For many years the legal and regulatory environment applicable to the private investment fund industry (which includes hedge funds, private equity funds and similar vehicles) enabled it to operate with little oversight relative to other investment products. Recently, however, on the heels of the 2010 Dodd Frank financial reform legislation and a more enforcement-oriented mindset on the part of regulators, the industry and some of its long-standing practices have come under greater scrutiny. This article discusses a particular area of increased focus – whether in-house and third-party marketers of private funds must register as broker-dealers and the implications of failing to register. In addition to the newly relevant, but longstanding broker-dealer registration requirements, this article addresses recent legislation which has lifted a ban on general solicitation in connection with certain private offerings of securities by private investment funds (and other issuers) and how it may impact the obligations of the fund managers and their marketers.
The spotlight shifts
In a speech on 5 April 2013, David Blass, Chief Counsel of the Securities Exchange Commission’s (SEC) Division of Trading and Markets, cautioned the private investment fund industry that the SEC had its eye on a “significant area of concern”: in-house and third-party marketers that solicit investors for funds, without becoming registered broker-dealers. Blass identified a number of factors that such funds should consider when weighing their decision to register, including the primary activities of the employee and their compensation structure. A person engaged in the business of effecting transactions in securities for the account of others, especially transactions “at key points in the chain of distribution”, must generally register as a broker-dealer. Additionally, it is unlawful to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security without being so registered. A failure to register should be of great concern to fund managers because investors may seek rescission of transactions entered into with unregistered brokers and the SEC may seek a host of other remedies for violations. Once a fund is successfully sued for employing an unregistered broker, in addition to paying damages and other sanctions associated with the suit, the fund must also disclose this information in future offerings and sales. With the potential for serious repercussions for failure to comply with the broker-dealer registration requirements under Section 15 of the Securities Exchange Act of 1934 (the “Exchange Act” – codified at 15 USC Section 78a et seq.) cited above, fund advisers would be well advised to take this requirement seriously.
Is your marketer actually a broker?
Section 3(a)(4) of the Exchange Act broadly defines a “broker” as “any person engaged in the business of effecting transactions in securities for the account of others” and the SEC staff shares an equally liberal interpretation. A person may be found to be acting as a broker if that person participates in securities transactions “at key points in the chain of distribution.” Generally, a person engaged in the business of effecting transactions in securities for the account of others must register as a broker-dealer with the SEC, as a member of the Financial Industry Regulatory Commission (FINRA), and comply with any applicable requirements under state law. Although the Exchange Act does not explicitly define “engaged in the business”, subsequent court and SEC interpretations have developed the “engaged in the business” test.
Private funds typically market through one of three strategies: (1) in-house employees that are dedicated to the marketing process and may be compensated on a commission basis; (2) the fund and manager have informal arrangements with third-party finders and other sourcing agents (any of which may or may not be registered as broker-dealers) where the finders or agents are typically compensated through a share of the management and performance compensation received; and (3) the funds enter into formal placement arrangements with major investment firms. The first two strategies raise significant questions regarding broker-dealer registration and potential liability.
An in-house or third-party marketer may need to register if they are engaged in the following activities:
• Identifying potential purchasers of fund interests;
• Marketing securities to investors;
• Soliciting or negotiating securities transactions;
• Providing advice as to the merits of a fund investment; or
• Handling customer funds and securities.
In his 2013 speech, Blass provides questions that advisers and managers should ask themselves in order to determine whether or not registration will be required. Chief among these questions is how the adviser solicits and retains investors. The duties and responsibilities of adviser personnel performing the soliciting and marketing is another determining factor. “[A] dedicated sales force of employees working within a ‘marketing’ department may strongly indicate that they are in the business of effecting transactions in the private fund.” Another consideration is whether or not the marketing personnel have other responsibilities. If their primary function is to solicit investors, registration is likely required.
