In January, the Securities and Exchange Commission issued a “no action letter” widely and wrongly interpreted as legalizing the role of unregistered broker/dealers as compensated M&A finders.
The Securities Exchange Act of 1934 requires that broker/dealers register with the Financial Industry Regulatory Authority, or FINRA. The legal definition of “broker” seems clear: They are in the business of effecting transactions in securities of third parties.
Your everyday broker who buys and sells securities is in such business. Your public underwriter is a broker/dealer. But what about some individual making introductions between a buyer and seller of securities of a private company, or between a company that wishes to sell itself and its potential buyer? Are those transactions that the law intended to regulate?
How the SEC works
If you violate a federal law, the SEC can enjoin you, sue you, try to put you in jail. What happens if the law is ambiguous?
Take the definition of “broker.” What does it mean to be in the “business” of buying and selling securities? What if you do it only once? Or occasionally? What if you have another business (lawyer or consultant); a company needs to be acquired, and you make introductions to “find” the buyer. Is that the kind of function the law was intended to reach?
Whether an M&A deal is cash or stock is driven by the tax situations and risk tolerance of the parties. M&A transactions may be either, depending on factors having nothing to do with securities laws.
The functions of an M&A finder are identical whether the company ends up sold for cash or stock. Why require an expensive federal registration if the transaction turns out involving securities, but not if it is an asset deal?
When there is statutory ambiguity, the SEC may promulgate formal clarifying rules or issue formal guidance. The SEC has never issued regulations, nor a clear position paper, concerning finders. Rather, the SEC has relied on contradictory interpretations embodied in its least robust format: the no action letter.
A no action letter is just that: The staff of the SEC, having received an inquiry, issues a letter saying the staff will not recommend the commission take enforcement action if the transaction is undertaken.
The no action letter does not have binding precedent of a court case, nor the protections afforded by a clear rule or statute. It doesn’t even say that the transaction does not violate law. It simply says: “If you do it, we won’t sue you this time.”
What happens in practice?
When I started practicing in the 1960s, finders were ubiquitous, regularly financing smaller companies through the sale of securities. The theory was that they weren’t the kind of “brokers” the law intended to regulate; they were players in private transactions and were the grease to facilitate emerging enterprises.
Over time, SEC enforcement was quixotic. By the 1970s, regulators got tougher. State regulators were particularly adamant, but state enforcement was rare.
And the truth was that a “finder” seldom simply said, “Why don’t you two guys talk” and then did nothing else.
Finders negotiated the deal. That was why they received compensation. By the 1980s, the SEC displayed substantial confusion with respect to regulating finders who did more than merely “find.”
In the 1985 Dominion Resources no action letter, the SEC declared that it would not recommend action even when the finder designed the securities, provided issuer financial guidance, and negotiated the transaction.
You may have noticed the lines from the Paul Anka song “It’s a Sin” at the start of this column. Anka’s sin was his desire to act as an unregistered finder. In an oft-cited letter from July 1991, the SEC granted no action to the singer, permitting him to obtain a 10 percent finder’s fee for introducing investors to a hockey team (this wasn’t even an M&A transaction; it was a securities issuance, although Anka’s role was merely introducing parties).
Lawyers latched onto the letter, which permitted an unregistered finder in the direct sale of securities. But over time the SEC slowly backed away from issuing finder-related no action letters, and in March 2000 the staff formally withdrew the Dominion Resources letter.
Through that period, few finders bothered to register and few were caught. Meanwhile, more and more securities lawyers began warning companies that unregistered finders were dangerous. The transaction was illegal, the purchasers might be entitled to rescind the transaction, and there might be civil fines or criminal enforcement.
The American Bar Association in 2002 and again in 2005 formally proposed an approach to registration referred to as “broker/dealer lite.” Since registering as a broker/dealer was onerous, time consuming and expensive, and imposed controls not applicable to finders who did not handle securities trades or money, perhaps the SEC would adopt a regulation that established simplified registration? The SEC did not act.
In 2008, the SEC posted a “Guide to Broker/Dealer Registration,” which acknowledged that the necessity for registration is not always clear, and that finders and business brokers may well be securities brokers if they find investors or buyers of businesses, even in a single instance.
Was the SEC saying finders must register?
In 2012, the ABA again promulgated a broker/dealer lite solution. For a while commentators thought that the proposal would gain traction, in light of the 2012 federal JOBS Act, which promoted deregulation of securities transactions to assist capital formation and domestic job creation. But that initiative also died.
January no action letter
Three different law firms wrote to the SEC requesting that the staff not recommend enforcement action against an “M&A broker.”
In January, the staff granted the no action request. What is a finder permitted to do under the January letter?
First, we are talking only about M&A transactions; there is no relief for a finder involved in issuance of securities outside an acquisition.
Next, the buyer must actively operate a company after the transaction, owning at least 25 percent of the vote or equity (this draws the line between an equity financing, in which the finder is regulated, and an acquisition transaction, in which the finder is not).
The M&A broker cannot bind either party to the contract, cannot directly or indirectly finance the transaction, cannot handle funds or securities, and must not be involved in a transaction in which securities are available for public sale.
The transaction cannot involve an acquisition by a shell corporation. If the M&A broker purports to represent both buyer and seller, it must make written disclosure and obtain written consent. If the buyers are a group, the group cannot be formed by the M&A broker.
Securities issued in such transactions are restricted and not publicly traded. There are “bad boy” provisions preventing people who have run afoul of the securities laws from functioning as M&A brokers.
Some of the legal press trumpeted that the January letter opened the way for finders to operate without registration. That is a dangerous and inaccurate conclusion.
Limitations on January letter
• First, it applies only to M&A intermediaries, not securities offerings.
• Second, since this is a no action letter, it can be abandoned by the SEC. The SEC famously backed off the Anka and Dominion no action letters.
• Next, the January letter may be reshaped by presently pending legislation exempting M&A brokers for private companies, subject to certain size limitations.
• The January letter doesn’t say that finders are not brokers; it just says the SEC won’t bring suit. The January letter is not binding on state regulators, who historically have been more adamant. (A few states have separate regulatory schemes for “business brokers,” but that is not the majority.)
• Finders who are not registered may be unable to collect their fees, because their contract is illegal. One such finder, suing for the balance of his fee, even has been required to disgorge the retainer already paid.
• Purchasers of businesses may have a right to rescind their purchase by reason of the failure of a finder to register. It is conceivable that the client retaining the unregistered finder may be able to sue the finder for damages.
• SEC rules require disclosure of all material information in securities transactions. Perhaps the risk of private suit, illegality or rescission, arising from finder non-registration, is a material fact that, if omitted, constitutes a “10b5 violation.” A disclosure might need a risk factor like: “If the purchaser structures the transaction as a sale of securities rather than of assets, the finder not having registered as a broker, the transaction may be illegal, may be subject to rescission, and may constitute a violation of laws requiring disclosure in the event the purchaser later effects any transaction subject to SEC regulation.”
The conclusion? The January letter is very far from an effective solution to a serious issue. We need definitive federal statutory or regulatory relief deregulating M&A finders, which also preempts any contrary state regulation. MLW
Stephen M. Honig practices at Duane Morris in Boston.