Over the last several years, the question of whether private fund advisors – private equity, real estate, private debt, and hedge fund managers – are required to register as broker-dealers has come up in a number of contexts.
Long before the SEC’s “Sunshine Speech” in 2014 , the regulator made headlines in 2010 when Andrew Donohue, director of the Division of Investment Management at the time, suggested to the industry that the mere selling of their funds might trigger the requirement that they register as a broker-dealer. Although this question continued to be raised without real follow-up during many routine examinations, the industry’s strong reaction and push-back seemed to pause the broker-dealer registration discussion.
More recently, the broker-dealer registration question has once again emerged in the context of transaction fees related to portfolio companies. Yet, after several major enforcement actions related to these fees were handed down, it was only on June 1, 2016, that the SEC brought the first enforcement proceeding against a private equity manager for failure to register as a broker-dealer. Over the coming weeks and months there will likely be follow-up by the regulator as well as industry debate on its actions.
Whether because of the sale of private funds to limited partners (LPs) by your investor relations staff or portfolio company transaction fees taken by the firm, your firm may be required to register as a broker-dealer in the coming years. The purpose of this article is not to debate the merits of registration, but to help private equity firms and CCOs think through the issues related to registration and to understand the many critical steps that are required as part of the registration process.
Broker-dealer entity and reorganization
The first step in your registration process is to create the broker-dealer legal entity and plan how to move your existing business and functions into it. This seems like a relatively straightforward process, but several important factors need to be considered. From a cultural and organizational standpoint, reorganization will be the most difficult hurdle to overcome and will generate the most showstopping issues.
Organizationally, the most critical restriction to broker-dealers is the requirement to be relatively independent of the larger or affiliated organization. For example, the broker-dealer must have its own Generally Accepted Accounting Principles financials, regulatory capital, and balance sheet. In addition, the new entity must have its own regulatory supervisory structure and dedicated personnel. Supervision of broker-dealer staff can only be done by individuals who hold the Series 7 and 24. This creates reporting line issues for many organizations.
In addition, organizations are often concerned about Financial Industry Regulatory Authority (FINRA) exam staff reviewing processes that are outside their jurisdiction and authority. Therefore, it is necessary to take a surgical approach to moving people and activities into the broker-dealer. For example, reporting line issues may occur when the investor relations head, who traditionally reports to an unregistered portfolio manager outside the broker-dealer, is named president of the broker-dealer and head of the supervisory chain. Reporting line issues can also occur for finance and compliance staff, as well as deal professionals responsible for, among other things, the work related to transaction fees.
Additional organizational issues may relate to ethical wall restrictions on data and transactions, compensation, and costs, such as those related to carry and the objective of limiting FINRA’s regulatory scope. While there are solutions to these issues, they require a great deal of private equity-oriented organizational and cultural knowledge combined with broker-dealer regulatory knowledge. All solutions will involve trade-offs in cost, efficiency, and control, and senior management must be aware of and respect these trade-offs.
Registration process
The broker-dealer registration process can be summarized in five steps:
1. Drafting and reviewing regulatory forms and applications, includingForm BD and the FINRA New Membership Application;
2. Training and licensing supervisors and staff;
3. Developing business and financial models and key policies and procedures;
4. Reviewing materials and the pre-membership interview; and
5. Starting operations and the first FINRA exam.
The key difference between the SEC and FINRA registration processes is that SEC registrations are generally expedited while FINRA registrations can take more than six months and involve a great deal of testing and review prior to any approvals.
The FINRA registration process focuses on the following key areas:
• Financial and compliance processes and controls;
• Reviews of the business plan and financial projections;
• Testing and interviewing of management to ensure regulatory and business competence;
• Technology; and
• The marketing and supervisory oversight process.
Broker-dealer regulatory examinations
There are a number of differences between FINRA’s examination approach and that of the SEC investment advisor examination staff. First, where the SEC staff has struggled to review new investment advisor registrants mostly due to volume, you can expect a regulation-mandated visit from the FINRA examination team within the first six months to a year of registration.
The first exam, while cordial and even supportive according to some, will generally be a full exam that covers the full scope of broker-dealer rules. Afterwards, you can expect a visit from FINRA examiners every two to three years (this may be slightly longer or shorter based on a number of factors including the results of the first examination).
Exams include testing and interviews across a full range of broker-dealer requirements, as well as extensive testing of the compliance and supervision processes. I have often heard that these exams feel like two separate examinations, the first focused on regulatory finance, capital, and reporting, and the second focused on sales practice, supervision, and employee compliance.
In addition, examination teams often do not have significant experience with alternative asset managers, particularly private equity firms. Therefore, you will be required to collaborate closely with examiners in order to explain the “square peg in a round hole” issues that you will encounter.
Finally, while FINRA’s core examination process will be similar to the SEC’s process, FINRA’s follow-up and enforcement process for violations is different and will require some guidance and navigation. For example, occasionally an aggregation of minor recurring deficiencies can result in a small fine. In contrast, the SEC generally either issues a deficiency letter or takes legal action.
Planning and management
Although the broker-dealer registration process is an organizational and cultural challenge and requires a heavy workload, it is not insurmountable. Many alternative asset managers and private equity firms have registered as broker-dealers for a variety of reasons and have dealt with FINRA examinations and restrictions for many years. The key takeaway is that while investment advisor registration is relatively straightforward, broker-dealer registration and the resulting reorganization require significant planning and management. While it will take some time to see how this issue plays out with regulators, firms and their CCOs are advised to begin the planning and analysis process now.
If you do not receive this within five minutes, please try to sign in again. If the problem persists, please email: