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David W. Blass, Chief Counsel, Division of Trading and Markets, SEC, recently gave a speech before the American Bar Association Trading and Markets Subcommittee on April 5, 2013. The topic of the speech was whether and when investment advisers to private funds are required to register with the SEC as broker-dealers. 

As a result of Title IV of the Dodd-Frank Act, most advisers to private funds (hedge funds and private equity funds) are required to register with the SEC, whereas these funds had previously taken advantage of a registration exemption known as the “private adviser exemption,” which was eliminated by the Dodd-Frank Act and replaced with several narrower exemptions.  So more private fund advisers are now subject to SEC regulation, and the SEC will be stepping up its private fund adviser examinations due to the new regulatory requirements and the SEC’s own observations about the conduct of private fund advisers.  The purpose of the speech by Mr. Blass was to provide private fund advisers with the tools necessary to examine their own conduct (which will be under new scrutiny from the SEC due to the investment adviser regulation) vis-à-vis broker-dealer activity (which they may have previously overlooked) so that the private fund advisers can be prepared for broker-dealer registration or can alter their practices so as to avoid registration.

As a reminder, the general rule is that any person engaged in the business of effecting transactions in securities for the account of others must register as a broker-dealer.  The determination of whether a person is “engaged in the business . . .” is based on a case-by-case analysis of the facts, but one factor in particular – the receipt by the person of transaction-based compensation (a “salesman’s stake”) – has been said to be a “hallmark” of broker-dealer status.

Mr. Blass provides a road-map for private fund advisers to begin a self-analysis to determine whether they might be approaching broker-dealer status.  He advises that private fund advisers should examine their practices with the following points in mind:

  • With regard to soliciting and retaining investors, a dedicated sales force of employees carrying out a marketing function “may strongly indicate that they are in the business of effecting transactions in the private fund.”
  • If employees who solicit investors have no other duties, or if they spend the great majority of their time carrying out the investor solicitation function, then the adviser might be a broker-dealer.
  • Compensating employees who solicit investors in any way (bonuses, etc.) that is linked to successful investments may indicate broker-dealer status.
  • If a private equity fund executing a leveraged buyout strategy collects fees other than advisory fees that are linked to an acquisition or disposition – for example, if the manager directs a portfolio company to pay fees to the adviser or its affiliates, even if the payment is nominally for investment banking activity such as negotiating the transaction, soliciting purchasers, etc. – then the transaction-based compensation threshold may be triggered.  “The combination of success fees which cause the adviser to take on a salesman’s stake and the activities involved in effecting securities transactions appear, at least on their face, to cause such an adviser to fall within the meaning of the term ‘broker.’”

Mr. Blass also addressed three strands of push-back the SEC has received from private fund advisers seeking to avoid broker-dealer registration:

  • The advisers are not engaging in broker-dealer activity when the transaction-based payments offset or reduce the amount of the advisory fee.  Mr. Blass agrees, conceptually, that in this instance the transaction-based compensation is merely another way of paying the advisory fee.
  • Where the general partner of the fund is also the adviser to the fund or an affiliate of the adviser to the fund, then the general partner should be viewed as the same person as the fund such that the adviser is not engaging in securities transactions “for the account of others.”  This rationale is not plausible to Mr. Blass, who notes that if the general partner and the fund are the same person, then there is no need to pay the fee to any person other than the fund.
  • The SEC should not spend it’s time taking on registration of private fund advisers as broker-dealers without an underlying policy objective.  Mr. Blass sees the situation as dependent on the activities of the private fund advisers, though, rather than the SEC.  If private fund advisers are not prepared to register as broker-dealers, then they should avoid engaging in broker-dealer activity.

Mr. Blass concluded by noting that, in his view, it would not be difficult for private fund advisers to alter their practices in order to ensure that they do not fall within the broker-dealer definition.

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