SEC Enforcement Heightens Concern over Broker-Dealer Registration for Private Equity Firms

About the Authors:

Michael C. Keats is a partner in the Litigation and Capital Markets/Securities Practice Groups of Stroock & Stroock & Lavan LLP. Lior J. Ohayon is a partner in Stroock’s Private Funds Practice Group. Michael Benz is an associate in Stroock’s Corporate Practice Group. Joel T. Dodge is an associate in Stroock’s Litigation Practice Group.

The Securities and Exchange Commission (SEC) recently announced it had settled charges for alleged unregistered brokerage activity and other alleged securities law violations with private equity fund advisory firm Blackstreet Capital Management (BCM). The enforcement action, in which a general partner was found to have improperly acted as an unregistered broker-dealer after earning a success fee on portfolio transactions that BCM brokered in-house, signals the SEC’s increasing scrutiny of sponsors and managers engaging in similar activities.

Background on Broker-Dealer Registration in Private Equity Transactions

Private equity firms often assume that success fees charged on portfolio company transactions are safe from the broker-dealer registration obligations of Section 15 of the Securities Exchange Act of 1934, which require any person engaged in the business of effecting securities transactions for the account of others to register with the SEC and join a self-regulatory organization.

Sponsor confidence in this assumption was first called into question when, on April 5, 2013, David Blass, then chief counsel in the SEC’s Division of Trading and Markets, raised the specter of registration in a speech before the American Bar Association. Mr. Blass, speaking only for himself and not on behalf of the SEC, told the assembled audience that broker-dealer registration requirements broadly extended to whenever “the private fund adviser, its personnel, or its affiliates receive transaction-based compensation for purported investment banking or other broker activities relating to one or more of the fund’s portfolio companies.”

To Mr. Blass, it was “crystal clear” that “at least for potential broker-dealer status questions, the fund and the general partner are distinct entities with distinct interests,” and that a mere “salesman’s stake” in any sale of a security by an entity other than its issuer was sufficient to require registration. In a subsequent informal exchange on September 26, 2013, Mr. Blass further stated that the SEC, except in the foreign broker-dealer context, had never used “sophistication of the purchaser” as a factor in determining if an entity’s activity would require it to register as a broker-dealer. (The structure of private equity transactions, in which sophisticated investors are plainly aware of the close relationship of a fund to its sponsor or manager, was sometimes perceived to obviate the regulatory concern that underlies the broker-dealer registration requirement—that unsophisticated investors would be unaware of the potential conflicts of interest between the issuer of a security and the entity effecting the sale of that security.)

Uncertainty ensued, which eased somewhat when the SEC issued a no-action letter on January 31, 2014, (the M&A Broker No-Action Letter) that allowed brokers to engage without registration in certain activities related to the purchase or sale of privately held companies, including the receipt of transaction-based compensation, considered the “hallmark” of broker-dealer activity by the SEC. The letter itself, however, conditioned the exemption on a lengthy list of factors and was ineffectual unless also adopted by applicable state law regulators. In many ways, the relief experienced by the private equity community from the M&A Broker No-Action Letter arose not so much from actual guidance but from the appearance that the SEC had pulled away from the narrower, more aggressive enforcement posture articulated by Mr. Blass the preceding year.

SEC Enforcement Action against Blackstreet Capital Management

After a couple of years of relative stalemate, this interpretative tug of war resumed anew in mid-June with a sudden and forceful pull from the SEC, as it formally settled an enforcement action against BCM. In the Matter of Blackstreet Capital Management, LLC, et al., No. 3-17267 (June 1, 2016), available at https://www.sec.gov/litigation/admin/2016/34-77959.pdf.

BCM is a Maryland-based private equity fund advisory firm owned by Murry N. Gunty. BCM, a registered private equity fund adviser that was neither registered as, nor affiliated with, a broker-dealer, provided investment advisory services to two private equity funds that invested in undervalued portfolio companies, for which BCM received a management fee. (According to SEC order, BCM neither admitted nor denied the SEC’s findings as determined in the settlement.)

