Buyer Beware! No, Seller Beware!

What every seller should know about a business sale transaction.

The statistics and projections are staggering:

  • It is projected that the number of new businesses will increase by 22% every five years.
  • “An estimate of 65% to 75% of all small businesses will go up for sale in the next five to 10 years. Why? Retiring baby boomers.” – Inc. Magazine, April 2008.
  • A PricewaterhouseCoopers survey confirms that one out of every two company owners intend to sell their businesses within the next 10 years.
  • The Exit Planning Institute projects that in the next 12 to 15 years, in excess of 8,000,000 privately held businesses will be sold.
  • Most business owners’ exit plans do not take into consideration the supply demand implications associated with the millions of businesses that will be placed on the market.
  • 90% of all businesses with employees are family owned (30% are owned by individuals who are 55+ years old).
  • A significant percentage of business owners plan the exit from their businesses for less than six months, resulting in a sales price of 50%–70% of its potential value.
  • “ . . . 87% of all business equity transfers involve a mergers & acquisitions (M&A) intermediary and/or a CPA.”
  • Industry experts believe that engaging an M&A intermediary to assist in a transaction can result in an average increase of 20% in the purchase price and significantly enhance the probability the transaction will close successfully.

With conservative projections of a threefold increase in business sale transaction activity, the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA), formerly known as the NASD, have determined it is time to increase the regulatory control over this process. (The SEC and FINRA were created by the Securities Exchange Act of 1934. The SEC is an independent agency of the U.S. government responsible for enforcing federal securities laws and regulating the securities industry. FINRA is the self-regulatory organization (SRO) responsible for regulatory oversight of all securities firms and their registered representatives doing business with the public.)

The timing of their actions is, in no small part, due to the baby boomers approaching retirement age. This group is composed of individuals born between 1946 and 1964. Latest census figures indicate they number 78,200,000, with 54 percent of them being self-employed. Their impact on the U.S. economy is nothing short of astounding. Currently, they generate over two trillion dollars a year, or 77 percent of the financial assets in the country. Simple math tells us that in 2009, they are between 45 and 63 years old. As a group, they are not financially able to retire without a continuing stream of income. Ninety percent of those between the ages of 45 and 55 have less than $250,000 in savings, and 55 percent have less than $50,000. Considering the high cost of health care, which continues to rise, and 20 to 25 years of retirement to fund, they will need every dime they can get from their investments and the sale of their businesses.

The SEC and FINRA have begun the process of forever changing the manner in which businesses in the United States will be sold in the future. These changes will affect buyers, sellers, business brokers and anyone receiving a finder’s fee for introducing parties to a transaction.

For decades, business brokers (as a group) and finders have been largely unregulated. Except as it related to the sale of stock of a company, there were no federal regulations imposed on them. Each state has its own regulations, which vary broadly. Some states require a business broker to maintain a real estate sales license, one requires business brokers to be licensed as Registered Investment Advisors and others only require that the individual pay a fee to register and provide a disclosure document to clients.

However, on February 17, 2009, FINRA proposed to the SEC a rule change to adopt Rule 1032(i). On April 13, 2009, the SEC issued an order approving the rule change, without modification. As of the date of this writing, it only applies to those securities firms and their employees that are currently licensed by FINRA and subject to FINRA rules and SEC regulations. But in the next few months, this will change.

In the past, business brokers and other unregistered financial intermediaries have pretty much “flown below the regulatory radar.” They have avoided scrutiny by predominantly being involved in asset sales, which are not defined in the Securities Act of 1933 as a “security.” If a transaction strayed into the “gray area,” they requested, or relied on, various SEC No-action Letters that have been issued over the years. (No-action Letters are issued by the SEC in response to submissions, typically by law firms on behalf of clients who are not certain whether a particular product, service or action would constitute a violation of the federal securities law. They 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, conclude that the SEC staff would not recommend enforcement action against the requester based on the facts and representations described in the submission.)

In some cases, these financial intermediaries knowingly violated securities laws, hoping they would be lucky enough to avoid the potential legal ramifications for themselves and their clients. They cross their fingers and hope everything goes fine for the buyer or that the statute of limitation tolls before any issues are raised by the buyer.

The Securities Act of 1933, in Section 2(1), states: “The term ‘security’ means any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘security’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.” This definition applies to both the securities of publicly traded companies and privately held companies.

