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Broker-Dealer Registration for Private Fund Managers: What Are the Requirements?


12/19/13

Synopsis:
 
The increasing significance of private fund advisers in the financial marketplace has prompted the Securities and Exchange Commission (SEC) to focus on the way in which private fund managers market to investors and raise capital. New regulatory requirements, coupled with the SEC’s own observations on the conduct of private fund advisers, has uncovered broker-dealer registration issues that could amount to serious consequences for private fund managers that do not comply with SEC requirements.
 
Issue:
 
As a result of the Dodd-Frank Act, most private fund managers are required to register with the SEC and are thus subject to SEC regulation. David Blass, Chief Counsel of the SEC’s Division of Trading and Markets, has indicated there are certain activities that could cause a private fund adviser to be required to register as a broker-dealer. The two activities include: (1) a fund adviser that pays its personnel transaction-based compensation for selling interests in a fund, or that has personnel whose only or primary functions are to sell interest in the fund; and (2) a private fund adviser, its personnel, or its affiliates that receive transaction-based compensation for purported investment banking or other broker-dealer activities relating to one or more of the fund’s portfolio companies. 
 
According to Blass, acting as an unregistered broker-dealer can carry significant consequences, including sanctions by the SEC and the potential right to rescission, whereby securities transactions intermediated by an inappropriately unregistered broker-dealer could potentially be rendered void. As an example, the SEC announced in early 2013 the settlement of enforcement proceedings against a private equity firm, one of its partners and an unregistered finder, for the finder’s solicitation of more than $500 million in capital commitments for two private funds in violations of the broker-dealer registration provisions of the 1934 Act. The fund sponsor paid a penalty of $375,000, and the partner paid a penalty of $75,000 and agreed to a nine-month suspension from acting in a supervisory capacity at an investment adviser or a broker-dealer. The finder agreed to be barred from the securities industry.
 
Moreover, Blass suggests that an investor may have the right to rescind its investment in a fund if the investment transaction was consummated using an unregistered broker-dealer. Blass notes that these issues are not unique to advisers to private equity funds; they are of potential interest to all private fund managers in connection with fundraising activities, including managers of private equity funds, hedge funds, and real estate funds.
 
While some participants in the private fund industry may inappropriately rely on exemptions or interpretive guidance to avoid broker-dealer registration, any person engaged in the business of effecting transactions in securities for the account of others must generally register under Section 15(a) of the Exchange Act as a broker-dealer. 
 
The importance is particularly heightened where there is also compensation that depends upon the outcome or size of the securities transaction – or transaction-based compensation – as the SEC has long viewed the receipt of transaction-based compensation as a hallmark of being a broker-dealer.
 
In determining whether any activities may be approaching or crossing the line that would require broker-dealer registration, private fund advisers may want to consider the following:

  • How does the adviser solicit and retain investors? A dedicated sales force of employees working within a “marketing” department may strongly indicate the business of effecting transactions in the private fund.
  • Do employees who solicit investors have other responsibilities (i.e., are the primary functions of these employees to solicit investors)?
  • How are personnel who solicit investors for a private fund compensated?  Do those individuals receive bonuses or other compensation that is linked to successful investments?
  • Is a transaction fee charged in connection with a securities transaction?
     

What Does CohnReznick Think?
Fund managers should review their policies and procedures regarding their fundraising efforts. This review should incorporate who is performing the services and how the management company, as well as employees, are compensated. We also suggest that the results of this process be discussed with counsel to ensure compliance with the SEC regulations.

Contact:
 
For more information, please contact Jay Levy, Partner and Financial Services Industry Practice Leader, at 646-254-7412, or visit CohnReznick’s Financial Services Industry Practice webpage.


Circular 230 Notice: In compliance with U.S. Treasury Regulations, the information included herein (or in any attachment) is not intended or written to be used, and it cannot be used, by any taxpayer for the purpose of i) avoiding penalties the IRS and others may impose on the taxpayer or ii) promoting, marketing, or recommending to another party any tax related matters.

This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

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