Playing it safe

After the revelation that a former political operative earned a tidy living collecting sham finders’ fees in exchange for commitments from the New York State Common Retirement Fund, some industry observers wondered how to tell a real placement agent from a fake. One of the major criteria that the real placement agents pointed to was registration with the Financial Industry Regulatory Authority (or an analogous regulator such as the Financial Services Authority in the UK) as a broker-dealer. Registration indicates that you are thoroughly knowledgeable about private and public placements, and that you are subject to oversight and periodic audits – all of which should encourage in-house IR professionals at registered investment advisors to consider going through the process.

Though third-party placement agents are almost always registered as broker-dealers, in-house fundraisers at private equity firms are often not. There are a variety of safe harbours that exempt them from this requirement. First, only professionals working at registered investment advisors can register as broker-dealers, and most private equity firms are not (yet) registered investment advisors. Second, even at a registered investment advisor, an IR professional is not deemed to be a broker as long as certain requirements are met: the fund is being marketed to less than 100 people, the fundraiser has substantial other duties in addition to his role as a marketer, or the fundraiser hasn’t sold any other securities in the prior 12 months.

But even if an IR professional isn’t required to register, it might behoove him to, says Charles Lerner, principal at compliance consulting firm Fiduciary Compliance Associates. One reason is that US public pension plans could well start requiring that all fund marketers they interact with be registered broker-dealers, to avoid a repeat of the problems at New York State Common Retirement.

Becoming a broker-dealer is also worthwhile simply as an educational process, says Kelly DePonte, a partner at placement agency Probitas Partners and a longtime broker-dealer. Understanding the regulations for private placements is crucial. If a firm breaks any of these rules during the fundraising process – for instance, if a managing partner is quoted in the press talking about the fact that the firm is in the market – the entire fundraising process can be compromised. Once one of the rules has been breached, the Securities and Exchange Commission could later deem the fundraising as a public offering, giving investors room to seek restitution for losses. The only way to mend the breach is to stop fundraising for a certain period of time and then start over, a delay that no firm wants.

Even if none of the private placement rules are breached, an aggrieved LP could still in hindsight try to prove that the IR person who sold them a security was legally bound to register but failed to do so – and as a result wasn’t trained to ensure the suitability of the security for the client, Lerner says.

“This poses complex questions both of a regulatory and a factual nature,” Lerner says. “It is a good idea to consult and get advice on a firm’s particular situation, as to whether their investor relations or marketing staff are required to be registered as broker-dealers.”

Study hard
Becoming a registered broker-dealer isn’t just a matter of filling out forms. An IR professional who wants to become a broker-dealer will have to get buy-in from the whole firm. First, the firm itself has to become a broker-dealer. This requires filling out Form BD, supplying FINRA with certain background information, and complying with certain minimal capital requirements depending on the type of security being offered. Each state has its own broker-dealer requirements as well, so the firm must research and comply with the relevant requirements for each state in which it does business.

Then, whoever is interfacing with clients and selling securities has to take two tests: the Series 7 and the Series 63. These aren’t “gimme” tests, DePonte says – he knows people who failed the tests three times before passing. Whoever supervises the broker-dealer is required to take the Series 24, and the firm’s CFO or controller must take the Series 27. All of these people must file a Form U-4 as well, in which they report their prior employment history and disciplinary history. With exceptions for some types of securities, all the partners, officers, directors and employees of a broker-dealer also have to be finger printed.

One of the problems with the registration process, however, is that most of the information that is tested has to do with marketing public securities to unsophisticated public investors, DePonte says.

“The portions of the Series 7 test that are really applicable to private placements with sophisticated investors are extremely small,” he says. “It’s basically one-size-fits-all.”

After the initial registration, the firm is subject to periodic audits by FINRA, and the firm’s personnel have to meet continuing education requirements, usually through online classes.

The firm is also subject to stricter fiduciary requirements, among them antifraud provisions that prohibit “misstatements or misleading omissions of material facts, and fraudulent or manipulative acts and practices” in the marketing of securities. Broker-dealers must comply with NASD Rules of Fair Practice, and have an obligation to recommend only those specific investments or overall investment strategies that are suitable for their customers. The firm’s employees are also subject to stricter insider trading restrictions and monitoring.

In a world of increasing regulation and a renewed focus on consumer protection, it’s possible that soon private equity firms will be required to go through this process.

“If regulation is passed that requires organisations of a certain size to be registered, I would think that not only the IR staff would have to be registered, but you could read the regulations such that if you’re one of the partners and you’re involved in the fund marketing process and you’re meeting with investors, you have to be registered too,” DePonte says. “It would be a major change in the way in which things are done.”