Private Placement Brokers Should Be Legalized Along with M&A Brokers

In 2005, an American Bar Association task force published an exhaustively researched report that highlighted a huge “gray market” of unregistered brokerage activity, conducted by people that sometimes refer to themselves as “finders,” that is critical to the development of early stage companies, but operating in technical violation of the Securities Exchange Act of 1934 (“ABA Report”). Other than occasional enforcement actions against bad actors, the SEC did little to address this problem until early 2014, when it issued a No-Action letter which blessed certain restricted activities of merger and acquisition brokers (“M&A Brokers”). The SEC’s approach to other private placement brokers has been to restrict their activities even further. Compare Paul Anka, SEC No-Action Letter (July 24, 1991) (granting legal “finder” status) with Brumberg, Mackey & Wall, PLC., SEC No-Action Letter (May 17, 2010) (restricting “finder” status). Courts have not always agreed with the SEC. See SEC v. Kramer, 778 F.Supp.2d 1320 (M.D. Fla. 2011) (proposing a non-exhaustive six-factor test for registration).

On January 6th, the first day of the 114th Congress’s new session, the House of Representatives considered H.R. 37. This bill proposes again multiple pieces of legislation that passed the House in the previous congress but were not taken up by the Senate. The bill has now been remanded to the House Committee process. H.R. 37 contains eleven separate items which would affect the current financial regulatory landscape. One of the proposed provisions responds to concerns about financial intermediaries such as finders that participate in mergers and acquisitions. This blog post advocates that Congress, while considering legalization of M&A Brokers, should also legalize a limited class of private placement brokers.

Generally, any person in the business of effecting the sale or purchase of a security must register with the SEC as a “broker” defined in Section 3(a)(4) of the Exchange Act. Section 401 of H.R. 37 would create a registration exemption for merger and acquisition brokers by amending Section 15(b) of the Exchange Act.

H.R. 37 defines an M&A Broker as “a broker engaged in the business of effecting securities transactions solely in connection with the transfer of ownership of an eligible privately held company….” In addition, the M&A Broker must reasonably believe that the person acquiring securities or assets of the privately held company will control and be active in its management, and if any person is offered securities in exchange for the privately held company’s securities or assets, the person should have reasonable access to certain information about the privately held company’s financials before the transaction has been consummated. Also, in order to receive M&A Broker status, and thus be relieved from registration, the M&A Broker must not engage in certain conduct. M&A Brokers would be prohibited from (1) receiving, holding, transmitting, or having custody of funds or securities in connection with the transfer of ownership; and (2) being involved in a public offering of securities. Although H.R. 37 creates a new refuge for financial intermediaries who deal solely with merger and acquisition transactions from having to register with federal authorities, it offers no relief to other private placement brokers.

The concern over whether and how to legalize and regulate M&A Brokers has recently been the subject of an SEC No-Action letter. The SEC, on January 31, 2014, issued a No-Action letter in which a “M&A Broker” (as defined by the requesting letter) engaged in certain activities with a privately held company (“SEC No-Action Letter”). The terms and restrictions of this No-Action letter are largely incorporated into H.R. 37.

Neither the SEC No-Action Letter nor H.R. 37’s M&A Broker exemption goes far enough in addressing many of the concerns that surround unregistered financial intermediaries. If Congress is going to tackle this issue, it needs to be more thorough and concurrently address financial intermediaries that deal in private placements as well.

Many of the concerns and issues that unregistered financial intermediaries raise for companies, investors, and regulators are thoroughly discussed in the ABA Report. Unregistered financial intermediaries may partake in offerings that are fraudulent, disturb compliance procedures, and sell and advertise bad products, all while putting their own interest first to try to unfairly profit from the transaction. Consequently, the actions of the unregistered financial intermediary could put the transaction in jeopardy by triggering provisions causing the transaction to be rescinded, or place the company or investors in the middle of an enforcement proceeding by securities regulators.

On the other hand, financial intermediaries can be of great significance to small businesses that cannot find or secure enough funding to become successful. With only hundreds of thousands of dollars or a few million dollars of capital needed, small businesses will not garner the attention of most registered broker-dealers or institutional or professional capital providers that only back larger transactions. As a result, small businesses are left to seek out friends and family in order to raise enough money, which is often not enough. Financial intermediaries can help by identifying a source of funds not usually available to a business or provide introductions when a company is seeking suitable investors.

H.R. 37 should take into account and balance the good that financial intermediaries, including private placement brokers, can provide against their possible fraudulent and illegal behavior. The bill essentially fails to cover enough ground to legalize or adequately regulate these actors and should entail other conduct, specifically private placements, that financial intermediaries are involved in.

Much of the language contained in H.R. 37’s M&A Broker exemption seems to be drawn directly from the SEC No-Action Letter. There, the authors of the request for no-action emphasized that the buyer and seller in merger and acquisition transactions will often be represented by attorneys, accountants, and other business consultants while conducting due diligence and negotiating the transaction. The no action request was not so limited, however, and neither was the no action relief granted.

It should be recognized that issuers and investors who are involved in private placements of small, privately held companies may be more vulnerable to bad broker behavior. The amount of resources some small businesses have at their disposal is often less than those of parties who are seeking to transfer ownership of an already established and successful company. It is essentially because small, privately held businesses are capital poor and just starting out, that they are susceptible to illegal or unfair practices of financial intermediaries who are looking to make a quick buck. It is therefore essential that Congress address the need for this “gray market” to become legalized and appropriately regulated, but such regulation can be performed on a scale much less extensive than is currently imposed upon registered broker-dealers.

As documented by the ABA Report, private placement brokers are integral and essential to the U.S. capital market and the development of a prosperous small business sector. Congress should not pass up this opportunity to legalize and appropriately regulate this “gray market.”

Parker MacIntyre provides legal and compliance services to investment advisers, broker dealers, registered representatives, hedge funds, and issuers of securities, among others. Our regulatory practice group assists financial service providers with complex issues that arise in the course of their business, including complying with federal and state laws and rules. Please visit our website for more information.

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