Small businesses frequently encounter challenges connecting with investors. The amount sought is typically below a level that would attract venture capital but beyond the levels that can be provided by friends, family and personal financing. The primary option for most larger businesses is a “Broker-Dealer” fully registered with both the Securities Exchange Commission (the “SEC”) and the various states. However, few registered broker-dealers are willing to work on a small sale or raise capital in small transactions.
Company Risks
The result is that many businesses fall prey to using the most available other option, “consultants” or “finders” who are not registered broker-dealers. Using an unregistered “finder” however limits the extent to which it can lawfully perform the work and be paid the compensation desired. If the finder does not satisfy the applicable regulatory requirements, the company not only faces the prospect of having the entire sale or all (or portions) of the investment rescinded by the buyer or investors, but the company may also be subject to aiding and abetting liability proceedings brought by regulatory authorities. Under these circumstances, the fact that the company may not have to pay the finder fee is of small consolation.
Requirements:
Longer lists of the factors that impact whether a finder is required to register are set out below, however, generally, the SEC and federal law require that a finder be registered as a Broker-Dealer” REGARDLESS OF THE SIZE OF THE TRANSACTION if it:
a) Receives transaction-based compensation, i.e., a commission or some form of compensation that varies with the size or type of the resulting investment;
b). Engages in “pre-screening” potential investors to determine their eligibility to purchase securities; and/or
c). Engages in “pre-selling” the issuance to gauge the level of interest.
Most states also have laws that are identical or similar. The regulators and courts have demonstrated a predisposition to requiring broker-dealer registration for the protection of issuers, investors and buyers.
“Finders” Are Not Approved to do the work of Broker Dealers:
For many years, the American Bar Association, the United States Treasury Department and the SEC (to name a few) have proposed carving out a place for finders while still protecting investors – proposing a lower level of regulation (and expense) matched to a lower level of permitted intermediary activity. In 2018, for example, the SEC made such a proposal, but no further action has been taken. Some states, like California and Texas, allow “limited registration” of intermediaries who can provide some but not all services, but the registration and “finding” activities are only effective and authorized within the state. In all other states, there are no exceptions.
Despite many years of clarification efforts, grey areas remain. Leaving aside state law registration requirements, under Federal case law, SEC releases and SEC no-action letters, the following factors (among others) are considered.
Some of the factors typical of activity where the intermediary is extremely likely required to register as a broker-dealer:
- Participates in discussions and negotiations between the issuer and the potential investors;
- Assists in structuring transactions;
- Receives transaction-based compensation, i.e., a commission or some form of compensation that varies with the size or type of the resulting investment;
- Engages in “pre-screening” potential investors to determine their eligibility to purchase securities;
- Engages in “pre-selling” the issuance to gauge the level of interest;
- Conducts or assists with the sale of securities;
- Provides advice regarding the value of securities;
- Locates issuers on behalf of investors;
- Solicits new clients;
- Disseminates quotes for securities or other pricing information;
- Actively (rather than passively) finds investors;
- Sends private placement memoranda, subscription documents, and due diligence materials to potential investors;
- Advises on portfolio allocations to accommodate an investment;
- Provides analyses of potential investments; and
- Provides potential investors with confidential information identifying other investors and their capital commitments.
Factors typical of intermediaries who would probably not be required to register as a broker-dealer:
- Introduces investors to issuers or their promoters without further involvement in discussions between the issuer and the investor(s) and without giving advice on the investment’s structure or suitability;
- Receives compensation for making introductions and the compensation is not tied to the success of the raising of capital (i.e., not a commission);
- Assists in transactions that convey all of a business’s equity securities or assets to a single purchaser or group of purchasers; and
- Does 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.
An Additional Exception: “M&A Brokers” or “Business Brokers”
As noted above, limited participation by an intermediary engaged in the business of effecting securities transactions solely in connection with the transfer of ownership and control of a privately-held company might not require registration as a broker-dealer. The U.S. Securities and Exchange Commission (“SEC”) issued a no action letter in 2014 (“M&A Broker Letter”), which defined an “M&A Broker” and outlined ten factors (all of which must be satisfied) summarized below:
- The M&A Broker will not have the ability to bind a party to an M&A Transaction.
