On June 1, 2016, the SEC issued a press release that announced a Maryland-based private equity fund advisory firm and its owner have agreed to pay more than $3.1 million to settle charges that they engaged in brokerage activity and charged transaction-based fees without registering as a broker-dealer and committed other securities law violations.

The SEC found that the private equity advisory firm performed in-house brokerage services rather than using investment banks or broker-dealers to handle the acquisition and disposition of portfolio companies for a pair of private equity funds. The private equity advisory firm fully disclosed to its funds and their investors that it would provide brokerage services in exchange for a fee, yet the firm failed to comply with the registration requirements to operate as a broker-dealer.

The issue of unregistered broker-dealer activity being conducted by private equity fund advisers was raised in April 2013 when it was highlighted in a speech given by David Blass, then Chief Counsel of the SEC Division of Trading and Markets. Mr. Blass said in remarks to the ABA Trading and Markets Subcommittee that private fund advisers routine practice of taking transaction fees appeared to “fall within the meaning of the term ‘broker.’ He noted that SEC staff members were observing that certain newly registered private fund advisers were receiving “transaction-based compensation” for investment banking and other traditional broker activities relating to their funds’ portfolio companies.i

Mr. Blass noted two scenarios where a private equity fund adviser may be required to register as a broker-dealer: (1) where the adviser “pays its personnel transaction-based compensation for selling interests in a fund” or has personnel “whose only or primary functions” are selling fund interests and (2) where the adviser, its affiliates or its personnel “receive transaction-based compensation for purported investment banking or other broker activities” relating to fund portfolio companies.

The SEC had been relatively quiet on the issue since the 2013 remarks by Mr. Blass. There had been speculation that the SEC was considering a special exemption for private-equity advisory firms to enable these firms to continue collecting such fees in the future without registering as a broker-dealer. If such an exemption were being considered, the SEC would be unlikely to pursue enforcement action over past deals. In light of the present enforcement action, it appears that this speculation was unfounded.

In the June 1, 2016 press release, Andrew J. Ceresney, Director of the SEC Enforcement Division. stated “The rules are clear: before a firm provides brokerage services and receives compensation in return, it must be properly registered within the regulatory framework that protects investors and informs our markets, Blackstreet clearly acted as a broker without fulfilling its registration obligations.”

The SEC found that in connection with the acquisition and disposition of portfolio companies or their assets, some of which involved the purchase or sale of securities, the private equity advisory firm provided brokerage services to and received transaction-based compensation from the portfolio companies. This activity caused the private equity advisory firm to be acting as a broker. The private equity advisory firm, however, has never been registered with the SEC as a broker.

The SEC specifically identified the following activities in which the private equity advisory firm received transaction-based compensation in violation of Section 15(a)(1) of the Securities Exchange Act of 1934, as amended (“Exchange Act”).

  • Soliciting Deals
  • Identifying Buyers or Sellers
  • Negotiating and Structuring Transactions,
  • Arranging Financing
  • Executing the Transactions

This case also had findings of violations of the Investment Advisers Act of 1940, as amended, aside from the Exchange Act violation. It is unclear if these additional findings of violations may have piqued the SEC’s interest in this case or whether it may have been the unregistered broker issue. However, the press release issued by the SEC was titled “Private Fund Adviser Acted As Unregistered Broker,” so one can infer that the Exchange Act violation was the headline issue upon which the SEC focused.

It should also be noted that $1,877,000 received in transaction-based compensation represented 80 percent of the disgorgement amount and 60 percent of the total settlement amount of $3.1 million.

Approximately a week after this decision was announced, Robert B. Baker, assistant regional director at the SEC’s Enforcement Division’s Asset-Management unit remarked at the SuperReturn U.S. conference in Boston:

“That’s the first case of a private-equity adviser violating section 15(a) of the [Securities Exchange Act of 1934] for acting as a broker and failing to register as a broker. Advisers should be carefully considering whether their conduct violates this rule.”

Private equity advisers ought to review all sources of transaction-based fees and determine whether those fees flow from activities the SEC has specifically identified in this case as causing a violation of Section 15(a)(1) of the Exchange Act for acting as an unregistered broker. If such fees are a part of the private equity adviser’s business, private equity advisory firms should consider various options. A private equity advisory firm may, depending upon the particular facts and circumstances, partner with an existing broker-dealer, form a captive broker-dealer or determine whether the firm’s activities can fit within the narrow exception provided by the SEC in the M&A Broker letter issued by the SEC on January 31, 2014 (and revised on February 4, 2014).ii 

A potential alternative approach for a private equity fund adviser that wished to collect fees on this basis would be to await passage of the recently proposed rules for “Capital Acquisition Broker”iii and register as a Capital Acquisition Broker under this new regulatory regime when it becomes applicable. The Capital Acquisition Broker rules can be characterized as a “light” version of broker-dealer dealer registration with limited business activities that may be conducted. These rules, if adopted as proposed, will likely provide a solution to full broker-dealer registration that would enable a private equity fund advisor to collect fees without fear of violating Section 15(a)(1) of the Exchange Act. It should be noted that FINRA filed an extension on June 14, 2016 that will enable the SEC to continue its review of these rules until August 19, 2016.

iA Few Observations in the Private Fund Space, David W. Blass, Chief Counsel, SEC Division of Trading and Markets (April 5, 2013)

iiThe M&A Broker letter and the letter that requested it can be found at: https://www.sec.gov/divisions/marketreg/mr-noaction/2014/ma-brokers-013114.pdf

iiiThe various Capital Acquisition Broker rules proposals can be found at: http://www.finra.org/industry/rule-filings/sr-finra-2015-054