United States: Current SEC Broker-Dealer Registration Issues Concerning Private Investment Funds

Last Updated: April 17 2013
Article by Jessica Forbes and Gregory P. Gnall

A recent speech given by David W. Blass, the Chief Counsel of the Division of Trading and Markets at the Securities and Exchange Commission ("SEC") and enforcement proceedings brought against a finder who was found to be acting as an unregistered broker-dealer and a private fund adviser which engaged him indicate that the SEC has a renewed interest in the way in which private funds, including hedge funds, private equity funds and real estate funds, market and solicit investors for such funds. Therefore, private fund advisers should review their solicitation activities, including the use of finders and internal personnel to market fund interests, to determine whether such activities implicate broker-dealer registration with the SEC.

Blass Speech

Speaking before the American Bar Association's Subcommittee on Trading and Markets on April 5, 2013,1 Mr. Blass summarized the SEC's long-held position that private fund advisers engaged in the solicitation of investors through their employees, combined with either of the following factors, may indicate that the firm or such employees may be required to register as a broker-dealer under Section 15(a) of the Securities Exchange Act of 1934 (the "Exchange Act"):

a. The SEC has long viewed receipt of transaction-based compensation as a "hallmark of being a broker." Therefore, the method through which a private fund adviser compensates its personnel for raising investments in its funds may require the adviser or its employees engaged in fund raising activities to register as a broker-dealer.

b. A dedicated sales force, or a group of employees whose primary responsibility is soliciting investors, "may strongly indicate that they are in the business of effecting transactions in the private fund, regardless of how the personnel are compensated."

According to Blass, when advisory personnel engage in the following activities, they may be regarded as being "in the business of effecting transactions in securities for the account of others'"2: marketing fund interests to investors, soliciting or negotiating securities transactions in the funds, or holding customer funds or securities. The issue is more acute when the adviser's personnel or outside unregistered "finders" (as we will discuss in the recent enforcement proceedings, below) receive "transaction-based compensation" (i.e, compensation based, directly or indirectly, on the success of placing the investment). The reasoning of the SEC is that such compensation creates a "salesman's stake" in the transaction, which creates a potential conflict.

On the registration issue for solicitation activities, Blass advised private fund advisers to consider the following issues:

  • "How does the adviser solicit and retain investors?" If personnel engaging in marketing activities are part of a dedicated marketing team, the adviser or the personnel may be required to register as a broker-dealer.
  • "Do employees who solicit investors have other responsibilities?" If their primary roles are to solicit investors, they also may need to register.
  • "How are personnel who solicit investors for a private fund compensated?" It is not enough that an adviser not directly engage in paying transaction-based compensation through transaction-by-transaction success fees; the adviser needs to ensure that it is not paying such compensation indirectly through discretionary bonuses tied to amounts of investments raised by particular employees.

Mr. Blass also mentioned SEC Rule 3a4-1 ("Issuer's Exemption") as an exemption from registration under the Exchange Act for companies whose employees engage in some solicitation activities for an offering of their securities (including private fund interests). He noted that private funds typically do not rely on this exemption, presumably because the exemption is limited to a single offering in a twelve-month period. However, the Issuer's Exemption is a non-exclusive safe harbor, and broker-dealer registration is not necessarily implicated if all of its conditions are not satisfied.

Noting that the Dodd-Frank Act requires most private fund advisers to register with the SEC as investment advisers under the Investment Advisers Act of 1940 (the "Advisers Act"), Blass suggested that such newly registered advisers, as they go through their first SEC exams under the Advisers Act, consider not only their compliance with that Act, but also whether their activities may require their personnel to register as broker-dealers.

Blass also discussed other fees, such as those paid to advisers of private equity funds (so-called "investment banking fees"), for arranging portfolio investments by the fund, an activity that also may be regarded as coming within the definition of a "broker." While offsetting investment banking fees against the advisory fee appears to be acceptable to the SEC, when they are not 100% offset, they may be regarded as transaction-based compensation requiring registration as a broker-dealer. The SEC does not accept the argument that a fee paid by a fund to its general partner does not involve a transaction "for the account of others," since the fund and the GP are distinct legal entities.

Blass suggested that the SEC may be willing to consider a new private fund adviser exemption, similar to the Issuer's Exemption, for solicitation activities, and invited those present to suggest how such an exemption might work. However, he made clear that any arrangement allowing transaction-based compensation for such activities would likely not be within the acceptable parameters of such a rule.

