Brokers who specialize in the sale or purchase of private companies (“M&A Brokers”) have long been an uncomfortable fit under the rules applying to securities broker-dealers. M&A Brokers typically provide advisory services to owners of a private business, or to private equity funds and strategic buyers seeking to acquire a private business. Generally, M&A Brokers don’t have retail customers, don’t carry customer accounts, don’t execute trades, and don’t carry an inventory of securities. However, many M&A transactions involve the purchase of shares, share for share exchanges, or other securities transactions, and facilitating such transactions could fall within the definition of “broker-dealer” in the Securities Exchange Act of 1934 (the “Exchange Act”). As a result, for many years M&A Brokers were subject to a regulatory scheme that ill-suited their business.
Nearly a decade ago, the staff of the Securities and Exchange Commission (SEC) attempted to address this anomaly by issuing the M&A Brokers No-Action Letter. In this no-action letter, the SEC staff stated that it would not seek to require the registration of brokers who limit their business to facilitating M&A transactions involving privately held companies. The relief is conditioned upon a number of requirements, including that the transaction must result in the buyer acquiring and exercising control of the private company, and that any securities issued in the transaction would be restricted securities. The no-action letter does not impose any size limitation on the private companies. The only limitation is that the private company must not be an SEC-reporting company and it must be a going concern.
The M&A Brokers No-Action Letter provided welcome relief to the industry. However, it suffers from two constraints: it does not apply to state broker-dealer registration requirements and, as a no-action letter, it could be reversed relatively easily by the SEC.
To address these constraints, a number of legislative proposals were introduced in Congress seeking to create a statutory exemption for M&A Brokers. In addition, the North American Securities Administrators Association (NASAA) adopted a model rule that largely aligned with the M&A Brokers No-Action Letter, but which imposed a size limitation on the private companies that would be covered by the relief. Approximately half the states have adopted a version of the NASAA model rule.
The New Federal Statutory Exemption
Congress has created a new statutory exemption for M&A Brokers through an amendment to the Exchange Act that will go into effect in late March 2023. The amendment creates a new exemption from the broker-dealer registration provisions of the Exchange Act for M&A Brokers (the “Federal Exemption”). The Federal Exemption is conditioned upon the M&A Broker refraining from the following activities:
- Having custody of the buyer or seller’s funds or securities,
- Engaging in any public offering of securities as part of the transaction,
- Providing financing for the transaction,
- Assisting in obtaining financing from an unaffiliated third party unless any compensation for such arrangement is fully disclosed to the parties and the financing arrangement otherwise complies with applicable laws,
- Facilitating a transaction involving a shell company (other than a shell company formed solely to effect a business combination or reincorporation),
- Representing both the buyer and the seller unless they have provided written consent after receiving appropriate disclosures,
- Forming a consortium of buyers,
- Facilitating a sale to a passive buyer or group of buyers, and
- Acquiring authority to bind either the seller or the buyer.
These conditions generally align with the M&A Brokers No-Action Letter.
The Federal Exemption is only available for transactions involving an “Eligible Privately Held Company,” as defined in the amendment. In a significant departure from the M&A Brokers No-Action Letter, the Federal Exemption adds a size limitation for eligible companies, which are defined as companies that:
- are not subject to SEC reporting requirements,
- have EBITDA of less than $25 million in their last complete fiscal year, and
- have gross revenues of less than $250 million in their last complete fiscal year.
The Federal Exemption conforms with the M&A Brokers No-Action Letter by limiting the exemption to transactions whereby the buyer obtains and exercises control over the private company. Control is deemed to pass if the buyer acquires at least 25% of the voting power of the target company, or, in the case of a partnership or limited liability company, has the right to receive upon dissolution, or has contributed, 25 percent or more of the capital.
Finally, in conformance with the NASAA model rule but in a departure from the M&A No-Action Letter, the Federal Exemption is not available to a broker if the firm or any of its officers, directors, or employees have been barred or suspended by a U.S. securities regulator.
Benefits and Limitations of the Federal Exemption
The principal benefit of the Federal Exemption is that it is statutory and can only be amended by Congress. SEC no-action letters, while providing useful guidance, are not binding on the SEC and may be revoked or modified in the future by the SEC.
However, the Federal Exemption suffers from two significant drawbacks. First, it does not apply to the states. Some of the congressional proposals regarding M&A Brokers would have preempted state law on this issue. The decision not to preempt state law leaves unresolved the potential for conflicting requirements that would impair the usefulness of the Federal Exemption. NASAA’s model rule would largely bridge this gap; however, not all states have adopted the NASAA model rule. In some states, such as California, the availability of an exemption for M&A Brokers that are not registered with the SEC is unclear. Unfortunately, the Federal Exemption will not solve this problem for M&A Brokers.
In addition, the inclusion of a cap on the size of eligible private companies results in the Federal Exemption being unavailable for transactions involving a significant subset of private companies. Many successful closely held companies exceed the $25 million cap on EBITDA and/or the $250 million cap on revenues. The services rendered in M&A transactions for such companies do not differ materially from those rendered for smaller companies, and transactions involving these companies are eligible for relief under the M&A Brokers No-Action Letter. Hopefully, the SEC will not revoke or modify that no-action letter as a result of the new legislation. It would be an ironic outcome if the net effect of the Federal Exemption was to force more M&A specialists to register with the SEC as broker-dealers.