Articles Posted in Broker Dealers

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Chair Mary Jo White’s remarks on August 5, 2015 highlighted the SEC’s continuing implementation of the Dodd-Frank Act. Title VII of the Dodd-Frank Act requires the SEC and CFTC to establish a regulatory framework for the over-the-counter swap market. The SEC is specifically tasked with regulating security-based swap (“SBS”) dealers and major participants.

The Dodd-Frank Act added Section 15F to the Exchange Act requiring the SEC to adopt rules to provide for the registration of SBS dealers and major participants. Once registered, SBS dealers and major participants will be required to update information about their business activities, structure, and background in addition to information about affiliates. Moreover, SBS dealers and major participants will be immediately subject to SEC examination and inspection authority upon registration.

Additionally, SBS dealers and major participants are required to perform documented due diligence to ensure there is a framework to enable compliance with federal securities laws. The due diligence will serve as the basis for the senior officer of the SBS dealer or major participant to certify that written policies and procedures reasonably designed to prevent violations of federal securities laws have been implemented at the time of registration.

Under Section 15F(b)(6) it is unlawful, unless otherwise provided by rule, regulation, or order of the SEC, for SBS dealers or major participants to permit a statutorily disqualified associated person to effect or be involved in effecting SBS transactions on their behalf. However, to facilitate the registration process of entities currently engaged in SBS business the SEC provides a limited exception from the statutorily disqualified associated person bar if (1) the associated persons are not natural persons and (2) the statutory disqualifications occurred prior to the compliance date of the final rule once it is published in the Federal Register.

In light of the statutory disqualifications that will apply to dealers and major participants; the SEC has proposed Rule of Practice 194 which provides a process to determine whether it is in the public interest to permit a statutorily disqualified associated person to continue to engage in SBS transactions on behalf of a SBS entity. Comments on proposed Rule of Practice 194 will be due 60 days after it is published in the Federal Register.

Read the SEC release on SBS registration rules HERE.

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Chair Mary Jo White’s opening remarks on July 15 kicking off the annual broker-dealer compliance outreach program drew a parallel between the goals and work of the SEC and those of compliance professionals. Ms. White acknowledged the challenges and hardship that compliance professionals face, the critical importance of their role to investors and the integrity of the markets. Her acknowledgment comes after the upset that compliance professionals experienced when BlackRock’s CCO was found personally liable and slapped with a civil penalty. (See our previous post regarding BlackRock’s censure and its compliance officer’s personal liability.) Ms. White’s assurance that “it is not our intention to use our enforcement program to target compliance professionals” was hedged by her statement that “we must, of course, take enforcement action against compliance professionals if we see significant misconduct or failures by them.”

Ms. White named the following examination priorities: fee structures; suitability; order routing conflicts; recidivist representatives; microcap activity; excessive trading; transfer agent activity; and issues of importance to retail investors and investors saving for retirement.

Read more of Chair Mary Jo White’s opening remarks at the Compliance Outreach Program for Broker-Dealers HERE.

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A U.S. person with a financial interest in or signature authority over a foreign bank, securities (including brokerage account, margin account, mutual fund, trust) or other financial account in another country that has an aggregate value exceeding $10,000 at any time during the 2014 calendar year must file FinCEN Report 114 by June 30, 2015. FinCEN Report 114 supersedes Form TD F 90-22.1. Individuals filing the report must file electronically through the BSA E-Filing System.

For additional information on filing FBAR, see the Treasury Department’s FBAR E-Filing FAQs and the BSA E-Filing System FAQs.

If you need assistance, please call an attorney in our Investment Funds and Investment Management group.

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The Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (“OCIE”) recently released its annual examination priorities.  In 2015, OCIE will focus on three primary “themes” involving broker-dealers, investment advisers and transfer agents:

  1. Retail Investors – OCIE will look at important matters for retail investors and investors preparing for retirement including whether the products, advice, services and information being offered to them is consistent with current laws, rules and regulations;
  2. Market-Wide Risks – this is a broad theme which focuses on structural risks and trends involving whole industries or multiple firms; and
  3. Data Analytics – OCIE continues to increase its ability to analyze large amounts of data to identify registrants that may be conducting illegal activity.

