SEC Advisory Committee Calls for Bringing 'Finders' in From the Shadows

NEW YORK (The Deal) -- An influential advisory committee to the Securities and Exchange Commission believes it's high time the regulator bring private placement "finders" out of the shadows.

The commission's Advisory Committee on Small and Emerging Companies had a spirited discussion about finders June 3 in a public session in Washington, but ran out of time before it could fashion a recommendation. Instead, the committee decided to explore the subject further in the coming weeks. Committee Chairman Stephen Graham, a partner in the Seattle office of law firm Fenwick & West LLP, said the committee would take up finders in a telephone conference and likely fashion a formal recommendation for the SEC to consider at its next quarterly meeting in September.

Although the SEC has never officially defined what a "finder" is, they have nevertheless become fixtures in the world of small-cap and early-stage capital raising. Finders are intermediaries who are not registered with the SEC or the Financial Industry Regulatory Authority and they aren't formal employees of registered broker-dealers. They are often used as middlemen by companies too small or too under-capitalized to put an investment bank on retainer for a private placement, and they are paid for bringing investors into deals.

The SEC has gone to a great deal of time and expense to carefully define what a broker-dealer is via extensive regulations. No one is allowed to engage in selling stock without a license, and they must be registered. Finra rides herd on the broker-dealer industry as its self-regulatory organization. But finders aren't regulated, having long functioned in a gray area, bringing investors into placements that investment banks find too small or too much trouble. The finders keep a low profile and provide a variety of services, including sometimes creating financial structures for deals and advising companies.

"They can help companies. They have knowledge of the niche, though they are not broker-dealers," Graham said. "But there are also people in this area who are not ethical and can cause problems for issuers and investors."

An exception is made by the SEC for a person who introduces an investor to an issuer and accepts a finder's fee regardless of whether a stock sale takes place. But anyone who does this more than once is considered to likely be "engaged in the business of selling securities for compensation," which requires either a license or registration, or both.

"Sometimes I will run into a finder who says they aren't registered because they have only 'sold stock once,' and they have only done that three times," said John Borer III, senior managing director with Benchmark Co. LLC and a member of the advisory committee.

Part of the problem with finding an answer to the finder issue is that finders have no organization lobbying the SEC orCongresson their behalf.

"The trouble with lobbying is that, at some point, the lobbyist has to say who paid them, and finders are in the shadows because they aren't registered," said Peter LaVigne, a partner with Goodwin Procter in New York.

"They are a silent constituency," said George Yardley, a partner at Shumaker, Loop & Kendrick in Tampa and a member of the advisory committee.

Yardley's observation is correct as far as it goes. Finders do not have their own association to plead their case to the SEC. Still, finders do have some advocates.

In a letter to the SEC in 2013, the National Small Business Association defended the importance of finders for small companies.

"Finders play an important role in introducing entrepreneurs to potential investors and raising capital necessary to launch or grow their businesses," the association said. "They can reduce the cost of raising capital and increase the likelihood of raising needed capital, particularly for entrepreneurs who have a limited number of pre-existing relationships with accredited investors."

Likewise, the American Bar Association has been after the SEC for years to fashion a coherent set of regulations that would allow for finders to do their work on behalf of smaller companies, and take securities lawyers caught in the middle of the transactions off the hook. In 2002, the ABA proposed "Form 1010-EZ-Private Placement Broker/Dealer" to sign up finders with less regulation than broker-dealers. The so-called "broker-dealer lite" regulation failed to find favor with the SEC.

Three years later, an ABA task force issued a 71-page report and set of recommendations on private placement broker-dealers. The task force's goals were to facilitate capital formation by small companies and reduce illegal activity by finders. The report called for sales of securities to be made only to accredited investors and only in private placements. Disclosure of finder payments would be required. Finders would be exempt from the SEC's and Finra's broker-dealer definitions, but they could share fees with broker-dealers.

The report maintained that registration of broker-dealers was too expensive for the finder industry and regulations like those imposed on the brokerage industry were unnecessary for finders. The SEC's Government-BusinessForumon Small Business Capital Formation supported the concepts in the report, and the SEC asked the ABA to draft amendments to the report.

But the National Association of Securities Dealers, the predecessor to Finra, said the membership fees that finders could afford wouldn't pay for the regulation of the intermediaries, so the finder initiative, at that time, died a quiet death.

The SEC's annual forum on small business capital formation has, since then, consistently recommended that the commission should take action on the finder issue. In 2009, a forum report concluded, "As recommended by its own Advisory Committee on Smaller Public Companies and recommended by the SEC Government-Business Forum's 2006, 2007 and 2008 Final Reports, the Commission should adopt rules recommended by the ABA Taskforce in 2005."

In 2012, the ABA pushed for another version of guidelines for finders, suggesting that the SEC could exempt finders from federal registration if the intermediaries would register with the states. But this initiative also faded into the ether.

The 2014 Forum report called on the SEC to, "Join with the North American Securities Administrators Association and Finra in the effort to implement the basic principles of the ABA Task Force on Private Placement Brokers. To achieve this goal (the commission should) join NASSA and Finra in developing a timeframe for quarterly or other regular meetings-with specified benchmarks-until a mutually agreeable regime of finder registration and regulation is achieved."

