Last week David Blass, Chief Counsel, Division of Trading and Markets, SEC, discussed when investment advisers to private funds (private equity funds and hedge funds) could be viewed as engaging in activities that require them to register as broker-dealers. The general rule is that a person engaged in the business of effecting securities transactions for the account of others must register with the SEC as a broker-dealer unless an exemption or other relief is available.
One activity that Mr. Blass brought attention to is the sale of interests in a private fund by an investment adviser, particularly when the adviser's compensation is tied to the outcome or size of the transaction (transaction-based compensation). In such cases, the adviser can be viewed as a securities salesman or having a "salesman's stake" in the transaction, which is indicative of being a broker. Other factors that may indicate broker-dealer status include the adviser having a dedicated sales force whose function is to solicit and retain investors and such employees' primary responsibility is to solicit investors.
Another activity that may require a person to register as a broker-dealer is the receipt of fees in addition to advisory fees, such as fees for investment banking activities relating to portfolio companies in connection with negotiating transactions, identifying and soliciting purchasers or sellers, or structuring transactions. These fees may be paid by a portfolio company of the fund to an affiliate. Payment of such fees are akin to transaction-based compensation that is linked to the adviser effecting a securities transaction. If such payments offset or otherwise reduce the amount of the advisory fee payable by the fund, then in Mr. Blass' view, this would not appear to raise broker-dealer registration concerns. If, however, the rationale for why this activity does not raise broker-dealer registration concerns is that the transaction is not "for the account of others" in the case where the general partner of the fund (acting as the adviser) receives the transaction fee, then in Mr. Blass' view, the mere fact that the fee is payable to someone other than the fund suggests that the fund and the general partner are distinct entities with distinct interests.
Acting as an unregistered broker-dealer could lead to sanctions by the SEC and cause the subject transaction to be potentially rendered void. Given these consequences and the increased attention being given to the issue by the SEC, a fund adviser should be cautious when engaging in activities that may require it to register as a broker-dealer.