as Co-Chair and then Chair. After graduating from Columbia University Law School in 1960, Ms. Colish served on the staff of the SEC, including as Special Counsel to the New York Regional Administrator (1967-69).

She acknowledges the valuable assistance of Valentino Vasi, Esq., also Counsel to Carter Ledyard & Milburn, in the preparation of this article and the ongoing work of the Task Force.