TECHNIC AL
Private Investment Funds and Unregistered Marketers Registration may be necessary for some following SEC shift LIAM O’BRIEN and C. MARK LASKAY, MCCORMICK & O’BRIEN LLP, with LAUREN PARRA and JOHN S. KEATING
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or many years the legal and regulatory environment applicable to the private investment fund industry (which includes
hedge funds, private equity funds and similar vehicles) enabled it to operate with little oversight relative to other investment products. Recently, however, on the heels of the 2010 Dodd Frank financial reform legislation and a more enforcement-oriented mindset on the part of regulators, the industry and some of its long- standing practices have come under greater scrutiny. This article discusses a particular area of increased focus – whether in-house and third-party marketers of private funds must register as broker- dealers and the implications of failing to register. In addition to the newly relevant, but longstanding broker-dealer registration requirements, this article addresses recent legislation which has lifted a ban on general solicitation in connection with certain private offerings of securities by private investment funds (and other issuers) and how it may impact the obligations of the fund managers and their marketers.
The spotlight shifts In a speech on 5 April 2013, David Blass, Chief Counsel of the Securities Exchange Commission’s (SEC) Division of Trading and Markets, cautioned the private investment fund industry that the SEC had its eye on a “significant area of concern”: in-house and third-party marketers that solicit investors for funds, without becoming registered broker-dealers. Blass identified a number of factors that such funds should consider when weighing their decision to register, including the primary activities of the employee and their compensation structure. A person engaged in the business of effecting transactions in securities for the account of others, especially transactions “at key points in the chain of distribution”, must generally register as a broker-dealer. Additionally, it is unlawful to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security without being so registered. A failure to register should be of great concern to fund managers because investors may seek rescission of transactions entered into with unregistered brokers and the SEC may seek a host of other remedies for violations. Once a fund is successfully sued for employing an unregistered broker, in addition to paying damages and other sanctions associated with the suit, the fund must also disclose this information in future offerings and sales. With the potential for serious repercussions for failure to comply with the broker-dealer registration requirements under Section 15 of the Securities Exchange Act of 1934 (the “Exchange Act” – codified at 15 USC Section 78a et seq.) cited above, fund advisers would be well advised to take this requirement seriously.
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Is your marketer actually a broker? Section 3(a)(4) of the Exchange Act broadly defines a “broker” as “any person engaged in the business of effecting transactions in securities for the account of others” and the SEC staff shares an equally liberal interpretation. A person may be found to be acting as a broker if that person participates in securities transactions “at key points in the chain of distribution.” Generally, a person engaged in the business of effecting transactions in securities for the account of others must register as a broker-dealer with the SEC, as a member of the Financial Industry Regulatory Commission (FINRA), and comply with any applicable requirements under state law. Although the Exchange Act does not explicitly define “engaged in the business”, subsequent court and SEC interpretations have developed the “engaged in the business” test.
Private funds typically market through one of three strategies: (1) in-house employees that are dedicated to the marketing process and may be compensated on a commission basis; (2) the fund and manager have informal arrangements with third-party finders and other sourcing agents (any of which may or may not be registered as broker- dealers) where the finders or agents are typically compensated through a share of the management and performance compensation received; and (3) the funds enter into formal placement arrangements with major investment firms. The first two strategies raise significant questions regarding broker-dealer registration and potential liability.
An in-house or third-party marketer may need to register if they are engaged in the following activities:
• Identifying potential purchasers of fund interests; • Marketing securities to investors; • Soliciting or negotiating securities transactions; • Providing advice as to the merits of a fund investment; or
• Handling customer funds and securities.
In his 2013 speech, Blass provides questions that advisers and managers should ask themselves in order to determine whether or not registration will be required. Chief among these questions is how the adviser solicits and retains investors. The duties and responsibilities of adviser personnel performing the soliciting and marketing is another determining factor. “[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.” Another consideration is whether or not the marketing personnel have other responsibilities. If their primary function is to solicit investors, registration is likely required.
Compensation is also a key factor in determining the registration requirement. When the individual’s compensation depends on the outcome or size of the transaction, rather than a flat fee, retainer or salary, these activities weigh even more heavily toward the need to register. According to Blass, as a bright-line rule, transaction-based compensation arrangements entered into by private fund managers require broker-dealer registration. If the personnel receive commissions, bonuses or other types of compensation linked to successful investments, then registration is required. Furthermore, registration may be required even when compensation is not based on specific transactions. “A person’s receipt of transaction- based compensation in connection with [marketing] activities is a hallmark of broker-dealer activity.”
Despite recent SEC action and the Blass speech, a US District Court rejected the SEC’s view that transaction-based compensation alone requires broker-dealer registration. In SEC v. Kramer, the court refused to follow Blass’s bright-line test, instead electing to impose another test that employed several non-determinative factors.
When that marketer is a broker-dealer According to §15(a)(1) of the Exchange Act (15 U.S.C. §78o(a)(1)), it is unlawful for a person to make use of the mail or any means of interstate commerce to effect any transaction in, or to induce or attempt to induce the purchase or sale of, any security unless that person is registered as a broker-dealer. Therefore, if a fund uses unregistered solicitors they may be in violation of the law and in turn create liability for the individual, the fund and the fund manager. In the SEC decision In the Matter of Ranieri Partners LLC and Donald W. Phillips, the Commission determined that an independent consultant had operated as an unregistered broker. The consultant’s solicitation efforts included: sending private placement memoranda, subscription documents, and due diligence materials to potential investors; urging at least one investor to consider adjusting its portfolio allocations to accommodate an investment with Ranieri Partners; and providing potential investors with his analysis of Ranieri Partners’ fund strategy and performance track record. As illustrated by the Ranieri decision and discussed further in the “Consequences of Violating the Registration Requirement” section below, an unregistered individual who identifies potential purchasers of fund interests, markets securities to investors, solicits or negotiates securities transactions, provides advice as to the merits of a fund investment, or handles customer funds and securities, will likely be found in violation of federal securities law. While that is certainly a problem for that individual, the greater concern for the fund
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