Retail Investors – Advisers to retail investors and investors saving for retirement will be scrutinized by the SEC in 2015. The OCIE will assess fee selection where the adviser offers a variety of fee arrangements as well as reverse churning. Further, where advisers recommend moving retirement assets from employer-sponsored plans into other investments or accounts, OCIE will examine whether the sales practices used were improper or misleading. OCIE will also be reviewing the suitability of complex or structured products and higher yield securities and how well representatives in branch offices are being supervised by the home office.  The SEC may have an interesting opportunity to demonstrate whether it is serious in going after those who target seniors.

On February 5, 2015, SEC Commissioner Luis A. Aguilar and Investor Advocate, Rick A. Fleming, gave speeches at The American Retirement Initiative Winter Summit about advocating for investors saving for retirement and protecting elderly investors from financial exploitation.

Under the umbrella theme of “retail investors,” the OCIE will be assessing alternative investment companies and the focus of the exams will be (i) liquidity, leverage and valuation; (ii) the way the funds are marketed; and (iii) the internal controls, staffing, funding and empowerment of boards, compliance and back-offices. Mutual funds with material exposure to interest rate increases will be reviewed by OCIE to ensure they have the appropriate compliance policies and procedures and trading and investment controls in place to prevent their disclosures from being misleading and to be sure their investment and liquidity profiles are consistent with the fund’s disclosures.

Assessing Market-Wide Risks – The OCIE will focus in 2015 on structural risks and trends that involve whole industries or multiple firms. In collaboration with the Division of Trading and Markets and the Division of Investment Management, the OCIE will monitor the largest asset managers and broker-dealers. Through a risk-based approach, the OCIE will conduct annual examinations of all clearing agencies that have been designated systemically important. Furthering the OCIE’s 2014 efforts to examine the cybersecurity preparedness of registrants, 2015 will see a continuation of the initiative and an expansion of the initiative to include transfer agents. OCIE will also be looking into whether firms are giving priority to trading venues due to credits or payments for order flow, thus violating their best execution duties.

Data Analytics – The OCIE has made strides in developing data analytics that it can use to identify and examine firms and other registrants that may be engaged in fraudulent or illegal activity. The examination initiatives the OCIE will be using data analytics to examine include recidivists, microcap fraud, excessive trading and anti-money laundering.

Other Initiatives – Along with the primary themes discussed above, the SEC will continue to examine never-before examined investment advisers and newly registered municipal advisers. Advisers to private equity funds can expect to have their fees and expenses examined as a result of OCIE’s observed high rates of deficiencies. In addition to examining proxy advisory service firms, OCIE will also look at investment advisers’ compliance with their fiduciary duty to vote proxies on their investors’ behalf.

Advisers and broker-dealers should always be prepared for an SEC examination and ensure all written policies and procedures are in place and regularly audited for efficacy and compliance. Should you be subject to an examination, any deficiencies noted by the SEC should be addressed and rectified in a timely manner.

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Certain Commodity Futures Trading Commission (CFTC) exemptions require annual affirmation, including CPO exemptions under Regulation 4.5, 4.13(a)(1), 4.13(a)(2), 4.13(a)(3), and 4.13(a)(5) and CTA exemptions under Regulation 4.14(a)(8). If you rely on one of these exemptions, you must affirm the annual claim of exemption by March 2, 2015 using the NFA Exemptions website. http://www.nfa.futures.org/NFA-electronic-filings/exemptions.html

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On February 3, 2015, the Securities and Exchange Commission (“SEC”) released two publications addressing cybersecurity at advisory and brokerage firms. The first publication, a Risk Alert, relays the findings from the examinations of more than 100 investment advisers and broker-dealers and focuses on how they: (i) establish cybersecurity policies, procedures and oversee the processes; (ii) identify cybersecurity risks; (iii) protect information and networks; (iv) identify and address the risks associated with funds transfer requests, remote access to client information and third-party vendors; and (v) detect activity that is unauthorized.  The SEC’s Office of Investor Education and Advocacy released the second publication which provides tips for investors to better safeguard their online investment accounts. Their recommendations include using a strong password and a two-step verification process.

