The Securities and Exchange Commission (SEC) is cracking down on
private fund [1] managers for not using registered
broker-dealers for fundraising. At the same time, recent public
comments by the SEC staff indicate that certain activities of
private fund managers may require that they become registered with
the SEC as broker-dealers. These recent comments also indicate a
willingness to entertain suggestions to create a useful exemption
from broker-dealer registration specific to private fund
managers.
Ranieri Partners Enforcement Action
The SEC charged Ranieri Partners LLC ("Ranieri"), a
private equity fund, with raising over $500 million in capital
commitments through a third-party consultant who was not registered
with the SEC as a broker-dealer. Under the terms of the settlement,
announced on March 8, 2013, Ranieri agreed to pay a $375,000 fine,
one of Ranieri's managing directors (who functioned as a
marketing/sales employee of Ranieri) agreed to pay a $75,000 fine
and refrain from acting in a supervisory role at any investment
adviser or broker-dealer for nine months, and the SEC permanently
barred the third-party consultant from working in the securities
industry. Notably, the SEC did not allege when bringing the
enforcement action that fraud was committed against the investors
in Ranieri (either by Ranieri or the third-party consultant).
Moreover, in addition to charging the third-party consultant with
violating the Securities Exchange Act of 1934 (the "Exchange
Act") by acting as an unregistered broker-dealer, the SEC
charged Ranieri with causing such violations and charged the
employee of Ranieri with aiding and abetting such violations. This
appears to be a novel SEC enforcement action in that it is focused
on penalizing the private fund manager and its marketing personnel
as well as the unregistered broker-dealer.
Recent Comments of SEC's Chief Counsel to the Division of Trading and Markets
On April 5, 2013, less than a month after the announcement of
the Ranieri settlement, David Blass ("Blass"),
the chief counsel of the SEC's Division of Trading and Markets,
delivered a speech on these issues to the American Bar
Association's Trading and Markets Subcommittee at the ABA's
Business Law Section 2013 Spring Meeting held in Washington, DC.
Blass's remarks, which were later posted on the SEC's
website, focused on the SEC staff's "increased examination
focus on private fund managers, both due to the new regulatory
requirements and [the SEC's] own observations in the private
fund space."
Blass highlighted in his remarks the SEC's growing concern and
focus with respect to private fund managers' use of fundraisers
(internal and external) to attract capital. In particular, Blass
discussed private fund managers that pay their personnel
"transaction-based compensation" for selling interests in
a fund.
It is well known that persons engaged in the business of effecting
transactions in securities for the account of others must generally
register under Section 15(a) of the Exchange Act as a broker.
Common broker activities include (1) marketing securities or
interests in funds to investors; (2) soliciting or negotiating
securities transactions; and (3) handling customer funds and
securities. Blass stated that:
[T]he importance of each of these activities is heightened where there also is compensation that depends on the outcome or size of the securities transaction ? in other words, transaction-based compensation, also referred to as a "salesman's stake" in a securities transaction. The SEC and SEC staff have long viewed receipt of transaction-based compensation as a hallmark of being a broker.
Noting the Ranieri settlement, Blass emphasized that
the SEC's recent focus on the use of unregistered broker-dealer
fundraisers by private fund managers "demonstrate[s] that
there are serious consequences for acting as an unregistered
broker, even where there are no allegations of fraud." Blass
notes that, in his view, private fund managers may not be fully
aware of all the activities that could be viewed as soliciting
securities transactions or the implications of compensation
methods, including compensation of internal staff of the private
fund managers.
Beyond "transaction-based compensation," Blass commented
on the not-uncommon situation where a private fund manager has
personnel whose only or primary functions are to sell interests in
a fund. Blass noted that:
[A private fund manager with] a dedicated sales force of employees working within a "marketing" department may strongly indicate that [such employees] are in the business of effecting transactions in the private fund, regardless of how the personnel are compensated.
Accordingly, private fund managers should not consider
themselves out of the ambit of the SEC's scrutiny simply
because their fundraising efforts may be conducted solely
"in-house" or because their compensation is not expressly
tied to capital-raising efforts (e.g., fixed salaries and fixed
bonuses).
Determining whether a person should register as a broker-dealer is
often a fact-intensive determination. Blass offered some basic
questions that private fund managers should consider when making
this determination. These included:
- How does the private fund manager solicit and retain investors?
- Do employees who solicit investors have other responsibilities or is their primary responsibility soliciting investors?
- How are employees who solicit investors for a private fund compensated? Do those individuals receive bonuses or other types of compensation that are linked to capital raising?
- Does the private fund manager charge a transaction fee in connection with a securities transaction (e.g., a "closing" fee in connection with the closing of an acquisition of a portfolio company by a private equity fund manager that is paid at the closing to the private fund manager)?
