Broker in disguise?

It may seem counterintuitive, but certain actions could trigger broker-dealer status for private equity firms. Pepper Hamilton funds partners Christopher Rossi and Gregory Nowak provide an in-depth discussion about when GPs might have to consider registering as such.

Editor’s note: A shorter, edited version of this article appeared in the September edition of PE Manager. Below is the full unedited response to what is proving to be a perplexing challenge for many private equity firms.


ABC Capital Partners, a private equity firm and investment adviser to PE Fund I, is raising capital for PE Fund II. ABC Capital has been approached by Finders ‘R Us to assist ABC Capital in its fundraising efforts for PE Fund II. Finders would like to be paid a percentage of the amounts it successfully raises for PE Fund II. Can ABC Capital retain Finders to assist in PE Fund II’s capital raising efforts? In addition, can employees of ABC Capital solicit potential investors for PE Fund II without ABC Capital being required to register as a broker-dealer?

PE Fund I is negotiating to sell Acme, one of its portfolio companies. ABC Capital introduced Acme to multiple potential buyers, including the current prospective buyer, helped value and prepare Acme for sale, advised Acme with respect to alternative transaction structures and sale terms and conditions, and assisted Acme in PE Fund I’s negotiations with Acme. In doing so, ABC Capital has expended significant time and resources and would like Acme to pay it a transaction fee for the services it has provided to Acme in an amount equal to a percentage of the purchase price paid if the sale of Acme is completed.  Do these activities require ABC Capital itself to register as a broker-dealer?


ABC Capital will need to evaluate whether Finders’ fundraising activities for PE Fund II and desired compensation structure require Finders to be registered as a broker-dealer with the SEC and FINRA. In addition, ABC Capital will need to evaluate its own internal marketing and fundraising practices as well as how it compensates those of its employees who engage in marketing and fundraising activities for PE Fund II to determine whether these activities and compensation practices require ABC Capital to be registered as a broker-dealer. Similarly, ABC Capital will need to determine if its receipt of the proposed transaction fee from Acme causes ABC Capital to be a “broker.” There could be significant consequences to Fund I, Fund II, ABC Capital and its principals (such as SEC sanctions and investor rescission rights) if either Finders or ABC Capital is required to be, but is not, so registered.


The Securities Exchange Act of 1934 defines a broker as “any person engaged in the business of effecting transactions in securities for the account of others,” and makes it unlawful for a “broker” to “effect any transactions in, or attempt to induce the purchase and sale of, any security” unless properly registered as a broker-dealer. Thus, the prohibition on unregistered broker-dealer activities not only extends to actual sales or purchases of securities, but also to solicitations for purchases or sales of securities. To determine whether a person is “engaging in the business of” or “effecting transactions in” securities for the account of others, the SEC and courts look to a variety of factors, including whether the person:


• works as an employee of the issuer;   
• receives a “commission” or a salary;
• sells or earlier sold securities of other issuers; 
• participates in negotiations to a material extent between the issuer and an investor;
• provides either advice or an evaluation as to the merit of the investment or provides a valuation of the investment; and
• actively (rather than passively) finds investors.

These factors are not exclusive and courts have observed that some factors are more indicative of broker conduct than others. The determination of whether a person is a broker is fact intensive. Courts have emphasized the regularity in which a person participates in securities transactions as one of the primary indicia of “engaging in the business.” In addition, courts and the SEC have referred to a person’s receipt of transaction-based compensation as the hallmark of being a broker-dealer. Indeed, recent SEC enforcement cases and no action letters have focused upon transaction-based compensation as being a determinative factor given the inherent conflicts of interest created when a person has a “salesman’s stake” in the outcome of a securities transaction, particularly when the person engages in similar activities for other issuers. A person can still be considered a broker, though, if his or her activities fall within the definition of a “broker” even if the compensation he or she receives is not transaction-based.

Rule 3a4-1 under the Exchange Act (the so-called “issuer exemption”) provides a non-exclusive safe harbor which permits persons associated with an issuer to engage in certain activities without being considered a broker. Within the private funds context, these associated persons include any partner, officer, director or employee of a general partner of, or investment adviser to, a private fund issuing interests to investors. So long as the associated person is not subject to statutory disqualification, he or she may: (1) offer and sell securities to certain types of financial institutions (e.g., banks and insurance companies); (2) engage in capital raising activities for the issuer if he or she has substantial job responsibilities for or on behalf of the issuer other than capital raising, and he or she has not participated in selling an offering of securities for any other issuer within the prior 12-month period; or (3) limit participation to preparing and delivering written communications to potential investors so long as he or she refrains from engaging in any oral solicitation activities, or to performing ministerial and clerical work with respect to capital raising activities. However, no associated person who is or was within the prior 12-month period associated with a broker-dealer can come within the issuer exemption, and the issuer exemption is not available to an associated person if he or she receives any commissions or other special remuneration based directly or indirectly on the success of the issuer’s securities offering.

