April 30, 2013

Senior SEC Lawyer Remarks Indicate Continued Focus on Private Fund Adviser Activities and Broker-Dealer Registration Issues

Less than a month after the Securities and Exchange Commission (“SEC”) took action against a private equity firm and its consultant for violating the broker-dealer registration requirements of the Securities Exchange Act of 1934 (“Exchange Act”) [1], a senior member of the staff of the SEC’s Division of Trading and Markets signaled the SEC’s continued interest in examining private fund advisers’ compliance with broker-dealer registration requirements. David W. Blass, the Chief Counsel of the SEC’s Division of Trading and Markets, delivered prepared remarks at the April 5 meeting of a subcommittee of the American Bar Association in Washington, D.C., in which he discussed SEC concerns in two key areas: (i) the use and compensation of employees of private fund advisers or managers to market interests in funds advised or managed by such advisers or managers and (ii) the receipt of compensation from portfolio companies by advisers or managers of private equity funds for “investment banking” or other transaction-related activities. Although Mr. Blass gave the customary disclaimer that his views do not represent the views of the SEC or the staff of the SEC, his remarks indicate that the SEC intends to scrutinize private fund advisers’ activities in these two areas, and any associated compensation, to determine whether those activities require the private fund advisers or their employees to register as broker-dealers.

Mr. Blass encouraged private fund advisers and managers to review their current fundraising and business practices to determine whether any activities “that may be approaching or crossing the line would require broker-dealer registration.”  He encouraged private fund advisers to be proactive in avoiding problems, and indicated a willingness to consider relief for private fund advisers “with appropriate conditions or other parameters.” 

This Client Alert briefly describes Mr. Blass’ remarks and some of the associated issues.


Definition of Broker and Required Registration Under the Exchange Act

The Exchange Act defines a “broker” as “any person engaged in the business of effecting transactions in securities for the account of others.”  However, a person may also be found to be acting as a broker if that person participates in securities transactions “at key points in the chain of distribution.”[2]  Section 15(a) of the Exchange Act requires broker-dealers to register with the SEC if they “induce or attempt to induce the purchase or sale of any security.”

Test for Broker-Dealer Registration Under the Exchange Act

Mr. Blass noted that the test for broker-dealer registration is quite broad and fact-based. In particular, he listed three factors that may require broker-dealer registration of advisers to private funds:

  • Marketing securities (shares or interests in a private fund) to investors;
  • Soliciting or negotiating securities transactions; or
  • Handling customer funds and securities.

Mr. Blass observed that when compensation is tied to the success or size of the securities transaction, the above factors become more important, as the “SEC and SEC staff have long viewed receipt of transaction-based compensation [as] a hallmark of being a broker.”  However, a person does not have to receive transaction-based compensation in order to be considered a broker-dealer and may still be required to register as a broker-dealer because of that person’s participation in securities transactions.

Sales of Fund Interests by Officers and Employees

Fund interests are often sold through officers and employees of the private fund adviser or manager, and Mr. Blass noted that not all fundraising by an adviser requires broker-dealer registration. He provided specific considerations that may assist private fund advisers, managers and their counsel in determining whether employees of a private fund adviser or manager are acting as broker-dealers, including:

  • Whether the fund has a dedicated sales force working in a “marketing” department;
  • Whether employees who solicit investors also have other responsibilities or if their primary responsibility is to solicit investors;
  • Whether employees who solicit investors receive compensation connected to successful commitments by investors; and
  • Whether the fund or adviser charges transaction fees for securities transactions or fees that are linked to securities transactions.

Mr. Blass indicated that a dedicated “marketing department” may be a strong indicator of broker-dealer activities, along with compensation connected to successful fundraising. He also noted parenthetically that labeling matters, and that having employees working in a “sales” or “marketing” department may strongly indicate that they are in the business of effecting transactions in securities, regardless of how they are compensated. While Mr. Blass’ list of considerations indicates that the SEC staff may not view employees with substantive responsibilities other than fundraising as brokers, he did not provide guidance as to what those responsibilities are or how one would determine if an employee’s primary responsibility is to solicit investors. However, private fund advisers and managers that are not registered as broker-dealers should consider reviewing their fundraising structure and whether they have employees whose sole or primary responsibility is fundraising.

Private fund advisers or managers should expect that when conducting examinations of registered fund advisers the SEC staff may review internal marketing arrangements to determine whether there are employees who are only, or mostly, marketers, or are paid on that basis. In recent examinations, the staff has expected the fund manager to explain why broker-dealer registration is not required in that context.

