Broker-Dealer Registration Concerns for Private Fund Sponsors

Broker-Dealer Registration Concerns for Private Fund Sponsors

February 28, 2014 | By Keith Martin in Washington, DC

When raising a new fund, a sponsor focuses primarily on attracting sufficient capital and achieving fundraising targets. Measures to raise capital can include reaching out to investors in current managed funds, using internal marketers to attract new investors and hiring one or more placement agents. 

In any case, the means employed by in-house marketers to attract investors can potentially give rise to an obligation to register as a broker-dealer under the U.S. Securities Exchange Act of 1934 (Exchange Act) with the Securities and Exchange Commission (SEC) and certain state and federal self-regulatory organizations. The failure to do so when required can have significant consequences for the sponsor and the marketer. In a speech given on April 5, 2013, David Blass, Chief Counsel of the SEC’s Division of Trading and Markets, reminded the industry of the need to be mindful of these regulations. He also noted that, to the extent a private fund adviser has a dedicated sales force or employees who dedicate a portion of their time to marketing activities, the adviser should be prepared to answer an SEC examiner’s questions as to why such people are not required to be registered as broker-dealers.[1]

Broker-Dealer Registration Requirements

Section 15 of the Exchange Act requires “brokers” and “dealers” to register with the SEC and join a self-regulatory organization such as FINRA. The Exchange Act generally defines a “broker” (under Section 3(a)(4)(a)) as any person engaged in the business of effecting transactions in securities for the accounts of others, and a “dealer” (under Section 3(a)(5)) as any person engaged in the business of buying and selling securities for their own account through a broker or otherwise.

The Exchange Act does not define the term “engaged in the business” as it is used in the definition of “broker” or “dealer.” Subsequent court and SEC interpretations indicate that the presence of a combination of factors will make it more likely that a person will satisfy the “engaged in the business” test:

  • Receiving transaction-based compensation (i.e. a “success fee”) for successful subscriptions, instead of a flat fee, retainer or salary;
  • Identifying potential purchasers of fund interests;
  • Soliciting subscriptions, advertising fund interests or otherwise dealing in securities;
  • Participating in negotiations between the sponsor and potential investors or providing advice as to the merits of a fund investment; or
  • Dedicating a substantial portion of the employee or third party’s time and responsibility to any of the activities described above.

The failure to register as a broker-dealer when registration is required can have significant consequences for the sponsor and marketer involved. In certain circumstances, an investor subscribing through an unregistered broker-dealer can have rights under federal and state law to rescind its investment. Additionally, the SEC and state regulators have the power to impose sanctions or initiate disciplinary proceedings against unregistered broker-dealers and the firms that employ them. These sanctions can potentially trigger the Dodd-Frank Act’s “bad actor” disqualification rules, which would prevent the manager from relying on the Rule 506 exemptions from SEC registration when raising a new fund, including the ability to use general solicitation and general advertising in marketing fund interests.[2]

Remarks of David Blass, Chief Counsel of the SEC’s Division of Trading and Markets

David Blass’ April 5, 2013 speech to the American Bar Association Trading and Markets Subcommittee generally focused on two topics. First, he discussed the traditional issue of whether a private fund’s marketing and sales efforts give rise to broker-dealer registration obligations. Second, whether the receipt of transaction-based compensation when affecting securities transactions at the portfolio company level triggers broker-dealer registration. Part of the stated goal of his speech was to raise awareness of the existing rules with private fund advisers and their counsel, so that they may prepare in advance for potential inquiries during an SEC examination. We also note that many state regulators regularly review Form D filings from their jurisdictions and may initiate examinations and enforcement actions against suspect issuers and placement agents.

Blass raised other relevant concerns and legal considerations for advisers in the midst of examining their marketing activities:

  • Transaction-based compensation has long been viewed by the SEC as a “hallmark of being a broker” in connection with a securities transaction like a subscription in a private fund.
  • A dedicated sales force of employees whose responsibilities mainly consist of soliciting investors working in a marketing department for a fund adviser may indicate that they are engaged in the business of effecting transactions in the fund’s securities, regardless of how they are compensated.
  • Employees who solicit investors and have few other responsibilities are likely to be considered engaged in the business of being a broker-dealer.
  • The “issuer exemption” provided by Rule 3a4-1 (a non-exclusive safe harbor) under the Exchange Act rarely applies in the private fund context, primarily because it restricts marketing personnel from receiving transaction-based compensation and limits their activity to specific categories including, among others, marketing solely to registered to broker-dealers and other institutional investors, selling securities once every twelve months, and delivery only written communications to potential investors.

Blass also stated that certain longstanding private equity practices in connection with portfolio company activities, including the receipt of transaction-based compensation, raise a number of broker-dealer concerns. Subjectively, private fund managers may justify their receipt of transaction-based compensation for securities transactions at the portfolio company level as “regular investment banking activity.” However, Blass noted that most investment banks are in fact registered broker-dealers. This concern could potentially be allayed if transaction fee income were to offset the management fee payable to the manager. 

We note that this is a rapidly evolving area, and members of the SEC staff have indicated a potential willingness to explore the application of existing rules in light of market practices. One example includes a recent no-action letter issued on January 31, 2014,[3] which permits “M&A Brokers” to engage in certain types of marketing activities without triggering the need to register in connection with the sale of a privately-held company.


