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Private Equity Fund Managers as Unregistered Broker Dealers – Sanctions and Rescission


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.