Earlier this month, the SEC sent a message to the private equity industry regarding unregistered broker-dealer activity. The SEC charged an SEC-registered investment adviser to a private equity fund and its principal with violating Section 15(a) of the Securities Exchange Act for providing brokerage services and receiving transaction-based compensation in connection with the purchase and sale of portfolio companies while not being registered as a broker-dealer. Notably, the title used by the SEC for its press release was “SEC: Private Equity Fund Adviser Acted as Unregistered Broker,” even though the SEC also charged the adviser with three violations of the Investment Advisers Act. A copy of the press release can be found here and a copy of the SEC’s order for In the Matter of Blackstreet Capital Management, LLC can be found here.
The issue of whether or not private equity fund advisers are engaging in unregistered broker-dealer activity received national attention when it was highlighted in a speech given in April 2013 by David Blass, then chief counsel in the SEC’s Division of Trading and Markets, to the American Bar Association. The Dodd-Frank Act required most private fund advisers to register with the SEC as investment advisers. The SEC had been examining the newly registered advisers and Mr. Blass’ comments were based on reports by the examination staff that private fund advisers and individuals associated therewith were receiving transaction-based compensation for providing investment banking and other brokerage services to portfolio companies. The prospect of losing substantial revenue from providing services to portfolio companies was a major concern for many private equity fund advisers in the buyout space and the source of significant debate among legal practitioners. For a few years after the speech, the industry was confronted with minor developments on this issue, some of which were confusing and/or unhelpful. Mr. Blass gave another speech where he appeared to have backed away somewhat from his initial position; the American Bar Association and industry associations reached out to the SEC a number of times for clarity but with little progress; and, in response to a request from a small group of practicing attorneys, the SEC issued a no-action letter for “M&A Brokers” in January 2014, which is available here. Since that time, the SEC has focused on a number of other issues in the private equity industry, while the legal community debated whether various service and fee arrangements between private equity fund advisers and portfolio companies should result in the adviser being deemed to be improperly engaged in unregistered broker-dealer activity.
In the present case, Blackstreet Capital Management was the adviser to two private equity funds. Both funds invested in leveraged buyouts of businesses with revenue between $20 million and $100 million. Notably, the limited partnership agreements for the funds expressly permitted Blackstreet Capital to charge transaction or brokerage fees. Blackstreet Capital was registered with the SEC as an investment adviser but not as a broker-dealer.
According to the SEC, “rather than employing investment banks or broker-dealers to provide brokerage services with respect to the acquisition or disposition of portfolio companies,” Blackstreet chose to perform the services “in-house.” The SEC noted that Blackstreet engaged in the following activities: “soliciting deals, identifying buyers or sellers, negotiating and structuring transactions, arranging financing and executing the transactions.” Blackstreet received approximately $1.8 million in transaction-based compensation for providing these services.
The SEC charged Blackstreet with violating Section 15(a)(1) of the Exchange Act, which makes it unlawful for a broker to effect transactions in securities unless registered with the SEC under Section 15(b). Section 3(a)(4) of the Exchange Act generally defines a “broker” as any person engaged in the business of effecting transactions in securities for customers. Blackstreet also was found to have engaged in a number of violations of the Advisers Act that are unrelated to the broker-dealer charge. In total, Blackstreet was ordered to pay disgorgement of approximately $2.3 million, prejudgment interest of $283,787, and a civil money penalty of $500,000. The SEC took into account the remedial actions of Blackstreet and its principal.
Unfortunately, the disclosures contained in the SEC’s order provide very little guidance regarding the details of the case (which is typical), so we are left with a number of unanswered questions. We know that Blackstreet disclosed (presumably in the fee section of the limited partnership agreement) that it was going to engage in broker-dealer activity and would receive a fee for doing so and in fact engaged in those activities and received fees that the SEC labeled as “transaction-based compensation.” (The SEC has been focusing generally on the fees and expenses charged by private equity fund advisers to their clients and the adequacy of the related disclosures. Moreover, depending on the nature and scope of the disclosure, the SEC may have viewed Blackstreet as “holding itself out” as a broker.) There is no mention in the order that Blackstreet offset these deal fees against the management fees and/or carried interest it was earning from the funds (although based on the other allegations in the Order, most likely there was no full or partial offset of fees). The SEC noted that some of the transactions involved securities transactions, which means that Blackstreet presumably worked on a number of asset deals. Therefore, we don’t know if Blackstreet provided investment banking services in connection with the purchase or sale of most of its portfolio companies, less than 50 percent, or simply one. Arguably, the SEC can take the position that even one deal meets the requirement that a person is “in the business” of effecting transactions in securities.
It is no secret that the SEC has always looked askance at any activity that looks like brokerage services, especially when combined with a transaction-specific fee. Prior to Mr. Blass’ speech, the SEC had already been pruning the so-called “finders exemption” until, practically speaking, it no longer exists. Likewise, the M&A Broker no-action letter is generally not available to most private equity fund advisers. With this recent order against Blackstreet, the SEC clearly has not changed course and advisers to private equity funds are well advised to be careful when engaging in activities that involve transaction-related compensation and, therefore, may lead to a characterization as an unregistered broker.
There are a number of key takeaways that private equity funds, independent sponsors, and other registered investment advisers that are not also registered as a broker-dealer should take from theBlackstreet Capital Management, LLC matter. These include:
- The acceptance of transaction-based compensation with respect to the completion of a securities transaction is generally an indication of broker-dealer activity. The SEC has indicated that this general statement remains true in the context of transactions involving the purchase or sale of a portfolio company in a stock deal or the reorganization of the portfolio company by way of the sale of new equity or debt and regardless of the fact that the transaction in question is privately placed and limited to highly sophisticated, institutional investors.
- The term “transaction-based compensation” means fees or other compensation that is contingent upon the success of a securities transaction. Transaction-based compensation includes success fees, as well as commissions, mark-ups, mark-downs, and sales loads or any other fee that is contingent upon the completion of a specific securities transaction.
- Though not entirely free from doubt, arrangements that fully offset transaction-based compensation against management fees and other allowable advisory compensation paid to a registered private equity fund advisor should not trigger broker-dealer registration issues.
- While it seems likely that the SEC would consider the specific services performed by Blackstreet (i.e., soliciting deals, identifying buyers or sellers, negotiating and structuring transactions, arranging financing, and executing the transaction), as problematic when coupled with transaction-based compensation, it is not entirely clear whether the SEC believes all fees that are contingent upon the closing of a securities transaction to be problematic or whether there might be other contingent fees that might be allowable (i.e., that would not trigger broker-dealer registration requirements). If so, it seems likely that allowable services would be of a type that are customarily performed by consultants and professional service providers (e.g., legal, accounting, due diligence expertise and analysis and complex modeling), or that significantly supplement such services. It would also seem likely that the SEC would expect such fees to be clearly disclosed to investors, for the payment to be reasonable in view of the services performed and for the performance of such services to be documented.
- In any event, care should be taken to ensure that activities and services are not characterized in a manner that suggests that the adviser, or any person associated with the adviser, including any third party, is acting as a “broker-dealer” or “investment bank” or that such services or activities are “brokerage” or “investment banking” services.
- Payment of transaction-based compensation to a third party that is not registered as a broker-dealer can lead to aiding and abetting or other actions by the SEC’s Enforcement Division.