Recent SEC Actions Focus on Broker-Dealer Activity of Private Funds, Highlight Perils, and Generate Controversy

A recent public statement by a member of the senior staff (“Staff”) of the Securities and Exchange Commission (“SEC”) and recent SEC enforcement actions have reminded private equity and other private fund managers (such as hedge fund and venture capital advisers), M&A firms and consultants, about the perils of raising capital or engaging in transactions without paying attention to the broker-dealer registration requirements of the Securities Exchange Act of 1934 (“Exchange Act”).1 A recent pair of enforcement cases underscores these issues, and rescission by investors remains a rare, but potent, ancillary consequence.

On April 5, 2013, David W. Blass, Chief Counsel of the SEC’s Division of Trading and Markets discussed In the Matter of Ranieri Partners (“Ranieri”),2 recent SEC enforcement actions against a private equity manager and its finder, and warned an American Bar Association (“ABA”) committee, in a speech that attracted considerable attention, that more actions along the lines of Ranieri could be expected. The Ranieri cases, in particular, are noteworthy because the SEC brought enforcement actions not only against a finder who was acting as an unregistered broker on behalf of private equity funds, but also against the funds’ investment manager and a managing partner.3

Mr. Blass also identified factors that private funds and others should consider in determining whether an adviser and its internal sales staff might be subject to broker-dealer registration requirements.4 He focused on, among other things, the receipt of transaction-based compensation both by internal sales staff based on the initial investments, as well as by the managers of private equity funds receiving transaction fees. He said the Staff understands that the latter practice is common among private equity funds using a leveraged buyout strategy.

This OnPoint discusses the comments made by Mr. Blass, together with the SEC’s recent action in Ranieri.

Views of the Chief Counsel of the Division of Trading and Markets5

The Warning - Marketing

Mr. Blass is the SEC Staff member primarily responsible for interpreting the SEC’s broker-dealer registration requirements. In his remarks to the ABA, Mr. Blass indicated that the SEC Staff would be “putting an increased examination focus on private fund advisers” and suggested that private fund advisers “may not be fully aware of all of the activities that could be viewed as soliciting securities transactions, or the implications of compensation methods that are transaction-based.” Mr. Blass stated that, given the “significant consequences of acting as an unregistered broker-dealer and the increased attention being given to this issue by the SEC staff...private fund advisers should consider reviewing their practices to determine whether any activities that may be approaching or crossing the line would require broker-dealer registration.” He added that the SEC Staff already was focusing on these issues.

Mr. Blass noted that “absent an available exemption or other [no-action or exemptive] relief, a person 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.” He indicated that some of the activities or factors that might trigger the broker-dealer registration requirement include (1) marketing securities such as private fund interests, (2) soliciting or negotiating securities transactions, or (3) handling customer funds or securities. Mr. Blass emphasized that a hallmark of broker activity is receipt of transaction-based compensation (a “salesman’s stake”) in connection with a securities transaction.

Mr. Blass said the Staff is concerned about the broker-dealer status of not only outside consultants, like the finder in Ranieri, but also the status of the internal sales staff of the adviser. Mr. Blass described three types of broker-dealer registration issues the Staff has observed in connection with newly registered private fund advisers. One involves the adviser’s employees’ receipt of transaction-based compensation for sales of interests in a fund. Another pertains to employees of the adviser whose primary function is to sell interests in advised funds, whether or not such employees receive transaction-based compensation.6

The Controversy – Investment Banking

The third issue raised by Mr. Blass involves the receipt by the adviser, its employees or affiliates, of transaction-based compensation – often from portfolio companies – for services labeled as “investment banking.” While he spoke directly to private equity managers, he also noted that the same analysis would apply to business development companies and other funds.

