The following is an edited version of a speech given April 5 by David W. Blass, chief counsel of the Securities and Exchange Commission's Division of Trading and Markets, before the American Bar Association's Trading and Markets Subcommittee.
I have had the great pleasure over the last year or so to work with members of the Trading and Markets Subcommittee and other ABA groups on a number of initiatives surrounding one broad and oftentimes tricky question: When is a person required to register with the SEC as a broker-dealer? This group knows how vitally important it is to settle some of the questions that have been open for a decade or more.
I and my staff have already begun talking with you about such perennial hits as placement agents, so-called “finders,” and business or [mergers-and-acquisitions] brokers. Most recently, we have had lengthy discussions with various members of this subcommittee about Rule 15a-6, the rule exempting from registration certain non-U.S. resident persons engaged in business as a broker or dealer entirely outside the U.S. These discussions led the staff to publish responses to frequently asked questions about the rule to address some of the issues that you have told us have been a source of confusion. We view the FAQs as an initial set of staff guidance about issues that commonly arise under Rule 15a-6. They do not break new ground, but I believe they are important to ensuring that regulators and market participants are operating under a common understanding of how the rule works. We are very much open to exploring opportunities for additional guidance through subsequent FAQs.
While Rule 15a-6 is a perennial topic, so too are others that we have been discussing with various members and committees of the ABA, as well as other interested groups. I have in mind the broker-dealer registration requirements as they apply to the group I mentioned earlier — placement agents, finders, and business or M&A brokers. The staff has been considering a wide spectrum of options for certain of these market participants, ranging from potential recommendations for exemptions to working collaboratively with the Financial Industry Regulatory Authority Inc. on a more customized approach for regulation of market participants who perform only limited broker functions.
The staff's consideration of this latter approach, which has the potential benefit of removing some barriers to entry, has been greatly facilitated by the work being done for the regulation of funding portals. Introduced by the Jumpstart Our Business Startups Act, funding portals are intended to perform limited functions for crowd-funding offerings. Because their functions are limited (for example, they do not come into possession of customer funds or securities, or provide investment advice), funding portals receive lighter regulatory treatment, including being subject to a customized set of rules under Finra's rule book (as compared to fully registered broker-dealers) and receiving an exemption from broker registration with the SEC.
WHO IS A BROKER?
Today, I would like to add a new topic of discussion that refers back to our broad theme of broker-dealer registration. The issue arises in the private-fund-adviser world. As you are well-aware, private funds have become an increasingly large part of the financial marketplace in the last couple of decades. Their significance was recognized in the Dodd-Frank Act, and related SEC rules, which impose new registration and reporting requirements on private-fund advisers.
Many private-fund advisers are quite rightly coming to terms with the requirements under the Investment Advisers Act of 1940 that are newly applicable to them. They are probably focused on recent enforcement actions under that act, as well as concerns expressed by the SEC's senior enforcement and examination teams. While it is absolutely right and appropriate that private-fund advisers devote their resources to complying with the requirements under the Advisers Act, I would like to be sure that the private-fund-adviser community is not overlooking significant areas of concern under the Securities Exchange Act of 1934 — activity that could cause a private-fund adviser to be required to register as a broker-dealer.
The reason I focus on the broker-dealer issue in this context is because of some practices that the staff has observed in connection with newly registered private-fund advisers. This is an issue that warrants some attention before examiners arrive. To date, the issue has come in two flavors. I will describe these in more detail shortly, but the first flavor (let's call it plain vanilla) involves 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. In the second flavor (a bit more unusual, say, dark chocolate with a subtle infusion of habañero), the private-fund adviser, its personnel or its affiliates receive transaction-based compensation for purported investment banking or other broker activities relating to one or more of the fund's portfolio companies. This second practice is common at advisers of certain types of funds, such as private-equity funds that execute a leveraged-buyout strategy. I should note that these issues are not unique to advisers of private-equity funds or even advisers to private funds. Advisers to other types of funds, including business development companies, also will want to think through their practices.SALES IN PRIVATE FUNDS
In a speech several years ago, the director of the Division of Investment Management at the time expressed concern that some participants in the private-fund industry may be inappropriately claiming to rely on exemptions or interpretive guidance to avoid broker-dealer registration. As this group knows quite well, absent an available exemption or other relief, a person engaged in the business of effecting transactions in securities for the accounts of others must generally register under Section 15(a) of the Exchange Act as a broker.
The test for broker-dealer registration is broad and depends on various activities a person performs in one or more securities transactions. Some examples of activities, or factors, that might require private-fund-adviser personnel to register as a broker-dealer include:
• Marketing securities (shares or interests in a private fund) to investors.
