Aiding and Abetting Liability of Fund Manager for Use of Unregistered Broker – Recent SEC Enforcement Action

Focus: Use of Finders and Other Unregistered Consultants in Capital Raising

Some issuers, including investment, real estate, venture capital and private equity funds, as well as operating companies, use finders or other consultants who are not registered as broker-dealers to raise capital. Although there is a very narrow exception for finders who do no more than provide a list of potential investors and receive a fee for the list of names not based on the success of the offering, many consultants operate outside of the limits of the exception. Fund managers and company officers have understood that the consultant could be liable for failure to register, but what is the liability of a fund manager or company and its principals for using an unregistered consultant? The SEC has recently provided an answer in a pair of related settled enforcement actions, one against an unregistered broker and the second against the fund manager that hired the broker and a senior executive officer of the fund manager. Although these cases involve a private equity manager and its funds, they are significant to all private issuers of securities, including operating companies seeking to raise capital by issuing stock or other securities.

Summary of Enforcement Actions

On March 11, 2013, the SEC announced that it had settled charges in two complaints against a private equity firm (“PE Firm”), a former senior executive officer of the firm (“Executive”) and a consultant (“Consultant”) who solicited more than $500 million in capital commitments for private funds managed by the PE Firm (Release Nos. 34-69090 and 34-69091). In the complaint against the Consultant, the SEC alleged that he violated Section 15(a) of the Securities Exchange Act of 1934 (“Exchange Act”), which requires persons engaged in the business of acting as brokers to register with the SEC. In the second complaint, the SEC alleged that the PE Firm caused the violation of Section 15(a), and that the Executive aided and abetted and caused the violation of Section 15(a) by the Consultant.

The following facts are taken from the complaints:

• The Consultant had been in the asset management and investment advisory business from 1986 to 2000. In November 2002, in response to SEC allegations that he had violated provisions of the securities laws in connection with the investment of pension fund assets, the Consultant agreed to entry of a cease and desist order and was barred from association with an investment adviser for two years.
• The Executive was a long-time friend of the Consultant. In 2008 and again in 2010, he caused the PE Firm (through an affiliate) to engage the Consultant to find investors for two funds. The PE Firm agreed to pay the Consultant 1% of all capital commitments made to the funds by investors introduced by the Consultant.
• The Consultant was not registered as a broker-dealer or a registered representative of a broker-dealer during the period of his engagement by the PE Firm.
• The Executive was generally aware of the Consultant’s prior disciplinary history and knew that the Consultant was not registered as a broker.
• The Executive informed the Consultant that his activities on behalf of the PE Firm were to be limited to contacting potential investors to arrange meetings for the principals of the funds and that the Consultant was not permitted to provide private placement memorandums (“PPMs”) to potential investors or to contact investors directly to discuss his views of the merits and strategies of the funds.
• Despite those instructions, the Consultant solicited investors personally and delivered PPMs to investors, and the Executive was aware of the Consultant’s activities. The Consultant also engaged a sub-agent to solicit a state retirement system and paid him part of the fees he received from the PE Firm. The specific circumstances giving rise to the allegations include both successful relationships for which the consultant was paid, and unsuccessful introductions that did not result in any capital being raised for the funds.

On the basis of those facts, the SEC alleged that the Consultant had violated Section 15(a) of the Exchange Act, and he consented to entry of an order barring him from, among other things, association with a broker or dealer, and requiring payment of disgorgement and prejudgment interest totaling about $2.8 million, payment of which was waived because of his financial condition.

The SEC alleged that the PE Firm had caused the Consultant to violate Section 15(a), and the PE Firm consented to an order requiring it to cease and desist from committing or causing any violations of Section 15(a), and to pay a civil penalty of $375,000. The SEC alleged that the Executive willfully aided and abetted and caused the Consultant’s violations of Section 15(a). The Executive consented to an order (i) requiring him to cease and desist from committing or causing any violations of Section 15(a), (ii) suspending him from association with any broker, dealer, investment adviser or other registered person for nine months and (iii) requiring him to pay a civil money penalty of $75,000.