If a transaction involves the sale of the stock of a company, it is a securities transaction. If there is a promissory note issued for payment of a portion of the purchase price over time, regardless of whether or not the sale is of stock or assets, that portion of the transaction involves a security. If a seller is represented in a securities transaction by an unregistered financial intermediary, the seller is under no legal obligation to pay any transaction based commission to the unregistered intermediary on the securities portion of the transaction, regardless of the terms of the seller’s contract with the intermediary.

Individuals acting as unregistered financial intermediaries can be CPAs, mergers and acquisition specialists, business brokers, real estate agents, insurance agents, consultants, individuals familiar or connected with investor or angel investor networks, persons engaged to identify and secure investment capital, retired issuer executives, community or national leaders and occasionally celebrities. They have also been known to act as finders or investment bankers, and some even provide deal related business plans, offering letters, or private placement memorandums. If (1) the transaction involves securities, (2) compensation for their services is calculated as a percentage of the value of the transaction and (3) payment is only received if the transaction closes successfully, they are probably unregistered intermediaries violating securities laws.

Unregistered financial intermediaries can create a myriad of problems for a seller, including violations of securities laws through advertising, engaging in a general solicitation and misrepresentation of—or failure to disclose—material facts, just to name a few. If an unregistered intermediary is determined to be “engaged in the business of selling securities for compensation,” that person may be subject to criminal and/or civil legal actions.

Failure to comply with securities laws allows a buyer to rescind or undo the purchase of securities from the seller and get back the money the buyer paid, or recover damages. No seller wants to be in the position where a buyer takes over his/her company, mismanages it, effectively runs it into the ground and then says, “you violated securities laws and therefore I want all my money back—and oh by the way, here’s your ruined company back…thanks for the no-cost test drive.” Generally, the federal statute of limitations for noncompliance with the requirement to register securities is one year from the date of violation. State remedies and statutes of limitations vary (i.e., in California, it is the earlier of two years after the violation or one year after discovery of the facts constituting the violation). Sometimes a seller will make a rescission offer to the buyer(s) to eliminate the potential risk exposure of a buyer exercising rescission rights in the future.

The recently SEC-approved FINRA Rule 1032(i) has every appearance of an intention to broaden FINRA’s regulatory scope. It establishes a new class of securities licensing, Limited Representative – Investment Banking, for individuals associated with a securities firm and involved in: “(i) advising on or facilitating debt or equity securities offerings through a private placement or public offering . . .” and “(ii) advising on or facilitating mergers and acquisitions, tender offers, financial restructurings, asset sales, divestitures or other corporate reorganizations or business combination transactions, including but not limited to rendering fairness, solvency or similar opinions.”

The SEC has approved a new qualifications examination (the Series 79 exam), a corresponding fee schedule, and established November 2, 2009 as the date upon which Rule 1032(i) will become effective. For anyone currently licensed as a Series 7, and engaged in investment banking activities covered by Rule 1032(i), there will be a six-month opportunity to opt in to the Investment Banking Representative registration without being required to pass the Series 79 exam. This opt-in period ends May 3, 2010.

There are two very significant aspects of the rule that should not be overlooked. First, the usage of the phrase “advising on or facilitating” is so broad in nature it is difficult to imagine what kind of material participation in a transaction an individual might have that could not be incorporated within that phrase. Second, the term “asset sales” is included—a term that is currently not part of the definition of a security in the Security Act of 1933. This second item is specifically significant. Since asset sales were never considered a security, they were always a “safe harbor” by which business brokers and other unregistered intermediaries were able to conduct business without violating securities laws.

In 2005, the American Bar Association (ABA) Task Force on Private Placement Broker-Dealers prepared a report and recommendation regarding the issues surrounding unregistered financial intermediaries. Since that time, the International Business Brokers Association (IBBA) and the Alliance of Merger & Acquisition Advisors (AM&AA), along with support from other local and regional business broker associations, have also set forth proposals regarding licensing and regulatory exemptions. They are referred to as the Private Placement Broker-Dealer (PPB), the M&A Broker (M&AB) and the Small Business Sale Exemption. Although there have been numerous meetings and presentations regarding these proposals to SEC staff members and representatives of the North American Securities Administrators Association (NASAA), they all preceded FINRA’s proposed Rule 1032(i), which was approved by the SEC on April 13, 2009.