Mr. Blass noted that portfolio companies of private equity funds often pay what he views as investment banking-like fees to the fund manager or affiliates for arranging various types of financing or capital raising for the portfolio company, and that the fees appear to him to be transaction-based compensation that would trigger broker-dealer registration requirements.7 Mr. Blass mentioned that if such fees completely offset advisory fees charged by the private fund manager, “one might view the fee as another way to pay the advisory fee, which...would not appear to raise broker-dealer registration concerns.” He also indicated that he would be willing to consider the broker-dealer registration analysis more generally.8

Although Mr. Blass did not identify what regulatory interests, other than (in his view) transparency, would be served by requiring private equity managers to register as broker-dealers, he rejected the notion that the investment manager and the fund should be viewed as the same.9 He stated that it was “crystal clear” to him that if the manager retained any portion of the transaction fee, the manager and the fund were distinct entities for purposes of his analysis.

Because the SEC believes these fees have been commonplace in the industry, Mr. Blass’ statements will generate considerable concern. Mr. Blass’ comment that the SEC Staff is interested in talking about these issues suggests that more guidance may be forthcoming; however, he also “encouraged” private fund advisers to evaluate their practices. It appears that he intends that such evaluation of these issues could cause some private fund advisers to consider registering as broker-dealers or changing their compensation arrangements.

Suggestions by Mr. Blass

Mr. Blass suggested that “private fund advisers should consider reviewing their practices to determine whether any activities that may be approaching or crossing the line would require broker-dealer registration.”10 While his comments appear to be related primarily to marketing, no assumption should be made that other practices would be exempt from evaluation. Some of the issues that Mr. Blass noted should be considered by private fund advisers in connection with this broker-dealer registration question include:

Does the adviser have a dedicated sales force or marketing department? Do employees who solicit investors have other responsibilities? How are employees compensated?

He noted that the conditions of Exchange Act Rule 3a4-1, a non-exclusive safe-harbor from broker-dealer registration (the misnamed “issuer’s exemption,” which is really a conditional exemption for employees of an issuer), may be difficult for some private fund advisers to satisfy. The major conditions of the Rule require that employees (1) must limit their solicitation activities to certain specified financial institutions; (2) must perform substantial other duties for the issuer not related to marketing, may not have been registered as a broker-dealer or associated person of a broker-dealer in the previous 12 months, and may not participate in an offering more often than once every 12 months; or (3) may not engage in individualized oral interaction with investors. While Rule 3a4-1 does not permit payment of transaction-based compensation, many funds that do not engage in frequent offerings of securities are able to rely on the rule to raise assets. However, as Mr. Blass notes, advisers who become more active in raising capital, as well as the limitations on frequency of offerings and direct communications, often preclude reliance on the safe harbor.

Some Hope?

Having raised a number of issues, without providing any concrete answers, Mr. Blass did offer some hope. He indicated that many of the practices to which he referred were common. He also recognized that the burden and expense, particularly to small advisers, of registering or hiring a broker-dealer to engage in marketing, could be significant. However, he suggested that there are a “wide array” of options available to private fund advisers to raise capital without triggering broker-dealer registration requirements.

Mr. Blass also mentioned that he was gathering information and seeking to interact with the industry on various issues. For example, he indicated interest in exploring exemptions tailored to private fund advisers, noting, however, that transaction-based compensation would remain “problematic.” He stated that he had in mind, however, a potential exemption, like Rule 3a4-1, but tailored to private funds.

Finders and Consultants

While the focus of Mr. Blass’ speech was on internal marketing of funds and investment banking activity of advisers, he also commented on the recent SEC Ranieri actions, which involved the use of third-party finders to market private equity funds. Finders are usually third parties who capitalize on professional or social connections with potential investors to introduce such investors to investment opportunities at hedge, venture capital and private equity funds. Frequently, finders supplement an adviser’s internal sales efforts, which can be driven by portfolio managers as well as dedicated sales staff.

Finders typically receive a fee for their efforts and are commonly compensated on a contingent fee basis. If a securities product is being offered,11 such as an investment fund or private equity investment, the individual or firm engaged in the marketing effort may fall within the definition of a “broker” in Section 3(a)(4) of the Exchange Act and be subject to the broker-dealer registration requirements of Section 15(a).

