The January 31, 2014, M&A Broker No-Action Letter

Has the Securities and Exchange Commission given M&A business brokers the “green light” to engage in securities transactions?

The Securities and Exchange Commission (SEC) issued a January 31, 2014, No-Action Letter indicating it would not take enforcement action against an M&A broker contemplating a securities transaction.

Securities and Exchange Commission

On January 31, 2014, the Securities and Exchange Commission (SEC) issued a No-Action Letter involving an M&A broker (the “M&A Broker” letter).  In the letter, the SEC indicated—based on the facts presented—that it would not take any action under Section 15(a) of the Securities Exchange Act of 1934 (Exchange Act) in connection with the purchase or sale of a privately held company without registering as a broker-dealer pursuant to Section 15(b) of the Exchange Act. 

The letter (and guidance) is important for what it suggests, namely that business brokers that follow certain strictures will not be required to register as a broker-dealer.  A long-standing issue for business brokers is whether the broker-dealer regulations apply to them as business facilitators.  For many years there was an open question as to whether a sale of all or a controlling interest in a business was a securities transaction or effectively a sale of the assets of the company (and not a securities transaction). In Landreth  Timber Co. v. Landreth, 471 U.S. 681 (1985)—a case involving the transfer of 100 percent of the stock of a closely held corporation— and a companion case, Gould v. Reufenacht, 471 U.S. 701 (1985), whichinvolved the transfer of 50 percent of the stock of a closely held corporation, the U.S. Supreme Court answered the question definitively. The Court held that this type of transaction involves a sale of “securities” within the meaning of the Securities Act of 1933 (the Securities Act) and the Exchange Act.

As a result of the above precedent, the general view was that a person that is in the business of effecting the sale of operating businesses (emphasis provided) through the sale of securities generally could be viewed as falling within the meaning of the term “broker” as defined in Section 3(a)(4) of the Exchange Act.  Absent an exception or exemption, that person would be required to register as a broker-dealer pursuant to Section 15(a) of that Act and become a member of a self-regulatory organization.   If, however, the transaction were structured as an asset sale and did not involve the sale of securities, a person could engage in the same types of “brokering” activities without registering as a broker-dealer.

This No-Action Letter provides important “guidance” despite the fact that such  letters provide limited protection; a No-Action Letter is limited to the requester.  No-Action letters  are sought by individuals or entities that are not certain whether a particular product, service, or action would constitute a violation of the federal securities law.  Parties can request a “No-Action” Letter from the SEC staff. Most  letters describe the request, analyze the particular facts and circumstances involved, discuss applicable laws and rules and, if the staff grants the request for no action, concludes that the SEC staff would not recommend that the commission take enforcement action against the requester based on the facts and representations described in the individual’s or entity’s request.  The SEC staff sometimes responds in the form of an interpretive letter to requests for clarifications of certain rules and regulations.  According to the SEC and as noted above, the “no-action relief is limited to the requester and the specific facts and circumstances set forth in the request. Significantly, the SEC staff reserves the right to change the positions reflected in prior no-action letters.”

This No-Action Letter seems to suggest that the SEC now recognizes that there are some important distinctions between the “M&A Broker” (the Main Street business broker) and the broker-dealer servicing the lower middle market and larger publicly held entities that are  required to register with FINRA.  The No-Action letter states that:

An “M&A Broker” for purposes of this no-action letter is 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.

In this  letter, the SEC further underscores the importance that the exempt transactions contemplated by the requester should only involve a privately-held company.  The SEC adds: 

A “privately-held company” for purposes of this no-letter is 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. 

The SEC added that “any privately-held company that is the subject of this letter would be an operating company that is a going concern and not a ‘shell’ company.”

The above guidance is more detailed and appears to supplement earlier No-Action letters issued in 1986 and 2006.  The SEC staff issued two letters providing limited relief in this area; in  Country Business, Inc. (SEC No-Action Letter, November  8, 2006) (“Country Business” ), and International Business Exchange  Corporation (SEC No-Action  Letter, December  12, 1986) (individually, a “Letter”, and collectively, the “Letters’). 

