White Paper:Exemption from Registering with the SEC as a Broker Dealer

On January 31, 2014, the SEC’s Division of Trading and Markets issued a “no action” letter, in which the Division will not recommend enforcement if a M&A broker were to effect securities transactions in connection with the transfer of ownership of a privately held company under certain conditions.

History:  There is no nationally recognized license specifically for merger and acquisition (“M&A”) or business broker services. Accordingly, most practitioners have relied upon state real estate broker licenses for their transaction activities. Most states require a realty license to sell a business property, and some states stipulate that a broker must hold a realty license to sell a business. Therefore, over time, the real estate broker license became the defacto license for this niche service.  However due to the vagaries of different state laws, M&B brokers operating a transaction that cross state lines were subject to various state based requirements. In California, a broker dealer registration is not required (Rule 260.204.5) in connection with mergers, consolidations or purchase of corporate assets, and who does not receive, transmit, or hold for customers any funds or securities in connection with such transactions.


Another area of concern arose when the buyer purchased the stock of the small business versus the assets. Was this a sale of securities or not? Section 15(a)(1) of the Securities Exchange Act of 1934 makes it unlawful for any person or entity to “effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security” unless such person or entity is registered as a broker or dealer with the Securities and Exchange Commission (“SEC”). Section 3(a)(4)(A) defines a broker as any person engaged in the business of effecting transactions in securities for the account of others.  Many state securities boards have adopted similar rules.

Some intermediaries will attempt to avoid securities registration by calling themselves “finders” and/or “consultants,” while working for consulting fees, instead of at-risk compensation like success fees.  Aside from the fact that the arrangement may not be cost-effective for the client company, there is no guarantee that the gambit will be a successful evasion of the requirement to register for other reasons (though it would reduce risk).  Despite the lack of success-based compensation, the duties performed generally require registration, unless the intermediary’s role is limited strictly to making introductions (and even that possible exclusion is only supported by SEC No Action Letters and state case law, not federal statutory law).

The new no-action letter operates as an exemption from registration for M&A brokers that effect transactions in securities in connection with the purchase or sale of a business and permits M&A brokers to advertise privately held companies for sale, advise their clients on structuring the transaction, provide valuation advice as to the securities being sold in the transaction and receive transaction-based compensation, without registering as a broker-dealer.  The M&A Brokers letter does not, however, exempt finders who introduce passive investors in connection with securities offerings.

Eligibility Criteria: The exemption granted pursuant to the M&A brokers letter is limited and only applies if 10 criteria are satisfied:

  • The broker cannot have the ability to bind a party to the transaction.
  • The broker cannot, directly or indirectly through affiliates, provide financing for the transaction.
  • The broker cannot have custody or control of, or otherwise handle funds or securities issued in connection with, the transaction.
  • The transaction cannot involve a public offering or a “shell” company.
  • If representing both buyers and sellers, the broker must disclose who it represents and obtain consent to joint representations.
  • If the transaction involves a group of buyers, the group must have been formed without the involvement of the broker.
  • The buyer or group of buyers must control and actively operate the company or the business conducted with the assets of the business.  Control will be presumed if the buyer, or buyer group 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% of 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.
  • The transaction cannot involve transfers of interests to “passive” buyers.
  • Any securities issued in the transaction must be restricted securities under Rule 144(a)(3) of the Securities Act of 1933.
  • The broker must not have been barred or suspended from associating with a broker-dealer.

M&A brokers need to be aware that the no-action letter has no effect on state securities laws, most of which also have broker-dealer regulation and registration requirements.  Many states are likely to continue to take the position that M&A brokers are subject to their regulatory regimes notwithstanding the SEC’s revised position at the federal level. In California for example, this exemption does not relieve anyone from California’s licensing requirements under Real Estate Law, which defines a “real estate broker” as any person who sells or offers to sell, buys or offers to buy, solicits prospective sellers or purchasers of, solicits or obtains listings of, or negotiates the purchase, sale or exchange of real property or a business opportunity. (Cal Bus & Prof Code 10131(a)).


FINRA perspective:

The Financial Industry Regulatory Authority (“FINRA”) proposed FINRA Rule 1032(i) creating a new Limited Representative – Investment Banking Registration Category and Series 79 Investment Banking Exam. The new rule which was adopted by the SEC became effective November 2, 2009.

