Industry participants are well-advised to review their practices to ensure compliance with the Advisers Act, and the SEC’s and SEC’s Staff’s interpretations of when registration as a broker-dealer is required.

In a recent Securities and Exchange Commission (SEC) enforcement action against, and settlement with, Black Street Capital Management, LLC (the registered investment adviser or RIA) and one of its principals, the SEC alleged various broker-dealer violations of the Securities Exchange Act of 1934 (Exchange Act) and other violations of the Investment Advisers Act of 1940 (Advisers Act).1 This summary focuses on the broker-dealer issues.

The SEC alleged that the RIA and its principal received transaction-based compensation for the provision of brokerage services in connection with the acquisition and disposition of portfolio companies held by the funds managed by the RIA. This occurred even though neither the RIA nor its principal was registered as, or affiliated with, a broker licensed under the Exchange Act.

The funds invested primarily in undervalued portfolio companies that were deemed to be mismanaged, unprofitable or orphaned by a parent conglomerate or that had limited earnings potential in declining markets. The RIA was paid a management fee equal to 2 percent of the aggregate capital commitment, subject to reduction following expiration of the capital commitment period. The general partners of the funds (the GPs) were affiliates of the RIA and were also entitled to a carried interest of 20 percent of the sum of all distributions in excess of the sums contributed by the limited partners in fund 1, and up to 25 percent in fund 2.

Each of the funds was governed by a limited partnership agreement (LPA) that expressly permitted the RIA to charge transaction-based (i.e., “brokerage”) fees on the sale of securities in portfolio companies held by the funds. Accordingly, this was not a case of inadequate disclosure or lack of investor consent. Rather, the SEC found that, instead of engaging licensed 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 RIA had performed these services in-house, even though it was not licensed to do so. The “brokerage” services performed included soliciting deals, identifying buyers or sellers, negotiating and structuring transactions, arranging financing, and executing the transactions. According to the SEC, the RIA received at least $1,877,000 in transaction-based compensation in connection with providing these “brokerage” services.

In its “Guide to Broker-Dealer Registration,” dated April 2008 (the SEC Guide), and in reliance on section 3(a)(4)(A) of the Exchange Act, the SEC has defined the term “broker” to refer to “[a]ny person engaged in the business of effecting transactions in securities for the account of others.” The SEC Guide continues:

Sometimes you can easily determine if someone is a broker. For instance, a person who executes transactions for others on a securities exchange clearly is a broker. However, other situations are less clear. For example, each of the following individuals and businesses may need to register as a broker, depending on a number of factors:

  • “finders,” “business brokers,” and other individuals or entities that engage in the following activities:
    • Finding investors or customers for, making referrals to, or splitting commissions with registered broker-dealers, investment companies (or mutual funds, including hedge funds) or other securities intermediaries;
    • Finding investment banking clients for registered broker-dealers;
    • Finding investors for “issuers” (entities issuing securities) even in a “consultant” capacity;
    • Engaging in, or finding investors for, venture capital or “angel” financings, including private placements;
    • Finding buyers and sellers of businesses (i.e., activities relating to mergers and acquisitions where securities are involved).

Included in this laundry list are also “persons that act as ‘placement agents’ for private placements of securities” and “persons that effect security transactions for the account of others for a fee, even when those other people are friends and family members.”

The SEC Guide suggests four questions that should be asked to determine whether an individual or entity is acting as a broker:

  • Do you participate in important parts of a securities transaction, including solicitation, negotiation or execution of the transaction?
  • Does your compensation for participation in the transaction depend upon, or is it related to, the outcome or size of the transaction or deal? Do you receive trailing commissions such as 12v-1 fees? Do you receive any other transaction-related compensation?
  • Are you otherwise engaged in the business of effecting or facilitating securities transactions?
  • Do you handle the securities or funds of others in connection with securities transactions?

A “yes” answer to any of these questions indicates that you may need to register as a broker.

With that test in mind, the answer to the broker registration question would appear to be clear — clear as mud, unfortunately. Black Street and its principal were ordered to pay, jointly and severally, disgorgement of $2,339,000, prejudgment interest of $283,737 and a civil money penalty of $500,000. The order does not break out the specific activities to which each of the disgorgement, interest and penalties were attributable.

Pepper Points

  • Private fund managers and other participants in the securities industry need to take their responsibilities under the Exchange Act seriously. The Exchange Act is, after all, a criminal statute. It speaks in terms of certain activity being “unlawful” unless certain conditions are met.
  • The notion that an RIA’s registered status under the Advisers Act somehow provides “cover” to the officers, directors and other employees to engage in activities that require a different license — namely, a broker-dealer license — is widely held but, unfortunately, not supported by the statutes or rules, practices or interpretive guidance issued by the SEC or its Staff. That is to say, if a manager of a private fund (that owns a portfolio company) participates materially in the solicitation, arranging and sale of portfolio company securities, and receives transaction-based compensation in exchange for or as a result of those services having been rendered, the recipient must be registered as a broker-dealer, and the individual participants must be licensed registered representatives and associated persons of that licensed broker-dealer.
  • The touchstone is, of course, the receipt of transaction-based compensation in connection with the sale or placement of securities on behalf of a third party. The SEC Guide further states that receiving transaction-based compensation is not the only way that an individual or a firm can trip the broker-dealer registration requirements.
  • As noted in footnote 1, there were other securities law violations found by the SEC. Was the presence of other violations sufficient to tip the scales on this one issue? In order words, if this were the only infraction, would the penalties have been quite as large? No one knows. But the fact remains that the SEC has staked out a very expansive view of when broker-dealer registration is required.
  • Finally, there are several important questions to consider:
    • Can a manager who receives a management fee recommend that a portfolio company (where it is providing management services, presumably as a member of the board of directors or otherwise) engage in a strategic transaction?
    • Can a fund manager participate in the vetting of potential purchasers and service provides?
    • Can the fund manager recommend the investment opportunity to friends, family and other persons that the investment manager might happen to be aware of?
  • The answer to these questions is “yes,” provided that the RIA does so as a finder and does not receive a separate revenue flow or fee in exchange for the services rendered. Once a portfolio company or a purchaser of its securities is deemed to be paying to the RIA a fee separate from the management fee that the RIA is earning as the manager of the fund, questions will arise.

If the RIA in the present case had also been cross-registered as a broker-dealer and the principals involved were licensed registered representatives of that broker-dealer, would the brokerage transaction-based fee be a problem? Not under the broker-dealer rules but, depending on the language in the LPAs, a separate revenue flow of this magnitude might very well be viewed as posing a conflict of interest that the GPs of the funds could not consent to because the GPs are affiliates of the RIA. Principal transactions require the specific consent, not only of the GPs of the funds, but also either of a majority of the limited partners in the fund itself or of a board of directors or advisory committee composed of limited partners responsible for deciding these types of conflicts.

One can only surmise that this will not be the last enforcement action by the SEC on this topic. Industry participants are well-advised to review their practices to ensure compliance with the Advisers Act, and the SEC’s and SEC’s Staff’s interpretations of when registration as a broker-dealer is required, and should also review fund LPAs and disclosure documents. Industry participants should also review conflicts of interest policies and their operation in practice to ensure resolution of such conflicts in accordance with fund documents in a fair and transparent fashion.