In Country Business, the SEC staff agreed not to recommend enforcement action under Section 15(a) if Country Business engaged in certain limited activities without registering as a broker-dealer.  The staff based its relief on representations that:

1. if a decision is made to effect the transaction by a sale of securities, Country Business would have a limited role in negotiations between the seller and potential purchasers or their representatives and would not have the power to bind either party in the transaction;
2. the business represented by Country Business would be a going concern and not a “shell”  organization;
3. the selling company satisfies the size standards for a “small business” pursuant to the Small Business Size Regulations issued by the U.S. Small Business Administration;
4. only assets would be advertised or otherwise offered for sale by Country Business;
5. if the transaction is effected by means of securities, it would be a conveyance of 100 percent of the equity securities to a single purchaser or group of purchasers formed without the assistance of Country Business;
6. Country Business would not advise the two parties whether to issue securities or otherwise to effect the transfer of the business by means of securities, or assess the value of any securities sold (other than by valuing the assets of the business as a going concern);
7. the compensation of Country Business would be determined prior to the decision on how to effect the sale of the business, would be a fixed fee, hourly fee, a commission, or a combination thereof, based upon the consideration received by   the seller, regardless of the means used to effect the transaction and would not vary according to the form of conveyance ( i.e., securities rather than assets);
8. the compensation of Country Business would be received in the form and at the times described below; and
9. Country Business would not assist purchasers with obtaining financing, other than providing uncompensated introductions to third-party lenders or help with completing the paperwork associated with loan applications.

Significantly, Country Business permitted the intermediary to receive transaction-based compensation.  Under the Letter, the compensation had to be  determined prior to the decision on how to effect the sale of the business and had to be paid in cash.  Additionally, the SEC deferred to the parties on the issue of compensation and enabled them to agree, prior to the decision on how to effect the sale of the business, to defer the intermediary’s compensation to the same extent that the consideration paid by the purchaser to the seller is deferred (i.e., if consideration to the seller from the purchaser is paid in part upon, and in part after, closing, the intermediary could likewise receive its compensation in part upon, and in part after, closing). 

Furthermore, Country Business imposed significant restrictions on the role, and hence the utility, of the intermediary.  Only the assets of the business may be listed for sale.  The intermediary cannot advertise or otherwise promote the sale of securities.  Any decision to effect the transfer of a business by means of a securities sale must be made solely by the purchaser and seller without the recommendation of the intermediary.  If a decision is made to effect the transaction by a sale of securities, the intermediary must limit its role to the following:

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

An intermediary seeking to rely on Country Business also cannot otherwise be involved in negotiating the terms of the sale between or among the parties, or offer advice to either the purchaser or seller about the value of the securities, other than valuing the assets of the business as a going concern.  Although the intermediary may prepare a detailed description of the seller’s company based on information supplied by the seller, including historical financial data and publicly available information, the intermediary must apprise potential purchasers that it makes no representations about the accuracy of the information provided.

International Business Exchange Corporation, which was issued 20 years earlier, differed from Country Business in two significant ways.  First, it did not include any reference to the size of the business being sold, but excluded only entities that are not closely held.  Second, International Business Exchange  Corporation  did not require that a compensation determination be made prior to determining the structure of the transaction, but only that compensation not vary by the type of transaction.

A person involved in the sale of a closely held company had to be concerned since these earlier No Action letters did not answer to the extent, if any, that  intermediaries  could engage in negotiations on behalf of a client, or whether they could advise the client whether to issue securities.  It was also unclear whether transactions were limited to the sale of 100 percent of the equity of the company to be acquired.  Moreover, these two No-Action letters left unclear whether alternative fee arrangements were permissible in connection with the sale of larger businesses.  The M&A Broker No-Action Letter provides important additional guidance these latter letters left unanswered.

So, does this M&A Broker No-Action Letter provide the proverbial “green light” to business brokers to engage in the sale of securities?  The guidance suggests that the answer is potentially “yes,” provided the business broker limits the scope of the activities and represents operating companies… but then again, No-Action letters are unique to the requester, and the SEC reserves the right to change its views.  Despite the latter point, International Business Exchange, Country Business and M&A Brokers No-Action Letter suggests that the SEC will not take action in the market segment most the bulk of the business brokers operate in.  That said, the above impressions are just my views, not a legal opinion.  For a legal opinion, contact qualified counsel or better yet, ask the SEC to issue a no-action letter. 

Roberto Castro, Esq., MST, MBA, CVA, CPVA, is a managing member of North Central Washington Economic, Forensic and Business Valuation Advisors, LLC, and The Law Office of Roberto Castro, PC, which serves the Douglas, Chelan, Grant, Okanogan, Kittitas, and Yakima Counties.  Both are new firms that opened in January 2014. Mr. Castro is also Technical Editor of NACVA’s QuickRead.  When he resided in Utah, he managed Wasatch Business Valuation & Litigation Support Services, LLC, www.wasatchbusval.com. Mr. Castro is a Washington State attorney, CV, and is available to handle commercial and personal economic damages analysis, valuation advisory services and bankruptcy/turnaround work. His legal practice focuses on bankruptcy (commercial, creditors, andconsumer), estate and gift, and succession and exit planning. Roberto can be reached at either Roberto.Castro@wasatchbusval.com or RobertoC1@NACVA.com.