SEC Targets Broker-Dealer Registration

Oct 17 2013 | 1:03pm ET

The Securities and Exchange Commission's crackdown on insider trading has been a high-profile campaign that has included some high-profile hedge fund industry targets, but the market watchdog is also keeping a close eye on another aspect of private fund activity—transactions that may require the adviser to register as a broker-dealer.

“[T]he SEC is bringing cases in this area and has been sounding this alarm bell since April,” Perrie Weiner, global co-chairman of securities litigation at law firm DLA piper, told FINalternatives.

The April alarm bell took the form of an address to the American Bar Association by David Blass, chief counsel for the SEC's trading and markets division, during which he said it was “vitally important...to settle some of the questions that have been open for a decade or more about who needs to register with the SEC as a broker-dealer.”

While underlining that his views were his alone and not those of the Commission, Blass focused in on the “two flavors” of the issue that have come to his attention:

“[T]he 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,” he said.

“In the second flavor (a bit more unusual, say dark chocolate with a subtle infusion of habanero), 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.”

To determine whether they need to register, Blass suggested private fund advisers ask themselves a series of questions including: How do we solicit and retain investors? Do employees who solicit investors have other responsibilities? How are personnel who solicit investors compensated? Do we charge a transaction fee in connection with a securities transaction?

Case In Point

Registration as a broker-dealer is “arduous and time consuming (approximately six to nine months),” said Weiner, “and, thereafter, the fund would be subject to, among other things, another inspection scheme.”

But there are no viable alternatives to registration for firms who fail to qualify for an exemption “other than to assume the risk of an enforcement action,” said Weiner.

One firm that found that our the hard way was New York-based private-equity firm Ranieri Partners.

In March of this year, Ranieri settled SEC accusations it had violated Section 15(a) of the Exchange Act—the rule exempting from registration certain non-U.S. resident persons engaged in business as a broker or dealer entirely outside the United States.

The SEC said that William Stephens, a consultant at Ranieri, went further than his role as a "finder" allowed. Instead of just introducing investors to the firm, Stephens continued to work with them after the introduction had been made, including on transactions and analysis, activities the SEC said should have not been undertaken by a person not registered as a broker. The settlement saw Stephens barred from the securities industry, his boss pay $75,000 and Ranieri pay $375,000 although none admitted nor denied wrongdoing.

Weiner noted another potential hazard: “The failure to register also raises the potential for a disgruntled investor of such a fund to later claim that the fund should have been registered at the time the investment was made and that, therefore, the investor should be entitled to rescission, or some other sort of relief.”

Weiner said he would also advise private fund advisors to examine whether Rule 3a4-1, i.e., the 'issuer exemption'—which many funds were, and are, relying on as a rationale for not registering—applies. 

To qualify, he said, “You have to meet one of these conditions: (a) the person limits the offering and selling of the issuer’s securities only to broker-dealers and other specified types of financial institutions; (b) 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; or (c) the person limits activities to delivering written communications by means that do not involve oral solicitation by the associated person of a potential purchaser.”

Blass, in his April speech, referenced the issuer exemption noting that it “could be difficult for private fund advisers to fall within these conditions.”


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