In sum, private fund managers need to look at not just their
fundraising activities but also their fee arrangements, including
fees paid to employees of the private fund manager, in connection
with the underlying investment activities of the fund. This also
reinforces the SEC's trend toward constraining the permissible
activities of "finders," and more often than not, these
persons will be deemed to be, just as in Ranieri,
"engaged in the business of effecting transactions in
securities for the account of others." Fund managers should be
aware that issuances of interests in the funds marketed by private
fund managers, if intermediated by an inappropriately unregistered
broker-dealer, could potentially be subject to a right of
rescission by the investors in such fund.
Inapplicability of the Issuer's Exemption
Additionally, Blass commented on the difficulty of private fund
managers in utilizing the Exchange Act's "issuer's
exemption," found under Rule 3a4-1, that is a nonexclusive
safe harbor under which associated persons of certain issuers can
participate in the sale of an issuer's securities in certain
limited circumstances without being considered a broker. In order
to rely on the "issuer's exemption" from
broker-dealer registration, a person must satisfy one of the
following three conditions: (1) the person limits the offering and
selling of the issuer's securities only to broker-dealers and
other specified types of financial institutions; (2) the person
performs substantial duties for the issuer other than in connection
with transactions in securities, was not a broker-dealer or an
associated person of a broker-dealer within the preceding 12
months, and does not participate in selling an offering of
securities for any issuer more than once every 12 months; or (3)
the person limits activities to delivering written communication by
means that do not involve oral solicitation of a potential
purchaser by the associated person. It is often difficult for
private fund managers and their marketing personnel to satisfy any
of these three conditions, which is why Exchange Act Rule 3a4-1 is
not always an available exemption for private fund managers.
Potential Exemption for Private Fund Managers?
Importantly, Blass noted that he was "keenly aware that
many advisers, particularly smaller advisers, may not be able to
afford or be able to either hire a broker-dealer or register as
broker-dealers themselves." Accordingly, he invited comments
as to whether a broker-dealer exemption specific to private fund
managers would be helpful, and also stated that he had in mind a
"potential exemption like the issuer exemption, but one
written specifically for private fund managers."
Broker-Dealer Issues Arising in Private Equity Fund Transactions
Blass also discussed the common practice in private equity
transactions of the private fund manager receiving certain fees in
addition to advisory fees (e.g., "closing fees" or
"success fees"), paid in connection with certain
liquidity events such as a purchase or sale of a portfolio company
(including in an IPO context). He stated that this practice may
trigger activities requiring broker-dealer registration for the
fund manager, if the transaction involves an issuance or sale of
securities (e.g., an equity or debt financing conducted in
connection with the liquidity event). Given how common this
practice is in the private equity business, including for services
involving negotiating deals, identifying and soliciting purchasers
or sellers of securities, and/or structuring transactions, these
comments from Blass should not go unnoticed.
Blass notes that on the surface, these types of fees may cause an
adviser to fall within the meaning of the term "broker"
(described above). However, Blass does state that he recognizes
such transaction fees are common in the private equity business. He
notes that if management fees otherwise due the private fund
manager are wholly offset by such transaction fees (which is a
fairly common practice for control investments, at least in part if
not in the entirety), then the payment of such transaction fees, if
done in such manner, would not, in itself, in his opinion, appear
to raise broker-dealer registration concerns. Blass notes that the
SEC staff is interested in talking these issues over and encourages
private fund managers to think about their practices in this
regard.
Conclusion
The Ranieri settlement and the comments by Blass highlight
the SEC's heightened focus and crackdown on the use of
unregistered fundraisers and placement agents by private fund
managers. Further, Blass's comments reiterate the difficulty
private fund managers face in using unregistered fundraisers, both
internally and externally, without running afoul of the securities
laws. Although Blass indicated his willingness to consider a
broker-dealer registration exemption specific to private fund
managers, without such an exemption in place, private fund managers
should examine carefully their retention of fundraisers and
placement agents and the role of employees of the fund manager who
focus on the fundraising process. Additionally, the comments from
Blass pertaining to the common private equity practice of paying
certain types of fees to private fund managers (or their
affiliates) in connection with the closing of purchases or sales of
portfolio companies indicate that these are areas that should be
carefully reviewed by fund managers and their portfolio companies
to ensure compliance with applicable securities laws.
Please contact the Day Pitney attorneys listed to the right to
discuss any questions you may have about broker-dealer
registration, the use of fundraisers and placement agents, and the
issues arising from "closing fees" or "success
fees" payable to a fund manager.
[1] A "private fund" is defined as an issuer that would be an investment company under the Investment Company Act of 1940 but for the exemptions under Section 3(c)(1) and Section 3(c)(7) of that Act.
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