SEC Issues No-Action Letter Regarding Treatment of Certain Unregistered M&A Broker-Dealers

by Jackson Walker

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The staff of the Securities and Exchange Commission's Division of Trading and Markets (the "Staff") recently issued a no–action letter (the "Letter")1 that provides significant new guidance with respect to the involvement of certain merger and acquisition brokers (as defined in more detail below, "M&A Brokers") in transactions involving privately held companies. As discussed below, the Letter will in some cases provide enhanced flexibility for unregistered M&A Brokers to assist with transactions and receive transaction–based compensation. However, it is important for M&A Brokers and private companies to be aware of significant limitations on the relief afforded to M&A Brokers under the letter. For example, a broker receiving transaction–based compensation in connection with an offering of securities by an issuer seeking to raise capital generally would not be able to rely on the Letter to avoid federal broker–dealer registration. Additionally, as discussed below, there remain significant state "blue sky" regulations on broker–dealer activities that are not preempted or otherwise modified by the Letter. Accordingly, M&A Brokers and private companies should consult legal counsel before attempting to rely on the Letter for any purpose.

Background and Regulatory Context
The involvement of intermediaries in private M&A transactions has for decades been a significant source of uncertainty for securities practitioners, who have generally taken the view, on the basis of sparse case law and SEC guidance, that an M&A Broker (particularly one receiving a transaction–based fee) falls within the meaning of the term "broker" under Section 3(a)(4) of the Securities Exchange Act of 1934 and, absent an available exemption, is required to register as a broker–dealer and become a member of a self–regulatory organization (FINRA).

Since the U.S. Supreme Court's 1985 decision in Landreth Timber Co. v. Landreth2 (and its companion case, Gould v. Ruefenacht3), it has been settled that a transaction involving the purchase or sale of stock (even 100% of a closely held private corporation's stock) should be treated for regulatory purposes as a sale of securities and not as the functional equivalent of an asset sale. The anomalous result—that an M&A Broker involved in a sale of stock would be required, absent an available exemption, to incur the cost and burden of registering as a broker–dealer, while an M&A Broker involved in an otherwise economically equivalent asset sale would not—led to the issuance of two no–action letters, International Business Exchange Corporation4 and Country Business, Inc.5 (collectively, the "Prior Letters"), in which the SEC indicated that it would not recommend enforcement action against M&A Brokers who engage in certain limited activities without registering as broker–dealers.

M&A Brokers who sought to rely on the Prior Letters faced a daunting and somewhat arbitrary set of limitations on their activities. Among other things, both of the Prior Letters would have required a sale of 100% of the securities of the target company and would have significantly limited the role and utility of the M&A Broker seeking to avoid federal registration.

New SEC Guidance
The Letter removes some of the more onerous requirements of the Prior Letters and expands the scope of activities in which M&A Brokers may engage without federal registration. Specifically, the Staff indicates that, under certain circumstances discussed below, it would not recommend enforcement action "if an M&A Broker6 were to effect securities transactions in connection with the transfer of ownership of a privately held company7...without registering as a broker–dealer pursuant to Section 15(b) of the Exchange Act." Subject to the conditions below, an M&A Broker would be permitted under the Letter to play an active role in an M&A Transaction8 and to solicit interested parties, advertise a company for sale, participate in negotiations, advise the parties to issue securities or otherwise effect the transfer of the business by means of securities, assess the value of any securities sold, and receive transaction-based compensation, among other things.

The Letter is predicated on the following conditions and assumptions:

1. The M&A Broker will not have the ability to bind a party to the M&A Transaction;
2. The M&A Broker will not directly or indirectly provide financing for the M&A Transaction and, where the M&A broker assists the parties in securing financing from unaffiliated third party lenders, the M&A Broker must follow all applicable laws (including, as applicable, Regulation T) and disclose any compensation in writing to the client;
3. Under no circumstances will the M&A Broker have custody, control, or possession of or otherwise handle funds or securities issued or exchanged in connection with the M&A Transaction or other securities transaction for the account of others;
4. The M&A Transaction must not involve a public offering, must be conducted under an applicable exemption from registration under the Securities Act of 1933, and may not involve a "shell company" except for a "business combination related shell company" defined under Rule 405 of the Securities Act of 1933;
5. To the extent the M&A Broker represents both buyers and sellers, the M&A Broker will provide clear written disclosure as to the parties it represents and obtain written consent from both parties to the joint representation;
6. The M&A Broker will facilitate the M&A Transaction with a group of buyers only if the group is formed without assistance from the M&A Broker;
7. The buyer, or group of buyers, in the M&A Transaction will, upon completion of the M&A Transaction, control and actively operate the target company or the business conducted with its assets;9
8. No M&A Transaction will result in the transfer of interests to a passive buyer or group of passive buyers;
9. Any securities received by the buyer or the M&A Broker in an M&A Transaction will be restricted securities within the meaning of Rule 144(a)(3) under the Securities Act of 1933 because the securities would have been issued in a transaction not involving a public offering; and
10. The M&A Broker (and, if the M&A Broker is an entity, each officer, director and employee of the M&A Broker) (i) must not be barred from association with a broker–dealer by the SEC, any state or any self–regulatory organization, and (ii) must not be suspended from association with a broker–dealer.