FINRA Rule 1032(i) “requires an associated person to register with FINRA as a Limited Representative – Investment Banking Representative and pass a corresponding qualification examination if such person’s activities include:

(1)           advising on or facilitating debt or equity securities offerings through a private placement or a public offering, including but not limited to origination, underwriting, marketing, structuring, syndication, and pricing of such securities and managing the allocation and stabilization activities of such offerings, or

(2)           advising on or facilitating mergers and acquisitions, tender offers, financial restructurings, asset sales, divestitures or other corporate reorganizations or business combination transactions, including but not limited to rendering a fairness, solvency or similar opinion.”


Taking its cue from the SEC no-action letter, FINRA has proposed establishing a “streamlined set” of regulatory rules called the Limited Corporate Financing Broker Rules (“LCFB Rules”) that are tailored to address and apply exclusively to the LCFB’s limited business activities. The proposed LCFB Rules define an LCFB as any broker that solely engages in any one or more of the following activities:


  • advising an issuer, including a private fund, concerning its securities offerings or other capital raising activities;
  • advising a company regarding its purchase or sale of a business or assets or regarding its corporate restructuring, including a going-private transaction, divestiture or merger;
  • advising a company regarding its selection of an investment banker;
  • assisting in the preparation of offering materials on behalf of an issuer;
  • providing fairness opinions; and
  • qualifying, identifying, or soliciting potential institutional investors.

As proposed by FINRA, an LCFB does not include any broker or dealer that carries or maintains customer accounts, holds or handles customers’ funds or securities, accepts orders from customers to purchase or sell securities either as principal or as agent for the customer, possesses investment discretion on behalf of any customer, or engages in proprietary trading of securities or market-making activities.


The proposed LCFB Rules are deceptively short and succinct because most of the proposed rules merely incorporate by reference the corresponding FINRA rule applicable to registered full service broker-dealers. For example, LCFBs would generally be subject to the same membership procedures and approval standards as other registered broker-dealers, as well as FINRA’s rules relating to investigations and sanctions, codes of procedure and arbitration and mediation. LCFB principals and representatives would also be subject to the same registration and qualification examination requirements as principals and representatives of other FINRA members; although they would have a more streamlined continuing education requirement.


On the other hand, the LCFB Rules would impose a more streamlined know-your-customer and suitability obligations than are imposed under current FINRA rules, as well as an abbreviated version of FINRA’s rule that prohibits false and misleading statements in a firm’s public communications. The streamlined set of LCFB conduct rules would include the present FINRA conduct rules and interpretative guidance related to the standards of commercial honor and principles of trade, use of manipulative, deceptive or other fraudulent devices and transactions involving FINRA employees. Moreover, LCFBs would still be subject to all of the SEC rules and regulations applicable to broker-dealers.


The FINRA comment period expired on April 28, 2014.


Private Equity/Fund Implications:

The SEC Letter may have significance for managers of private funds. Last year, David Blass, the signer of the SEC Letter, outlined in a speech the need for private fund managers to consider their potential obligation to register as broker-dealers if their employees were performing certain securities-related tasks. While that speech raised concerns about broker-dealer obligations for private fund managers, Mr. Blass also indicated an intention for the SEC staff to reconsider past policies in this area. Although the SEC Letter did not address all the issues raised in the Blass speech, including the issue of deal-based fees for private equity fund managers, the letter may be an indication of a willingness by the SEC Staff to reexamine prior positions. Additionally, the issue of deal-based fees was not presented to the SEC staff in the incoming letter. It remains to be seen if and how the SEC will address deal fees for private equity firms. In any event, managers of private funds and private equity funds considering transactions involving M&A Brokers will now have more certainty in the regulatory requirements applicable to such M&A Brokers.


Issuer exemption:

Blass warned that many private fund advisers may be erroneously relying on an exemption available to certain issuers. The “issuer exemption,” a safe harbor found at Rule 3a-4-1 under the Exchange Act, is an exemption from broker-dealer registration afforded to the associated persons of certain businesses that issue a security. However, among other things, the issuer exemption is not available to firms, including private fund advisers or their affiliates, whose personnel are compensated in connection with their participation in the securities transaction through the payment of commissions or other remuneration based either directly or indirectly on transactions in securities.


