New Federal Legislation Would Scale Federal Securities Regulation of Mergers and Acquisition Intermediaries in Smaller Private Company Transactions

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1 New Federal Legislation Would Scale Federal Securities Regulation of Mergers and Acquisition Intermediaries in Smaller Private Company Transactions Robert N. Rapp of Calfee, Halter & Griswold LLP Mergers and acquisitions firms (M&A firms) face uncertainty in carrying out their engagements as intermediaries in transactions involving the actual or potential sale or exchange of securities, or in investment banking activity generally, over whether they may be or become subject to regulation as securities broker-dealers under federal and state securities laws. Business brokers likewise carry out their activities in a state of relative uncertainty over the application of broker-dealer registration or licensing requirements. In either case, the costs of compliance, and the consequences of noncompliance, with regulatory requirements that may govern at least some of their activities are substantial. As a practical matter, the regulatory burden, and compliance-driven costs that ultimately are passed on to business buyers and sellers, are not justifiable in circumstances involving smaller private company transactions in which the intended protections of full-scale brokerdealer regulation under federal and state securities laws are arguably not needed. Against this backdrop, on June 6, 2013, legislation was introduced in the U.S. House of Representatives which, if enacted, would address some of the regulatory uncertainty faced by M&A firms and business brokers regarding the application of broker-dealer registration requirements under the Securities Exchange Act of 1934 (the Exchange Act). H.R the Small Business Mergers, Acquisitions, Sales, and Brokerage Simplification Act of introduced by Representative Bill Huizenga (R-Michigan), would amend the Exchange Act to create a new category of transaction intermediary to be called a Merger and Acquisition Broker (M&A Broker), to be registered as such with the U.S. Securities and Exchange Commission (SEC) by a simplified notice filing procedure. The proposed legislation is specifically aimed at intermediaries involved in smaller, privately held company transactions, with the objective of providing a regulatory scheme that is appropriate to the limited scope of intermediary activity in that transaction context. An M&A Broker is thus defined for purposes of the proposed legislation as: [A] broker engaged in the business of effecting the transfer of ownership of an eligible privately held company, regardless of whether the broker acts on behalf of a seller or buyer, through the purchase, sale, exchange, issuance, repurchase, or redemption of, or a business combination involving, securities or assets of the eligible privately held company. Meeting the definition, however, is expressly conditioned upon the broker reasonably believing that the transaction effects an actual change in control of the private company, and that certain financial information has been provided, or made available, to any person

2 who is offered securities in exchange for securities or assets of the eligible privately held company. An eligible privately held company is one that meets two conditions. The first is that, in simplest terms, it is not a public company. In regulatory terms, that is to say that the company does not have any class of securities registered, or required to be registered, with the SEC under the Exchange Act, and is not therefore a reporting company. Secondly, in the fiscal year ending immediately before that in which the services of an M&A Broker is initially engaged, the company must meet either or both of the following financial conditions: (1) The company s EBITDA is less than $25 million; and/or (2) gross revenues of the company are less than $250 million. These financial criteria would be subject to inflation adjustment every five years. M&A firms serving as intermediaries in the facilitation of transfers of ownership of these private companies in transactions involving stock or other securities, would need only to register with the SEC by filing a publicly accessible electronic notice containing such information concerning the M&A Broker and its associated persons that the SEC may require. There are certain bad boy disqualifications from registration. However, to the extent that the activities of an eligible M&A Broker are within the scope of activities described in the Bill, the M&A Broker, and all persons associated with the M&A Broker, would be exempt from federal broker- dealer registration requirements, and also be exempt from membership in and regulation by the Financial Industry Regulatory Authority (FINRA). Existing state securities laws would continue to apply, although the Bill requires cooperation and coordination between the SEC and states to establish appropriate and uniform standards and qualifications for persons associated with an M&A Broker. The Broker-Dealer Conundrum for M&A Firms In 1985, the U.S. Supreme Court (in Landreth Timber Co. v. Landreth) rejected the socalled sale of the business doctrine and held that the federal securities laws apply to sales of all of the outstanding stock of a business, without regard to the fact that the transaction amounts to the sale of the entire business or the transfer of all control. The sale of the business doctrine, espoused by number of lower federal courts, posited that although such transactions were effectuated by the sale or exchange of stock -- expressly defined to be a security for purposes of the federal securities laws -- the context was such that stock used in this manner should not fall within the statutory definition of a security. Rejecting the doctrine, the Supreme Court opined that stock possessing all traditional characteristics is a security without regard to its role in the sale of an entire business. The Supreme Court thus extended application of the federal securities laws to mergers and acquisitions involving the sale or exchange of stock, with the immediate impact on M&A firms arising from securities broker-dealer registration requirements. The Exchange Act defines broker broadly as any person engaged in the business of effecting transactions in securities for the account of others. The Exchange Act further provides: It shall be unlawful for any broker or dealer... to make use of the mails or any means or instrumentality of interstate commerce to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security... unless such broker or dealer is registered in accordance with [the further provisions of the Exchange Act]. As part of the dual federal-state structure of securities regulation in the United States, individual state Blue Sky laws also require registration or licensing of broker-dealers

