Private Funds and Managers – Navigating Broker-Dealer Requirements

07 November 2017 ILPA EM Showcase Publication
Author(s): Kevin C. McNiff


When looking to raise capital, broker-dealer compliance may not be at the forefront of a private fund manager’s mind. However, engaging individuals (including the fund manager’s employees) or firms to identify, introduce or negotiate with potential investors can trigger a host of adverse regulatory consequences—including rescission rights and civil penalties—where such “finders” were not properly registered as a broker-dealer or broker-dealer representative.

Issuer’s Exemption and Associated Persons

Under Section 3(a)(4) of the Securities Exchange Act of 1934 (the “Exchange Act”), a broker is a person engaged in the business of effecting transactions in securities for the accounts of others. Under Section 3(a)(5) of the Exchange Act, a dealer is a person engaged in the business of buying and selling securities for the person’s own account. This excludes a person that buys and sells securities for its own account and not as part of a regular business. Section 15(a) of the Exchange Act prohibits a person from acting as a broker or dealer without registering as a broker-dealer with the SEC under Section 15(b) of the Exchange Act, absent an applicable exemption.

Under the “Issuers’ Exemption,” an issuer (including a private fund) that deals only in its own securities (such as limited partnership interests) is neither a broker nor a dealer as it does not effect transactions for the accounts of others and is not engaged in the business of buying and selling securities for its own account. However, where a private fund’s employees or agents regularly market the fund and solicit investors, they may be deemed to be acting as an unregistered broker-dealer, particularly where those individuals receive commissions for their efforts. The SEC generally takes the position that the payment of a commission or other transaction-based compensation may be sufficient to trigger broker-dealer registration requirements, even in the absence of other qualifiers (see Paul Anka SEC No-Action Letter (July 24, 1991)).

Rule 3a4-1 promulgated under the Exchange Act provides a non-exclusive safe harbor from broker-dealer registration for associated persons of an issuer. An “associated person,” in the context of a private fund, is a natural person who is a partner, officer, director or employee of (i) the private fund, (ii) where the private fund is a limited partnership, its corporate general partner, or (iii) a company or partnership that controls, is controlled by, or under common control with, the private fund.

For Rule 3a4-1 to apply, the private fund’s associated person must not be (i) subject to any “bad actor” disqualifications under Section 3(a)(39) of the Exchange Act, (ii) compensated through commissions, and (iii) an associated person of a registered broker-dealer. In addition to those general restrictions, associated persons may only place securities to a limited class of investors, such as banks, registered investment companies or state-regulated insurance companies. They must also perform substantial duties on behalf of the private fund other than the marketing of fund interests, must not have been associated with a broker-dealer for the prior 12 months, and not have participated in more than one offering for the private fund in a 12-month period. Finally, associated persons must restrict their activities to either preparing written materials to be approved by a senior management person of—or investment adviser to—the private fund, or responding to investor inquiries (provided that the responses are included in the fund’s PPM or other offering document).

Placement Agents and Finders

A private fund or investment adviser can establish an affiliated broker-dealer to act as placement agent in connection with the marketing and sale of fund interests. Doing so may prove beneficial to large sponsors desiring to pay commissions to its internal marketing personnel and avoid restrictions in several states on using private placement agents in marketing funds to state and local government pension plans. However, broker-dealer registration is a lengthy and complex process and involves significant ongoing compliance requirements. Consequently, emerging fund managers may find it more practical to engage an unaffiliated third-party broker-dealer to serve as a placement agent.

Private funds, particularly those advised by emerging fund managers with reduced budgets, often forego registered broker-dealers and instead engage unaffiliated “finders” to identify, introduce, and negotiate with potential limited partners. However, one or more of the following activities by a finder in connection with fund marketing is likely to constitute acting as a broker-dealer, requiring SEC registration of the finder under Section 15(a) of the Exchange Act:

  • Engaging in the solicitation of prospective investors
  • Receiving commissions or other transaction-based compensation
  • Providing advice on the potential investment in the private fund
  • Engaging in negotiations on behalf of a fund concerning the potential investment, or
  • Having prior securities sales experience or a disciplinary history in connection with selling securities.

The cost to a fund or its manager of working with an unregistered broker-dealer can be high. The limited partner sourced by that unregistered broker-dealer would obtain a right of rescission of the fund’s partnership interests under Section 29(b) of the Exchange Act and applicable state securities laws. Of greater concern, the fund may be unable to rely on registration exemptions in future offerings of securities, and the SEC, through its investigative authority under Section 21(a) of the Exchange Act, may subject the fund or its manager to accounting and disgorgement of profits, civil penalties and other equitable relief. To avoid these and other consequences (such as the reputational harm arising from regulatory investigation), fund sponsors should conduct thorough due diligence of their placement agents, resist the temptation to engage unregistered finders, and work with fund formation counsel to understand the limits of their fundraising activities.