Even with respect to associated persons that do not receive transaction-based compensation, in order to be covered by the issuer exemption, private fund managers must satisfy one of three conditions:

  1. Personnel must limit their participation to transactions involving the offering and selling of the issuer’s securities only to broker-dealers and other specified types of financial institutions;
  2. Personnel must perform substantial duties for the issuer other than those in connection with transactions in securities, must not have been a broker-dealer or an associated person of a broker-dealer within the preceding 12 months, and must not participate in selling an offering of securities for any issuer more than once every 12 months; or
  3. Personnel must limit their activities to delivering written communication by means that do not involve oral solicitation by the associated person of a potential purchaser.

If a private fund manager or its associated personnel receive transaction-based compensation or if they receive transaction-based compensation but fail to meet any one of the above listed criteria, then registering as a broker-dealer and/or broker-dealer representative and becoming a member of an SRO,like FINRA, may be inevitable unless the firm changes its marketing practices.


Rescission rights

Liability in the securities world can be severe. Liability is based on one of two violations: (1) Selling securities without an exemption or registration; or (2) fraud in the sale of the securities.


Failure to sell pursuant to an exemption or registration is a bright-line violation where the only question is “did the company comply with the terms of the applicable registration or exemption provision?” If yes, there is no violation. If not, the company and its officers and directors could be subject to both civil and criminal sanctions. The company could be forced to conduct a rescission offering whereby it would have to contact every person who purchased its securities in the illegal offering and offer to repay them. The securities regulators could also impose fines and sanctions on the company, making it difficult for the company to conduct further offerings to raise more money. Officers and directors can likewise be subject to fines and sanctions, including being held liable for any rescission offer, if such person knew or reasonably should have known of the facts that gave rise to the liability. It is possible that a company could be subject to liability under the federal laws and the laws of each state in which securities were sold.


Bad Actors Rule

On July 10, 2013, the Securities and Exchange Commission (the “SEC”) adopted a final rule to implement a prohibition on the use of the exemption from registration provided by Securities Act Rule 506 of Regulation D for any offering in which certain felons and other bad actors are involved. The disqualification of “bad boys” from Rule 506 offerings is required pursuant to Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”). Dodd-Frank instructs the SEC to issue disqualification rules for Rule 506 offerings that are substantially similar to the bad actor disqualification provisions currently contained in Regulation A. The SEC’s final rule is generally consistent with the proposed rule issued on May 25, 2011, and amends Rule 506 by including new paragraph (d). The new Rule 506(d) covers the following persons: (i) the issuer and any predecessor of the issuer or affiliated issuer; (ii) directors, executive officers, officers participating in the offering, general partners and managing members of the issuer; (iii) 20% beneficial owners of the voting equity securities of the issuer (calculated on the basis of voting power); (iv) promoters; (v) investment managers and principals of pooled investment funds; and (vi) persons compensated for soliciting investors as well as the general partners, directors, officers and managing members of any compensated solicitor. This alert refers to persons covered by this new rule as “covered persons.”


Under the new rule, an issuer cannot rely on a Rule 506 exemption from registration if the issuer or any other covered person listed above had a “disqualifying event.” These “disqualifying events” include the following:


Criminal convictions in connection with the purchase or sale of a security or involving the making of false filings with the SEC or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities; Court injunctions and restraining orders in connection with the purchase or sale of a security or involving the making of false filings with the SEC or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities; Final orders from certain state governmental authorities, federal banking agencies, the CFTC and the National Credit Union Administration that (i) bar the covered person from associating with a regulated entity or engaging in the business of securities, insurance or banking or in savings association or credit union activities or (ii) are based on fraudulent, manipulative or deceptive conduct; Certain SEC disciplinary orders; Certain SEC cease-and-desist orders; Certain SEC stop orders; Suspension or expulsion from membership in a self-regulatory organization; and U.S. Postal Service false representation orders.


The final rule provides an exception from disqualification when the issuer can show that it did not know, and in the exercise of reasonable care, could not have known that a covered person with a disqualifying event participated in the offering. Such exception preserves the intended benefits of Rule 506 by reducing the risk that issuers could lose the benefit of a Rule 506 exemption as a result of disqualifications they did not know about.


Disclosure:  This paper is NOT legal advice and the reader is reminded to consult with a qualified attorney.