The Private Equity Fund Managers' Dilemma: Register as Broker-Dealers or (Potentially) Cease Collecting Fees for "Investment Banking Activities"?

Greg Kahn, Esq. and Eliza Sporn Fromberg, Esq. of Day Pitney LLP

In his April 5, 2013 comments addressed to the Trading and Markets Subcommittee of the American Bar Association (posted on the SEC's website) [1], David Blass, the chief counsel of the SEC's Division of Trading and Markets, made several suggestions that appear to be new SEC staff regulatory initiatives. One alarming comment is Blass’s suggestion that private fund managers' receipt of transaction fees in connection with the purchase, sale or recapitalization of a portfolio company, if accompanied by a securities issuance, may trigger broker-dealer status questions. Considering the costs of broker-dealer registration, the ongoing compliance burden, and the serious consequences of failing to register (including potential rescission of securities transactions), Blass's comments could create significant problems for private equity funds, particularly small funds, and independent sponsors (a/k/a fundless sponsors or pledge funds) that rely on these "transaction fees" or "closing fees" as part of their revenue streams.

Blass focused on the common practice of charging fees that compensate the private equity fund adviser for "investment banking activity," including negotiating transactions, identifying and soliciting purchasers or sellers of the securities of the portfolio company or structuring transactions. He noted that "taking [this] activity out of the private equity space and applying it in other contexts would leave little question about the need for broker-dealer registration."

To the extent that the fund manager takes a full offset of those transaction fees against the manager's advisory fee, Blass noted that, in his opinion, no broker-dealer registration issues appeared present, as the transaction fee was effectively an indirect way to pay the advisory fee. However, a full management fee offset is uncommon in the industry.

The Exchange Act defines a "broker" generally as "any person engaged in the business of effecting transactions in securities for the account of others." Blass noted that, in light of this definition, some market participants argue that there is no "broker" activity because the general partner (the typical recipient of the transaction fees as opposed to the fund itself) should be considered to be the same person as the fund and that, therefore, there are no transactions in securities "for the account of others" that would trigger broker-dealer registration requirements. However, Blass rejected this reasoning. In Blass's view, the fact that the fee is paid to someone other than the fund makes clear that "at least for potential broker-dealer status questions, the fund and the general partner are distinct entities with distinct interests."

Smaller private equity funds, independent sponsors and pledge funds often depend on "investment banking" type fees. These sponsors and funds now may face a requirement to either: (i) undertake the financial burden and compliance requirements of registering as a broker-dealer, (ii) surrender some degree of independence (and pay over a share of the fees) by affiliating with a registered broker-dealer, or (iii) cease charging fees linked to the effecting of securities transactions. On the other hand, Blass noted that he was "keenly aware that many advisers, particularly smaller advisers, may not be able to afford or be able to either hire a broker-dealer or register as broker-dealers themselves." Accordingly, he invited the industry to express its views as to whether a broker-dealer exemption specific to private fund managers would be helpful.

The potential impact of Blass's comments on independent sponsors (a/k/a fundless sponsors and pledge funds) is perhaps the most severe. An independent sponsor is a private equity-type professional investor that does not have a captive or committed fund that it manages or advises. It not only needs to raise the capital required to complete each transaction on a per transaction basis, but also does not actively manage a fund that pays it recurring management fees or other regularly recurring revenue. Independent sponsors have become more prevalent in recent years as raising committed funds has become increasingly difficult, time-consuming and costly for traditional private equity sponsors. Additionally, the lack of liquidity and poor returns experienced by many investors in many traditional private equity funds in recent years has made traditional private equity funds with long lock-ups, lack of transparency and high fees less attractive to many investors. Generally, independent sponsors undertake the costs of searching for a transactions, including travel, due diligence costs, and professional fees, with the expectation that the sponsor will be reimbursed at the closing out of the use of proceeds and also paid a fee for the time and efforts it spent on the transaction and getting it to a successful closing. Waiving the collection of such "transaction" or "closing" fees is not a viable option for these independent sponsors.

Private fund managers and fundless sponsors would be wise to heed the SEC's admonition to grapple with these issues in advance of a visit from the SEC's examiners, and to determine whether to revise their compensation arrangements or move forward with the broker-dealer registration process.

[1] David W. Blass, Chief Counsel, U.S. Securities and Exchange Commission, Division of Trading and Markets, Address to the Trading and Markets Subcommittee of the American Bar Association: A Few Observations in the Private Fund Space (Apr. 5, 2013), available at

Greg Kahn, Esq.,

Greg is Counsel in the Corporate and Business Law department. Prior to joining Day Pitney, he served as Partner and General Counsel of a lower middle-market private equity sponsor that he co-founded which made control investments in small, privately-held businesses, focusing on distressed and special situations investments.

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Eliza Sporn Fromberg, Esq.,

Eliza Sporn Fromberg's practice concentrates on broker-dealer regulatory, compliance, enforcement, litigation and arbitration matters. She assists broker-dealers and their associated persons in responding to regulatory examinations and inquiries and represents members of the financial services industry in enforcement proceedings before the SEC, Department of Justice, FINRA, and other SRO and state regulators. She also conducts internal investigations.

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Day Pitney LLP

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Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances, and reflects personal views of the authors and not necessarily those of their firm or any of its clients. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from Day Pitney LLP This work reflects the law at the time of writing in May 2013.