Fundraising for Mid-Sized PE Funds: Should You Use a Registered B/D?

Dec 6 2016 | 8:18pm ET

Editor's note: When does a fund sponsor need to use a registered broker/dealer when raising capital? At first blush, the rules governing registration requirements and the exemptions available to private funds seem clear, and the use of a placement agent can often solve any potential issues. However, as discussed by Cole Schotz partner Chris Kula, securities laws have not entirely adapted to the realities and developments in the private fund space. When added to a renewed focus on private fund compliance by regulators, the question of whether to raise capital through a registered B/D remains highly relevant for any alternative investment manager looking to grow assets. 

Fundraising for Mid-Sized Private Equity Funds – Should You Use a Registered Broker-Dealer?
By Chris Kula, Partner, Cole Schotz P.C.

For private funds in fundraising mode, particularly first-time funds, getting to a successful closing is paramount.  Marketing the fund to the right investors and obtaining commitments can be difficult even if economic conditions are ripe.  The fund sponsor and its principals may have good connections, but is that enough? Often not. Can fund sponsors even go out and market the fund’s interests without registering as a broker-dealer?  It depends. At first blush, using a placement agent should solve the problem, but it’s often not that simple and those that are actually registered broker-dealers can be expensive, not to mention that a degree of control over the sales process is lost.  

This highlights the friction regarding how to go about successfully raising capital from investors while complying with securities laws that have not quite adapted to the realities of the private fund space, particularly for smaller and mid-sized funds.  To add to this dynamic, the SEC is aggressively focusing on compliance issues with private funds, including the use of unregistered broker-dealers and finders, and has recently brought several high profile enforcement actions on that topic.  

In this article, we will explore what activities trigger the need to register as a broker-dealer, why it is important for a private fund to use a registered broker-dealer in connection with such activities, what are the main alternative approaches, and how the industry would benefit from adapting the current regulatory scheme to address the issue going forward.      

What is a Broker-Dealer?

Section 3(a)(4) of the Securities Exchange Act of 1934 (the “Exchange Act”) defines a “broker” generally as “ any person engaged in the business of effecting transactions in securities for the account of others.”  This is a broad definition that sweeps in many market participants and activities.  One of the most common hallmarks of being a “broker” is the receipt of compensation that depends on the outcome or size of the securities transaction – or transaction-based compensation – as this is indicative of a “salesman’s stake” in a securities transaction.  Marketing fund interests and soliciting investors, negotiating or executing securities transactions, and handling customer funds and securities are also strong indicators of being a broker under the securities laws.  

Those falling within the definition of broker under the Exchange Act are required to register with the SEC as a broker-dealer, absent an available exemption.  Broker-dealer regulation at the state level also needs to be considered.  The breadth of the “broker” definition, the lack of a de minimus test, and the dearth of exemptions - such as the so-called “finders” exemption outlined in the Paul Anka no-action letter which has been narrowed to the point of practically being irrelevant - make it difficult for most placement agents or intermediaries that receive transaction-based compensation to avoid the obligation to be registered as a broker-dealer.  See Paul Anka, SEC No-Action Letter (July 24, 1991).  See also John W. Loofbourrow Associates, Inc. SEC No-Action Letter (June 29, 2006).  

As such, the first thing a fund sponsor should check when looking to retain a placement agent is to make sure it is a registered broker-dealer (or associated with a registered broker-dealer).  This information is publicly available and can be readily checked on the FINRA’s BrokerCheck website.   

Issuer’s Exemption

The so-called “issuer’s exemption” under Rule 3a4-1 promulgated under the Exchange Act provides “associated persons of an issuer” with relief from being deemed a broker (and having to register with the SEC in such connection), provided certain conditions are met.  However, the ability of private funds to rely on the issuer’s exemption is dubious.  One of the main requirements is that such associated person does not receive transaction-based compensation in connection with its participation directly or indirectly in securities transactions – a recurrent theme here.  In the private fund context, it is difficult to be sure that an employee’s bonus for example is not related to or derived in connection with securities sales.  In addition, the associated person must meet one of the following conditions: (1) its participation is restricted to transactions between the issuer and registered broker-dealers or certain other regulated entities; (2) it primarily performs substantial duties for the issuer other than in connection with transactions in securities, was not a broker-dealer (and was not associated with a broker-dealer) within the preceding 12 months, and does not participate in selling an offering of securities for the issuer more than once every 12 months; or (3) its participation is restricted to ministerial matters (essentially preparing or delivering PPMs and responding to inquiries within the context of the PPM).  So even if there is no transaction based compensation, it is often difficult for fund personnel to satisfy the other conditions to the rule since fundraising often involves fund personnel that are part of a dedicated salesforce (e.g., marketing or investor relations departments) and is undertaken on an ongoing basis rather than once every 12 months.  

As a result, the issuer’s exemption often does not exempt the activities of fund personnel in connection with fundraising from the broker-dealer registration requirements.  Given the inability to rely on the issuer exemption in many cases, it is even more important that the fund retain a broker-dealer to reduce exposure from its broker-related activities.

Risks of Broker-Dealer Violations

So what’s the risk if the fund sponsor does not use a registered broker-dealer to raise capital for the fund?  For starters, hiring an unregistered broker-dealer to effect a securities transaction is a violation of federal and many state laws, particularly in view of Section 29(b) of the Exchange Act.  This can impact funds in many different ways ranging from catastrophic to being a nuisance and include (i) SEC enforcement actions that involve steep civil and criminal penalties, industry stigma, and being tagged with “bad boy” status (and the resulting loss of the ability to use of Regulation D as a private placement exemption); (ii) rescission rights requiring the fund to pay back investors their invested capital plus interest (sometimes with a penalty), causing a financial hit to the fund and the disruption of the fund’s operations; and (iii) negative disclosures in PPMs and offering documents in connection with the use of an unregistered broker-dealer that can impact the success of future financings for years (keeping in mind that omitting to disclose such items opens the fund up to liability under Rule 10b-5 promulgated under the Exchange Act), among other things.  Form D and other “blue sky” filings in connection with many private placements require disclosure of sales compensation paid to placement agents in such offering – making it harder to avoid the unregistered broker-dealer issue.  The upshot of this is that failing to utilize a registered broker-dealer poses many risks to the fund’s business and, while it is often hard to quantify the risks at the outset, they simply cannot be ignored.    

