United States: Private Equity Fund Adviser Fined For Failing To Register As Broker

Last Updated: June 8 2016
Article by Steven D. Lofchie

Most Read Contributor in United States, September 2017

The SEC settled charges against a private equity fund advisory firm and its owner for engaging in brokerage activity and imposing fees without registering as a broker-dealer, among other securities law violations.

The SEC alleged that the advisory firm provided brokerage services to, and received transaction-based compensation from, portfolio companies without registering with the SEC as a broker-dealer: "Rather than employing investment banks or broker-dealers to provide brokerage services with respect to the acquisition and disposition of portfolio companies, some of which involved the purchase or sale of securities, [the advisory firm] performed these services in-house, including soliciting deals, identifying buyers or sellers, negotiating and structuring transactions, arranging financing, and executing the transactions. [The advisory firm] received at least $1,877,000 in transaction-based compensation in connection with providing these brokerage services."

Other violations with which the advisory firm was charged included the following:

  • improperly charging two portfolio companies in one fund with operating partner oversight fees;
  • improperly using fund assets to make political and charitable contributions, as well as to pay for entertainment expenses;
  • improperly purchasing shares in portfolio companies directly from a departing employee, thereby depriving the fund of the right to purchase the shares; and
  • failing to adopt and implement written policies and procedures reasonably designed to prevent Investment Advisers Act rule violations.

In addition, the SEC alleged that the advisory firm's owner acquired the interests of defaulted limited partners ("LPs") improperly, instead of causing the LPs to forfeit their interests back to the fund, as provided in its governing documents. The SEC determined that the owner then directed the fund's general partner (whom the owner also controlled) to waive the obligation to satisfy future capital calls associated with new investments.

The firm and its owner agreed to (i) be censured, (ii) cease and desist from engaging in further violations, (iii) pay a combined disgorgement of $2.339 million, including $504,588 that will be distributed back to the affected clients, and (iv) pay $283,737 in interest, as well as a $500,000 penalty.

Commentary

Like many enforcement actions that have interesting components, this one also includes a number of mundane (which is not to say minor) components; e.g., favoring the adviser over the fund investors, inadequate disclosure, poor recordkeeping, and the improper use of fund assets.

Previously, SEC staff warned investment advisers about two situations in which an adviser could be deemed to have acted illegally as a broker-dealer: (i) when an adviser (or, more often, its employee) is compensated for selling fund shares, and (ii) when a private equity adviser compensates itself as an investment banker in connection with putting deals together that involve portfolio companies. (See SEC Chief Counsel David Blass Clarifies When Private Fund Employees Are Required to Register as "Brokers" (with Lofchie Comment).)

In the first case, SEC staff seemed to indicate that it would not actively pursue advisers marketing their in-house funds, subject to some cautionary material conditions (i.e., an indication is not enforceable). In the second, SEC staff seemed to regard advisers acting as investment bankers as a far more serious issue, since such brokerage activities (unlike those of the first type) are subject to an inherent conflict of interest and often entail large amounts of money being paid to the adviser without any disclosure to investors in the fund. Similarly, the SEC warned investment advisers about a potential conflict of interest when the employees of a private equity adviser are paid by portfolio companies for providing management services to the companies themselves. Obviously, there is no way to obtain approval for that kind of conflict of interest if the compensation arrangements are not disclosed to a fund's shareholders first.

Related Links

SEC Order

SEC Press Release

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