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On April 8, 2013, we reviewed a recent speech by David Blass, the Chief Counsel of the Division of Trading and Markets of the Securities and Exchange Commission (the “SEC”), in which Mr. Blass provided his views on whether certain investment fund managers might be operating in a way that would require registration as a broker dealer.  For hedge fund managers, the problem typically arises in the context of paying internal sales people based on the amount of capital raised.  As we noted, the widespread misreading or abuse of Rule 3a4-1, the issuer’s exemption safe harbor on which so many hedge fund managers rely, is now clearly on the SEC’s radar.

But there are other ways to become entangled in broker dealer registration requirements that many private equity funds (and some hedge funds) will also need to consider.  The SEC staff is aware that advisers to some private funds, such as managers of private equity funds executing a leverage buyout strategy, may collect fees other than advisory fees, some of which look suspiciously like brokerage commissions.  It is not uncommon for a fund manager to direct the payment of fees by a portfolio company of the fund to one of its affiliates in connection with the acquisition, disposition (including an initial public offering), or recapitalization of the portfolio company.  These fees are often described as compensating the fund manager or its affiliated company, or personnel for “investment banking activity,” including negotiating transactions, identifying and soliciting purchasers or sellers of the securities of the company, or structuring transactions.  These are typical investment banking activities for which registration as a broker dealer is required.

Perhaps through its presence exams, the SEC staff recognizes that the practice of charging these transaction fees is fairly common among certain private equity fund managers.  Blass suggested that if the payment of these investment banking type fees were used to offset the management fee, then a valid argument could be made that no separate brokerage compensation was generated.  However, the industry argument that the receipt of such fees by the general partner of the fund should be viewed as the same person as the fund, so there are no transactions for the account of others was not an argument that the SEC staff appeared ready to endorse.  As long as the fee is paid to someone other than the fund for the types of activities described above, then the general partner or its affiliate would need to go through the analysis as to why broker dealer registration is not required.  The private equity fund bar has also advanced the policy argument that requiring private equity fund managers to register as broker dealers serves no useful purpose.  This policy argument that advocates the position that the SEC should exempt certain firms and not others for the same conduct, as attractive as it might be for managers of private equity funds, is a total non-starter from the regulator’s perspective.  The SEC staff will remain fixated on the type of activity and the fees generated from that activity when attempting to determine whether registration is required.

Particularly among private equity fund managers, many of which have not had a history of being a regulated entity, this violation of the broker dealer registration requirement is not viewed as a serious matter because “everyone else is doing it.”  But the SEC is putting private equity on notice that this is an area that the staff will focus on in examinations and will eventually bring enforcement action.  In addition to being subject to sanctions by the SEC, another possible consequence of acting as an unregistered broker-dealer is the potential right to rescission by investors.  A transaction that is intermediated by an inappropriately unregistered broker-dealer could potentially be rendered void.  A purchaser of securities would typically seek to void a transaction if the price had moved against him, leaving the fund manager scrambling to make up the difference between the sales price and the value at rescission.   Private equity fund managers and those hedge fund managers that conduct similar activities should give greater attention to this issue for which the SEC staff has provided fair warning.

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This article was published by CounselWorks and is reprinted here with permission.


April 12, 2013

Dear Friends,

Yesterday, the SEC testified before Congress providing an update on the implementation of the JOBS Act. Regarding the implementation of the lift on the prohibition against general solicitation, the SEC said its staff are “developing recommendations for the Commission’s consideration as how to best move forward.”

The JOBS Act passed in April 2012 and a rule for this provision has yet to be finalized.  “The longer we wait for action by the regulators, the more our engines of economic growth will continue to simply tread water, or worse yet starve, for lack of opportunity,” said Congressman David Schweikert (R-Ariz), a participant in CounselWorks’ 2012 SummerTime Summit and Chairman of the House Small Business subcommittee on regulations.

Please click here for a link to the SEC’s testimony and click here for a link to the transcripts and video of the full hearing.