This is exacerbated by the SEC’s recent scrutiny on private funds and its tougher stance on the unregistered broker-dealer activities by private funds, as evident the positions taken by the SEC in recent enforcement actions.  In March 2013, the SEC changed New York-based private equity firm Ranieri Partners, a fund executive, and an unregistered broker with violating securities laws in connection with soliciting fund investments.  Ranieri Partners hired an unregistered broker as a consultant and paid him fees to solicit investors.  The consultant was supervised by a senior executive at the fund who aided and abetted the securities violations by providing key fund documents and information and ignoring red flags that the consultant went well beyond the limited role of a finder and was actively soliciting investments.  In settling the charges, Ranieri Partners and the senior executive were subjected to penalties of $450,000 in total for the violations.  See In the Matter of Ranieri Partners LLC and Donald W. Phillips, SEC Release No. 34-69091, Administrative Proceeding File No. 3-15234 (March 8, 2013).    

More recently, the SEC charged Blackstreet Capital Management with performing in-house brokerage services, rather than using investment banks or broker-dealers in connection with the sale and disposition of portfolio companies.  Although the focus in Blackstreet was on the fund’s brokerage activities with respect to its portfolio companies, rather than fundraising, the fundamental broker-dealer registration issues facing private funds remain the same.  Notwithstanding that Blackstreet fully disclosed it would provide brokerage services in exchange for a fee, the SEC focused on the firm’s failure to comply with the broker-dealer registration requirements – indicating that Blackstreet clearly acted as a broker without fulfilling its registration requirements.  In settling the charges, Blackstreet Capital agreed to pay over $3.1 million.  See Blackstreet Capital Management, LLC and Murray N. Gunty, SEC Release No. 34-77959 (June 1, 2016).  This was a major step backwards from the M&A Brokers No-Action Letter (February 4, 2014), which effectively broadened the exemption for brokerage activities in connection with the sale of businesses.

Broker-Dealer Registration and Alternative Approaches

Dealing with how to address broker-dealer registration can be a vexing problem for many funds.  Registering the fund or its affiliate as a “captive” broker-dealer is a time consuming and extremely costly process involving an up-front cash outlay that is prohibitive for many smaller funds, notwithstanding that having the ability to control the sales process and retain commissions or brokerage fees inherent in this approach could be attractive for larger funds.  

Similarly, hiring a third-party registered broker-dealer, while saving the fund the major undertaking involved in registering, can also be costly and a degree of control over the sales process and investor selection is often sacrificed.

Alternatively, having fund personnel become licensed with a third-party registered broker-dealer that “carries” their registration – essentially taking responsibility for supervising their brokerage related activities - involves the broker taking a sizeable cut of their commission and such approach has not yet withstood SEC scrutiny.  Although such broker-dealer would likely be responsible for any failure to properly supervise fund personnel, one cannot rule out potential exposure to the fund in connection with such arrangement.  

Relying on SEC no-action letter relief and the significantly narrowed “finders” exemption presents an avenue to compliance.  However, the utility in taking this approach is debatable, given the finders role is limited to introducing investors and the fund likely cannot rely on the issuer’s exemption in connection with the more active role fund personnel would be required to take on as a result. 

While the SEC’s allowance of general solicitation in connection with private placements under Rule 506(c) promulgated under the Securities Act of 1933, as amended, was a step in the right direction and should prove helpful in terms of leading to the introduction of a wider array of qualified investors to funds, in many cases it will not dispense with the need for brokers that can more actively garner interest in the fund’s offering, nor help a fund or its personnel address the fundamental broker-dealer issues they may face in terms of their own fundraising activities.  The same can be said about the use of on-line investment platforms like the ones evidently used by DarcMatter, Sliced Investing and those permitted in the AngelList SEC No-Action Letter (March 28, 2013) and FundersClub SEC No-Action Letter (March 26, 2013) which avoided broker-dealer registration by choosing to be subject to investment advisor regulation and to receive carried interest instead of transaction-based compensation.

The lack of real alternatives to registration highlight the need to have a “light” version of broker-dealer registration that is less burdensome and more tailored to the private fund space (and the private capital markets in general).  David Blass touched on this in his speech to the ABA Trading and Markets Subcommittee in April 2013 titled “a Few Observations in the Private Fund Space” when he indicated a willingness to discuss an exemption for private funds predicated upon the issuer’s exemption.  More recently, FINRA issued a concept release regarding “broker-dealer lite” registration but this attempt does not appear to provide much relief from the registration process for “regular” broker-dealers.  The discussion of the need for a simplified version of broker-dealer registration in the private placement context has been in focus since the American Bar Association’s Report and Recommendations of the Task Force on Private Placement Broker-Dealers dated June 20, 2005.  Yet despite this, nothing “workable” has been put into effect.  


Private funds should not ignore the risks involved in failing to utilize a registered broker-dealer in connection with the placement of fund interests.  Subject to the limited ability to rely on the alternative approaches mentioned above, the answer to the question of whether a fund sponsor should use a registered broker-dealer to market and sell fund interests is a resounding yes.  

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