3 (defined equally broadly) who engage in business as such in their state. A handful of states, Ohio being one example, have codified elements of the sale of the business doctrine in order to exclude or exempt M&A firms or business brokers engaged in effectuating transfers of 100 percent of the ownership of a business by means of stock from broker-dealer licensing requirements or, in some cases, requiring some lesser form of registration. There is, however, no uniformity among states in regard to any relief from broker-dealer registration or licensing requirements for M&A firms or any intermediary in sales of an entire business or transfers of 100 percent of control. And where exclusions or exemptions exist, they are restrictive. In Ohio, for example, the exclusion from the definition of broker-dealer is conditioned on, among other things, the intermediary not receiving transaction-based compensation. M&A firms acting as intermediaries in transfers of ownership or control, however structured, involving stock or other securities thus today face the full scope of federal broker-dealer regulation and, in the absence of an available exclusion or exemption, state securities laws in the conduct of their business. Moreover, neither federal nor state securities laws regarding broker-dealers make any distinction between the size or scope of any sale of a business transaction. Privately negotiated transactions between privately held companies are viewed no differently than complex M&A transactions involving public companies and investors fairly considered as needing the benefit of securities law protections achieved through application of broker-dealer regulatory requirements to intermediaries generally. Seeking Common Ground on Permitted M&A Activity Outside the Ambit of Broker- Dealer Regulation M&A firms and business brokers have sought to establish some reasonably clear criteria upon which to assess what activity may be undertaken without triggering broker-dealer registration requirements. Over the years, a handful of SEC No-Action Letters have issued by which the staff of the SEC acknowledged several limitations on intermediary activities on which firms may rely to avoid broker-dealer status. In one of the most widely cited of these No-Action Letters (Country Business, Inc.) the SEC staff identified several factual predicates for avoiding application of federal broker-dealer registration requirements. They include: The intermediary having a limited role in negotiations between the seller and potential purchasers or their representatives, and having no power to bind either party in the transaction; The Selling Company satisfying the size standards for a "small business" pursuant to the Small Business Size Regulations issued by the U.S. Small Business Administration; Only assets will be advertised or otherwise offered for sale by intermediary; If the transaction is effected by means of securities, it will be a conveyance of all of the business's equity securities to a single purchaser or group of purchasers formed without the assistance of the intermediary; The intermediary will 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); The intermediary's compensation will be determined prior to the decision on how to effect the sale of the business, will be a fixed fee, hourly fee, a commission, or a combination thereof, that is based upon the consideration received by the seller,

