Broker-Dealer Registration for Private Funds
The SEC has recently put private fund managers on notice that they may, in fact, be engaging in broker-dealer activities and may be required to also register as a broker-dealer and subject to FINRA oversight.
This white paper highlights the fact that many Private Funds and their advisers engage in activities that are considered broker-dealer activities. The SEC has put them on notice that they probably do not qualify for any exemption and should either change practices or register as a broker-dealer.
Read this article to learn about:
- The transaction-based compensation arrangements that may require
- The criteria needed to meet the requirements of an exemption from
- The consequences of a private fund continuing unregistered broker-dealer activities
- How to best evaluate your need for broker-dealer registration and the safest course of action
In 2011, the SEC adopted Dodd-Frank driven regulations which required advisers to hedge funds and other private funds to register as investment advisers. The private fund industry was faced with major challenges as it adapted to doing business in a regulated environment. Private fund managers, though not thrilled with the new requirement, completed their registrations, implemented compliance programs, and suddenly found themselves subjected to SEC “presence exams,” for the first time. Many private fund managers feel they’ve weathered the storm of regulation and can breathe a sigh of relief, but another wave of oversight may be headed their way. The SEC has recently put private fund managers on notice that they may, in fact, be engaging in broker-dealer activities and may be required to also register as a broker-dealer and subject to FINRA oversight.
Transaction-Based Compensation and Dedicated Sales Teams
For years, private fund managers have entered into arrangements whereby certain internal persons are compensated, in whole or in part, based on their successful efforts in marketing the interests of the private fund. While securities transaction-based compensation has long been the standard for evaluating whether broker-dealer registration is necessary, the SEC has been lax in enforcing these requirements on private fund advisers. As emphasized in an April, 2013 speech delivered by David Blass, Chief Counsel of the SEC’s Division of Trading & Markets, however, this may be set to change. Blass signaled that certain common, transaction-based compensation arrangements entered into by private fund managers will require broker-dealer registration. In fact, depending on the circumstances, broker-dealer registration may be required even under certain circumstances where compensation is not based on specific securities transactions.
Private fund managers should review their marketing and compensation practices, asking questions such as: How are investors solicited and retained? What are the duties and responsibilities of personnel performing solicitation and/or marketing efforts? A dedicated sales force of internal employees working in a “marketing” department may strongly indicate that the manager is in the business of effecting transactions in the private fund, regardless of how the personnel are compensated. It is important to understand that regardless of whether or not an employee’s activities are “dedicated” to solicitation and/or marketing, if the individual’s primary responsibility is to solicit investors, the employee may be engaged in a broker-dealer activity regardless of whether other duties are also performed. Personnel receiving bonuses or other types of compensation based on successful investments, would typically be deemed to be receiving transaction-based compensation.
In addition to considering employee compensation, firms must review any other transaction-based revenues received by the firm or its affiliates. These considerations are more likely to apply to the investment banking-type fees that private equity fund advisers or their affiliates often charge to the portfolio companies invested in by the private equity fund. However, these issues may also be relevant to the advisers of funds engaged in direct lending or other types of funds that generate income outside of the increase or decrease of securities’ prices. For firms engaged in these activities, one way to avoid a broker-dealer registration requirement would be to wholly reduce or offset such investment banking or transaction-based fees against management fees that would normally be due to the private fund manager.
Seeking to avoid the registration requirement will be difficult for some private fund managers as the guidance issued by the SEC thus far often raises more questions than it answers when applied to real life situations. For example, if a private equity fund adviser is seeking to launch a new fund, it may have certain staff engaged nearly fulltime in marketing activities, whereas, during the investment phase of the fund, staff is not engaged in marketing activities at all. Or, again, if a hedge fund manager bases year-end staff bonuses in part on marketing efforts, what percentage of the bonus could be based on such marketing efforts before the scales are tipped and broker-dealer registration is required? What if the bonus is based on marketing efforts, but not necessarily a percentage of investments made as a result of such efforts? In anticipation of regulatory response to this emerging issue, these, and many more questions, must be carefully considered by the private fund adviser.
The Private Fund Adviser Landscape
The Dodd-Frank Act’s elimination of private fund registration exemption resulted in an explosion of newly registered advisers, with in the addition of more than 1,500 new investment advisory firms being registered in 2012 alone.1
In 2012, 3,856 advisers (36.7%) reported advising 26,202 private funds, approximately 26.7% of which are funds of funds. Hedge funds and private equity funds represent the largest portions of this group, comprising nearly 75% of all reported private funds, with hedge funds making up 40.8% and private equity funds making up approximately 33.1%. The total gross asset value of reported private funds is approximately $8.1 trillion, more than 16.4% of all reported RAUM, with an average gross asset value of $308.9 million. The median gross asset value, on the other hand, is approximately $47.7 million.