Compensation is also a key factor in determining the registration requirement. When the individual’s compensation depends on the outcome or size of the transaction, rather than a flat fee, retainer or salary, these activities weigh even more heavily toward the need to register. According to Blass, as a bright-line rule, transaction-based compensation arrangements entered into by private fund managers require broker-dealer registration. If the personnel receive commissions, bonuses or other types of compensation linked to successful investments, then registration is required. Furthermore, registration may be required even when compensation is not based on specific transactions. “A person’s receipt of transaction-based compensation in connection with [marketing] activities is a hallmark of broker-dealer activity.”
Despite recent SEC action and the Blass speech, a US District Court rejected the SEC’s view that transaction-based compensation alone requires broker-dealer registration. In SEC v. Kramer, the court refused to follow Blass’s bright-line test, instead electing to impose another test that employed several non-determinative factors.
When that marketer is a broker-dealer
According to §15(a)(1) of the Exchange Act (15 U.S.C. §78o(a)(1)), it is unlawful for a person to make use of the mail or any means of interstate commerce to effect any transaction in, or to induce or attempt to induce the purchase or sale of, any security unless that person is registered as a broker-dealer.Therefore, if a fund uses unregistered solicitors they may be in violation of the law and in turn create liability for the individual, the fund and the fund manager. In the SEC decision In the Matter of Ranieri Partners LLC and Donald W. Phillips, the Commission determined that an independent consultant had operated as an unregistered broker. The consultant’s solicitation efforts included: sending private placement memoranda, subscription documents, and due diligence materials to potential investors; urging at least one investor to consider adjusting its portfolio allocations to accommodate an investment with Ranieri Partners; and providing potential investors with his analysis of Ranieri Partners’ fund strategy and performance track record. As illustrated by the Ranieri decision and discussed further in the “Consequences of Violating the Registration Requirement” section below, an unregistered individual who identifies potential purchasers of fund interests, markets securities to investors, solicits or negotiates securities transactions, provides advice as to the merits of a fund investment, or handles customer funds and securities, will likely be found in violation of federal securities law. While that is certainly a problem for that individual, the greater concern for the fund manager is the possibility that it may incur aiding and abetting liability for the marketer’s underlying violation, among other things.
Recent developments, including relaxed statutory and judicial standards for establishing aiding and abetting liability, are likely to encourage the SEC to bring more of such enforcement actions in the future. For instance, in In the Matter of Visionary Trading LLC, the SEC charged a manager and a registered broker-dealer with willfully aiding and abetting and causing an unregistered broker-dealer and its employees to violate the Exchange Act.
On the other hand, some recent case law suggests that the aiding and abetting charge in the Ranieri case and in other cases will not always apply. For example, in the Wexler v. KPMG LLP case a fund investor who lost his investment in the Madoff Ponzi Scheme brought suit against the fund manager. The New York Supreme Court dismissed the aiding and abetting claim, stating that there was no evidence the fund manager substantially assisted the fraud.
However, the Wexler case may be distinguishable on its facts. The fund manager in Wexler may have been unaware of the Madoff fraud since that is a fact intrinsic to a particular entity or person that the manager may or may not discover. In contrast, it may be more difficult for a fund manager to validly claim that it is unaware that, as a general rule, fund marketers are required to register as broker-dealers or qualify for a clear exemption from registration.
Although there is a possible safe harbour, known as the issuers exemption, in which certain associated persons (e.g., directors and officers) of the issuer (or certain affiliates) can participate in the sale of the issuer’s securities without being considered a broker, the exemption is inapplicable to most private fund marketers, mainly because it restricts them from being compensated based on their participation in the securities transaction. In order to qualify for the exemption, the associated person must satisfy three primary requirements and at least one of three alternative sets of conditions.
The primary requirements are that the associated person must not be: (1) subject to a statutory disqualification, as defined in Section 3(a)(39); (2) compensated in commissions; and (3) at the time of his participation an associated person of a broker or dealer. In addition to the three mandatory requirements, the associated person must satisfy one of the four criteria under Section 3a4-1(a)(4). The alternative set of requirements that may be most useful to fund managers are found in sub-clause (a)(4)(ii), which, in order to qualify, requires an associated person to: (i) have substantial other duties than marketing securities; (2) have not been associated with a broker-dealer in the prior 12 months; and (3) to not participate in securities offerings more than once every 12 months. Fund managers may qualify for this exemption, but a full-time employee in a marketing department offering securities on a continuous basis is unlikely to do so.