So, what will happen next?
With regulators, it’s all about the two “F’s” —fees and fines. FINRA is an SRO. It generates the funds it needs to operate its 2,800 employee organization by collecting registrations and processing fees from members and new applicants, and fines for member and registered representative rule violations. In 2008, FINRA regulatory actions collected $28 million in fines, expelled or suspended 19 firms, barred 363 individuals from the industry and suspended 321 others. This resulted in ordered or secured agreements to return more than $1 billion to investors.

Examining how regulators create and implement new rules will provide insight as to what most likely will happen next. (1) FINRA creates a rule and proposes it to the SEC for approval; (2) it is published in the Federal Register for comment; (3) the SEC either approves it in its original form, approves it with modifications or rejects it; (4) if it is for a new class of licensing and it is approved, a qualification exam is created; (5) the rule is implemented, applied to and enforced upon all licensed members of the securities industry. Remember, the SEC and FINRA can only control individuals who are currently licensed in the industry.

However, the SEC Division staff has requested (through IBBA’s attorneys) a “white paper” be authored by an IBBA committee quantifying the number of individuals that might be impacted by imposing regulatory scrutiny in the business brokerage industry. At the June, 2009 IBBA conference, the report to IBBA members disclosed this request and stated that the committee estimates as many as 120,000 individuals might be impacted. The IBBA and AM&AA representatives believe this information was requested in furtherance of their proposals, which are being discussed with SEC Division staff.

I disagree.
Twenty-five days after the SEC approved Rule 1032(i), Warner Norcross & Judd (a firm representing the IBBA and AM&AA) released an update on the M&A Broker Proposal. In it they state, “The proposals have the support of the SEC Division’s staff. They are ready to advance the rulemaking process when the Commissioners’ policymaking priorities allow . . . Given the daily Wall Street and Washington headlines, the staff would not make any prognostications about timing.”

I was first registered in the securities industry in 1982 and have had an opportunity to observe and participate in it over a 27-year period. The SEC Commissioners, not the SEC Division staff, are the policymakers and the decision-makers—and they made their decision when they approved Rule 1032(i). The SEC staff ’s function is to provide logistical and administrative support to the SEC Commissioners. In my opinion, the SEC staff has requested the information to prepare budgetary and manpower projections that will be necessary for regulatory supervision and enforcement actions once Rule 1032(i) is effective and expanded to apply to business brokers and other intermediaries who are currently not registered. Otherwise, FINRA would be imposing more stringent requirements on its members and registered representatives, which would, in essence, give unregistered individuals an advantage in the marketplace. Does this really seem likely? Why would FINRA disadvantage its own members and registered representatives? If this occurs, it will be the first time since FINRA was legislated into existence in 1938. If asked to opine as to future events, I would suggest a bill destined for Congressional vote would be amended to adding the term “asset sale” to Section 2(1) of the Securities Act of 1933; and when that bill became law, all future transactions involving asset sales would be securities transactions. Then, virtually every business sale would require participating intermediaries to be registered Series 79 Limited Representatives.

The SEC currently regulates 18,815 U.S. publicly traded companies—and in conjunction with FINRA (according to FINRA’s 2008 annual report), regulates nearly 4,900 brokerage firms, 172,000 branch offices, approximately 665,000 registered securities representatives and all their respective transactions.

If we are to accept Inc. Magazine, Pricewaterhouse Coopers and the EPI projections cited earlier in this article as being reasonable, there will be an average of more than 250,000 transactions per year for the next 10 to 15 years, the majority of which would be unregulated sales transactions (not involving securities as that term is currently defined). Add to this a substantial portion of the IBBA Committee’s projected 120,000+ potentially impacted parties, and you have a “target rich environment” for regulators to potentially generate a feast of registration fees and enforcement fines.

Business owners contemplating a transaction should be especially vigilant during these times of regulatory change. Be certain your advisors are properly registered, if applicable, under federal law and your state law. If your transaction involves securities, take care to engage legal representatives familiar with the implications of securities laws and how they affect your specific circumstances. They will assist you in the risk assessment process and preparation of the proper documentation memorializing compliance of the transaction with applicable securities laws.

Part II of this article will be published next quarter. In it, I will update you on progress in the regulatory change process, outline the steps involved in a transaction, discuss how transactional tax planning (TTP) can be used to get otherwise undoable deals done, reveal the part TTP can play in your estate planning process and provide tips on how to maximize your netafter- tax proceeds from the sale.