David Blass, chief counsel of the SEC’s Division of Trading and Markets, reinforced these principles in an April 5, 2013 speech with respect to two particular areas observed by the SEC during the so-called “presence exams” of the newly registered investment advisers to private funds currently being conducted by the SEC’s Office of Compliance Inspections and Examinations (OCIE). The first area involves the payment of transaction-based compensation by private fund advisers to their employees for selling interests in funds advised by the adviser and the SEC’s observation that many private fund advisers have employees whose only or primary function is to sell interests in the various funds it advises. The second area involves the receipt by private fund advisers, their personnel or affiliates of transaction-based compensation for purported “investment banking” type services provided to portfolio companies of the private funds they advise or manage.


ABC Capital should be guided by two companion March SEC administrative proceeding settlements with respect to its capital raising efforts for PE Fund II. The first settlement was with Ranieri Partners, LLC, a financial adviser to certain private equity finds, and its senior managing partner, Donald Phillips, who was in charge of raising capital for these funds. The second settlement was with William Stephens, who was engaged by Ranieri Partners as an independent consultant to “find” potential partners for these funds in exchange for a fee equal to 1 percent of all capital commitments made by investors introduced by Stephens. Stephens was not registered as a broker-dealer or associated with a registered broker at the time of, or any time during, his engagement. In addition, ABC Capital Partners should consider the remarks made by Blass in light of its own internal capital raising activities and practices to determine whether these activities and practices require ABC Capital to be registered as a broker-dealer or should be modified so as to not require such registration.  

Considerations for retention of Finders ‘R Us: On its face, Ranieri Partner’s arrangement with Stephens limited his activities to contacting potential investors for meetings with Ranieri Partners’ principals and prohibited Stephens from distributing PPMs and contacting potential investors directly to discuss the merits and strategies of the funds. In reality, however, Stephens was found to have engaged in active solicitation efforts of the kind customarily engaged in by brokers. These activities included: (1) sending PPMs, subscription documents and due diligence materials to potential investors; (2) urging at least one investor to consider adjusting its portfolio allocations to accommodate investments in the relevant Ranieri Partners managed funds; (3) providing potential investors with his analysis of these funds’ strategies and performance track records; and (4) providing potential investors with confidential information relating to the identity of other investors and their capital commitments. Although the engagement of Stephens was designed to have Stephens function as a “finder” who would merely make introductions to potential investors, the SEC’s view was that his actions went far beyond those of a finder.


By virtue of his action and receipt of transaction-based compensation, the SEC found that Stephens engaged in the business of effecting securities transactions without being properly registered as a broker.  This result does not seem very controversial under the facts and is consistent with existing law and SEC interpretations under similar facts.

The settlement in the companion proceeding against Ranieri Partners and Phillips was somewhat eye opening to those in the private funds industry, however, because it highlights that the risk of using an unregistered “finder” for capital raising purposes is not only a risk to the purported finder, but is also a risk to the private fund adviser and its personnel even if there are no allegations of fraud. In this settlement, the SEC found that Ranieri Partners and Phillips willfully aided and abetted Stephens’ violations by: (1) failing to adequately oversee Stephens’ activities; (2) actively assisting Stephens in his solicitation efforts by providing Stephens with key documents and information related to the Ranieri Partners-advised funds; and (3) failing to take adequate steps to prevent Stephens from having substantive contacts with potential investors. In addition to Ranieri Partners’ payment of a $375,000 civil penalty, Phillips paid a civil penalty of $75,000 and was suspended from acting in a supervisory capacity with, among others, any investment adviser for a period of nine (9) months. It should be noted that the sanctions agreed upon with Ranieri Partners and Phillips may have been more favorable than they otherwise could have been because the SEC considered Ranieri Partners’ remedial efforts in modifying its policies and procedures with respect to capital raising matters.

The take-away for ABC Capital and its principals is to refrain from engaging Finders ‘R Us to help raise the capital for PE Fund II if Finders is not properly registered as a broker-dealer. While the distinction between a finder and a broker is highly dependent upon the facts of a particular arrangement, the retention of Finders as a purported “finder” is very difficult as a practical matter because Finder’s role would need to be limited solely to making introductions. Thus, Finders would be prohibited from engaging in “value-add” activities of the kind expected by ABC Capital such as providing marketing, offering and subscription materials to potential investors or having any substantive discussions about PE Fund II with potential investors. In addition, ABC Capital and its personnel would need to supervise Finder’s activities to ensure Finder acted solely within the limited scope of its permitted activities. Finally, to the extent Finders has acted or presently acts in a “finder” capacity for others with respect to securities transactions (even if limited to making introductions), the more Finders appears to be “engaging in the business of” or “effecting transactions in” securities for the account of others, thereby triggering a requirement for Finders to be properly registered as a broker. It is very difficult, if not, impossible, for ABC Capital to police this activity. Indeed, Finders may very well be unwilling to disclose the information (especially the names of its other clients) that would be necessary for ABC Capital to enforce compliance.

