The bane of every start-up company is the never-ending quest to raise capital for its operations. Newly (and not so new) formed companies seemingly would do anything to raise funds. Over the course of many decades, these entities and those who operate them have employed numerous individuals to find them money. Now, however, Congress has made it more difficult to use these companies and individuals while seeking such capital.’
In recently implemented legislation, Congress exempted M&A brokers facilitating change-of-control transactions involving certain small privately held companies from federal broker-dealer registration. The problem: the New Exemption limits previous avenues of relief and does not preempt state laws, possibly creating inconsistent registration requirements.
Background
Securities Exchange Act of 1934 (Exchange Act) Section 15(a) requires registration with the United States Securities and Exchange Commission (SEC or Commission) of securities brokers, defined as “any person engaged in the business of effecting transactions in securities for the account of others.” Many have sought to avoid registration by characterizing themselves as business brokers or finders to “assist” companies in financing expeditions.
The SEC, in almost all cases, believes business brokers and finders should register as brokers and become members of the Financial Industry Regulatory Authority (FINRA). FINRA Rules consistently prohibit FINRA members from paying transaction-based compensation to non-members. See NASD Notice to Members 05-18. The SEC has been clear that, if companies pay transaction-based compensation in connection with nearly all securities transactions to an unregistered person or entity, the company itself would violate the law. The SEC determined a person who brokers the sale of a business or facilitates the placement of securities for compensation is a broker within the meaning of the Exchange Act. Notwithstanding the SEC’s position, many business brokers and finders (and desperate companies) choose to avoid the expense and regulatory oversight of registration with the SEC.
The New Exemption
Despite the need for capital in these trying economic times, Congress recently amended the Exchange Act to exempt certain "M&A brokers" from registration as broker-dealers, but with significant limitations. While the new exemption follows the no-action relief from the SEC's Division of Trading & Markets, dated January 31, 2014 as revised February 4, 2014 (MA Broker Letter), (https://www.sec.gov/divisions/marketreg/mr-noaction/2014/ma-brokers-013114.pdf) (Feb. 4, 2014), its terms are narrower than the prior relief. The new legislation applies only to M&A transactions for small entity issuers, and also does not preempt state law registration requirements for M&A brokers. Moreover, on March 29, 2023 – the same day the legislation became effective – the SEC withdrew the MA Broker Letter that had been more expansive.
The SEC’s Evolution Over Time
Over the years, various individuals and entities have sought guidance from the SEC Staff on the appropriateness of certain activities described as falling within the purview of the work of a finder or business broker through a series of no-action letters. No-action letters allow the SEC staff to evaluate a finder’s proposed activities and determine if registration as a broker-dealer is required prior to the undertaking of any of the stated activities. In the previous absence of statutory authority, these no-action letters were relied upon by securities practitioners as well as industry insiders to determine if the proposed party would be required to register as a broker-dealer.
Often the difference between registration or not was based upon the SEC’s focus on if the intermediary would earn compensation from its activities, and the intermediary’s level of participation in the transaction. For example, in 1972, the SEC Staff issued a no-action letter at the request of Corporate Forum, Inc. (Corporate Forum). See Corporate Forum, Inc.,SEC No-Action Letter, 1972 WL 9128 (Dec. 10, 1972). Corporate Forum’s proposed activities included seeking out merger and acquisition candidates as well as conducting any financial analysis requested by its client. The SEC Staff stated it would not recommend enforcement action if Corporate Forum did not register as a broker-dealer and conducted these activities. The SEC Staff seemed to emphasize Corporate Forum’s lack of participation in negotiations between its client and the merger and acquisition candidates.
However, the SEC Staff has not always been consistent in its position. In another 1972 no-action letter, the SEC Staff denied the relief sought by Fulham & Co., Inc. (Fulham & Co.), for similarly proposed activities, indicating that Fulham & Co. needed to register as a broker-dealer because, apparently, Fulham & Co. intended on directly participating in the negotiations between the interested parties. See Fulham & Co., Inc., SEC No-Action Letter, 1972 WL 9129 at 2 (Dec. 20, 1972). Similarly, the SEC Staff’s no-action letter to the Russell R. Miller Corp. (RRM), continued to focus on participation (or lack thereof) in negotiations, allowing the payment of the fee to occur upon consummation of a transaction, but where RRM would not participate in negotiations, nor would it provide any input as to if its fee would be paid in cash or securities. See Russell R. Miller & Co., Inc., SEC No-Action Letter, 1977 WL 10938 (Aug. 15, 1977).
The SEC Staff further elaborated on the finder’s proper role in conjunction with potential compensation in other no-action letters as well. Among these, the SEC staff issued a no-action recommendation regarding the proposed activities of International Business Exchange Corporation (IBEC). IBEC was involved in the advertising and sale of closely held entities where its role was limited to the transmission of documents between the interested parties. IBEC did not participate in negotiations and IBEC’s fee would be based upon the value of the transaction, determined prior to the time the parties agreed to the form of the consideration required to close the transaction. See Int’l Bus. Exch. Corp., SEC No-Action Letter, 1986 WL 67535 at *1-*2.
