On June 1, 2016, the Securities and Exchange Commission (“SEC”) brought and settled charges against a private equity fund adviser and its principal owner for engaging in brokerage activity without registering as a broker-dealer and failing to follow the terms of its funds’ governing documents.[1] The adviser and its principal agreed to pay more than $3.1 million to settle the charges.
The SEC found the adviser and its principal owner performed brokerage services with respect to the purchase and sale of portfolio companies by the funds it manages without registering as a broker in violation of Section 15(a) of the Securities Exchange Act of 1934 (“Exchange Act”). The adviser received at least $1,877,000 in transaction-based compensation in connection with these purportedly brokerage services.[2] It is noteworthy that the funds’ governing documents permitted the adviser to engage in these services on behalf of the funds.
In addition, the SEC found that the adviser charged two portfolio companies $450,000 in operating partner oversight fees and used fund assets to make political contributions, charitable contributions, and pay for the adviser’s entertainment expenses, which resulted in conflicts of interest. The funds’ governing documents did not permit these transactions, nor were the transactions otherwise disclosed to the funds’ investors.
The SEC also found that the adviser and its principal owner violated the funds’ governing documents in connection with the purchase of portfolio company interests and limited partnership interests in conflicted transactions. First, the adviser repurchased shares in a fund’s portfolio company from a departing employee without disclosing its financial interest or obtaining appropriate consent. Second, the principal owner acquired limited partnership interests from a defaulting limited partner instead of requiring the defaulting partner to forfeit its interest as contemplated by the fund’s governing documents. The principal owner also purchased limited partnership interests from selling limited partners and then directed the fund’s general partner to waive his obligation to satisfy future capital calls with respect to the acquired interests in violation of the fund’s governing documents.
The enforcement action serves as a reminder of the importance of compliance with the Exchange Act’s broker-dealer registration requirements. In the SEC's release about the action, SEC Enforcement Division Director Andrew J. Ceresney emphasized the need for a firm to properly register before providing brokerage services in exchange for compensation.[3] The SEC made clear the significance it places on registration of broker-dealers for the protection of investors.
The SEC noted that a broker acting to “effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security,” is acting unlawfully unless registered with the SEC. In this case, in alleging the adviser was acting as a broker and was required to register, the SEC order highlighted the adviser’s role in soliciting deals, identifying buyers or sellers, negotiating and structuring transactions, arranging financing, and executing the transactions, coupled with its receipt of transaction-based compensation for providing those services. Such services are relatively commonplace activities of private equity sponsors responsible for overseeing the purchase and sale of portfolio companies on behalf of the funds they manage. However, as this enforcement proceeding illustrates, such services can give rise to broker status issues when coupled with transaction-based fees.[4]
This enforcement proceeding also demonstrates the SEC’s focus on the importance of disclosure in a fund’s governing documents, particularly when it comes to fees and expenses. The action comes after SEC’s Office of Compliance Inspections and Examinations highlighted fees and expenses of private fund advisers as a focus in its stated Examination Priorities for 2016.[5] Failure to disclose fees and expenses may be seen as fraud or deceit upon a client under the Investment Advisers Act. Advisers must be careful to make clear what expenses will be charged to a client. If an adviser intends to charge certain expenses to a fund, they must be disclosed in the fund’s governing documents, and such expenses should be tracked carefully by the adviser to ensure that they are properly allocated to a fund. Further, the action serves as a reminder that advisers must follow a fund’s governing documents and appropriately resolve conflicts of interest, particularly with respect to transactions between an adviser and a fund.
Notes:
[2] The SEC’s order does not describe how the purported transaction-based compensation was structured. For example, it is unclear whether the purported brokerage services were conducted pursuant to an ongoing advisory or monitoring agreement between the adviser and the portfolio company.
[3] See SEC: Private Equity Fund Adviser Acted As Unregistered Broker, U.S. Securities and Exchange Commission 2016-100 (June 1, 2016). Note, however, that pursuant to a no-action letter issued by the SEC Division of Trading and Markets on January 31, 2014, an “M&A broker” (defined as a person engaged in the business of effecting securities transactions solely in connection with the transfer of ownership and control of a privately-held company to a buyer that will actively operate the company or the business conducted with the assets of the company) may, subject to certain conditions, provide brokerage services for transaction-based compensation without registering with the SEC.
[4] Note that in 2013, then Chief Counsel of the SEC’s Division of Trading and Markets David Blass suggested that a 100 percent offset of the fund’s investment management fee by any transaction-based fees received by the adviser would likely alleviate any broker status concerns. This case did not involve any fee offset, and it is therefore unclear whether that remains the position of the SEC staff.