The SEC’s recent examinations found 93% of examined broker-dealers and 83% of examined investment advisers have adopted cybersecurity policies, though, whereas 89% of the broker-dealers periodically audit compliance with the policies, only 57% of investment advisers conduct periodic cybersecurity compliance audits.  The SEC continues to place high importance on cybersecurity and every broker-dealer and investment adviser should ensure they have adequate written policies and procedures in place and test them periodically.

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The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) recently released its Examination Priorities for 2015.  The priorities represent certain practices and products that OCIE believes present a potentially higher risk to investors and/or the integrity of the US capital markets.  In 2015, OCIE’s priorities focus on issues involving investment advisers, broker-dealers and transfer agents and are organized into three thematic areas:

  1. Examining important matters to retail investors and investors saving for retirement, such as whether the information, advice, products and services offered is consistent with applicable law.  Specifically, OCIE has identified the following examination priorities:
  • Fee Selection and Reverse Churning – Where an adviser offers a variety of fee arrangements, OCIE will focus on recommendations of account types and whether they are in the best interest of the client at the inception of the arrangement and thereafter, including fees charged, services provided, and disclosures made about such relationships.
  • Sales Practices – OCIE will assess whether registrants are using improper or misleading practices when recommending the movement of retirement assets from employer-sponsored defined contribution plans into other investments and accounts, especially when they pose greater risks and/or charge higher fees.
  • Suitability – OCIE will evaluate registered entities’ recommendations or determinations to invest retirement assets into complex or structured products and higher yield securities and whether the suitability of the recommendations or determinations are consistent with existing legal requirements.
  • Branch Offices – OCIE will focus on registered entities’ supervision of registered representatives and financial adviser representatives in branch offices, and attempt to identify branches that may be deviating from compliance practices of the firm’s home office.
  • Alternative Investment Companies – OCIE will continue to assess alternative investment companies and focus on: (i) leverage, liquidity and valuation policies and practices; (ii) factors relevant to the adequacy of the funds’ internal controls, including staffing, funding, and empowerment of boards, compliance personnel, and back-offices; and (iii) the manner in which such funds are marketed to investors.
  • Fixed Income Companies – OCIE will determine whether mutual funds with significant exposure to interest rate increases have implemented compliance policies and procedures and investment and trading controls sufficient to ensure that their funds’ disclosures are not misleading.
  1. Assessing issues related to market risks.  Specifically, OCIE has identified the following examination priorities:
  • Large Firm Monitoring – OCIE will continue to monitor the largest broker-dealers and asset managers to assess risks at individual firms.
  • Clearing Agencies – OCIE will continue to examine all clearing agencies designated as “systemically important” under the Dodd-Frank Act.
  • Cybersecurity – OCIE will continue to examine broker-dealers and investment advisers’ cybersecurity compliance and controls and expand these examinations to include transfer agents.
  • Potential Equity Order Routing Conflicts – OCIE will assess whether firms are prioritizing trading venues based on payments or credits for order flow in conflict with their best execution duties.
  1. Analyzing data to identify and examine registrants that may be engaging in illegal activity, such as excessive trading and penny stock, pump-and-dump schemes. Specifically, OCIE has identified the following examination priorities:
  • Recidivist Representatives – OCIE will continue to try to identify individuals with a history of misconduct and examine the firms that employ them.
  • Microcap Fraud – OCIE will continue to examine broker-dealers and transfer agents that aid and abet pump-and-dump schemes or market manipulation.
  • Excessive Trading – OCIE will continue to analyze data from clearing brokers to identify and examine brokers that engage in excessive trading.
  • Anti-Money Laundering – OCIE will continue to examine firms that have not filed suspicious activity reports (SARs) or provide customers with direct access to markets of higher-risk jurisdictions.

In addition, OCIE has identified other examination priorities for 2015, including:

  • Municipal Advisors – OCIE intends to examine newly registered municipal advisors to determine whether they comply with recently adopted SEC and Municipal Securities Rulemaking Board rules.
  • Proxy Services – OCIE intends to examine proxy advisory service firms and investment advisers’ compliance with their fiduciary duty in voting proxies on behalf of investors.
  • Never-Before-Examined Investment Companies – OCIE will conduct focused, risk-based examinations of registered investment company complexes that haven’t been examined before.
  • Fees and Expenses in Private Equity – this continues to be an area that OCIE is focused on.
  • Transfer Agents – OCIE intends to examine transfer agents, particularly those involved with microcap securities and private offerings.