Another possible safe harbour exists in what is known as the finders exception. Based on a handful of SEC staff no-action letters, it is generally thought that persons who do nothing more than introduce prospective investors to the issuer are “finders,” not “brokers,” and are not required to register. A finder is prohibited from negotiating the transaction or receiving commissions related to the amount of the transaction. While a few no-action letters support this position and the SEC has not formally withdrawn them, the SEC has been reluctant to create an official “finder’s exemption.” Many securities practitioners view the finders exception to be too narrow to have any practical utility.
The SEC has cautioned that persons who find investors for issuers, even in a “consultant” capacity, may still need to register as a broker depending on a number of factors, including whether: (1) the finder participates in the solicitation, negotiation or execution of the transaction; (2) compensation is related to the outcome or size of the transaction; (3) the finder is otherwise engaged in the business of effecting securities transactions; and (4) the finder handles securities or funds of others. A “yes” answer to any of these factors indicates that registration may be required.
This area of regulation is currently in a state of flux and it remains to be seen if and how the SEC will enforce the provisions requiring broker-dealer registration for private fund marketers. In his speech, Blass floated the idea of creating an exemption specifically for private fund marketing, but wouldn’t budge on extending the hypothetical exemption to unregistered employees being paid on commission basis.
Consequences of violating the requirements
There are a broad range of consequences for failing to register in-house marketers as broker-dealers or using the services of an unregistered third party, and either of these violations can implicate the fund and its manager. The remedies available in an SEC enforcement action or private civil action include: the potential right of rescission on the part of investors under federal or state law; fines, disgorgement, injunctions and the suspension of some or all activity; potential reputational risks in the marketplace and negative publicity; and if any resulting disciplinary event reaches the level of a Rule 506(d) “bad act,” potentially losing the ability to issue fund securities under Regulation D.
The Exchange Act provides that a contract made in violation of the Act shall be void. If a purchase of fund securities through an unregistered broker-dealer is “rendered void, investors would then be entitled to demand rescission of their investment in the fund and the unwinding of their investment to the detriment of the fund, its investors and, of course, the fund adviser.” A private plaintiff seeking rescission of the contract under the Act bears the burden of proving the marketer was not registered and was required to be.
Such a rescission action must be brought within one year after the discovery that the sale was made in violation of the Exchange Act and within three years of such violation. The right to rescission applies to any purchaser in the transaction, and not just purchasers who had been located by unregistered marketers. In addition to the Exchange Act, many state statutes that provide for a right of rescission can be read broadly to apply againstan issuer if the purchaser bought securities through a marketer who was required to be registered as a broker under state law, but was not so registered.
Violating the broker-dealer registration requirement has even broader consequences for issuers. If the SEC determines that a finder was an unregistered broker-dealer, the issuer may be restricted from using any and all future registration exemptions under the Securities Act. Moreover, use of an unregistered broker-dealer may subject the issuer to liability for fraud under Section 20(e) of the Exchange Act. The issuer could be liable under the theory that they aided and abetted the unregistered broker-dealer in violating the Act. With such liability, both the finder and the issuer could be subject to civil monetary penalties and disgorgement of profits and/or commissions.
Ranieri Partners illustrates the real-world consequences of an issuer using an unregistered broker-dealer. The SEC not only found that the unregistered broker had violated the Exchange Act by failing to register as a broker-dealer, but that Ranieri Partners had caused the violations by failing to oversee his activities, and that the then managing partner had willfully aided and abetted the brokers’ violations by failing to limit his activities. As part of the settlement, the violating broker agreed to be permanently barred from the securities industry and to pay disgorgement and prejudgment interest in excess of $2.8 million.
