Middle Market M&A Brokers Get Relief
March 12, 2023
A new federal law goes into effect March 29, 2023 that conditionally exempts from broker-dealer registration persons who solely intermediate small, private company M&A deals. Persons who intermediate larger private company M&A transactions will not be eligible for the new exemption and will need to continue to rely on the SEC’s 2014 no-action letter. The new Federal legislation also does not preempt the states, so M&A intermediaries will need to continue to be mindful of state registration requirements.
Background
Most brokers are required to register with the SEC and join a “self-regulatory organization” such as FINRA. Section 3(a)(4)(A) of the Securities Exchange Act generally defines a “broker” broadly as any person engaged in the business of effecting transactions in securities for the account of others. Ordinarily, it’s fairly easy to determine whether someone is a broker. A person who executes transactions for others on a securities exchange is clearly a broker. Less clear is whether a person who intermediates only private M&A transactions, often structured as acquisitions of stock or as mergers in which securities get converted, is also a broker and required to register.
When you look at the general rationale for regulating broker dealers, it’s tough to justify applying such regulation on private company M&A brokers. Broker-dealer regulation is generally designed to prevent abuses involving high pressure selling tactics and custody of funds, two features that typically don’t apply to private company M&A deals. In a typical M&A transaction, unlike a stock trade, the acquiror usually engages in its own exhaustive due diligence of the target, and the intermediary does not typically custody funds. Nevertheless, the U.S. Supreme Court in 1985 opined that an M&A transaction involving a target’s stock is deemed to be a securities transaction. Consequently, many M&A advisors began registering with the SEC as broker dealers following the 1985 opinion.
2014 No-Action Letter
Since 2014, M&A brokers have sought to rely on an SEC no-action letter (the “NAL”), in which the SEC’s Division of Trading and Markets stated that it would not recommend enforcement action to the SEC if the M&A broker who requested the letter were to intermediate the transfer of ownership of privately-held companies and refrain from engaging in certain activities identified in the NAL. The NAL listed a bunch of deal activities that would make the relief unavailable, however, including providing financing for the deal, custodying funds or securities, arranging for a group of buyers and intermediating a sale to a “passive” buyer. All buyers would be required to control and actively operate the company or the business conducted with the assets of the acquired business.
But reliance on SEC no-action letters generally has risks. No-action relief is provided to the requester based on the specific facts and circumstances set forth in the request. In some cases, the SEC staff may permit parties other than the requestor to rely on the no-action relief to the extent that the third party’s facts and circumstances are substantially similar to those described in the underlying request, but the SEC staff always reserves the right to change the positions reflected in prior no-action letters.
NASAA Model Rule
The NAL also did not preempt state regulation, however, and in 2015 (the year after the NAL was issued) the North American Securities Administrators Association adopted a model state rule intended to codify the NAL. Only a handful of states have adopted the model rule, while a few others have enacted exclusions from the broker definition for brokers who transact solely with institutional investors or with a de minimis number of annual transactions.
New Federal Exemption
The new Federal exemption appears on page 1080 of the Consolidated Appropriations Act. It amends Section 15(b) of the Securities Exchange Act by providing an exemption for “M&A brokers”.
M&A Brokers
M&A broker is defined as a broker engaged in the business of effecting securities transactions solely in connection with the transfer of ownership of an “eligible privately held company”. Accordingly, a broker who intermediates private company M&A deals as well as other types of strategic transactions involving securities would not qualify.
The broker also has to reasonably believe that, as required in the NAL, the buyer in each intermediated transaction will “control” and “actively manage” the acquired company or business. Finally, in any transaction in which the seller receives securities of the buyer as acquisition currency, the broker must reasonably believe that the seller receives, or has reasonable access to, mandated financial information of the buyer.
Control and Active Management
Exempt M&A brokers must reasonably believe the seller in each intermediated transaction will control and actively manage the target post-closing. Control is defined as the power to direct the management or policies of a company, whether through ownership, by contract or otherwise. There is a presumption of control if the buyer has the right to vote or sell 25% or more of a class of the target’s voting securities, or in the case of a partnership or LLC, the right to receive 25% or more of the capital upon dissolution. Although not defined, “active management” can be established if the buyer elects officers, approves the annual budget or serves as an officer.
Eligible Privately Held Company
To qualify for the exemption, brokers may only intermediate acquisitions of “eligible privately held companies”. To qualify, the privately held company must not have any class of securities registered, or be required to file periodic reports, with the SEC. Also, in the fiscal year ending immediately before the fiscal year in which the broker was engaged, the company must either have EBITDA of less than $25 million or gross revenues of less than $250 million. This EBITDA and gross revenue cap is the most significant difference between the new statutory exemption and the NAL, which did not have a size of company test. The dollar caps are subject to an inflation adjustment every five years.
Excluded Activities
To qualify and maintain the exemption, an M&A broker has to avoid engaging in each of the following activities, any of which would lead to forfeiture of the exemption: taking custody of funds, participating in a public offering of securities, engaging in a transaction involving a shell company (other than acquisition vehicles), providing acquisition financing, arranging for acquisition financing without complying with applicable regulations or disclosing compensation therefor, representing both buyer and seller in a transaction without written consent from each, facilitating the formation of a buyer group, intermediating a transfer to a passive buyer or binding a party to a transaction.
Primary Takeaways
The new federal exemption is welcome relief for middle market M&A dealmakers. It removes the uncertainty associated with reliance on the NAL. But the federal exemption’s utility is unfortunately somewhat limited by the arbitrary size of target limitation, which will limit the range of transactions an M&A broker will be permitted to intermediate without forfeiting exemption eligibility. Eligible M&A brokers will also need to continue to be mindful of state registration requirements.