Advocates for finders may have struggled to make their case to the SEC, in part, because of a lack of numbers to back up their case.

"You can't point to any data to show how important finders are to small issuers," Graham said. "It's like trying to prove a negative."

In the meantime, companies, attorneys and advisers have relied on public statements by SEC officials, enforcement actions and no-action letters issued by commission staff to navigate what finders are and are not allowed to do.

The SEC has a history of issuing no-action letters regarding finder-related issues, and while the letters apply only to the specific situation cited by the SEC, the letters are closely followed by those in the industry as guideposts to the commission staff's thinking on the issue.

For instance, the SEC issued a no-action letter for Dominion Resources (D) in 1985, saying the commission would not require Dominion to register even though it intended to match investors with a securities issuer, negotiate transactions and provide financial advice. The letter became a landmark for finders.

Then in 2000, the SEC withdrew the letter, raising concerns in the finder community.

Finders have also relied on statements made in speeches by SEC officials as the legal basis for their business. In 2013, David Blass, then chief counsel for the SEC's Division of Trading and Markets, said in a speech to the ABA that if a private fund adviser had a dedicated sales force or employees dedicated to marketing, they might need to be registered as broker-dealers, as transaction-based payment was a hallmark of being a broker-dealer. The speech was viewed as a signal that the commission was now interpreting the definition of broker-dealer more broadly.

The most widely cited recent legal development for finders was the SEC's 2013 administrative action against Ranieri Partners, William Stephens and Donald Phillips. The commission alleged that Stephens solicited investors for a pair of private funds managed by Ranieri for compensation, although he wasn't registered or associated with a registered firm. The SEC also claimed that Ranieri caused Stephens' violations by not supervising his actions and that Phillips, a former Ranieri managing partner, aided Stephens.

In settling, Stephens agreed to a bar from the securities industry and paid $2.8 million in disgorgement of profits plus interest. Phillips agreed to a nine-month suspension and a $75,000 penalty. Ranieri paid a civil penalty of $375,000 and agreed to not violate broker-dealer statutes again. The fact that the fund manager and a managing partner were charged by the SEC was viewed as groundbreaking in the finder community as an indicator that the SEC was getting more aggressive in pursuing actions involving finders.

A request for another no-action letter from the commission, in January 2014, is also regarded as a landmark. The request, made by six lawyers, regarded the SEC's treatment of people brokering sales of businesses, including the sale of stock. The lawyers, Faith Colish and Ethan Silver of Carter, Ledyard & Milburn LLP; Eden Rohrer,Linda Lerner and Stacy Nathanson of Crowell & Moring; and Martin Hewitt, asked the SEC to assure them it would not take enforcement action regarding the sale or purchase of a business in which there was a stock component, despite the fact there was no broker-dealer registration. The SEC issued the letter giving "M&A" transactions some cover from the finder's controversy.

Companies that choose to employ finders may be facing risks that won't emerge until years later when the company goes public. Then, when the company registers its securities, the SEC can require it to rescind past securities offerings that are found to have been improper.

"Rescission is a real danger for companies that have used finders in the past because investors can come back, whether the company is getting ready to go public or not, and demand their investment back," said Borer.

A well-known example of how rescission can sideline a company took place with Great Neck, N.Y.-based Neogenix Oncology, a biotech company that used finders to raise $30 million in 2011. The SEC began a probe of how finders participated in the placement, and the company was unable to determine the potential rescission liability, delaying its SEC filings. The lack of timely filings with the SEC prevented the company from raising capital, and Neogenix filed for Chapter 11 bankruptcy.

SEC advisory committee member Yardley has proposed some ideas for how the commission should approach finders. A working definition of a finder along with some degree of regulation would seem to be almost automatic, he said. Limitations on the size or number of offerings could also be in order, Yardley said. Common sense regulation on finders would include prohibitions on handling either funds or stock and the only transactions allowed would be private placements.

Disclosures could likely include some form of registration with the SEC or Finra. Only representation of issuers would be allowed and the nature and amount of compensation would need to be fully disclosed, Yardley said.

When the advisory committee makes its recommendations to the SEC, it remains to be seen if the commission will act on them.

"From the point of view of certain people, the issue has been resolved and the existing framework is that resolution," David Pankey, a partner at McGuireWoods, said in an email. "Others think that a different approach would be preferable. In order to have a paradigm shift on this issue, a couple of things would be needed. A proposed approach that is practically feasible, regulatory and political persistence to advance the matter to conclusion and the ability to get various critical interests to see the need for a change, and support a specific approach."

"There is genuine interest among the commissioners on this issue," said Graham. "Chair White was around for more than half the day during our last session, and so were a couple of the other commissioners. I could see the commission taking the lead on this."

"It is encouraging that the committee is bringing this to the commission," said Eric Smith, a partner at Venable LLP. "With everything else they are trying to do, you just hope they can keep this on their radar."

Beyond the commissioners' willingness to take on the issue, Graham points to another challenge. "Finra is a difficult organization to work with," he said.

His concerns are echoed by Yardley. "The SEC has the authority to deal with the finders issue, but with everything it is dealing with, you can't expect them to do it alone, and I don't know that Finra is willing to take it up," he said.

The SEC and Finra did not make anyone available to comment for this article.

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