• Soliciting or negotiating securities transactions.
• Handling customer funds and securities.
The importance of each of these activities is heightened where there also is compensation that depends on the outcome or size of the securities transaction — in other words, transaction-based compensation, also referred to as a “salesman's stake,” in a securities transaction. The SEC and SEC staff have long viewed that receipt of transaction-based compensation is a hallmark of being a broker. This makes sense to me since the broker regulatory structure is built, at least in large part, around managing the conflict of interest arising from a broker acting as a securities salesman, as compared to an investment adviser, who traditionally acts as a fiduciary and should not have that same type of conflict of interest.
With this backdrop, a private-fund adviser (or counsel to a private fund adviser) should think through how the adviser goes about obtaining new investors and retaining existing investors. That is not to say that all investment-raising by a private-fund adviser results in the adviser being a broker-dealer. I believe that private-fund advisers may not be fully aware of all of the activities that could be viewed as soliciting securities transactions, or the implications of compensation methods that are transaction-based.
In order to help private-fund advisers think through this a little more, I thought I would run through some questions private-fund advisers might want to ask themselves with respect to activities or services that they may perform. For example, the adviser might want to consider the following:
How does the adviser solicit and retain investors? I recommend some thinking go into the duties and responsibilities of personnel performing such solicitation or marketing efforts. This is an important consideration because a dedicated sales force of employees working within a “marketing” department may strongly indicate that they are in the business of effecting transactions in the private fund, regardless of how the personnel are compensated.
Do employees who solicit investors have other responsibilities? If so, consider what those responsibilities are (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 types of compensation that is linked to successful investments? As previously noted, a critical element to determining whether one is required to register as a broker-dealer is the existence of transaction-based compensation.
Do you charge a transaction fee in connection with a securities transaction? In addition to considering compensation of employees, advisers need to consider the fees they charge and in what way, if any, they are linked to a security transaction.
Some ask us about the so-called “issuer exemption” in the context of private-fund advisers. That exemption, found in Exchange Act Rule 3a4-1, provides a nonexclusive safe harbor under which associated persons of certain issuers can participate in the sale of an issuer's securities in certain limited circumstances without being considered a broker. A person must satisfy one of three conditions to claim the issuer exemption from broker-dealer registration:
• The person limits the offering and selling of the issuer's securities only to broker-dealers and other specified types of financial institutions.
• The person performs substantial duties for the issuer other than in connection with transactions in securities, was not a broker-dealer or an associated person of a broker-dealer within the preceding 12 months, and does not participate in selling an offering of securities for any issuer more than once every 12 months.
• The person limits activities to delivering written communication by means that do not involve oral solicitation by the associated person of a potential purchaser.
I am keenly aware that many advisers, particularly smaller advisers, may not be able to afford or be able to either hire a broker-dealer or register as broker-dealers themselves. By raising the issues that I have just described, I am not saying that they need to do that in all circumstances. There is a wide array of options available to private-fund advisers to raise funds without triggering broker registration concerns. I have in mind a potential exemption like the issuer exemption, but one written specifically for private-fund advisers.PRIVATE-EQUITY PRACTICES
On a related note, the staff has observed that advisers to some funds — for example, advisers to private-equity funds executing a leveraged-buyout strategy — also may collect many other fees in addition to advisory fees, some of which call into question whether those advisers are engaging in activities that require broker-dealer registration. The fees are 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.
This practice appears to involve transaction-based compensation that is linked to the manager's effecting a securities transaction. The combination of success fees, which cause the adviser to take on a salesman's stake and the activities involved in effecting securities transactions appear to cause such an adviser to fall within the meaning of the term “broker.”CLOSING REMARKS
I raise all these issues to bring them to the attention of private fund advisers and their counsel, so they can grapple with them hopefully in advance of a visit from the SEC's examiners. Also, while some out there might think that acting as an unregistered broker-dealer should be viewed only as a technical violation, I want to take a moment and caution that engaging in these activities without registering can have serious consequences. In addition to being subject to sanctions by the SEC, another possible consequence of acting as an unregistered broker-dealer is the potential right to rescission. In other words, securities transactions intermediated by an inappropriately unregistered broker-dealer could potentially be rendered void. Given the significant consequences of acting as an unregistered broker-dealer and the increased attention being given to this issue by the SEC staff, private-fund advisers should consider reviewing their practices to determine whether any activities that may be approaching or crossing the line would require broker-dealer registration.
