The Securities and Exchange Commission is cracking down on private-fund managers for not using registered broker-dealers in fundraising. At the same time, recent public comments by the SEC staff indicate that certain activities of private-fund managers may require that they become registered with the commission as broker-dealers.
These recent comments also indicate a willingness to entertain suggestions to create a useful exemption from broker-dealer registration specific to such managers.
On April 5, David Blass, chief counsel of the SEC's Division of Trading and Markets, delivered a speech on these issues to the American Bar Association's Trading and Markets Subcommittee.
He highlighted the SEC's growing concern and focus with respect to private-fund managers' use of fundraisers, internal and external, to attract capital. In particular, Mr. Blass discussed private-fund managers who pay their personnel “transaction-based compensation” for selling interests in a fund.
It is well-known that those engaged in the business of effecting transactions in securities for the account of others generally must register with the SEC as brokers. Common broker activities include marketing securities or interests in funds to investors, soliciting or negotiating securities transactions, and handling customer funds and securities.
"SALESMAN'S STAKE'
Mr. Blass stated: “The importance of each of these activities is heightened where there also is compensation that depends on the outcome or size of the securities transaction — in other words, transaction-based compensation, also referred to as a "salesman's stake' in a securities transaction. The SEC and SEC staff have long viewed receipt of transaction-based compensation as a hallmark of being a broker.”
Noting the SEC's settlement with private-equity fund Ranieri Partners LLC in March for $375,000, Mr. Blass emphasized that the commission's recent focus on the use of unregistered broker-dealer fundraisers by private-fund managers “demonstrate[s] that there are serious consequences for acting as an unregistered broker, even where there are no allegations of fraud.”
In that matter, the SEC charged Ranieri with raising more than $500 million in capital commitments through a third-party consultant who wasn't registered with the commission as a broker-dealer. This appears to be a novel SEC enforcement action in that it is focused on penalizing the private-fund manager and its marketing personnel, as well as the unregistered broker-dealer.
IN-HOUSE FUNDRAISING
Beyond transaction-based compensation, Mr. Blass commented on the not-uncommon situation where a private-fund manager has personnel whose only, or primary, function is to sell interests in a fund.
He noted: “[A private-fund manager with] a dedicated sales force of employees working within a "marketing' department may strongly indicate that [such employees] are in the business of effecting transactions in the private fund, regardless of how the personnel are compensated.”
Accordingly, private-fund managers shouldn't consider themselves out of the realm of the SEC's scrutiny simply because their fundraising efforts may be conducted solely in-house or because their compensation isn't expressly tied to capital-raising efforts (e.g., fixed salaries and fixed bonuses).
Determining whether a person should register as a broker-dealer is often a fact-intensive determination.
Mr. Blass offered some basic questions that private-fund managers should consider when making this determination.
These included:
• How does the private-fund manager solicit and retain investors?
• Do employees who solicit investors have other responsibilities or is their primary responsibility soliciting investors?
• How are employees who solicit investors for a private fund compensated? Do those individuals receive bonuses or other types of compensation that are linked to capital raising?
KEEP AN EYE ON FEES
In sum, private-fund managers need to look at not just their fundraising activities but also their fee arrangements, including fees paid to employees of the private-fund manager in connection with the underlying investment activities of the fund.
Fund managers should be aware that issuances of interests in the funds marketed by private-fund managers, if intermediated by an inappropriately unregistered broker-dealer, potentially could be subject to a right of rescission by the investors in such funds.
Importantly, Mr. Blass noted that he is “keenly aware that many advisers, particularly smaller advisers, may not be able to afford or be able to either hire a broker-dealer or register as broker-dealers themselves.”
Accordingly, he invited comments as to whether a broker-dealer exemption specific to private-fund managers would be helpful, and also stated that he has in mind a “potential exemption like the issuer exemption but one written specifically for private-fund managers.”
Henry Massey is chair of Day Pitney's Broker-Dealer, Investment Advisers and Commodities practice group; Greg H. Kahn is counsel in the firm's corporate and business law department; and Samuel A. Jennings is an associate in the corporate and business law department.