Moreover, Ranieri Partners agreed to a civil money penalty of $375,000 and to cease and desist from causing any future violations of the Act. The managing partner also submitted to a cease and desist order, agreed to a $75,000 civil penalty, and accepted a nine-month suspension from acting in a supervisory capacity in the securities industry.
The potential for severe consequences resulting from the use of unregistered broker-dealers is also illustrated by the 2012 Chapter 11 filing of Neogenix Oncology Inc. In 2011, an SEC inquiry revealed that Neogenix had been making sales through unregistered third-party broker-dealers in violation of the Exchange Act. Consequently the firm had significant potential rescission liability for the securities sold in connection with the unregistered marketers. This potential liability caused uncertainty in their financial statements and due to the uncertainty, the Neogenix auditors were unable to sign-off on those statements. Without third-party auditor sign-off, Neogenix could not properly file quarterly and annual financial statements with the SEC and struggled to raise additional capital that was essential for the development stage company. Neogenix subsequently filed for bankruptcy in July of 2012.
Disclosing registration requirement violations
Once a fund uses an unregistered broker-dealer, the fund must satisfy certain disclosure requirements. Both federal and state securities laws require that a fund disclose if it has compensated any person to sell such securities. Failing to disclose such compensation can expose an issuer to potential liability for fraud under Section 10b-5 of the Securities Act. “Even if rescission is not demanded by prior investors, the use of an unregistered broker-dealer in a prior transaction will create disclosure requirements in subsequent financings, acquisitions, or offerings.” The risk of private suit, illegality or rescission, arising from finder non-registration, is a material fact that, if omitted, constitutes a 10b-5 violation. Note, however, that such failure to disclose is only fraudulent if the issuer knows the finder is not registered, but should be. Therefore, once a fund is successfully sued for employing an unregistered broker, they must disclose this information in future offerings and sales.
General solicitation and broker registration
One other factor that is increasing the SEC’s attention to marketing by private investment funds and broker-dealer registration is the recent enactment of the Jumpstart Our Business Startups Act (the JOBS Act), particularly Title II, Access to Capital for Job Creators. On 10 July, 2013, the SEC approved final rules under the JOBS Act to allow general solicitation and advertising in Rule 506 and Rule 144A offerings conditional on all purchasers being accredited investors. Although the JOBS Act was intended to encourage the funding of small businesses and start-ups, Title II opens the door for general solicitation by private investment funds. Some funds have already begun to take advantage of the recent changes with direct marketing efforts, despite not registering as broker-dealers. However, the increased risk of fraud and predatory targeting of unsophisticated investors that general solicitation creates may be expected to be exacerbated even further by the use of unregistered finders in those solicitation efforts. In light of the SEC’s general animus against unregistered finders which it views as presenting greater potential for abuse, the SEC is likely to increase its regulatory focus and scrutiny on the marketing activities of private funds that engage in general solicitation.
Given the SEC’s recent increased interest in the proper registration of marketers, fund managers should already be on notice that individuals, whether in-house or third-party, who engage in marketing securities will likely be required to register as broker-dealers. Without significant change to the compensation structure and job description of these marketers, it is unlikely that any of the current exemptions to registration will apply. As is evident from the experiences of Ranieri Partners and Neogenix, disclosure that a finder was in fact an unregistered broker-dealer can be the beginning of a long and arduous process for the issuer. Litigating these cases can be expensive and both the issuer and finder risk reputational damage regardless of the actual outcome of the case. Once the matter is disclosed to the public, both the issuer and the finder may be open to rescission liability, consequent monetary penalties and other liabilities. Therefore, issuers would be wise to heed David Blass’ warning and ensure their marketers are properly registered.
Liam O’Brien is a managing partner at McCormick & O’Brien LLP. He received his J.D. in 1991 from the University of Fordham School of Law. C. Mark Laskay is a partner at McCormick & O’Brien LLP. He has an LL.M. in International Business from the University of London, and a J.D. from the University of Texas School of Law. Lauren Parra is a J.D. Candidate 2015, at the University of Fordham School of Law. John Keating is a J.D. Candidate 2015, at the University of Fordham School of Law.