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The Felony at the Golf Club
SEC “finder” rules make it harder for startups to raise money
By Sara Hanks
Raising money for startups is hard. Even with all the innovations of the JOBS Act, which by and large permitted startups to use the internet and social media to attract investors’ attention to offerings hosted by online platforms, new companies can have trouble raising startup capital. People on those platforms tend to invest in the high-tech and the highball industries (offerings by consumer electronics companies and distilleries are popular), and the checks they write don’t often exceed $2,000. If you are building a company that makes sober things that don’t go beep and you need investors who can write $20,000 checks, where do you go?
Many entrepreneurs reach out to their local communities, as they always have. They talk to people in their faith and social groups. Very often, a friend will know one of those guys who knows some guys—a wealthy investor, who can put the entrepreneur in touch with some of his friends at the golf club who have invested in early-stage companies in the past. There’s just one problem: the guy with the bulging Rolodex wants some compensation if his contacts invest. That’s perfectly reasonable; he probably doesn’t know the entrepreneur well, and his own personal reputation will be on the line if something goes wrong.
These “finders” have existed as long as capitalism has existed, and in some ways they are essential to the effective allocation of capital. But there is a hitch: the SEC’s onerous broker-dealer registration requirements apply to finders. While there is no definitive list of the activities that result in being required to register as a broker, the SEC’s public guidance on the topic identifies individuals or entities engaged in finding investors for issuers, even in a “consultant” capacity, as those who may need to register as broker-dealers.
Registering as a broker is impractical or impossible for most finders. They need to pass the Financial Industry Regulatory Authority’s examinations and find a licensed brokerage willing to let them hang their shingle there. And most of them will object to the idea that getting compensation for making introductions now means they are subject to federal and state regulation.
But so long as a finder isn’t registered as a broker, a startup that uses his services is in peril. Sales of securities through a person who is an unregistered broker are subject to “rescission”—the requirement that the issuer offer to buy back the securities the finder placed. Moreover, if the rescission obligation isn’t mentioned to later investors, it could be an omission of a material fact by the startup—a further securities law violation.
And yet, because startups need money, US securities laws continue to be violated every weekend of the year in every golf club in the country, most often by people who don’t even realize those laws apply to them.
In the past, the SEC’s Division of Trading and Markets has issued “no-action” letters (letters reassuring the applicant that enforcement action won’t be taken against them if they act in the way they have described to the SEC) on finders’ activities, but the industry has moved on since that limited guidance was issued. For example, the non-broker online platforms hosting offering information about private placements are a relatively recent development. The Division is rumored to be concerned about a “slippery slope” if it allows certain activities, but the result is that all finders currently operate in what the American Bar Association Task Force on Private Placement Broker Dealers has termed a “vast and pervasive ‘gray market’ of brokerage activity.”
Various industry groups and advocates have urged clarity in this area. In 2005, the ABA task force issued its Report and Recommendations asking for clarification of finder status and recommending an exemption from registration or a simplified registration regime for finders. (The task force continues to make these recommendations) Likewise, the SEC’s Advisory Committee on Small and Emerging Companies in both 2015 and 2017 requested clarity and certainty in this area. The recommendations from nearly all the annual Government-Business Forums on Small Business Capital Formation in recent years also include requests to address the status of finders.
There have been several attempts to find a legislative, as opposed to regulatory, solution to the problem. In 2019, Rep. Ted Budd (R-NC) introduced the Unlocking Capital for Small Businesses Act, which would have created two levels of regulation: one for private placement brokers and another for finders. Private placement brokers would be subjected to a lighter regulatory regime, while finders would be exempted from registration as brokers. The definition of finders would include persons that received transaction-based compensation (1) equal to or less than $500,000 in any calendar year, (2) in connection with transactions that result in a single issuer selling securities valued at equal to or less than $15 million in any calendar year, (3) in connection with transactions that result in any combination of issuers selling securities valued at equal to or less than $30 million in any calendar year, or (4) in connection with fewer than 16 transactions that are not part of the same offering or are otherwise unrelated in any calendar year.
The bill – which, so far, has languished in Congress – is similar to many regulatory initiatives in that it attempts to define an activity that by its nature does not require extensive regulation and provides an exemption from that regulation. People who ask for introductions to other people do not generally expect the government to have a stake in that activity. People who make the introductions, even for compensation, do not reasonably expect that by doing so they are conducting business that needs to be overseen by a financial regulator. To the extent that finders make fraudulent misstatements, laws already exist to cover such contingencies. But it’s time to save the inadvertent villains of the golf club from regulation that helps no one and let them get on with helping small businesses find investors.
This is the third in a series of articles that will examine ways to help entrepreneurs who are seeking to start small businesses in the wake of the pandemic to access the capital they need. The first article in this series provides an overview of the challenges facing would-be entrepreneurs in the coronavirus economy. The second article concerns offering small businesses guaranteed access to credit. The fourth article concerns easing restrictions on lending by small banks. The fifth article proposes easing restrictions on the sale of securities by small startups. The sixth article argues that Congress should ease restrictions on peer-to-peer lending. The seventh article proposes several reforms to the Small Business Administration. The eighth and final article urges governments to create a better environment for small businesses by reducing uncertainty and reopening the economy.