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By William M. Sullivan, Jr. and Jay B. Gould

Under the Second Circuit’s new ruling, prosecutors have two large hurdles they must clear to convict under securities laws. First, they must prove that a defendant knew that the source of inside information disclosed tips in exchange for a personal benefit. Second, the definition of “personal benefit” is tightened to something more akin to a quid pro quo exchange.

For years, insider trading cases have been slam dunks for federal prosecutors. The United States Attorney’s Office in the Southern District of New York had compiled a remarkable streak of more than eighty insider trading convictions over the past five years. But that record has evaporated thanks to the United States Court of Appeals for the Second Circuit’s ruling in United States v. Newman, in which the Second Circuit concluded that the district court’s jury instructions were improper and that the evidence was insufficient to sustain a conviction.

The Second Circuit relied upon a thirty year old Supreme Court opinion, Dirks v. SEC, 463 U.S. 646 (1983), and highlighted the “doctrinal novelty” of many of the government’s recent successful insider trading prosecutions in failing to follow Dirks. Accordingly, the Court overturned insider trading convictions for Todd Newman and Anthony Chiasson because the defendants did not know they were trading on confidential information received from insiders in violation of those insiders’ fiduciary duties. More broadly, however, the Court laid down two new standards in tipping liability cases, both likely to frustrate prosecutors for years to come.

Tougher Disclosure Requirements

Section 10(b) of the Securities Exchange Act of 1934 and Securities and Exchange Commission rules 10b-5 and 10b5-1 generally prohibit trading on the basis of material nonpublic information, more conventionally known as insider trading. In addition, federal law also prohibits an individual (the “tipper”) from disclosing private information to an outside person (the “tippee”), if the tippee then trades on the basis of this private information. This disclosure—a breach of one’s fiduciary duty—is known as tipping liability. As with most crimes, tipping liability requires scienter, a mental state that demonstrates intent to deceive, manipulate, or defraud. In these cases, the government must show that the defendant acted willfully—i.e., with the realization that what he was doing was a wrongful act under the securities laws.

Until last week, willfulness had been fairly easy to show, and that was one of the principal reasons for the government’s string of successes. Prosecutors only had to prove that the defendants traded on confidential information that they knew had been disclosed through a breach of confidentiality. In Newman, however, the Second Circuit rejected this position outright. The Court held that a tippee can only be convicted if the government can prove that he knew that the insider disclosed confidential information in exchange for a personal benefit, and one that is “consequential” and potentially pecuniary.

This distinction may seem minor, but its impact is enormous. The government now must prove—beyond a reasonable doubt, no less—that a defendant affirmatively knew about a personal benefit to the source of the confidential information. From the prosecution’s perspective, this is a massively challenging prospect.

Tightened “Personal Benefit” Standards

The Second Circuit also clarified the definition of “personal benefit” in the tipping liability context. Previously, the Court had embraced a very broad definition of the term—so broad, in fact, that the government argued that a tip in exchange for “mere friendship” or “career advice” could expose a trader to tipping liability.

The Court retreated from this position and narrowed its standard. Now, to constitute a personal benefit, the prosecution must show an exchange “that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature” —in other words, something akin to a quid pro quo relationship. This, too, complicates a prosecution’s case significantly.

Implications of the Ruling

What effect will this ruling have moving forward? Of course, one effect is obvious from the start: prosecutors are going to have a much more difficult time proving tipping liability. But as with many new appellate cases, it may take some time to see how this rule shakes out on the ground in the trial courts. Here are a few things to keep in mind over the next few months and years.

