On June 1, 2016, the Securities and Exchange Commission issued a press release announcing that a private equity fund advisory firm and its owner have agreed to pay more than $3.1 million to settle charges that included engaging in brokerage activity and charging transaction-based fees without registering as a broker-dealer. In so doing, the SEC appears to have rekindled the fire under a long-simmering issue regarding the kinds of services that private fund advisers can provide to the portfolio companies of the funds they advise.
In April 2013, David Blass, then Chief Counsel of the SEC Division of Trading and Markets, created a stir when he said in remarks to the ABA Trading and Markets Subcommittee that private fund advisers should be concerned about some apparently common activities that might require them to register as brokers. 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.
In his remarks, Mr. Blass explained that certain fees collected beyond normal advisory fees can raise questions about whether an adviser is acting as a broker. He cited as examples fees described as compensation for “investment banking activities,” including fees for negotiating transactions, fees for identifying and soliciting purchasers and/or sellers, and fees for structuring transactions. Mr. Blass said that the payment of transaction-based compensation to an adviser for such services could cause the adviser to fall within the meaning of the term “broker,” and thus it would be required to register as such.
Mr. Blass acknowledged that a common argument against such arrangements requiring broker registration is that the payments are often structured to offset or otherwise reduce the advisory fee payable by the fund. He said that to the extent the advisory fee is reduced or offset by the transaction fee, the transaction fee could be viewed as simply another way to pay the advisory fee and that this, in his view, would not appear to raise broker registration issues. (Of course, like every speech given by a senior SEC staff member, the views expressed by Mr. Blass were his own and did not necessarily reflect the views of the SEC or its staff.) However, Mr. Blass also described a second argument that had been advanced under which the general partner of the fund (where the general partner is also the fund’s adviser or an affiliate of the adviser) directly or indirectly receives the transaction fee. In that case, it had been argued that the general partner should be viewed as the same person as the fund and therefore no transaction “for the account of others” (a key to being defined as a broker) occurred. Mr. Blass expressed skepticism as to the validity of that argument, questioning why such fee would be paid to anyone other than the fund itself. “That the fee is paid to someone other than the fund − here the general partner − makes crystal clear to me that, at least for potential broker-dealer status questions, the fund and the general partner are distinct entities with distinct interests.”
Mr. Blass’s comments certainly raised a significant amount of discussion at the time they were made. Moreover, at around the same time a number of private equity fund advisers were subject to routine SEC examinations, and among the exam findings many firms received was a finding that the adviser was receiving transaction-based fees in connection with the acquisition or sale of portfolio companies. That conduct may have constituted acting as a broker. The SEC noted in these findings that it had stated previously that a person may effect transactions in securities by assisting issuers to structure securities transactions, identifying potential purchasers, and soliciting securities transactions. The SEC explained its long-held position that soliciting securities transactions is a lynchpin for determining whether a person is effecting securities transactions which, when coupled with the receipt of transaction-based compensation, generally means the person or entity is acting as a broker and should be registered.
An end to the quiet
Notwithstanding Mr. Blass’s provocative remarks in 2013, and the spate of contemporaneous examination findings insinuating that private equity advisers might be acting as unregistered brokers, the SEC had been relatively quiet on the issue since then. However, on June 1, 2016, it issued a press release announcing that a private equity fund advisory firm and its owner had agreed to pay more than $3.1 million to settle charges that they engaged in brokerage activity and charged fees without registering as a broker-dealer, as well as committing a number of violations of the Investment Advisers Act. The firm and its managing member allegedly performed in-house services, rather than using investment banks or broker-dealers, related to the acquisition and disposition of portfolio companies for a pair of private equity funds the firm advised. While the firm fully disclosed to its funds and their investors that it would provide brokerage services for a fee, the firm failed to register as a broker-dealer in accordance with the requirements of the Securities Exchange Act.
In announcing the action, SEC Enforcement Division Director Andrew Ceresney stated that “[t]he 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," and that the firm “clearly acted as a broker without fulfilling its registration obligations.” Unfortunately, the SEC’s order is not particularly expansive with respect to the details of the violations charged.
With respect to the unregistered broker issue, the SEC simply states that although each fund’s limited partnership agreement expressly permitted the firm to charge transaction or brokerage fees, the firm “has never been registered with the Commission as a broker nor has it ever been affiliated with a registered broker.” It goes on to explain that “[r]ather than employing investment banks or broker-dealers to provide brokerage services with respect to the acquisition and disposition of portfolio companies, some of which involved the purchase or sale of securities, [the firm] performed these services in-house, including soliciting deals, identifying buyers or sellers, negotiating and structuring transactions, arranging financing, and executing the transactions.” For these services, the firm received more than $1.8 million in transaction-based compensation. Since Securities Exchange Act Section 15(a) makes it unlawful for any broker to effect transactions in, or to induce or attempt to induce the purchase or sale of, any security unless it is properly registered, the firm was found to have willfully violated, and its owner caused violations of, Section 15(a).
Is this a signal?
It’s difficult to determine whether the facts of this case caused it to stand out and warrant special consideration, or whether it is a signal that the SEC is re-engaged on the issue of private equity advisers acting as broker-dealers without proper registration and will be looking to bring more of these types of actions. As noted above, in total, the firm and the owner paid more than $3.1 million in disgorgement, prejudgment interest and civil money penalties. And while a number of other violations (under the Investment Advisers Act) were also involved in this matter, it can’t be ignored that the $1,877,000 in transaction-based compensation that the firm received represents 80 percent of the disgorgement amount and 60 percent of the total amount in penalties to be paid. Moreover, the headline on the SEC’s press release – “Private Equity Fund Adviser Acted As Unregistered Broker” – seems to be a pretty clear illustration of the importance the SEC was placing on the unregistered broker issue.
In any case, the fact that this issue is back on the SEC home page is a signal that private equity advisers should be taking a good look at their activities and performing a fresh analysis of whether some of those activities require registration as a broker-dealer.
If you would like to learn more about this issue and what it may mean for your business, or if you would like assistance in analyzing your activities and possibly becoming registered as a broker-dealer, please contact one of the authors named below or your usual DLA Piper contact. We would be happy to assist you.
Edward J. Johnsen
Wesley G. Nissen
David A. Goldstein
Robert B. Weiss
 A Few Observations in the Private Fund Space, David W. Blass, Chief Counsel, SEC Division of Trading and Markets (April 5, 2013), found here.
 Securities Exchange Act Section 3(a)(4)(A) defines a broker generally as “any person engaged in the business of effecting transactions in securities for the account of others.”