Applicability to Private Fund Managers
In recent years, statements by senior SEC staff have led many private fund managers to believe that the SEC is focusing more attention on broker–dealer issues arising in the private investment fund context—specifically issues with respect to (i) marketing activities conducted by employees of fund managers in an effort to sell interests in the funds they manage and (ii) fund managers who broker transactions for portfolio companies and receive transaction fees in connection therewith.10

Because private fund managers generally have custody of securities of their portfolio companies and have the power to bind their clients through control of the funds they manage, such managers would not likely be able to rely on the Letter in connection with transactions brokered for portfolio companies by such managers. However, in a recent presentation, senior SEC staff hinted that they consider the Letter a precursor to possible future action addressing private equity fund managers and issues relating to marketing activities and transaction fees.11 In the meantime, subject to applicable state law (discussed below), the Letter may provide fund managers some degree of enhanced flexibility to use third–party unregistered M&A Brokers in connection with portfolio transactions. Beyond that, it remains to be seen what, if any, relief may be forthcoming for fund managers as a result of the framework established in the Letter.

Possible Congressional Action
The Letter comes at a time when action with respect to the same array of issues is being considered by Congress. H.R. 2274, which was passed by the House of Representatives on January 14, 2014 and is currently pending in the Senate Committee on Banking, Housing and Urban Affairs, would permit an unregistered M&A Broker to participate in the sale of a privately held business with EBITDA of less than $25 million or gross revenues of less than $250 million if certain conditions are met (including that the buyer, alone or in concert, must control the business after the transaction and must receive certain disclosures). It is unclear at this point what effect the issuance of the Letter will have on discussions with regard to H.R. 2274. Until the passage of such a law or the adoption by the SEC of more formal guidance pursuant to its rulemaking authority, the positions expressed in the Letter may be subject to change with little notice.

State Regulation of Broker-Dealers
While the Letter offers important guidance for M&A Brokers with respect to federal broker–dealer registration requirements, it does not relieve M&A Brokers from their obligations under applicable state law. M&A Brokers may in some cases be able to identify exemptions from state–level broker–dealer regulations that are sufficient for such M&A Brokers to participate in certain transactions without registration. However, that analysis, like the analysis under the Letter, will necessarily be conducted on a transaction–by–transaction basis and in some cases will reveal a state–level regulatory regime that is more restrictive than what is contemplated by the Letter. For example, an M&A Broker operating in Texas would likely be required to register as a broker-dealer pursuant to the Texas Securities Act or, alternatively, as a "business broker" or "finder" if the services performed by the M&A Broker are limited to the extent required under Texas law.

It remains to be seen whether state securities regulators will find the line of reasoning adopted in the Letter persuasive and to what extent similar state–level guidance might be forthcoming in the future. In any case, M&A Brokers should seek the advice of counsel before providing services or accepting transaction–based compensation without registration in reliance on the Letter.

1Letter dated January 31, 2014 [revised February 4, 2014], from David W. Blass, Chief Counsel and Associate Director, Division of Trading and Markets, Securities and Exchange Commission, to Faith Colish, Martin A. Hewitt, Eden L. Rohrer, Linda Lerner, Ethan L. Silver and Stacy E. Nathanson.
2471 U.S. 681 (1985) (sale of 100% of target's stock is a sale of securities; "sale of business" doctrine inapplicable).
3471 U.S. 701 (1985) (sale of 50% of target's stock is a sale of securities; "sale of business" doctrine inapplicable).
4International Business Exchange Corporation, SEC No–Action Letter, December 12, 1986.
5Country Business, Inc., SEC No–Action Letter, November 8, 2006.
6For purposes of the Letter, the term "M&A Broker" means "a person engaged in the business of effecting securities transactions solely in connection with the transfer of ownership and control of a privately held company (as defined below) through the purchase, sale, exchange, issuance, repurchase, or redemption of, or a business combination involving, securities or assets of the company, to a buyer that will actively operate the company or the business conducted with the assets of the company. A buyer could actively operate the company through the power to elect executive officers and approve the annual budget or by service as an executive or other executive manager, among other things."
7For purposes of the Letter, the term "privately–held company" means "a company that does not have any class of securities registered, or required to be registered, with the Commission under Section 12 of the Exchange Act, or with respect to which the company files, or is required to file, periodic information, documents, or reports under Section 15(d) of the Exchange Act."
8For purposes of the Letter, the term "M&A Transaction" means "mergers, acquisitions, business sales, and business combinations between sellers and buyers of privately–held companies, without regard to the size of the privately–held companies."
9A buyer, or group of buyers collectively, would have the necessary control if it has the power, directly or indirectly, to direct the management or policies of a company, whether through ownership of securities, by contract or otherwise. The necessary control will be presumed to exist if, upon completion of the M&A Transaction, the buyer or group of buyers has the right to vote 25% or more of a class of voting securities; has the power to sell or direct the sale of 25% or more of a class of voting securities; or in the case of a partnership or limited liability company, has the right to receive upon dissolution or has contributed 25% or more of the capital. In addition to having control, the buyer or group of buyers must actively operate the company or the business conducted with the assets of the company.
10See, e.g., A Few Observations in the Private Fund Space, April 5, 2013, David W. Blass, Chief Counsel and Associate Director, Division of Trading and Markets, Securities and Exchange Commission.
11SEC Issues No–Action Relief for M&A Broker–Dealers: What Does This Mean for You? David W. Blass, Chief Counsel and Associate Director, Division of Trading and Markets, Securities and Exchange Commission, and Darren Vieira, Special Counsel, Division of Trading and Markets, Securities and Exchange Commission, moderated by Charles J. Morton, Jr., partner, and Scott E. Gluck, counsel, Venable LLP.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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