SEC Enforcement Proceedings

On March 8, 2013, the SEC brought and settled two related cases involving the engagement by Ranieri Partners of a "finder" to assist in the solicitation of investors for its private funds. In the Matter of William M. Stephens3

The SEC brought public administrative and cease-and-desist proceedings pursuant to Sections 15(b) and 21C of the Exchange Act and Section 9(b) of the Investment Company Act of 1940 (the "Investment Company Act") against Stephens, who acted as an independent consultant for Ranieri Partners LLC. Stephens actively solicited investors on behalf of private funds managed by Ranieri Partners' affiliates and, in return, received fees equal to 1% of all capital commitments made by investors he introduced to the funds, totaling approximately $2.4 million. Stephens was not registered as a broker or dealer or associated with a registered broker or dealer and had been previously barred from association with any investment adviser for a period of two years and never reapplied for permission to become associated with an investment adviser.

Stephens' solicitation efforts included:

a. Sending private placement memoranda, subscription documents, and due diligence materials to potential investors;

b. Attending meetings and participating in telephone calls with potential investors and urging at least one investor to consider adjusting its portfolio allocations to accommodate an investment with Ranieri Partners;

c. Providing potential investors with his analysis of Ranieri Partners' funds' strategy and performance track record; and

d. Providing potential investors with confidential information relating to the identity of other investors in the funds and their capital commitments.

Stephens was found to be acting as an unregistered broker-dealer, and a cease and desist order was entered; he was barred from associating with any broker-dealer or investment adviser. Disgorgement of the fees paid to him was ordered, but waived, due to Stephens' inability to pay.

In the Matter of Ranieri Partners LLC and Donald W. Phillips4

The SEC brought and settled administrative and cease-and-desist proceedings instituted against Phillips pursuant to Section 21C of the Exchange Act and Section 203(f) of the Advisers Act, and cease-and-desist proceedings against Ranieri Partners LLC pursuant to Section 21C of the Exchange Act.

Phillips, a Senior Managing Partner of Ranieri Partners, was in charge of raising capital for its private funds. Phillips was a long time friend of Stephens and generally aware of Stephens' disciplinary history with the SEC when he caused an affiliate of Ranieri Partners to retain Stephens to find potential investors. Ranieri Partners and Phillips provided Stephens with key documents and information and did not take adequate steps to prevent Stephens from having substantive contacts with potential investors.

The SEC found that Ranieri Partners and Phillips failed to adequately oversee Stephens' activities in a number of ways, including the following:  Although Stephens was not permitted to send documents such as PPMs and subscription documents to potential investors, he was able to obtain such documents from Ranieri Partners and to send those documents to potential investors.

  • Ranieri Partners received Stephens' requests for expense reimbursements reflecting extensive contact with potential investors.
  • Phillips assisted Stephens in his solicitation efforts by providing him with key fund documents and information. He failed to limit Stephens' activities despite being aware of the limited role Stephens was supposed to play. Even though Phillips became aware that Stephens was having substantive communications with potential investors, he failed to curb his activities and did little to monitor Stephens and others, aside from holding weekly meetings for Stephens and others to report their progress.

The SEC found that Ranieri Partners failed to adequately oversee Stephens' activities and that Phillips knowingly and willingly provided Stephens with substantial assistance while ignoring red flags indicating that Stephens had gone well beyond the limited role of a finder and was actively soliciting investments. Because of this conduct, Ranieri Partners was found to have caused and Phillips was found to have aided and abetted Stephens' failure to register as a broker-dealer with the SEC. They agreed to the entry of a cease-and-desist order and a $375,000 fine against Ranieri Partners and $75,000 fine against Phillips, who also was suspended from holding a supervisory position in the securities industry for nine months.

Significance of Developments

The enforcement actions discussed above and David Blass' speech indicate that the SEC may be focusing greater efforts on examining the ways in which private funds solicit investors, and demonstrate a willingness to bring actions not only against unregistered finders, but also the private fund advisers who engage them, at least when there is knowing conduct and active support of such activities. By bringing an action against Ranieri Partners for causing the violation and against its supervisor for aiding and abetting it, the message is that the adviser who engages a finder bears some responsibility for whether or not the finder should register as a broker-dealer. More generally, according to Mr. Blass, private fund advisers, particularly those that are newly registered, should carefully review their solicitation activities, especially their compensation practices, in preparation for their first investment advisory examinations, so that they or their employees are not viewed as acting as unregistered broker-dealers.


1 http://www.sec.gov/news/speech/2013/spch040513dwg.htm

2 See Exchange Act Section 3(a)(4).

3 http://www.sec.gov/litigation/admin/2013/34-69090.pdf

4 http://www.sec.gov/litigation/admin/2013/34-69091.pdf

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