Please feel free to contact us with any questions at (212) 867-0200 or e-mail us at

Thank you,



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In a speech before the American Bar Association’s Trading and Markets Subcommittee on April 5, 2013, David Blass, the Chief Counsel of the Division of Markets and Trading, put hedge fund managers and private equity fund managers on notice that they may be engaged in unregistered (and therefore, unlawful) broker dealer activities as a result of the manner by which hedge fund managers compensate their personnel and, in the case of private equity fund managers, the receipt of investment banking fees with respect to their portfolio companies.  The good news is that Mr. Blass indicated that the Staff of the Securities and Exchange Commission (the “SEC”) is willing to work with the industry to come up with an exemption from broker dealer registration for private fund managers that would allow some relief from the prohibitions against certain sales activities and compensation arrangements regarding the sales of private fund securities.  This post will address only the sales compensation activities of hedge funds with an explanation of the private equity investment banking fee discussion to follow.

Mr. Blass indicated that he believed that private fund advisers may not be fully aware of all of the activities that could be viewed as soliciting securities transactions, or the implications of compensation methods that are transaction-based that would give rise to the requirement to register as a broker dealer.

Mr. Blass provided several examples that fund managers should consider to help determine whether a person is acting as a broker-dealer:

How does the adviser solicit and retain investors?  Thought should be given regarding the duties and responsibilities of personnel performing such solicitation or marketing efforts. This is an important consideration because a dedicated sales force of internal employees working in a “marketing” department may strongly indicate that they are in the business of effecting transactions in the private fund, regardless of how the personnel are compensated.

Do employees who solicit investors have other responsibilities?  The implication of this point is that if an employee’s primary responsibility is to solicit investors, the employee may be engaged in a broker dealer activity irrespective of whether other duties are also performed.

How are personnel who solicit investors for a private fund compensated?  Do those individuals receive bonuses or other types of compensation that is linked to successful investments?  A critical element to determining whether one is required to register as a broker-dealer is the existence of transaction-based compensation. This implies that bonuses tied to capital raising success would likely give rise to a requirement for such individuals to register as broker dealers.

Does the fund manager charge a transaction fee in connection with a securities transaction?  In addition to considering compensation of employees, advisers also need to consider the fees they charge and in what way, if any, they are linked to a security transaction.  This point is aimed more at the investment banking type fees that a private equity fund might generate, but it would also be relevant in the context of direct lending funds or other types of funds that generate income outside of the increase or decrease of securities’ prices.

Mr. Blass also addressed the use or misuse of Rule 3a4-1, the so-called “issuer exemption.”  That exemption provides a nonexclusive safe harbor under which associated persons of certain issuers can participate in the sale of an issuer’s securities in certain limited circumstances without being considered a broker.  Mr. Blass stated his mistaken belief that most private fund managers do not rely on Rule 3a4-1, which, in fact, they do.  Blass suggests that private fund managers do not rely on this rule because in order to do so, a person must satisfy one of three conditions to be exempt from broker-dealer registration:

  • the person limits the offering and selling of the issuer’s securities only to broker-dealers and other specified types of financial institutions;
  • the person performs substantial duties for the issuer other than in connection with transactions in securities, was not a broker-dealer or an associated person of a broker-dealer within the preceding 12 months, and does not participate in selling an offering of securities for any issuer more than once every 12 months; or
  • the person limits activities to delivering written communication by means that do not involve oral solicitation by the associated person of a potential purchaser.

Mr. Blass rightly points out that it would be difficult for private fund advisers to fall within these conditions.  That, however, has not stopped most private fund managers from relying on some interpretation of the “issuer’s exemption” no matter how attenuated the adherence to the conditions might be.

Although Mr. Blass indicated a willingness to work with the industry to fashion an exemption from broker dealer registration that is specifically tailored to private fund sales, he also reminded the audience that the SEC is quite willing to take enforcement action against private funds that employ unregistered brokers.  Last month, the SEC settled charges in connection with alleged unregistered brokerage activities against Ranieri Partners, a former senior executive of Ranieri Partners, and an independent consultant hired by Ranieri Partners.  The SEC’s order stated (whether or not supported by the facts) that Ranieri Partners paid transaction-based fees to the consultant, who was not registered as a broker, for the purpose of actively soliciting investors for private fund investments. This case demonstrates that there are serious consequences for acting as an unregistered broker, even where there are no allegations of fraud.  The SEC believes that a fund manager’s willingness to ignore the rules or interpret the rules to accommodate their activities can be a strong indicator of other potential misconduct, especially where the unregistered broker-dealer comes into possession of funds and securities.

Private fund managers are encouraged to consider this statement and review their sales and compensation arrangements accordingly.