Finders have been a fixture in capital raising for many years. Historically, investment managers and others raising capital have taken steps to minimize the possibility that the finder would be considered to be a broker, by limiting the finder’s role in soliciting and selling securities and refraining from offering transaction-related compensation to the finder. Based on guidance in SEC no-action letters,12 in order to avoid the use of finders who are acting as unregistered broker-dealers, legal agreements with “finders” or “consultants” frequently limit their role to providing a list of potential investors or making an initial introduction, but do not permit such individuals to distribute materials, discuss the investment opportunity, or participate in negotiations.

As noted above, transaction-based compensation, or “success fees” are considered badges of broker activity. Thus, finders’ fees ideally are limited to fixed, relatively nominal payments that are made without regard to whether the investor actually invests. However, in many cases the practice has been to pay finders incentive compensation.13

Pay-to-play scandals involving public retirement systems in New York and California, however, have highlighted the widespread use of unregistered finders by managers seeking investments from public pension plans. As a result of these scandals, the role of unregistered finders, regardless of the level of their involvement in a transaction, has been under scrutiny by regulators and has generated restrictive laws and rules, as well as enforcement actions by state and federal agencies.14

The Ranieri Actions

Ranieri Partners (“Ranieri”) is a holding company for managers of several private equity funds that invest in real estate and other assets. The firm retained William Stephens, a former pension plan professional (“Stephens”), on the recommendation of Donald W. Phillips, a Senior Managing Partner (“Phillips”), to assist the firm in locating potential investors.15 Ranieri’s internal policies and its agreement with Stephens (which was drafted by outside counsel) limited Stephens’ role to making introductions and setting up meetings. He was not authorized to discuss the investments, provide information or documents, or participate in any negotiations with the potential investors.

Despite the constraints on his activity specified in his agreement with Ranieri, Stephens received an executive summary of the funds’ private placement memorandum (“PPM”) and sent the summary, subscription documents and due diligence materials to potential investors. He also provided them with his analysis of the funds’ strategy and performance track record, as well as lists of other investors and their capital commitments. The investors introduced by Stephens were primarily public institutions, including pension plans and endowments.

Stephens also employed a “subagent” to assist him in his efforts. Stephens provided information about the various Ranieri funds to his former colleagues and acquaintances. His efforts on behalf of the funds resulted in capital commitments of $569 million. Pursuant to his agreement with Ranieri, Stephens was entitled to receive a fee of 1% of all capital commitments made by investors he introduced to one of Ranieri’s funds and 0.3% of capital commitments by a particular investor to another affiliated fund, for aggregate transaction-related compensation of approximately $2.4 million.

The SEC found that Ranieri had informed Stephens that he was not permitted to contact investors directly to discuss his views of the merits and strategies of the private equity funds, or to provide documents and information to investors. However, the SEC further found that Raneiri failed to limit Stephens’ access to key documents (such as the PPM summary) that he shared with potential investors, or to otherwise supervise his activities. The SEC also noted that Phillips provided Stephens with information about the funds and was aware of Stephens’ substantive communications with investors.16 It noted that Phillips had received requests for expense reimbursements which reflected Stephens’ extensive contact with potential investors.

In its Orders, the SEC found that (1) Stephens acted as an unregistered broker-dealer in violation of Section 15(a) of the Exchange Act, (2) Ranieri caused Stephens’ violation of the broker-dealer registration requirements in Section 15(a) of the Exchange Act, and (3) Phillips, who introduced Stephens to Ranieri and was responsible for overseeing his activities, willfully aided and abetted and caused Stephens’ violations of Section 15(a).17 Ranieri and the Senior Managing Partner were ordered to cease and desist from further violations of Section 15(a) of the Exchange Act, and were fined $375,000 and $75,000, respectively. Stephens was ordered to disgorge his fees of $2.4 million, plus interest.

