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Private Equity Strategies

Regs Watch: SEC Cracks Down On Unregistered Broker Activities By Private Equity Firms

Wednesday, October 26, 2016

by Anthony Geraci | Geraci Law Firm

The Securities and Exchange Commission (SEC) granted a settlement offer on June 1 concerning violations by a Maryland-based private equity firm and its principal, Murry Gunty, of Section 15(a) of the U.S. Securities Exchange Act of 1934. Specifically, the allegations involved the breach of restrictions on providing unregistered brokerage services in addition to violations of Sections 206(2) and 206(4) and Rules 206(4)-7 and 206(4)-8 of the U.S. Investment Advisers Act of 1940 concerning fraudulent activity and material misrepresentation by financial advisers. The settlement resulted in the adviser disgorging the compensation he received as a result of his unlawful activity in addition to interest and a civil penalty.

The case, In the Matter of Blackstreet Capital Management, LLC, (SEC Release No 34-77959), represents the first instance in which the SEC has brought an action against a registered investment adviser for not formally registering as a broker, and as a result of their acceptance of capital garnered from transactions related to services provided to fund portfolio corporations.

Blackstreet gave advice regarding the acquisition and disposition of its funds’ portfolio organizations, which periodically encompassed buying and selling securities, soliciting potential business arrangements, selecting clients, planning financial arrangements, and processing transactions. The subsequent fees for these services were undeniably lawful and duly reported in the governing financial reports. However, the adviser collected more than $1.8 million of transaction-related payments without ever registering as a broker, thereby breaching the broker-dealer registration mandates of the Securities Exchange Act of 1934 and prompting the SEC to seek enforcement action.

The settlement potentially foreshadows the SEC taking the position that in certain situations, transaction fees may not be collected by private equity funds unless they are registered broker-dealers, despite the fact that equity funds have historically claimed their services related to facilitating portfolio company transactions does not involve activities that would mandate their registering as an official broker.

The Securities Exchange Act of 1934 prohibits a broker to “effect any transactions in…any security…unless such broker or dealer is registered,” and defines “broker” as “any person engaged in the business of effecting transactions in securities for the account of others.”

It follows then that a fund would only be required to register as a broker-dealer if it “engaged in the business of effecting a transaction” in securities for a third party. The Securities Exchange Act, however, is silent as to what constitutes being “engaged in the business of effecting transactions,” the only guidance within the industry being SEC press releases, or enforcement actions and federal court decisions on the matter.

The SEC initially hinted at their impending investigation of unregistered brokerage activity in an April 2013 speech by David W. Blass, SEC Chief Counsel of the Division of Trading and Markets. He said his staff was “putting an increased examination focus on private fund advisers,” specifically instances in which “the private fund adviser…receive transaction-based compensation for purported investment banking or other broker activities…[and] inappropriately claiming to rely on exemptions to avoid broker-dealer registration.”

Following the SEC’s successful enforcement of unregistered broker activity against Blackstreet, there is industry-wide speculation as to whether private equity advisers should cease collecting similar fees or should instead completely offset them against the management payment. Current market data trends indicate these fees are routinely being offset, either in part or in full, against the management compensation afforded to advisers. As a result of the Blackstreet settlement, investment advisers could avoid similar potential prosecution by examining any transaction-related fee agreements to determine if they constitute services requiring broker registration.

This article was published in Opalesque's Private Equity Strategies our monthly research update on the global private equity landscape including all sectors and market caps.
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