Additionally, in a 1991 no-action letter involving Paul Anka, the entertainer, the SEC Staff stated it would not recommend enforcement of the broker-dealer registration requirement against him. While registration would seemingly be required since Anka appeared to have been offered a contingent investment commission in exchange for providing a list of potential investors for investment in a professional hockey team, the SEC Staff granted no-action relief. See Paul Anka, SEC No-Action Letter (July 24, 1991). Apparently, the SEC Staff seems to have focused on the financial acumen of the potential investors in making this determination.
In later years, the SEC Staff, nonetheless, went further in defining certain standards it would consider in determining finder or business broker status as opposed to requiring broker-dealer registration. Accordingly, the SEC Staff issued a no-action recommendation regarding the proposed activities of Country Business, Inc. (CBI). See Country Bus., Inc., SEC No-Action Letter, 2006 WL 3289777 at 1. CBI anticipated “providing services that are more extensive than simply acting as a finder of potential purchasers of the business.” See Letter from Craig McCrohon, Counsel for Country Bus. Inc., to Catherine McGuire, Chief Counsel and Assoc. Dir., Div. of Mkt. Regulation, Sec. & Exch. Comm’n at 1 (Nov. 8, 2006). CBI intended to assist with the sale of closely held entities by, among other things: (1) transmitting documents between the parties; (2) valuing the assets of the business as a going concern; (3) providing the seller with administrative support; and (4) assisting the seller with preparation of financial statements. In granting the no-action relief, the SEC Staff, apparently, relied upon CBI’s avoidance on advising the interested parties on the form of consideration to be used in completing the transaction, and that CBI’s fee was to be determined prior to a decision on the structure of the transaction. Further, this fee would potentially be “a fixed fee, hourly fee, a commission, or a combination thereof, that is based upon the consideration received by the seller, regardless of the means used to effect the transaction, and will not vary according to the form of conveyance (that is, securities rather than assets).”
Taking a different view, the SEC Staff denied relief to Hallmark Capital Corporation (Hallmark) although its proposed activities were very similar to those described by CBI in its no-action letter. Hallmark Capital Corp., SEC No-Action Letter, 2007 WL 1879799 at 1. Hallmark described itself as “a financial consultant and finder for small businesses that assists the owners of businesses in raising capital, facilitates mergers and acquisitions and provides strategic business consulting services.” Id. at 2. Although the SEC did not state in detail its reasons, the difference seemed to be Hallmark’s fee was not fixed prior to a decision by the interested parties as to the structure of the transaction, and the fee had been set prior to the transaction as detailed in both the IBEC and CBI no-action letters. Compare Country Bus., Inc.,SEC No-Action Letterat 1 and Int’l Bus. Exch. Corp.,SEC No-Action Letter with Hallmark Capital Corp. Seemingly, these differences would indicate Hallmark would be acting more as a salesman where such compensation is normally tied to the transaction itself. In IBEC and CBI, the fee was akin to a “flat fee.”
This departure from the previous factors was solidified in March 2010, when the SEC Staff issued a response to a no-action request from the law firm of Brumberg, Mackey & Wall, P.L.C. (Brumberg). The Brumberg no-action letter moved closer to a one issue checklist – did the finder or business broker receive transaction-based compensation? If so, broker-dealer registration would be required since that factor alone, according to the SEC, would trigger such requirements.
Brumberg sought to introduce potential investors to a renewable energy company. In return, Brumberg would receive a percentage of the funds raised from those investors. Brumberg claimed it would not: (1) engage in any negotiations with investors; (2) provide potential investors any information about the energy company that could be used as the basis for funding-related negotiations; (3) be responsible for, or make any recommendation regarding, the terms, conditions or provisions of any agreement for an investment; or (4) provide any assistance to any potential investor regarding any transaction involving the financing of the energy company.
This seemingly innocuous description would have placed Brumberg firmly in line with previous SEC no-action relief, such as IBEC and CBI. Still, the SEC said “no.” The SEC switched its focus, underscoring its transaction-based compensation approach. The SEC Staff suggested Brumberg’s role of introducing potential investors to the company seeking financing constituted "pre-screening" potential investors to determine their eligibility to purchase securities, and "pre-selling" the company seeking financing. The SEC Staff emphasized that the transaction-based compensation Brumberg sought to receive would provide Brumberg a strong incentive to engage in "pre-selling," or other sales activities such that Brumberg would need to register as a broker-dealer if it proceeded with the proposed arrangement. See http://www.sec.gov/divisions/marketreg/mr-noaction/2010/brumbergmackey051710.pdf.
The M&A Broker Letter and State Regulation
However, in 2014, the SEC Staff informed the industry it would not recommend enforcement action for unregistered finders acting as M&A brokers for privately held companies. At the same time, the Staff did not comment on any state law issue. See M&A Broker Letter. Thus, to provide a limited exemption from registration, the SEC issued the MA Broker Letter setting forth guidelines that business brokers could follow to be exempt from federal broker-dealer registration.
Additionally, in 2015, the North American Securities Administration Association (NASAA) adopted a model rule (Model Rule), largely following the requirements of the MA Broker Letter. If adopted by a state, it provided a state level exemption from registration. About twenty states adopted the NASAA model rule, but, at no time, did everyone agree as to how to proceed.