- An M&A Broker will not directly, or indirectly through any of its affiliates, provide financing for an M&A Transaction. An M&A Broker that assists purchasers to obtain financing from unaffiliated third parties must comply with all applicable legal requirements and must disclose any compensation in writing to the client.
- An M&A Broker cannot have custody, control, or possession of or otherwise handle funds or securities issued or exchanged in connection with an M&A Transaction or other securities transaction for the account of others.
- No M&A Transaction will involve a public offering. Any offering or sale of securities will be conducted in compliance with an applicable exemption from registration under the Securities Act of 1933 (“Securities Act”). No party to any M&A Transaction will be a shell company, other than a business combination related shell company.
- To the extent an M&A Broker represents both buyers and sellers, it will provide clear written disclosure as to the parties it represents and obtain written consent from both parties to the joint representation.
- An M&A Broker will facilitate an M&A Transaction with a group of buyers only if the group is formed without the assistance of the M&A Broker.
- The buyer, or group of buyers will, upon completion of the M&A Transaction, control and actively operate the company or the business conducted with the assets of the business.
- No M&A Transaction will result in the transfer of interests to a passive buyer or group of passive buyers.
- Any securities received by the buyer or M&A Broker in an M&A Transaction will be restricted securities within the meaning of Rule 144(a)(3) under the Securities Act of 1933 because the securities would have been issued in a transaction not involving a public offering.
- The M&A Broker (and, if the M&A Broker is an entity, each officer, director or employee of the M&A Broker): (i) has not been barred from association with a broker-dealer by the SEC, any state or any self-regulatory organization; and (ii) is not suspended from association with a broker-dealer.
As a Practical Matter – No Safe Harbors
No single factor will determine whether an intermediary should register as a broker-dealer. All existing factors are considered together. The factors are not consistently applied in a manner to provide comfort. For example, receiving transaction based (success fee) compensation is a very important factor indicating that registration is required. In a situation, however, where the compensation received by an intermediary was not a success fee or otherwise based on the outcome of the transaction, the SEC took the position that a person who accepts a flat fee more than once is nonetheless required to register as a broker-dealer. In another situation – an M&A transaction – despite the position of the SEC in its M&A Broker Letter, the U.S. First Circuit Court of Appeals in a 2021 case, held that an intermediary in an M&A transaction violated the broker-dealer registration requirements. Moreover, applicable state law may not be (and is usually not) consistent with the M&A Broker Letter, and companies relying on Regulation D for exemption from registration will be required to disclose the name of the intermediary on Form D filed with the SEC.
This uncertainty in the legal guidelines is compounded by possible uncertainty of the scope of work envisioned by companies. They may wish to receive deal valuation and structuring advice. Management may not know at the time they retain the intermediaries whether to undertake an investment or a sale. They may seek an investment but be “open” to a sale at the right price. Alternatively, companies might start with an intended sale, engage an M&A broker and (through circumstances or otherwise) change to seeking investment, in which case the services provided by the intermediary within the guidelines of the M&A Broker Letter may no longer fall within those guidelines.
At the heart of this tortuous history are three basic common-sense themes. An M&A transaction is much more like a sale of the business rather than the sale of securities. In an investment transaction, securities are being offered and sold, but is the intermediary offering and selling the securities or solely providing its existing contacts to whom the company can thereafter do the selling and deal structuring? The greater the scope of work expected, the more likely it is that the intermediary must be registered. Finally (and unstated in most court decisions), did the intermediary disclose and faithfully perform its fiduciary duties to the parties, and was the intermediary perceived by the parties to have done so?
Recommendation
The ability of an intermediary to operate without broker-dealer registration is extremely limited. Companies should consider thoroughly researching their potential unregistered intermediaries, undertaking careful due diligence and establishing – not only by a written agreement but also in practice and expectation – the preclusion of any of the 15 registration factors enumerated above. In addition, companies might try to identify an intermediary recognized in the industry with a solid, existing contact list who will agree to a flat, non-success fee. Company accountants, lawyers and board members can be good referral sources.
Further Information
This alert is only a summary. Regulation of intermediaries continues to evolve. If you have questions concerning how regulation may apply to your company, please contact Russ Hansen (rhansen@princelobel.com; 617-456-8036), John Bradley (jbradley@princelobel.com; 617-456-8076), John Chu (jchu@princelobel.com; 617-456-8007), or Max Riffin (mriffin@princelobel.com; 617-456-8044).F