In light of David Blass’s speech and recent industry focus on this area, private fund managers should conduct a meaningful examination of their marketing practices and consider ways to mitigate potential risks arising from their marketing activities. This preparation is essential to preparing fund managers for potential questions from SEC examiners as to why marketers are not required to be registered as broker-dealers. Private fund managers should keep the following considerations in mind:

  • Transaction-based compensation: Any compensation policy that gives a marketer a “salesman’s stake” or otherwise makes it the marketer’s main incentive to sell fund interests rather than contribute to the overall successful performance of the fund may obligate the marketer to register as a broker dealer. This includes “discretionary” bonuses tied to the dollar amount of interests sold rather than general fund performance. Managers seeking to compensate marketers on a discretionary basis should consider documenting the “discretion” involved in calculating the compensation.
  • Identifying potential purchasers of fund interests: In general, an employee or third party whose responsibilities include providing leads to the manager for potential investors (and does not conduct any of the other activities described above) will not be considered to be engaged in the business of being a broker-dealer. However, broker-dealer registration concerns will be heightened where the marketer is paid a success fee based on the number of its leads that invest in the fund (instead of a flat fee or salary), where the marketer makes recommendations regarding the merits of an investment in the fund, or where the marketer dedicates a substantial portion of its time to generating leads and does not conduct other non-marketing services.
  • Soliciting subscriptions and advertising fund interests: Soliciting subscriptions and advertising fund interests by distributing marketing materials to or participating in meetings with potential investors on a non-regular basis generally will not give rise to broker-dealer registration obligations. However, the content of the marketing materials and investor meetings is a crucial element to consider. For example, a general discussion of a manager’s investment strategy and decision making process is less likely to raise broker-dealer registration concerns (as opposed to negotiations of specific fund terms). In addition, a marketer who maintains repeated contact with investors to whom it distributes marketing materials or meets at meetings is more likely to be viewed as engaging in broker-dealer activity.
  • Participating in negotiations or providing advice as to the merits of an investment: A detailed discussion of investment-specific fund terms, or a recommendation from a marketer as to the merit of a fund investment, is more likely to raise broker-dealer registration concerns. This can arise in a number of contexts outside the normal negotiation and advice context, including requests for due diligence materials that portray the manager or the fund in an overly favorable light, assuring potential investors that they will be able to negotiate certain specific terms into the fund documents, or answering a current investor’s question about the advisability of a future investment.
  • Dedicating a substantial portion of an employee’s or third party’s time and responsibility to marketing activities: In his speech, David Blass indicated that, although the infrequent conduct of passive marketing activity may not trigger broker-dealer registration obligations, if a fund manager’s employee or contractor spends a substantial portion of his or her time conducting even passive marketing activities, or if the scope of the employee or contractor’s engagement with the manager is substantially marketing related, the person is more likely to be considered to be engaged in broker-dealer activity.

The factors above should be considered in light of all of the facts and circumstances surrounding a manager’s marketing activities. Unfortunately, there are no hard and fast rules that fund managers can rely on to structure their marketing practices in a way that is guaranteed not to raise broker-dealer concerns. For instance, even if an employee spends only ten percent of his time on marketing activity, if that activity consists of recommending the purchase of an interest to potential investors, or if the employee receives a percentage of all capital commitments he generated, these activities raise broker-dealer registration concerns.

In addition to tailoring marketing activities and business practices, private fund managers may also consider alternatives that can mitigate the risks.

  • Third-party broker arrangements: Many registered broker-dealers enter into agreements with private fund managers so that the appropriate marketing individuals can become “associated persons” of the broker-dealer, even where they remain the employee of the manager. It is important that the broker-dealer supervise the marketing activities of these employees, that their compensation is made through the registered broker-dealer and that the associated persons disclose their relationship with the manager.
  • Broker-dealer registration: A manager can register as a broker-dealer, or form a marketing affiliate to employ and supervise its marketing staff and register the affiliate. Broker-dealer registration with the SEC requires significant time commitments (six to nine months), significant costs, minimum capital requirements and extensive reporting obligations. Because of these onerous requirements, broker-dealer registration is generally only pursued by managers for whom the receipt of transaction-based compensation is a material aspect of their business.
  • SEC no-action guidance: Managers can potentially seek no-action guidance. However, given the amount of time the SEC may take to respond, the level of detail required to receive no-action relief and the associated costs, this is not typically a practicable solution.

Moving forward, fund managers should be aware that the SEC is actively examining private fund managers’ marketing practices. In addition, recent enforcement actions (including In the Matter of Ranieri Partners LLC and Donald W. Phillips[4]) indicate that the SEC will not hesitate to initiate enforcement against managers and/or outside marketers who violate the broker-dealer rules. Finally, this is an evolving area, and recent remarks by SEC staff and industry participants (and the no-action letter issued on January 31, 2014 providing “M&A Broker” relief) indicate a willingness on the part of the SEC to explore existing rules in light of market practices.

  1. David W. Blass, Chief Counsel, Sec. Exch. Comm’n Div. of Trading & Mkts., A Few Observations in the Private Fund Space (April 5, 2013). The full text of David Blass’s speech can be viewed at
  2. Also, note that registered investment advisers are subject to certain restrictions on payments to solicitors, and solicitors are required to make certain disclosures to potential investors, pursuant to Rule 206(4)-3 under the Investment Advisers Act of 1940. Investment advisers are also subject to “pay to play” limitations under Rule 206(4)-5, which generally prohibits all investment advisers from receiving any compensation for investment advice to a government entity within two years after a political contribution has been made.
  3. M&A Brokers, SEC No-Action Letter, 2014 WL 356983 (January 31, 2014). The full text of the “M&A Broker” no-action letter can be viewed at
  4. Ranieri Partners LLC & Donald W. Phillips, Exchange Act Release No. 69091, 2013 WL 873219 (March 8, 2013). The full text of the Ranieri order can be viewed at