New M&A Statutory Broker Exemption
Jumping into this quagmire was Congress, which passed the Consolidated Appropriations Act, 2023 (Act) that was signed into law by President Biden on December 29, 2022. The Act contained a provision exempting brokers who facilitate small business M&A from registration with the SEC. See H.R. 2617, page 1080. Section 501 of Title V of Division AA of the Act amends Exchange Act Section 15(b) by adding a new subsection 15(b)(13), providing an exemption (New Exemption) from SEC registration for so-called “M&A brokers.”
However, to obtain the New Exemption a party must meet certain conditions. If a person meets the conditions of the New Exemption, the party may receive commissions for its brokerage services without having to register with the SEC as a broker-dealer. The New Exemption is supposedly intended to facilitate small business change-of-control transactions and create cost-saving opportunities for small businesses.
The New Exemption notably differs from the SEC Staff’s MA Broker Letter. The New Exemption is limited to transactions involving a change of control over small business entities, while the MA Broker Letter relief was broader, and conditioned relief, in part, on the fact that “[a]ny securities received by the buyer or M&A broker in an M&A Transaction will be 'restricted securities' within the meaning of Securities Act of 1933 (Securities Act) Rule 144(a)(3) because the securities would have been issued in a transaction not involving a public offering.” Although new Exchange Act Section 15(b)(13) does not explicitly address the restricted status of any securities transferred in a transaction brought about by an M&A broker who relies upon the New Exemption, the acquiring party needs to determine, as part of its compliance with the Securities Act, if any received securities are restricted securities.
Nonetheless, there is a slight benefit to the New Exemption. The New Exemption only requires the M&A broker have a reasonable belief the securities buyer of the eligible privately held company will control and be actively involved in its management, while the M&A Broker Letter required the securities buyer to control and actively operate the privately held company.
How the New Exemption Works?
The New Exemption defines an “M&A broker” as essentially a broker (and its associated persons) who is “engaged in the business of effecting securities transactions solely in connection with the transfer of ownership of an eligible privately held company regardless of whether the broker acts on behalf of a seller or buyer” or how the transaction is effectuated. See Exchange Act Section 15(b)(13). However, the M&A broker must reasonably believe that the buyer will control the eligible privately held company and can vote or direct the sale of 25% of a class of voting shares. Id.
To be an “eligible privately held company,” the acquired company must: (i) not have any class of securities registered with the SEC pursuant to Exchange Act Section 12 or subject to Exchange Act Section 15(d)'s filing obligations; and (ii) in the fiscal year prior to the engagement of the M&A broker, have (a) earnings of less than $25 million before interest, taxes, depreciation, and amortization, and/or (b) gross revenues of less than $250 million.
The real “bite” with the New Exemption is the list of activities precluding M&A brokers from taking advantage of the exemption, including, among other things:
- Directly or indirectly, receiving, holding, transmitting, or having custody of funds or securities of the parties in connection with the transaction;
- Directly, or indirectly through any of its affiliates, providing financing to a party to the transaction;
- Engaging in a transaction involving a shell company — other than a business combination utilizing a shell company formed solely for purposes of the combined transaction;
- Engaging in a transaction involving the transfer of ownership of an eligible privately held company to a passive buyer or group of passive buyers;
- Representing both the buyer and the seller in the same transaction without providing written disclosure to the parties represented and obtaining both their written consent to the joint representation;
- Assisting in the financing by any party from an unaffiliated third party without: (i) complying with all other applicable laws in connection with such assistance, including, if applicable, Regulation T; and (ii) disclosing any compensation in writing to the party;
- Assisting in the formation of a buyer group to acquire the eligible privately held company; and
- Binding a party to a transfer of ownership of an eligible privately held company.
However, to qualify for the New Exemption, neither the M&A broker nor its associated persons can have been barred by the SEC or any state or self-regulatory organization, such as an exchange or FINRA; or suspended from association with a broker or dealer.
Finally — and importantly — the New Exemption does not preempt states from instituting broker registration or other requirements. The Model Rule does not incorporate the many restrictions found in the New Exemption. However, the Model Rule does define “control” of a privately held company as at least a 20% voting interest in the company, instead of at least a 25% voting interest to establish “control” for Exchange Act registration purposes. The Model Rule also imposes limitations on the size of the acquired privately held company (either $25 million in earnings or $250 million in gross revenues). It remains to be seen if any of the various states will adopt new exemptions or amend their current M&A broker exemptions to match the terms of the New Exemption, even where an M&A broker is exempt from federal registration as a broker-dealer under the New Exemption. As such, the M&A broker may still be required to register with a particular state because it conducts M&A broker activity with those states’ residents.
Conclusion
In sum, Congress has enacted a new statutory exemption from federal broker-dealer registration for M&A brokers facilitating change-of-control transactions involving certain small privately held companies. Nonetheless, the New Exemption is limited, and curtails previous avenues of relief. Further, the New Exemption does not preempt state laws, thereby, raising the possibility of inconsistent “registration requirements.”
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