Suggestions for a Private Fund Adviser Exemption

Mr. Blass addressed the applicability of Rule 3a4-1, the so-called “issuer exemption,” to private fund advisers and noted that this exemption is generally not available to private fund advisers because private fund advisers typically have difficulty meeting one of the conditions of the rule. The exemptions in the rule for private offerings either limit employees to: one offering per 12-month period; to offers and sales exclusively to broker-dealers and certain other financial institutions; or to purely passive activity. However, he indicated that he was open to suggestions for an exemption from broker-dealer requirements specifically tailored to private fund advisers. Based on his comments, any such new rule could permit more than one offering per year but is unlikely to permit the payment of transaction-based compensation.

Transaction Fees Paid to Private Equity Fund Advisers

Mr. Blass also stated that the SEC staff has observed that the advisers to some funds, such as private equity funds executing a leveraged buyout strategy, may charge and collect fees from their portfolio companies in addition to the advisory or management fees they charge the funds. These fees include “fees the manager directs a portfolio company of the fund to pay directly or indirectly to the adviser or one of its affiliates in connection with the acquisition or disposition (including in an initial public offering) of a portfolio company or a recapitalization of the portfolio company.”  Mr. Blass noted that these fees are “sometimes described as compensating the private fund adviser or its affiliates or personnel for “investment banking activity,” including negotiating transactions, identifying and soliciting purchasers or sellers of the securities of the company, or structuring transactions.”

Mr. Blass expressed concern that certain of these fees, “at least on their face,” appear to be transaction-based compensation linked to a successful securities transaction, and may thus be characterized as compensation for acting as a broker. However, Mr. Blass noted that he is aware that such fees are common in the industry.

Mr. Blass seemed sympathetic to the argument that transaction fees may not be broker’s fees where the fees wholly offset or reduce the amount of the management fee otherwise payable to the fund; as such transaction fees may then be viewed as simply a different way to pay the management fee. However, he did not address the effect of a partial offset or reduction of management fees by transaction fees. It is also important to note that his discussion was limited to fees charged in connection with securities transactions, and not, for example, fees in connection with asset purchases or sales.

He encouraged private fund advisers to “think through these practices” and suggested it may be appropriate to change practices to avoid the issue. He stated that the SEC staff is open to discussing whether such fees in particular cases really are broker’s fees, and that the staff is interested in talking over these issues.

Finally, we note that the SEC inspection staff has also begun to ask registered advisers to produce information about fees other than management and performance fees (e.g. transaction, monitoring and directors’ fees), and to ask for specific information about offsetting or crediting of fees.


Mr. Blass’ speech highlighted two areas of focus for SEC staff when conducting examinations of private fund managers registered as investment advisers. Mr. Blass discounted the policy question, raised at the meeting, of why the SEC “would want to require a private equity fund manager to register as a broker-dealer” as not relevant. Instead, Mr. Blass stated that “unless prepared to register as a broker, a person should not engage in activities that trigger registration.”  He cautioned that unregistered broker-dealer activities should not be viewed as mere technical violations, but as actions that may bring SEC sanctions. In addition, he noted that “securities transactions intermediated by an inappropriately unregistered broker-dealer could potentially be rendered void.”  If such transactions were rendered void, investors would then be entitled to demand rescission of their investment in the fund and the unwinding of their investment to the detriment of the fund. Mr. Blass’ remarks suggest that the SEC staff may approach examinations from the perspective that, policy questions aside, private fund advisers should be prepared to explain why broker-dealer registration is not required as a result of their activities.


[1] Section 15(a) of the Exchange Act provides: (1) It shall be unlawful for any broker or dealer which is either a person other than a natural person or a natural person not associated with a broker or dealer which is a person other than a natural person (other than such a broker or dealer whose business is exclusively intrastate and who does not make use of any facility of a national securities exchange) to make use of the mails or any means or instrumentality of interstate commerce to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security (other than an exempted security or commercial paper, bankers' acceptances, or commercial bills) unless such broker or dealer is registered in accordance with subsection (b) of this section. (2) The Commission, by rule or order, as it deems consistent with the public interest and the protection of investors, may conditionally or unconditionally exempt from paragraph (1) of this subsection any broker or dealer or class of brokers or dealers specified in such rule or order.

[2] See Massachusetts Financial Services, Inc. v. Securities Investor Protection Corp., 411 F. Supp. 411, 415 (D. Mass.), aff'd, 545 F.2d 754 (1st Cir. 1976), cert. denied, 431 U.S. 904 (1977).