In 2012, the number of registered advisers reporting that more than 75% of their clients are hedge funds and other pooled investment vehicles increased by 87.8%, from 1,200 advisers in 2011 to 2,254 advisers in 2012. Of those advisers, 1,863 reported that 100% of their clients are hedge funds and other pooled investment vehicles. Even more advisers (2,333) reported that the assets of hedge funds and other pooled investment vehicles comprised more than 75% of their total RAUM.
1 All data from Evolution Revolution 2012—A Profile of the Investment Adviser Profession. © 2012 Investment Adviser Association and National Regulatory Services.
Blass warned that many private fund advisers may be erroneously relying on an exemption available to certain issuers. The “issuer exemption,” a safe harbor found at Rule 3a-4-1 under the Exchange Act, is an exemption from broker-dealer registration afforded to the associated persons of certain businesses that issue a security. However, among other things, the issuer exemption is not available to firms, including private fund advisers or their affiliates, whose personnel are compensated in connection with their participation in the securities transaction through the payment of commissions or other remuneration based either directly or indirectly on transactions in securities
Even with respect to associated persons that do not receive transaction-based compensation, in order to be covered by the issuer exemption, private fund managers must satisfy one of three conditions:
- Personnel must limit their participation to transactions involving the offering and selling of the issuer’s securities only to broker-dealers and other specified types of financial institutions;
- Personnel must perform substantial duties for the issuer other than those in connection with transactions in securities, must not have been a broker-dealer or an associated person of a broker-dealer within the preceding 12 months, and must not participate in selling an offering of securities for any issuer more than once every 12 months; or
- Personnel must limit their activities to delivering written communication by means that do not involve oral solicitation by the associated person of a potential purchaser.
If a private fund manager or its associated personnel receive transaction-based compensation or if they receive transaction-based compensation but fail to meet any one of the above listed criteria, then registering as a broker-dealer and/or broker-dealer representative and becoming a member of an SRO, like FINRA, may be inevitable unless the firm changes its marketing practices.
Blass cautioned that unregistered broker-dealer activities should not be viewed as simply technical violations, but as actions that may bring SEC sanctions. In addition, “securities transactions intermediated by an inappropriately unregistered broker-dealer could potentially be rendered void.” If such transactions were rendered void, investors would then be entitled to demand rescission of their investment in the fund and the unwinding of their investment to the detriment of the fund, its investors and, of course, the fund adviser.
Among other things, under certain circumstances, courts and/or regulators imposing remedies may also require the disgorgement of any fees and incentive compensation paid to the adviser that is attributable to or was paid from the capital account of any investor referred under an arrangement violating a requirement that the adviser register as a broker-dealer. Obviously, the regulatory, legal, financial and/or reputational consequences could permanently shutter the firm.
Private fund managers should immediately evaluate their needAC for registration as a broker-dealer. Qualified legal counsel or consulting firms, such as NRS, can provide assistance with the analysis and suggest alternative business practices to potentially avoid registration liability.
If a determination is made that registration is the safest course of action, private funds should understand that starting-up a new broker-dealer with an effective compliance infrastructure from day one is an arduous task - much more so than registering with the SEC as an Investment Adviser. FINRA membership does not come easily, and can take six to nine months (or longer).
Once approved for membership, the regulatory regime is arguably more rigid and oversight more frequent. A more thorough and active compliance program will be necessary to remain in good stead with examiners who will visit within 6 months of initial membership approval and thereafter at least once every three years.
An experienced and expert partner like NRS can make the process smoother and less complex. Because completing the membership application and related documentation requires in-depth knowledge and many hours, only a handful of law firms or compliance companies even offer this service, and even fewer for as long as NRS. It is strongly recommended that newly registered broker-dealers participate in a compliance support program for at least their first year as a FINRA member. In this way, NRS can assist as a compliance partner for the long haul.
Private fund managers have been asked to overcome wave after wave of new regulatory oversight and their survival requires focus and expertise. As the recognized experts in the industry, NRS has helped hundreds of private funds tackle their registration challenges to successfully register with state and Federal regulators. An experienced partner like NRS can help navigate through this new storm.