According to the SEC, BCM provided brokerage services to, and received deal fees from, portfolio companies of the funds in connection with buying and selling portfolio companies or their assets (some of which involved the purchase or sale of securities). (The SEC noted that, as part of BCM’s investment strategy for acquisition transactions, BCM would first form an acquisition vehicle, which BCM referred to as a portfolio company, and then the acquisition vehicle would purchase a controlling interest in the actual operating company.) Rather than engaging investment banks or broker-dealers to provide those brokerage services, BCM allegedly performed them in-house, including soliciting deals, identifying buyers or sellers, negotiating and structuring transactions, arranging financing, and executing the transactions. The SEC alleged that BCM received at least $1,877,000 in transaction-based compensation for providing these brokerage services.

Though the SEC order concluded only that BCM violated Section 15 of the Exchange Act by acting as an unregistered broker-dealer in this regard, the SEC’s press release opined further that “[t]he rules are clear: before a firm provides brokerage services and receives compensation in return, it must be properly registered within the regulatory framework that protects investors and informs our markets… Blackstreet clearly acted as a broker without fulfilling its registration obligations.”

The SEC order concluded by requiring BCM to pay more than $3 million in total fines, including disgorgement and interest penalties. The SEC also determined that BCM committed, among others, the following alleged securities law violations: (1) BCM charged its portfolio companies certain operating oversight fees that were not expressly authorized by the fund’s governing documents, which fees were not disclosed to the fund’s limited partners until after BCM received them; and (2) BCM used fund assets to make political and charitable contributions and to pay for entertainment expenses, neither of which purposes were expressly authorized by the funds’ governing documents. BCM allegedly further failed to adequately keep records of whether entertainment expenses were for business or personal use.

Implications

This recent SEC action suggests that sponsor concerns over Mr. Blass’s speech in 2013 were well founded. One immediate implication is that a sponsor or manager who performs in-house brokerage services for its portfolio companies may not receive transaction-based compensation unless it is registered as, or affiliated with, a broker-dealer.

Another implication appears to be that protections afforded by the M&A Broker No-Action Letter are indeed limited. Additional SEC guidance will be required, however, to determine how robust such inferences will ultimately prove. For example, to qualify for the M&A broker exemption under the M&A Broker No-Action Letter, the broker may not do, among other actions, any of the following:

  1. Have the power to bind any party to the transaction.
  2. Directly, or indirectly through affiliates, provide financing for the transaction.
  3. Handle funds or securities issued or exchanged in the transaction.
  4. Arrange a group of buyers (unless the group was formed without the broker’s effort).
  5. Facilitate a purchase or sale for less than 25 percent of voting securities.
  6. Facilitate a transaction resulting in the transfer of interests to a passive buyer.
  7. Facilitate a transaction where any party is a shell company.
  8. Fail to be in compliance with bad boy provisions.

Because the SEC order did not mention the M&A Broker No-Action Letter in its ruling, it is not yet known whether the SEC considered the M&A broker exemption relevant at all. Even if it did, it is unclear whether BCM’s alleged structuring of brokered transactions failed to meet one or more of the factors listed above, and if so, whether any of the factors weighed more heavily in the SEC’s analysis. Consequently, additional SEC guidance will be required to determine what structuring considerations might be advantageous for unregistered sponsors or managers who would like to receive success fees for brokerage activity performed in-house on behalf of their portfolio companies. It should be noted that Mr. Blass stated that to the extent an advisory fee is wholly reduced or offset by the amount of the deal fee, such fee could be viewed as another way to pay the advisory fee, which would not raise broker-dealer registration concerns.

Conclusion

Unless and until the SEC issues further favorable guidance on this issue, sponsors or managers who expect to receive a deal fee for portfolio transactions (and do not qualify for relief under the M&A Broker No-Action Letter) should consider registering as a broker-dealer or else engage or affiliate with a registered third party broker-dealer to effect the securities transactions of their portfolio companies on their behalf.

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