4 regardless of the means used to effect the transaction and will not vary according to the form of conveyance (i.e., securities rather than assets); and The intermediary will 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 The SEC staff reiterated these guidelines subsequently in another no-action letter (International Business Exchange), and, as discussed later, the interpretative guidance they provide plays significantly into the implementation and enforcement elements of H.R were it to be enacted. States may or may not follow the guidance set out by the SEC staff. It has no binding effect on states in the application of their own broker-dealer registration and licensing requirements. If enacted, H.R would not pre-empt state registration licensing authority over M&A Brokers, but it does mandate cooperative efforts to establish consistent standards of training and qualifications of persons associated with M&A Brokers. Notably as well, the Alliance of Merger & Acquisition Advisors (AMAA) has already developed and presented proposed model state rules to the North American Securities Administrators Association (NASAA), with the objective of establishing a coordinated system of simplified state registration and regulation on M&A Brokers. Right-Sizing Federal Securities Regulation of M&A Brokers Summing up newly introduced H.R in this way, the International Business Brokers Association, Inc. (IBBA) and the Alliance of Merger and Acquisitions Advisors (AMAA) have jointly described the proposed legislation as addressing an urgent need to reduce the regulatory costs incurred by the buyers and sellers of smaller privately held companies for professional brokerage services, while enhancing their protection through well-defined, appropriately scaled and cost-effective federal regulation of M&A Brokers. IBBA reports that an estimated $10 trillion of privately owned businesses will be sold or closed as baby boomers retire. New entrepreneurs should be encouraged to acquire and grow existing businesses and, says IBBA, simplified regulation of business brokerage services will reduce costs and better protect business owners. As discussed earlier, the centerpiece of right-sizing under the proposed legislation is to create a new category of M&A Broker, registered with the SEC in a simplified system using a public notice filing. Beyond the notice filing procedure, and baseline definitions, H.R does not prescribe particular regulatory requirements for the conduct of a M&A Broker s business. Rather, the SEC would be given rulemaking authority to implement and enforce the new registration procedure and the conduct of M&A Brokers. However, the proposed legislation specifically directs the SEC, in the exercise of that rulemaking authority, to codify interpretive guidance given by the staff of the Commission in the Country Businessand International Business Exchange No-Action Letters with respect to circumstances under which registration as an M&A Broker under the new provision would not be required. Moreover, in applying various Exchange Act requirements generally applicable to registered broker-dealers, H.R directs the SEC to tailor applications by taking into account the nature of the transactions in which M&A Brokers are involved, and the limited scope of their activities. Looking Ahead: From One Size to Right Size

5 The current federal securities regulatory structure for broker-dealers is one-size-fits-all. The result, as a practical matter, is that M&A firms performing an important intermediary role in the purchase and sale of smaller privately held companies face a constant challenge in weighing the regulatory risks associated with bringing parties together, advising and assisting in structuring transactions, facilitating the completion of transactions, and, not the least, being paid for their services. Regulatory risk translates into regulatory cost, and increases the likelihood that no intermediary services will be available at all. That said, it is not surprising that the principal sponsor, and others supporting H.R. 2274, emphasize the transactional and job-creating impact of the proposed legislation in terms best stated by Representative Huizenga: By simplifying the regulation and reducing the cost of these business brokerage services, these privately-owned companies would be able to safely, efficiently and effectively sell their company while preserving and protecting jobs at these companies. NASAA, on behalf of state securities regulators, and FINRA, the broker-dealer selfregulatory organization that would be excluded from any role in regard to M&A Brokers, have not weighed in on H.R. 2274, but no doubt will do so. The Bill is now before the Subcommittee on Capital Markets and Government Sponsored Enterprises of the House Financial Services Committee. There is bipartisan support (co-sponsors are Representatives Brian Higgins, D-N.Y., and Bill Posey, R-Fla., and an initial hearing entitled Reducing Barriers to Capital Formation was held June 12, Few would question the need to address the regulatory uncertainty faced by M&A firms in the context addressed by H.R Whether an entirely new class of M&A Brokers is the answer remains to be seen. Robert N. Rapp, Partner, rrapp@calfee.com Bob handles financial market regulatory and complex litigation matters for a wide range of market participants and financial intermediaries. He is a noted author and teacher on law, theory and practice in financial markets. Full Bio ( Calfee, Halter & Griswold LLP Calfee, Halter & Griswold LLP is a full-service corporate law firm with more than 150 attorneys located throughout our Cleveland, Columbus and Cincinnati, Ohio offices. As a founding member of Lex Mundi, we also offer international representation through a network of independent law firms with access to 21,000 attorneys located in more than 100 countries. Website ( Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances, and reflects personal views of the authors and not necessarily those of their firm or any of its clients. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced

6 with permission from Calfee, Halter & Griswold LLP. This work reflects the law at the time of writing in October 2013.