Unregistered Broker-Dealers and Private Equity Firms
On June 1, 2016, the Securities and Exchange Commission (the “SEC”) announced a settlement with Blackstreet Capital Management, LLC (“BCM”), a Maryland-based private equity firm, and its principal, Murry Gunty, that could negatively impact the ability of private equity funds to charge transaction fees in the future. Private equity funds have long charged fees at the closing of portfolio company transactions for their work in facilitating those transactions. These fees have become an important aspect of private equity fund compensation.
The settlement indicates that the SEC may now be taking the position that in certain circumstances transaction fees may not be charged by private equity funds unless they are registered broker-dealers. Private equity funds have historically taken the position that their work in facilitating portfolio company transactions does not involve the activities that would require a broker-dealer registration. The historical lack of enforcement actions by the SEC against private equity funds for failing to be registered has lead the private equity industry to believe that the SEC (at least tacitly) agreed with them that transaction fees could be charged without a broker-dealer registration.
The recent settlement with BCM, however, calls this conclusion into question. It now appears that the SEC believes, at least in some circumstances, that private equity funds must be registered broker-dealers or collection of a transaction fee will be unlawful. If this settlement is indicative of a desire by the SEC to bring actions against private equity funds for failing to be registered, a substantial source of private equity fund revenue may be in jeopardy.
While all of the facts in the BCM matter cannot be gleaned from the settlement, the SEC alleged that in exchange for some $1.8 million in transaction fees over a period of seven years, BCM engaged in brokerage activities which required registration. The activities the SEC alleged required a broker-dealer registration included “soliciting deals, identifying buyers or sellers, negotiating and structuring transactions, arranging financing, and executing the transactions.” These activities are commonly undertaken by private equity funds executing portfolio company transactions.
The Securities Exchange Act of 1934 (the “Exchange Act”) makes it unlawful for a “broker” to “effect any transactions in . . . any security . . . unless such broker or dealer is registered.” A “broker” is defined as “any person engaged in the business of effecting transactions in securities for the account of others.” Thus, a fund should only be required to register as a broker-dealer if it is “engaged in the business of effecting transaction” in securities for third parties.
Unfortunately, the Exchange Act does not define what constitutes being “engaged in the business of effecting transactions”. The only guidance we have comes from SEC pronouncements and enforcement actions, and the rulings of the federal courts who have evaluated the question.
In April 2013, David Blass, Chief Counsel of the SEC’s Division of Trading and Markets, spoke to a subcommittee of the American Bar Association on the issue of broker-dealer registration. He stated that a fund with a department of employees who sell interests in private funds could indicate that the adviser is “in the business” of effecting transactions in the private fund. Also, if an employee’s primary function is to solicit investors and/or the employee receives transaction-based compensation, then the employee also may be acting as a broker. Rule 3a4-1 under the Exchange Act describes the circumstances under which an issuer’s employees may effect transactions in the issuer’s securities without registration as brokers.
In February 2014, the SEC issued a no-action letter stating that it would not seek enforcement against “M&A Brokers” (defined, for purposes of the letter, as persons engaged in the business of effecting securities transactions solely in connection with the sale of privately-held businesses as a whole) whose practices meet the conditions set out in the letter.
The SEC also published a “Guide to Broker-Dealer Registration” on its website in which the SEC provides a list of individuals and/or entities that may need to register as a broker. This list includes “finders”, “business brokers”, and other individuals or entities that engage in finding buyers and sellers of businesses (i.e., activities relating to mergers and acquisitions where securities are involved). Below is a non-exhaustive list of the factors most frequently used by the federal courts to determine whether an individual or entity acted as a broker:
- whether the individual (or entity) worked as an employee of the issuer;
- whether the individual (or entity) received a commission rather than a salary;
- whether the individual (or entity) sells or earlier sold the securities of another issuer;
- whether the individual (or entity) participated in negotiations between the issuer and investor;
- whether the individual (or entity) provided either advice or a valuation as to the merit of an investment;
- whether the individual (or entity) actively (rather than passively) found investors;
- whether the individual (or entity) received transaction-based compensation; and
- The regularity of participation in securities transactions at key points in the chain of distribution.
Ultimately, the SEC relies on some combination of the above factors and also looks at the actual conduct of the individual or entity involved to make its determination.
The BCM settlement has only made private equity broker-dealer registration requirements more confusing. SEC Commissioner Michael Piwowar met with private equity CFOs and CCOs this week to discuss this murky issue. Hopefully, these meetings inspire the SEC to issue more concrete guidance.
 In the Matter of Blackstreet Capital Management, LLC and Murry N. Gunty, File No. 3-17267.
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