Increased Scrutiny of SEC Broker Dealer Registration Requirements

Placement Agents and Transaction Fees Risk Triggering SEC Broker-Dealer Registration Requirements

David W. Blass, chief Counsel of the Security and Exchange Commission (the “SEC”), used his speech to the American Bar Association this month to move market participants and regulators towards a common understanding of “broker-dealer registration” regulation in the US, encourage Private Funds to review their fund raising arrangements and invite suggestions for an exemption “written specifically for private fund advisers” to the existing registration requirements.

Legal Background:
Under the US the Exchange Act a “broker” is largely defined as any person engaged in the business of effecting transactions in securities for the account of others. Absent an available exemption or other relief, such activity generally triggers a requirement to register under Section 15(a) of the Exchange Act and become a member of FINRA. It is worth noting that such a registration is arduous and expensive to the point that Mr Blass specifically acknowledged that “many advisers, particularly smaller advisers, may not be able to afford… to either hire a broker-dealer or register as a broker-dealer themselves.”

In response to the above, private funds have typically adopted the view that:
(i) a sponsor selling interests in a private fund either is not “engaged in the business of effecting transactions” or is not acting for the account of others; and
(ii) that receipt of transaction fees by a private fund sponsor should not trigger broker status.

SEC Scrutiny:
As private funds have become an increasingly important participant in the financial marketplace the SEC has however increased its scrutiny of private fund advisers and existent market practices. In this context, Mr Blass emphasized the “serious consequences” that would apply to a unregistered broker-dealer by reference to the recent Ranieri case brought by the SEC in March 2013.

In this case the SEC charged Ranieri Partners LLC (“Ranieri”), a private firm that had raised over $500m using an unregistered consultant whose compensation was calculated as a percentage of capital commitments made to the funds by investors introduced by it. Despite the fact that no fraud was alleged to have been committed by either Ranieri of the consultant, the SEC penalised Ranieri’s fund manager and marketing personally in addition to the unregistered consultant. In this action the SEC applied the following sanctions:
(i) $375,000 applied on Ranieri;
(ii) $75,000 applied to a director of Ranieri that had acted as a marketing employee;
(iii) the above director was also restricted from acting in a supervisory role at any investment adviser or broker-dealer for nine months; and
(iv) the third-party consultant was permanently barred from working in the securities industry.

As noted in his Mr Blass’s speech, a possible consequence of acting as an unregistered broker-dealer is that securities transactions intermediated by an unregistered broker-dealer could potentially be rescinded/rendered void.

Placement Agents/Finders as Broker-Dealers:
Whilst not all fund raising that utilise an external fund-raiser would give rise to a broker-dealer registration requirement, Mr Blass described a number of indicative activities that the SEC consider might betoken a registration requirement. These include:
(i) Marketing securities (shares or interests in a private fund) to investors;

(ii) Soliciting or negotiating securities transactions; or

(iii) Handling customer funds and securities.

The above activities will be particularly relevant if they are remunerated by a compensation structure that is dependent upon the outcome or size of the securities transaction i.e. a “salesman’s stake.” Mr Blass, for example, noted that “the SEC and SEC staff have long viewed the receipt of transaction-based compensation as a hallmark of being a broker.”

Fund Manager Staff as Brokers:
Mr Blass’s speech further noted that a private fund manager with a dedicated sales force of employees working within a fund’s marketing department may risk falling within the broker-dealer definition. That is private fund managers are not exempt from SEC scrutiny merely as a result of fundraising functions being “in-house” or because their compensation is not expressly tied to capital-raising efforts (e.g., fixed salaries and fixed bonuses).

Mr Blass offered some basic questions that private fund managers should consider when when reviewing their fundraising staff structures. These included:
(i) What role is played by these staff in soliciting and/or retaining investors?
(ii) Do employees who solicit investors have other responsibilities or is their primary responsibility soliciting investors?
(iii) How are employees who solicit investors for a private fund compensated? I.e. do these employees receive transaction-based compensation?

In relation to the above, Mr Blass noted the “Issuer exemption” available under Exchange Act Rule 3a4-1 is generally unlikely to be available to private fund advisers.

Private Equity Fund Practices:
[In Europe market standard is for private fund sponsor’s receipt of transaction-based fees (e.g. “closing fees” or “success fees”) is largely, if not entirely, offset against advisory fees payable by the fund.] Mr Blass noted that such arrangements, in his view, “would not appear to raise broker-dealer registration concerns.”

In contrast many US based funds operating leverage buyout strategies will directly retain “investment bank activity” fees charged to a portfolio company as compensation for structuring transactions and soliciting purchasers etc. Such a structure may give rise to a registration requirement. As Mr Blass noted “taking the activity out of the private equity space and applying it in other contexts would leave little question about the need for broker-dealer registration.”

A number of parties have suggested to the SEC that such practices should not give rise to a registration requirement as the general partner should be viewed as the same person as the fund, i.e. no transactions are undertaken for the “account of others.” Mr Blass strongly attacked this suggestion stating that the fact that “the fee is paid to someone other than the fund — here the general partner — makes crystal clear to me that, at least for potential broker-dealer status questions, the fund and the general partner are distinct entities with distinct interests.”

Next Steps:
Mr Blass’s speech included an appeal to Private Funds to actively engage in open dialogue with the SEC and propose suggestions for the creation of a specific exemption from the broker-deal registration requirements for private fund managers. Nonetheless, the recent enforcement action and on-going scrutiny undertaken by the SEC demonstrates that this continues to be a key area of concern for the SEC and Private Fund Managers should proactively review (a) transaction fees they charge portfolio companies, (b) their engagement of placement agents and (c) the roles undertaken by in-house staff that focus on fund raising.

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