In a speech before the American Bar Association’s Trading and Markets Subcommittee on April 5, 2013, David Blass, the Chief Counsel of the Division of Markets and Trading, put hedge fund managers and private equity fund managers on notice that they may be engaged in unregistered (and therefore, unlawful) broker dealer activities as a result of the manner by which hedge fund managers compensate their personnel and, in the case of private equity fund managers, the receipt of investment banking fees with respect to their portfolio companies. The good news is that Mr. Blass indicated that the Staff of the Securities and Exchange Commission (the “SEC”) is willing to work with the industry to come up with an exemption from broker dealer registration for private fund managers that would allow some relief from the prohibitions against certain sales activities and compensation arrangements regarding the sales of private fund securities. This post will address only the sales compensation activities of hedge funds with an explanation of the private equity investment banking fee discussion to follow.
Mr. Blass indicated that he believed that private fund advisers may not be fully aware of all of the activities that could be viewed as soliciting securities transactions, or the implications of compensation methods that are transaction-based that would give rise to the requirement to register as a broker dealer.
Mr. Blass provided several examples that fund managers should consider to help determine whether a person is acting as a broker-dealer:
How does the adviser solicit and retain investors? Thought should be given regarding the duties and responsibilities of personnel performing such solicitation or marketing efforts. This is an important consideration because a dedicated sales force of internal employees working in a “marketing” department may strongly indicate that they are in the business of effecting transactions in the private fund, regardless of how the personnel are compensated.
Do employees who solicit investors have other responsibilities? The implication of this point is that if an employee’s primary responsibility is to solicit investors, the employee may be engaged in a broker dealer activity irrespective of whether other duties are also performed.
How are personnel who solicit investors for a private fund compensated? Do those individuals receive bonuses or other types of compensation that is linked to successful investments? A critical element to determining whether one is required to register as a broker-dealer is the existence of transaction-based compensation.This implies that bonuses tied to capital raising success would likely give rise to a requirement for such individuals to register as broker dealers.
Does the fund manager charge a transaction fee in connection with a securities transaction? In addition to considering compensation of employees, advisers also need to consider the fees they charge and in what way, if any, they are linked to a security transaction. This point is aimed more at the investment banking type fees that a private equity fund might generate, but it would also be relevant in the context of direct lending funds or other types of funds that generate income outside of the increase or decrease of securities’ prices.