  • This ruling may cause some immediate fallout. For example, there are currently several similar cases in New York that are pending for trial or appeal, and these may now result in acquittals or vacated convictions. In fact, some defendants who previously took guilty pleas in cooperation with Newman and Chiasson’s case are considering withdrawing their pleas in light of this decision. Moving forward, look to see the SEC and potential defendants adjusting their behavior and strategies in light of this ruling. In fact, just this week, a New York Federal Judge expressed strong reservations about whether guilty pleas entered by four defendants in an insider trader case related to a $1.2 billion IBM Corp. acquisition in 2009 should remain in light of Newman.
  • This is also welcome news for tippees who did not interact directly with the source of the inside information. Although the source of the leak may still be prosecuted as usual, this ruling may shield a more remote party from an indictment. As the Newman court noted, the government’s recent insider trading wins have been “increasingly targeted at remote tippees many levels removed from corporate insiders.” Now, without clear evidence that the insider received a quantifiable benefit and that the tippee was aware of such benefit for providing the information, cases against such “remote tippees” will be tremendously more difficult to prove.
  • But, caution should still reign where tippees deal more directly with tippers. The tippees in this case were as many as three or four steps removed from the tippers. It is not difficult to imagine the Court coming out the other way if Newman and Chiasson had been dealing with the tippers themselves.
  • One enormous question mark is to what extent the standards expressed in this case will affect the SEC’s civil enforcement suits. We will have to wait and see, but traders should still use caution. Because civil suits require a substantially lower burden of proof and lesser standard of intent compared to criminal cases, it is possible that these new rules may offer little protection from a civil suit. Additionally, SEC attorneys will probably emphasize this distinction to courts in an attempt to distinguish their enforcement suits from Newman and Chiasson’s criminal case, but whether this tactic is effective remains to be seen.
  • Although the Court refined the meaning of a personal benefit, the definition is still purposefully flexible. This case tells us that abstract psychic benefits—friendship, business advice, church relationships—are not enough, but what about anything just short of exchanging money, favors, or goods? We don’t yet know, and for that reason clients should exercise care.
If you have any questions about the content of this alert,   please contact the Pillsbury attorney with whom you regularly work, or the   authors below.
Jay B. Gould (bio)San Francisco

+1.415.983.1226

jay.gould@pillsburylaw.com

William M. Sullivan (bio)Washington, DC

+1.202.663.8027

wsullivan@pillsburylaw.com

 

The authors wish to thank Robert Boyd for his valuable assistance with this client alert.

 

About Pillsbury Winthrop Shaw Pittman LLP
Pillsbury is a full-service law firm with an industry focus on energy & natural resources, financial services including financial institutions, real estate & construction, and technology. Based in the world’s major financial, technology and energy centers, Pillsbury counsels clients on global business, regulatory and litigation matters. We work in multidisciplinary teams that allow us to understand our clients’ objectives, anticipate trends, and bring a 360-degree perspective to complex business and legal issues—helping clients to take greater advantage of new opportunities, meet and exceed their objectives, and better mitigate risk. This collaborative work style helps produce the results our clients seek.

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On November 25, 2014, the Securities and Exchange Commission (the “SEC”) brought charges against a Swiss-based bank that should serve as notice to all non-U.S. banks that maintain relationships with clients who have moved to the U.S., as well as U.S.-based banks that provide services to clients who have relocated to other countries.  The SEC found that HSBC’s Swiss-based private banking arm violated U.S. securities laws by providing investment advisory and brokerage services to U.S. clients without being properly registered as either an investment adviser or a broker-dealer.  HSBC Private Bank (Suisse) agreed to admit wrongdoing and pay $12.5 million to settle the SEC’s charges in a combination of disgorgement, prejudgment interest, and penalties.

How often do financial institutions, foreign or U.S., put themselves in the position of willfully violating the securities and banking laws of other countries?  Pretty routinely, as it turns out.  By way of example, suppose you are a citizen of a European Union country with a local banking relationship.  You work for a large multi-national company that offers you a promotion, but that new job is in New York.  Not one to decline an opportunity, off you go to the Center of the Universe.  You open a new bank account at a local New York bank, but you maintain your European bank relationship because you have a consolidated banking, investment advisory and brokerage relationship there that has worked quite well for you.  The relationship manager at your European bank certainly does not want to give up the revenue stream from your lucrative relationship, particularly now that you are making so much more money and you are willing to purchase and sell stocks more frequently.  Multiply this scenario several times over and before you know it, this certain European bank is routinely providing banking, investment advisory, and brokerage services to U.S. residents without being properly registered to do so.

