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State of SEC regulation in wake of Clayton commission

While it is premature to speculate on what a new federal administration may bring to SEC policy, we can pause to see where we are at the end of the administration of former Chair Jay Clayton and his Republican majority.

Indeed, in the waning months of the Clayton commission, there has been a flurry of activity aimed at deregulation in capital formation.

SEC rulemaking

In the second half of 2020, the SEC aggressively loosened the restrictions on capital formation for early stage or smaller enterprises, suggesting a concerted effort driven by philosophical underpinnings. Amidst numerous final rulemaking, much of a technical or operational nature, the SEC:

  • In August (effective Dec. 8, 2020), amended the definition of “accredited investor,” adding many more people and entities to this category. Accredited investors are entitled to participate in offerings not registered with (and supervised by) the SEC under so-called Regulation D.

Newly included in this favored cadre are holders of certain professional credentials, a broad sweep of affiliates of family offices, any entity with $5 million in investments (including cash and real estate), and key “knowledgeable” employees of an issuer. These latter two categories will feel familiar to senior practitioners, who remember that before Regulation D, the standard practice was to permit into unregistered issuances an investor who was  either “rich” or “smart” (standards so ambiguous that Reg D was born).

  • In November, issued a release announcing that changes were being made to ease the sale of unregistered securities, with the purpose to “promote capital formation and expand investment opportunities … .” The SEC increased the dollar limits applicable to exemptions from registration for a variety of pre-existing exemptions.

For Regulation A offerings (regulated more lightly by the SEC), the dollar limits of the two permitted categories were upped, the larger to $75 million.

For smaller offerings effected under the SEC crowd-funding regulation (offerings of limited size to any investor, with control over the amount each investor could commit), the amount of total sales permitted was increased almost five-fold.

Additionally, the SEC would permit single purpose entities (SPVs consisting of numerous small investors bunched together) to invest, a mechanical step facilitating the gathering together of small amounts of investment. (The crowd-funding provisions are delayed at this time.)

Finally, the lowest level of exempt offering under Rule 504 (part of Regulation D) was increased from $5 million to $10 million. Additional technical tweaks were made to applicable rules to facilitate all these unregistered offerings.

Part of the goal was to make emerging company offerings more accessible to persons of lesser means; opponents noted the speculative nature of such deals in concluding that the public was best served by restricting access as in the past.

  • In October, (the boldest effort) floated proposals concerning so-called financial finders.

Federal and state securities laws require brokers to register and be regulated, an expensive and tedious process.

Historically, individuals have served as “finders,” compensated by emerging companies for providing investors. Government regulators have uniformly stated that anyone conducting the business of brokering investments must register as a broker. Any company effecting a transaction using an unregistered broker suffered the risk of rescission on the part of investors.

Although the level of enforcement varied through the years, many issuers were affirmatively advised by their counsel to avoid use of unregistered financial finders, period.

Finders, and companies seeking financing, long have objected to barring unregistered finders. Over many years, there were proposals to permit unregistered finders, or to provide a less onerous mechanism to register them; on several occasions relief seemed imminent but never arrived.

Finally, in 2014, the SEC issued a no-action letter in effect permitting unregistered finders, subject to certain restraints to protect the investing public, but only in transactions involving an acquisition.

Although the no-action letter was not formally binding on the states, nor did it prevent investors in failed deals involving finders from bringing suit, the no-action letter changed the actual practices of many unregistered finders in acquisitions settings. However, there was no relief for financial finders, those raising investment capital.

On Oct. 7, 2020, sensing no doubt the volatility of the issues involved, the SEC took the unusual step of proposing executive action to exempt financial finders from broker registration or any registration at all. The commission divided on party lines, with the two Democratic members voting in the negative.

Before engaging with the voluminous comments filed with the SEC, note that (perhaps given the possible end to Republican control of the commission) the proposal was to become effective not by the usual lengthy rulemaking process typical for fundamental changes, but rather by commission waiver.

