In remarks before the American Bar Association’s Trading and Markets Subcommittee, the chief counsel of the SEC’s Division of Trading and Markets raised concerns about certain private fund practices that implicate the need for the fund advisor or other associated persons to register as broker-dealers under the Securities and Exchange Act of 1934 (the “Exchange Act”). 

In his remarks, the chief counsel pointed to two problematic industry practices.  First, offers and sales of fund interests by employees or consultants to the advisor or the fund and in particular the payment of transaction-based compensation to those persons.  The second practice involves the receipt by private fund advisors of transaction-based compensation in connection with portfolio company M&A and financing activities. 

Broker-Dealer Definition

Section 15 of the Exchange Act requires a person “engaged in the business” of acting as a “broker” or a “dealer” in securities to register with the SEC.  For purposes of the Exchange Act, persons are “engaged in the business” of buying and selling securities if they demonstrate a “regularity of participation” in such transactions.  The SEC and the courts interpret the phrase “engaged in the business” broadly.  Generally, if a person engages in more than one broker-dealer transaction, this part of the broker-dealer definition is satisfied.  The courts and the SEC have identified a number of business practices that constitute broker-dealer activity.  These so-called “badges” of broker-dealer activity include, but are not limited to:

  • marketing securities (shares or interests in a private fund) to investors;
  • soliciting or negotiating securities transactions; or 
  • handling customer funds and securities

The importance of each of these activities relative to the need to register as a broker-dealer is greatly heightened by the presence of transaction-based compensation (compensation that is based on the consummation or the size of the securities transaction).

Analyzing Private Fund Sales Practices

The chief counsel advised private equity funds to review their sales practices with a view to determining whether these practices implicate the need for the fund, its advisor or affiliated persons to register as broker-dealers.  In connection with this inquiry, the chief counsel recommended that advisors consider the following questions:

  • How does the advisor solicit and retain investors?
  • Do employees who solicit investors have other responsibilities?
  • How are personnel who solicit investors for a private fund compensated?
  • Does the fund charge a transaction fee in connection with a securities transaction?

If a fund uses specially retained employees or consultants who receive transaction-based compensation either directly or indirectly in connection with sales of fund interests then the fund should seriously consider changing its sales methods or registering as broker-dealer at some part of the distribution chain. 

The chief counsel also noted that the issuer exemption in Exchange Act Rule 3a4-1 does not provide a practical exemption for most funds or their advisors given its limited scope and the fact that funds may continue in a sales mode for an extended period of time.  As a result, it is difficult, if not impossible, for a private fund advisor to satisfy the conditions of the rule. 

State Broker-Dealer Laws

We are aware that certain states have taken the position that private equity and real estate funds who continuously sell their securities must register as broker-dealers in certain situations.  For example, in Maryland a general partner of a limited partnership (and therefore, by analogy, any officer or director of a corporation and any manager of a limited liability company and any general partner of a limited partnership) is presumed to be a “broker-dealer,” as defined by the Maryland Securities Act, if he, or an affiliated person (a person who directly or indirectly, through one or more intermediaries, controls, or is under common control with, a corporation), engages in three or more offerings of securities during any consecutive twelve month period.  Maryland Securities Act Release No. 18 issued May 10, 1974.

Broker-Dealer Issues Arising from Private Fund M&A and Financing Activities

Often private advisors to leveraged buy-out funds receive fees paid by portfolio companies in consideration for the advisor or its affiliates performing so-called “investment banking activities,” including negotiating transactions, identifying and soliciting  purchasers or sellers of the securities of the portfolio company, or structuring transactions.  The chief counsel noted that these business practices appear to involve the receipt of transaction-based compensation that is linked to effecting transaction in securities.  The implication is that advisors and others that receive transaction-based compensation must be registered as a broker-dealer. 

What to do Now

Overall, the remarks of the Chief Counsel were conciliatory and were designed to begin a dialog on reaching an industry consensus about the appropriate types of practices and also perhaps explore whether there is a need for a separate exemption from broker-dealer registration for private funds and their advisors. 

Nevertheless, the chief counsel’s remarks closely follow on the heels of the SEC’s announcement of administrative sanctions against Ranieri Partners LLC, which controls two private fund managers, a former Ranieri executive, and a third party “finder” for violations of Section 15(a) of the Exchange Act.  The Ranieri Partners enforcement action sanctioned not only the so-called “finder” who engaged in soliciting investors and received transaction-based compensation, the SEC also sanctioned the sponsor of the private funds and an employee of the sponsor under the theory that they “caused” the violations by permitting the finder to engage in broker activities without registration.

We recommend that private funds and their advisers review their sales and solicitation practices to ensure that they are not using unregistered persons to conduct broker activities, especially where these persons are receiving compensation that is in any way related to sales of fund interests.