Impact of SEC Action on Fund Managers and Other Principals

Fund managers, company principals and their counsel have been aware that there is potential liability for issuers that use a finder or other consultant, if it is determined that the finder or consultant was required to be registered as a broker. That liability could be based on Exchange Act Section 29(b), which provides that contracts in violation of the Exchange Act are void as regards the rights of certain persons, or provisions of state securities laws affording a right of rescission to investors in transactions by an unregistered broker, for example, California Corporations Code Section 25501.5 (although state laws giving investors a private right of action against the issuer because of use of an unregistered broker are not common). In addition, activities of a finder or consultant could give rise to a claim that the introduction of investors in a Regulation D, Rule 506 offering by an unregistered person constitutes “general solicitation,” currently not permitted by Rule 502 of Regulation D, or may otherwise violate the conditions of private placement limitations imposed by other laws and regulations (such as CFTC exemptions used by many fund managers). The extent to which any of those claims would be effective against an issuer and its manager or principals (rather than the unregistered broker) has yet to be determined. Registered investment advisers are, of course, prohibited by Rule 206(4)-5(a)(2)(i) from providing payment to a third party that is not a regulated person to solicit a government entity for investment advisory services (which includes investment in an investment fund advised by the adviser).

By its recent enforcement action, the SEC has given notice that it can and will bring cases against issuers and their principals for causing or aiding and abetting violations of Section 15(a) by unregistered finders or consultants. Such arrangements are more likely to be uncovered with respect to investment funds now that more fund managers are registered as investment advisers and subject to examination by the SEC. The pair of cases reported here involved exacerbating facts, including the prior disciplinary history of the consultant; the amount of capital commitments for which the Consultant was responsible ($500 million) and the amount of his compensation ($2.4 million); and the knowledge of the PE Firm and Executive that the Consultant was exceeding the limits of the activities that he was permitted to engage in. It remains to be seen whether the SEC will bring actions for aiding and abetting in the absence of the same bad facts.

The consequences to persons who are disciplined for aiding and abetting unregistered brokers goes beyond the immediate penalties. Registered investment advisers must disclose the penalty in their Forms ADV. The order may also constitute a “statutory disqualification” as defined in Section 3(a)(39) of the Exchange Act, requiring the person to apply for a waiver in order to be registered. Such would be the case, for example, if the person’s registration were suspended for 12 months.

Steps To Take When Hiring Finders and Consultants

Fund managers and other companies engaged in private placements can take one or more of the following steps to avoid aiding and abetting unregistered brokers:

• Engage a registered broker-dealer as placement agent.
• Enter into agreements with registered representatives, and be sure that the representatives are acting with the permission of their registered firms and under their supervision. Some consultants provide a variety of services, only some of which constitute broker-dealer activity. If the relationship is structured properly, a consultant may perform broker-related activities as an associated person of a registered firm on an independent contractor basis.
• If using a finder, be familiar with SEC guidance on what a finder can and cannot do. Finders are generally permitted to provide lists of names, but should not negotiate with or provide offering materials to prospective investors. They may be paid a flat fee for the list of names, but should not be paid on the basis of the amount invested by introduced persons or the success of the offering. Consultants may provide general advice to the fund or company about marketing and positioning the business for an offering, and may train people who will be soliciting investors, but may not have contact with investors themselves.
• Ask for, and double check, information about the disciplinary history of the finder, and about other broker-type activities he or she may be involved in. A person who acts as a finder for multiple issuers is more likely to be considered “in the business” of being a broker, and therefore required to register.

Of course, officers, employees and other associated persons of fund managers and issuers may solicit investors in private offerings but that activity must be done in compliance with existing guidance for associated persons of an issuer deemed not to be brokers, including SEC Rule 3a4‑1.

Please contact your Goodwin Procter LLP attorney for additional information and advice.