The proposal contains two finder exemptions from federal brokerage registration. Since registration is triggered by being in the business of intermediating securities transactions, the first exemption allows an individual finder to turn over one name to an issuer company once a year; presumably such casual activity does not constitute being in the business, and finders could be compensated. The finder has no further role and does not work with or contact the investor.

The second exemption requires the finder to enter into a written agreement with the   issuer company, and the agreement and compensation must be disclosed to investors.  The offering can be made only by non-reporting companies and only to accredited investors (presumably protection against sales to investors who cannot fend for themselves).

The finder can have an active role: screening investors, distributing issuer materials, discussions with investors, attendance at meetings between issuer and investors. Finders cannot negotiate the terms of the deal, handle funds, prepare marketing materials, perform deal analysis, perform diligence, or arrange financing for investors.

At deadline for this article, no action had been taken by the SEC on this proposal.  Chairman Clayton and many staff have departed. The comments filed by the public are fascinating, although predictable. The comments capture the differing views of the role of regulation of unregistered company offerings. Does loosening restrictions empower investors and grant freedom in the marketplace? Or does it open the door for fraud on ill-prepared retail investors as to which government has a prophylactic role?

Selecting from the dozens of public comments on the proposal, we start with comments from Massachusetts Secretary of State William Galvin. Finders must be registered as they have conflicts of interest. Not even the single-transaction exemption should stand as it undermines regulation. The Massachusetts Securities Division has seen fraud from finders whose actions harm “a high risk segment of the market.” Protection by restricting sales to accredited investors is inadequate as the accredited investor financial qualifying threshold is too low. Finders implicitly are recommending an investment. The letter lists a page-and-a-half of finder fraud cases enforced by the commonwealth.

Comment from the association of state securities regulators (North American Securities Administrators Association, or NASAA) is to the same effect. The states continually find fraud on Main Street investors, particularly elder fraud, in unregistered offerings with no registered professionals involved. The financial level for an accredited investor has not been increased in 40 years. There is need for a balanced rule after full formal SEC rulemaking procedures.

honig-stephenWill the need to spur the post-pandemic economy lead to Democratic support for loosening controls on funding start-up or smaller enterprises?

FINRA is the self-regulatory organization with which brokers register. It supports capital formation for small businesses. For brokers registered with FINRA, there are rules that screen quality of brokers and prescribe how they may participate in unregistered financings. There is also a special tier of brokers, Capital Acquisition Brokers, which can advise companies and funds and effect placements to institutional investors. FINRA does not allow certain projections or unreasonable forecasts, requires disclosure of investment risks, and investigates misconduct. Using the undemanding rules applied to Capital Acquisition Brokers, FINRA (no surprise here) suggests that all financial finders should register with it. In the old days, we used to call this approach “broker dealer lite.”

The Heritage Foundation, a conservative think tank, presents extensive argument in favor of the SEC proposal, as democratizing access to investment opportunities while helping entrepreneurs of Middle America. Its comment contains economic analyses by geography in support of the need for finders to drive small businesses. Accredited investor standards (criticized as too low by many commentators) are too high for many areas of the country.

Finally the CFA Institute, a global nonprofit representing analysts, advisors and investment professionals, criticizes the proposal as not protective of investors, complaining that the absence of any requirements for disclosure of finder financial condition places investors at risk. It also asks for a formal rulemaking process, so that economic analysis and competitive impact could be considered. Finding the proposal over-broad and inviting fraud, CFA concludes that “the far-reaching exemption from the set of broker rules is neither necessary nor in the public interest.”


How will these fundamental questions be approached by a new federal administration? Will there be an undertaking to repeal what was done in August and November? A reversal of the finder proposal (opposed by the Democratic commissioners in 2020)?

Will the need to spur the post-pandemic economy lead to Democratic support for loosening controls on funding start-up or smaller enterprises?

And to what degree will politics infiltrate SEC regulatory policy?

Stephen M. Honig practices at Duane Morris in Boston.

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