It should be observed that, under the SEC’s recently promulgated rules under the JOBS Act lifting the ban on issuers engaging in general solicitation activities in private placements, many of the limitations on how potential investors can be contacted and the manner in which information concerning the issuer and the offering can be disseminated will no longer apply if the issuer files a Form D and sells securities only to accredited investors. These new rules go into effect on September 23, 2013. If done properly, ABC Capital can make directly available to potential investors on a website the information and materials that Finders is prohibited from providing to them, thereby reducing the need for Finders to distribute such information and potentially mitigating the risk of Finders engaging in prohibited activities.


ABC Capital should consider the following questions with respect to its own internal marketing and fundraising practices in PE Fund II’s capital raising efforts:

• do ABC Capital’s employees who are going to solicit investors for PE Fund II have duties and responsibilities other than the solicitation of investors; and
• how are the employees who will solicit investors for PE Fund II going to be compensated?

Blass observed that private fund advisers with dedicated sales forces working within a “marketing” department may strongly indicate that they are in the business of effecting securities transactions in the private funds they advise, irrespective of how they are compensated, and that the receipt by any employees who solicit investors of any compensation linked to successful investments would be considered transaction-based compensation, which is a critical element to determining whether such one is required to register as a broker-dealer. These questions and observations are largely consistent with the previously summarized requirements of the issuer exemption safe harbor found in Rule 3a-4.

Thus, if ABC Capital employees who solicit investors for PE Fund II have (or will have after the fundraising for PE Fund II is complete) substantial job responsibilities for or on behalf of PE Fund II other than capital raising, and they have not participated in selling an offering of securities for any other issuer (including, for example, PE Fund I) within the prior 12-month period, then such employees should not be viewed as being engaged in the business of effecting transactions in PE Fund II.

However, employees of ABC Capital who are or were within the prior 12-month period associated with a broker-dealer cannot fall within the Rule 3a-4 safe harbor with respect to PE Fund II. Finally, it is a precondition to any of ABC Capital’s employees falling within the issuer exemption safe harbor that he or she not receive any special compensation such as bonuses, commissions or other incentives (e.g., increased carry allocations with respect to PE Fund II) that are linked to PE Fund II’s successful fundraising efforts.  

Blass noted, without explaining why, that it could be difficult for private fund advisers to satisfy these conditions and went so far as to say that the issuer exemption is generally not used by such advisers. Perhaps he was focused on advisers to larger private fund complexes because those are the advisers undergoing the OCIE’s presence examinations. It seems advisers to smaller funds should have an easier time satisfying its conditions. Failure to satisfy the conditions of the issuer exemption does not necessarily mean that a private fund adviser or its personnel are “brokers.” If it is determined that such persons fall within the definition of a “broker,” then ABC Capital should restructure such person’s activities and, if necessary, compensation structure, to avoid broker classification.


ABC Capital should consider the observations made by Blass for guidance to determine whether the services it has provided to Acme in connection with its potential sale and receipt of a transaction fee at the time of the sale of Acme would require ABC Capital to be registered as a broker-dealer. Blass cited the combination of the receipt by a private fund adviser or one of its affiliates of transaction-based compensation in connection with the acquisition or disposition (including public offerings) or a recapitalization of a portfolio company as “at least on its face” causing such an adviser to fall within the meaning of the term “broker.” He noted that this practice seems to be common among private fund advisers, particularly those advising funds engaged in leveraged buyouts. He seemed receptive to the argument that if the advisory fee paid by the fund to the fund’s adviser is wholly reduced or offset by the amount of the transaction fee paid by the portfolio company, there may not appear to be any broker-dealer concerns because one might view the payment of the transaction fee as another way to pay the advisory fee. Thus, if the advisory fee received by ABC Capital from PE Fund I is reduced or offset by 100 percent of the proposed transaction fee to be paid in connection with the sale of Acme, then ABC Capital would fall into this construct. However, no definitive guidance from the SEC has been provided on this point and the OCIE is asking for documents and information pertaining to these types of fees. If the sale of Acme is structured as a sale of Acme’s assets, then broker-dealer concerns should be mitigated.


Blass noted that while the SEC is willing to work with the private fund adviser industry to craft workable exceptions tailored to the industry consistent with SEC’s mission of protecting investors, advisers need to understand that acting as an unregistered broker-dealer is not a mere “technical violation.” In light of the potentially serious consequences of being on the wrong side of this issue, advisers to private funds should consult with their counsel before engaging unregistered finders for capital raising purposes or entering into any agreements with their portfolio companies to receive transaction fees, and to help implement appropriate policies with respect to raising capital for investment funds they sponsor. Such advisers should also consult with their counsel to explore how the SEC’s new rules under the JOBS Act can help reduce their potential exposure under the broker-dealer determination rules.

Christopher Rossi and Gregory Nowak are partners in Pepper Hamilton’s corporate and securities practice and investment funds industry group.