The Ranieri actions cover relatively new ground, by charging both the fund manager and one of its managing partners with violations of the Exchange Act, based on the conduct of the finder. However, the actions are consistent with the disfavor that the SEC and other regulators have shown regarding the use of “finders,” “consultants” and “solicitors” in connection with investments by public retirement systems and endowments. It also is consistent with the new-found vigor with which the SEC is bringing actions for violating the broker-dealer registration requirements.18 Further, the SEC’s actions announce that, in addition to the limitations set forth in the finding agreement, a manager will need to take action to monitor the finder’s activities to ensure that such activities do not exceed what is permitted by the agreement or the limited role that has been accorded to finders that are not registered broker-dealers.

Further Scrutiny of Private Fund Sales Practices Likely

The speech by Mr. Blass, along with the SEC’s actions against Ranieri, its Senior Managing Partner and the unregistered finder, reflect a broader campaign by regulators to limit activity by unregistered brokers, particularly in connection with investments by public retirement plans. Developments noted below increase the likelihood that the area will receive further attention.

Advisers Act Rule 206(4)-5

Following the pay-to-play corruption scandals noted above, the SEC proposed a ban on the use of all third-party placement agents – whether or not they were registered with the SEC as broker-dealers or advisers – to raise money from public retirement systems. In the face of opposition by public plans as well as placement agents, the SEC revised the proposed rule, Rule 206(4)-5 under the Advisers Act, to prohibit investment advisers from making any payment for soliciting public investors, to persons who were not employees of registered investment advisers, registered municipal advisors, or registered broker-dealers. The SEC has delayed implementation of this portion of the rule until nine months after the compliance date of a final rule adopted by the SEC by which “municipal advisor” firms must register under the Exchange Act.19 Once the limitations in the rule become effective, firms such as Ranieri no longer will be permitted to use unregistered finders to solicit public funds.

State Actions

Some public retirement systems have banned the use of registered placement agents, as well as finders, to introduce investment opportunities. Others now require persons soliciting investments to register as “lobbyists” and may prohibit the manager from making contingent compensation payments in connection with an investment. More commonly, however, public retirement systems, as well as private retirement systems, now routinely include in their investment policies the obligation to require information regarding payments made to third parties and the experience of the individuals receiving the payments. In some cases, payments may only be made to internal sales staff or registered broker-dealers. In other instances, the failure to disclose payments made to third parties, such as finders, is a material breach of the investment management agreement. The State of New York has also taken enforcement action against unregistered finders under state law.20

Amendments to Form ADV and Form D

The SEC also has taken action to assure that payments to third parties are more transparent. The SEC recently modified Form ADV and Form D to require the provision of information about compensation paid to various parties to a transaction and the use of marketers, which would include unregistered finders. For example, Form ADV, which is filed by registered investment advisers, requires disclosure of third-party marketers, including finders, for each private fund reported. Form D, which is filed in connection with offerings of securities exempt from registration under the Securities Act of 1933 by Regulation D thereunder (private placements), and made available to state securities regulators, requires disclosure of entities receiving compensation in connection with the sale of Regulation D securities. Each of these disclosure requirements is designed to alert investors to payments made to third parties, and is also readily available to regulators who may inquire about the registration status of persons receiving payments.

Action Steps

Based on the developments noted above, firms should carefully consider whether their marketing efforts raise broker-dealer registration concerns.21

Marketing Activities

As suggested above, advisers to private funds should be cautious about the extent of their marketing activities and the compensation of persons engaged in marketing efforts. Some private funds use employees (portfolio managers and, in some cases, investor relations personnel) to market interests, but have not considered it necessary to register as a broker-dealer because they do not pay contingent compensation to such employees, among other factors.

