Raising Capital Using an Intermediary Finder: The Potential Impact of the SEC’s Proposed Conditional Finder Exemptions

In an industry already rife with significant regulatory complexities, cannabis issuers face challenges familiar to many small and emerging businesses raising capital. One of which is the regulatory minefield posed by hiring unregistered broker-dealers, also known as “finders,” to assist issuers with raising capital in private markets from accredited investors. This is particularly true for the capital raising ecosystem within the cannabis space, which, due to its federal illegality among other factors, lacks the type of established, robust capital raising networks available to other, more traditional industries.

This post is the first of two installments of a “mini-series” discussing the potential impact of the SEC’s proposed limited conditional “finder” exemptions on issuers’ capital raising efforts.

Overview

Earlier this fall, the SEC took a significant step forward by proposing an exemptive order offering limited conditional “finders” exemptions from broker-dealer registration to individuals assisting issuers with raising capital in private markets from accredited investors (the “Proposed Exemption”). The objective of the proposed new exemption is to advance one of the SEC’s stated missions to support the capital raising efforts of privately held businesses, and also to provide regulatory clarity to investors, issuers, and the intermediary finders who assist them.

If adopted, the Proposed Exemption would grant a conditional exemption from the broker registration requirements of Section 15(a) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). The SEC’s proposal would permit natural persons to engage in certain limited capital-raising activities on behalf of privately held companies and receive transaction-based compensation without requiring registration with the SEC as brokers. This proposal creates two categories of limited, conditional exempt finders: Tier I Finders and Tier II Finders. Each class of finders would be subject to certain limitations tailored to the scope of their respective activities. In each case, Tier I and Tier II Finders would both be permitted to accept transaction-based compensation under the terms of the proposed exemption.

Background

There has been a long-standing confusion among small and emerging businesses with respect to “finders” and activities of such individuals assisting such issuers with private placements. As Jay Clayton, Chairman of the SEC, has acknowledged, “[t]here has been significant uncertainty for years . . . about finders’ regulatory status, leading to many calls for Commission action, including from small business advocates, SEC advisory committees and the Department of the Treasury.”

Indeed, for decades, a proverbial fog has clouded the regulatory landscape governing finder intermediaries playing discrete roles in the match-making efforts to bridge the funding gap between private issuers and prospective investors. To add to this ambiguity, federal securities laws do not specifically define the term “finder,” nor do they detail permitted finder-related activities. A finder must instead seek to avoid being deemed a broker or dealer under federal securities laws or otherwise risk triggering the requirements to register with the SEC, which would necessitate compliance with all regulations thereunder.

The broker definition is the trickier one for finders to escape.  Section 15(a) of the Exchange Act requires a “broker” to be registered with the SEC. A broker is defined as “any person engaged in the business of effecting transactions in securities for the account of others.” The age-old question faced by finders (and issuers seeking to engage them for capital raising efforts) is this: Under what facts and circumstances may a person “find” or solicit investors on behalf of an issuer without crossing the line into broker-dealer territory requiring registration with the SEC.  However, as the SEC has noted, the lack of clarity as to where exactly that line is drawn has created uncertainty for all parties involved.

Over the years, the relevant no-action letters issued by the SEC’s staff have provided a modicum of guidance, but questions have continued to persist.  As a result, it has been difficult for small business issuers to clearly navigate the waters of using intermediaries that have not registered as brokers with the SEC to “find” investors – an issue that has been repeatedly highlighted in past reports by the American Bar Association Task Force on Private Placement Broker-Dealers, which has previously (and unsuccessfully) recommended the SEC’s adoption of a federal exemption for finders.

The Proposed Exemption relief seeks to bring clarity to the regulatory status of finders in a tailored manner that addresses the capital formation needs of issuers that are small businesses and start-up companies while preserving investor protections. If enacted, the order would provide clearer guidelines for issuers and finders receiving transaction-based compensation and could even potentially bridge the gap between issuers in complex, underdeveloped industries like cannabis and potential accredited investors. With the Proposed Exemption, (1) finders in compliance with its exemptive order would no longer risk facing sanctions from the SEC, and (2) issuers would no longer face the very real prospect that their privately placed securities might create a “put” or rescission right in favor of investors, conferring investors the right to require the issuer to return the invested funds.

The SEC’s proposal is consistent with advancing the Commission’s recent emphasis on facilitating the capital raising activities of private businesses and emerging growth companies, exemplified by (i) the SEC’s recent adoption of a final rule to expand the definition of “accredited investor,” and (ii) the SEC’s 2014 “M&A Broker” No-Action Letter regarding business advisers involved in the sale of a private company (“M&A Brokers”), permitting M&A Brokers facilitating securities transactions in connection with the transfer of ownership of controlling interests of privately held companies to receive transaction-based compensation without requiring broker registration.

