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Update on Broker-Dealer Issues for Alternative Advisers

On April 2013, the Chief Counsel of the SEC’s Division of Trading and Markets, David Blass, caused a stir with a speech questioning when broker-dealer requirements apply to private fund advisers. The speech primarily focused on two activities. First, internal marketing personnel involved in selling fund interests, and second, fees received by an adviser or its affiliates from a portfolio company during the acquisition, recapitalization, and disposition of the company. Now the SEC staff is busy providing further clarification on these topics—or at least the process the SEC is undertaking to consider the topic further.

At a PLI program at the end of 2013, Blass himself provided additional color, noting that his comments did not signify a new interpretation. He explained that one goal of his speech was simply to raise awareness of the existing broker-dealer requirements and how they might apply in the private fund space. These issues were coming up as a result of the examination of new PE registrants following Dodd-Frank. The agency thought it appropriate to put the entire industry on notice, as opposed to taking a firm-by-firm approach.

Another impetus for the April speech was the agency’s desire to get the ball rolling on a review of the broker-dealer regime as a whole. Specifically, the SEC is focusing on the triggers for registration. By opening a dialogue with the industry the staff is trying to tease out the issues that might be helpful for the Commission to address. Among these issues is the appropriate treatment of staff who have “mixed responsibilities” (i.e., one function is sales but the employee also has many other functions”) and the interplay with transaction-based compensation. Questions fielded by Blass’ team include: whether investor relations should be considered “other functions” or “sales”? What are the implications if sales responsibilities increase during fundraising periods? Can sales performance be at all considered in compensating the employee? Although Blass did not provide answers to these questions, he did say that the SEC is looking to apply a “rule of reason” approach in this area.

In the April speech, Blass sought comments as to whether a private fund broker-dealer exemption would be useful. In his update, he expressed doubt about the agency modifying the broker-dealer regime through rulemaking due to lack of bandwidth given more pressing priorities. However, he was hopeful that the agency would be able to offer at least some guidance in the future.

He said he expects guidance on the registration requirements for employees selling fund interests to come out before guidance on the portfolio company transaction fees, noting the latter is more complicated. Specifically, he characterized the private equity activities that cause concern as similar to those that so-called “business brokers / M&A brokers” face with respect to broker-dealer registration. As a result, the agency will need to harmonize its approach to both, which requires a complete understanding of the issues and comprehensive analysis of the effects of any guidance. Notably, in February 2014, the SEC issued a no-action letter that relieves "M&A brokers" from the need to register with the SEC as a broker-dealer if a series of conditions are met.

As part of this fact-finding process, many private equity advisers that receive transactions fees have been asked by examiners to prepare a memo explaining why they are not (or should not be) subject to broker-dealer requirements. This feedback will likely shape the SEC’s guidance. Blass has explained that multiple groups within the agency are working together to address these issues. The Division of Trading and Markets has an open dialogue with examiners and enforcement staff to give them a fair read on the law, and examiners have been relaying facts back about what they are seeing on the ground.

One issue that Blass said the agency is struggling with is how to deal with situations where an activity meets a hallmark of being a broker-dealer, but where the agency does not necessarily feel the need to act. For example, Blass pointed out that even though some fees advisers receive from portfolio companies are transaction-based compensation, the SEC recognizes that these fees are a significant part of the economics of the private equity business model and that sophisticated investors have agreed to the terms. Therefore, the SEC may not need to step into the negotiations. This is but one of many considerations on the private equity front, and Blass said that no timeline for a resolution has been set.

On a positive note, when the agency does act, Blass expects it to issues general guidance that more people can rely on rather than fact specific no-action letters with limited applicability.

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