In light of Mr. Blass’ comments, however, advisers should consider the functions and compensation of persons who interact with potential investors. Among the steps that may be taken are the following:

Inventory marketing activities to determine whether or not they raise any broker-dealer registration concerns. For example, an adviser might consider the frequency with which it raises capital, as well as the duties actually performed by individuals. Review job descriptions, terms of employment agreements, and compensation arrangements to minimize broker-dealer registration issues. For example, consider whether employment agreements, or bonuses, can be restructured to avoid compensation contingent on the sale of a security. Also, consider whether or not the terms used in job titles, descriptions, and employment agreements overly emphasize sales, if the person’s functions involve other activities, including portfolio management or client service. Consider whether the formation of a registered broker-dealer, or the use of registered placement agents, may be advisable to avoid future concerns.

Use of Finders or Consultants

Firms should also be particularly cautious when entering into relationships with unregistered “finders” or “consultants.” If a firm chooses to enter into a relationship with an outside consultant, the following measures, among others, may be appropriate:

Contracts with finders or consultants should avoid transaction-based compensation. If success-based fees are necessary, the activities of the finder or consultant should be narrowly limited to reduce the possibility that such individuals will be acting as unregistered broker-dealers. Firms should have procedures to monitor the actions of the finder or consultant (including the review of expense reimbursements, where appropriate) and assure that such individuals adhere to contractual limitations regarding the scope of their activities. Firms should be alert to any breaches of the contractual provisions. Contractual provisions should include warranties that the finder is acting in compliance with the federal securities laws, as well as any state and local laws, which may include requirements for lobbyist registration. In the event that state or local law, or the policies of the investor (e.g., public retirement system), either presently in place or enacted in the future, do not permit the payment of contingent compensation or finders’ fees, the agreement with the finder or consultant should permit a new investment or a continuation of the investment, but not require payment of any impermissible compensation to the finder or consultant. The contract generally should specify that the use of subagents, payments by the finder or consultant to subagents, and the sharing of commissions with third parties, should not be permitted without the written approval of the firm.

Transaction-Based Compensation – Investment Banking Activity

While many private equity fund advisers or managers charge transaction fees for portfolio company transaction assistance, as much as 80-100% of such fees frequently are used to offset management fees that would be payable to the adviser. Some private equity funds have not until recently thought it necessary to register as a broker-dealer, even where the amount of compensation is based upon a dollar amount of monies raised. It appears likely, however, that these practices will be reviewed more carefully by advisers in the coming months and years as the SEC increases its focus on private equity sponsors and learns more about the private equity industry. As Mr. Blass indicated, firms compensated with transaction fees may wish to consider whether or not those activities implicate broker-dealer registration requirements. They may wish to consider the following actions.

Review the fees charged in relation to the overall advisory arrangement. Consider, for example, whether there is any offset of advisory fees and how regularly the activity occurs. Should any of the fees be viewed differently than others? Do directors’ fees pose the same concerns as typical investment banking fees? Should 100% of the fees be given to the fund to offset advisory fees? Consider the range of activities engaged in by the manager. For example, transactions involving multiple investors may raise additional concerns for the SEC. Consider the compensation of persons involved in the activity, and whether they recently have been registered personnel of investment banking organizations. Also consider employment agreements and whether they provide for transaction-based compensation. Examine whether there are additional transaction-based fees related to securities issuances, how regularly this occurs, and whether there is any other offset.

Conclusion

The recent enforcement actions, SEC Staff statements, adoption of Rule 206(4)-5, and modifications to Form ADV and Form D aimed at identifying broker activity in non-public transactions where such activity has historically been opaque, suggest that the SEC is making a concerted effort to address unregistered broker activity. With new data about potential unregistered broker-dealers coming from Form ADV and Form D filings, enforcement actions may well become even more widespread. Moreover, disclosure provisions applicable to firms seeking investments from public pension plans make it far less likely that the role played by finders or consultants in a transaction will not be revealed and scrutinized. For these reasons, advisory firms should consider their marketing practices in light of the broker-dealer registration requirements.

Some of the issues raised by Mr. Blass, in particular, challenge current industry practice and will need to be monitored closely. Moreover, in light of the invitation provided by Mr. Blass, some firms may want to communicate with the SEC Staff, either directly or through trade associations, regarding the policy issues that surfaced in his speech.

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