Proposed Exemptive Order: Exempted Classes of Finders

The SEC’s proposed order would provide a nonexclusive safe harbor to exempt two classes of finders from broker-dealer registration: Tier I Finders and Tier II Finders. Each class of finders would be permitted to receive transaction-based compensation.

Tier I Finders

The activities of Tier I Finders would be limited to providing the contact information (for example, name, telephone number, e-mail address, and perhaps social media information) of prospective investors in connection with a single capital raising transaction by a single issuer in a 12-month period. A Tier I Finder would be prohibited from having any contact with a potential investor about the issuer.

This Tier I Finder category closely tracks the oft-cited 1991 SEC No-Action Letter to legendary singer and songwriter, Paul Anka, where Mr. Anka acted as a finder and received transaction-based compensation in connection with a private placement of securities in the United States without registration as a broker.  In 1991, Mr. Anka entered into an agreement with the Ottawa Senators, which was at the time seeking admission into the National Hockey League.

Mr. Anka provided the Senators a list of names of potential investors with whom he had a pre-existing relationship and reasonably believed to be accredited.  Significantly, Mr. Anka did not contact or otherwise solicit the potential investors directly.  Instead, a director, officer, employee, or majority owner of the Senators would contact prospective investors and would disclose to investors that Mr. Anka was the source of the referral. In exchange, Mr. Anka received a transaction-based success fee.

In issuing the no-action letter, the SEC highlighted a number of factors for reaching its no-action decision, including the fact that Mr. Anka did not engage in general solicitation, nor did he assist in the preparation of sales materials, perform independent analysis, engage in conducting any due diligence, assist or provide financing, valuation or investment advice, nor did he handle any funds or securities. Further, the SEC’s staff noted that Mr. Anka had not previously engaged to act as a finder in any private placement of securities. Even under these very limited circumstances, the SEC has subsequently declined to apply this no-action letter to seemingly analogous situations.

Tier II Finders

A Tier II Finder would be permitted to engage in additional solicitation activities on behalf of an issuer; however, 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; and
• arranging or participating in meetings with the issuer and investor.

Additional Conditions for Tier II Finders

Since Tier II Finders would have the ability to participate in a broader range of activities and have the potential to engage in more offerings with issuers and investors, the Commission has proposed additional, heightened requirements.

A Tier II Finder seeking to rely on the proposed exemption would need to satisfy certain disclosure requirements and other conditions. These include the requirement that the Tier II Finder provide appropriate disclosures relating to the Tier II Finder’s role and compensation. These disclosures would need to be made to prospective investors prior to or at the time of the solicitation. Further, prior to or at the time of any investment in the issuer’s securities, the Tier II Finder would be required to obtain from a prospective investor a dated written acknowledgment of receipt of the required disclosures.

Conditions for Both Tier I and Tier II Finders

Both Tier I and Tier II Finders would be subject to certain conditions. The proposed exemption for Tier I and Tier II Finders would be available only where:

• the issuer is not required to file reports under Section 13 or Section 15(d) of the Exchange Act;
• the issuer is seeking to conduct the securities offering in reliance on an applicable exemption from registration under the Securities Act of 1933, as amended;
• the Finder does not engage in general solicitation;
• the potential investor is an “accredited investor” as defined in Rule 501 of Regulation D 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; and
• 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.

Further, a Tier I and Tier II Finder would not be able 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 such purchases; or
• provide advice as to the valuation or financial advisability of the investment.

Finally, Tier I and Tier II Finders would not be able to rely upon the proposed exemption to engage in broker activity beyond the scope of the proposed exemption. Among other things, a finder would be prohibited from relying on the proposed exemption to (x) facilitate a registered offering, (y) a resale of securities, or (z) the sale of securities to investors that are not accredited investors or that the Finder does not have a reasonable belief are accredited investors.

Key Resources:

In an effort to assist small businesses, their investors, and other small business marketplace participants in understanding the impacts of the Proposed Exemption, the Commission has released two educational resources: 1) a short video that provides a brief, plain English overview of the proposal, and 2) an overview chart that illustrates a summary overview of key permissible activities, requirements, and limitations outlined in the Proposed Exemption.

Cannabis operators interested in meeting their working capital needs through private placement should review these resources and become apprised of potential opportunities and limitations thereof should the Proposed Exemption be adopted.