This same scenario can and often does play out in reverse.  A U.S. citizen moves to a foreign country and maintains his banking, investment advisory and/or brokerage relationships with a financial institution that is not qualified to do business in the client’s new country of residence and before you know it, the U.S. financial institution is in violation of the laws of the country in which its client now resides.  And, not to gratuitously pick on any particular jurisdiction, the provision of such services in some countries pourrait être criminelle.

In the case of HSBC, the SEC found that HSBC Private Bank and its predecessors began providing cross-border advisory and brokerage services in the U.S. more than 10 years ago on behalf of at least 368 U.S. client accounts and collected fees totaling approximately $5.7 million.  HSBC relationship managers traveled to the U.S. on at least 40 occasions to solicit clients, provide investment advice, and induce securities transactions.  These relationship managers were not registered in the U.S. as investment adviser representatives or licensed brokers, nor were they affiliated with a registered investment adviser or broker-dealer (or “chaperoned” by a registered U.S. broker-dealer).  The relationship managers also communicated directly with clients in the U.S. through overseas mail and e-mails.  In 2010, HSBC Private Bank decided to exit the U.S. cross-border business, and nearly all of its U.S. client accounts were closed or transferred by the end of 2011.

According to the SEC’s order, HSBC Private Bank understood there was a risk of violating U.S. securities laws by providing unregistered investment advisory and brokerage services to U.S. clients, and the firm undertook certain compliance initiatives in an effort to manage and mitigate the risk.  The firm created a dedicated North American desk to consolidate U.S. client accounts among a smaller number of relationship managers and service them in a compliant manner that would not violate U.S. registration requirements.  However, certain relationship managers were reluctant to lose clients by transferring them to the North American desk and stalled the process or ignored it altogether.  HSBC Private Bank’s internal review revealed multiple occasions when U.S. accounts that were expected to be closed under certain compliance initiatives remained open.  HSBC Private Bank admitted to the SEC’s findings in the administrative order, acknowledged that its conduct violated U.S. securities laws, and accepted a censure and a cease-and-desist order.

Foreign financial institutions, even those that have U.S. affiliates that are properly registered and regulated as banks, investment advisers, or broker-dealers should undertake a review of their client accounts to determine whether they are providing services that are in violation of applicable law.  It is possible, perhaps even likely, that even if a non-U.S. financial institution has properly registered U.S. entities, services are being provided to certain clients outside of those entities as a result of historical relationships.  U.S. banks should also determine whether they are providing financial services to relocated clients in countries that would either prohibit such services or require some form of notification or registration.  A failure to abide by the laws of non-U.S. countries could also place a U.S. institution in the position of violating certain U.S. laws that require diligence of and compliance with the laws of other countries.

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Private equity firms were put on notice last year that they may be subject to registration as broker dealers when David Blass, head of the Division of Markets and Trading at the Securities and Exchange Commission (“SEC”), provided his insights at an industry conference.  Since that time, the SEC has published their examination priorities list, which included the presence exams of new registrants, a portion of which would review that status of private equity fund managers under the broker dealer rules.  Following up on this warning to the industry, the SEC has also targeted unregistered brokers for enforcement action.

Recently, at a speech in front of another industry group, Mr. Blass provided further guidance on how a private equity firm might structure its compensation arrangements in order to avoid the need to register as a broker dealer.  Consistent with the advice that Pillsbury has been providing private fund clients for many years, Mr. Blass warned against paying “transaction based” compensation and further suggested that if a private fund employee has “an overall mix of functions,” and sales is one aspect of those duties, it is less likely that the SEC staff would view such an arrangement as one that would require broker dealer registration.  An employee of a private fund manager would not be prohibited from being compensated on the overall success of the firm, and certainly sales of fund securities contribute to that overall success.  But tying compensation to assets raised looks like the traditional broker dealer compensation and should be avoided.

Mr. Blass indicated that the SEC is close to finalizing guidance on issues connected to private fund manager employee compensation.  However, the SEC staff has further to go before providing guidelines to the industry on the broker dealer registration issues posed by deal fees that private equity firms sometimes collect on transactions.  It is unlikely that Mr. Blass will see his initiatives through to completion, as he will soon be joining the staff of the Investment Company Institute where he will one day lobby against his former positions.

If you would like additional background on how the private fund managers came to find themselves in the gray zone of broker dealer registration as a result of paying their employees for performance, you may want to re-visit this article.