SEC Enforcement Action Underscores Need To Evaluate Brokerage Activities of PE Fund Managers

07.20.2016

On June 1, 2016, the Securities and Exchange Commission (SEC) announced that Blackstreet Capital Management, LLC an SEC-registered investment adviser, and its owner, Murry N. Gunty, agreed to settle charges that they conducted brokerage activities without registering as a broker-dealer under the Securities Exchange Act of 1934, and committed other violations of the Investment Advisers Act of 1940.  The SEC’s enforcement action once again throws a bright light on the “transaction fees” paid to PE fund managers by portfolio companies and reflects continued scrutiny of the manager activities that generate such fees outside of the standard management fee paid by the fund.

According to the SEC’s order, as a result of a routine inspection and examination, the SEC found that Blackstreet was providing investment banking services to portfolio companies and charging success fees for the acquisition or disposition of the portfolio companies – all in lieu of using a third-party investment banking firm.  The services included soliciting deals, identifying buyers or sellers, negotiating the transactions, arranging financing and executing the closing.  According to the SEC, providing these services and receiving a transaction-related fee in connection with them, caused Blackstreet to be acting as a broker and requires a fund manager to register with the SEC as a broker-dealer, just as it would any other investment banker.

In addition to its activities as a broker, the SEC found the following violations of the Advisors Act:

• Blackstreet charged “operating partner fees” to portfolio companies of one fund that were not disclosed in the fund’s governing documents.
• Blackstreet used fund assets to make political and charitable contributions and pay entertainment expenses, none of which were expressly authorized by the funds’ partnership agreements.  Although Blackstreet later disclosed the use of fund assets and reimbursed the funds, with interest, for the charitable contributions and entertainment expenses, the disclosures were inadequate because they were not made until after fund assets were spent.
• Blackstreet acquired shares in a portfolio company from a departing employee without obtaining investor consent or providing appropriate disclosure.
• Gunty failed to provide adequate disclosure when he acquired fund interests from certain limited partners and then caused the general partner to waive his obligation to make capital contributions.  Although Gunty did not participate in the gains from investments for which he did not make capital contributions, the waivers reduced the amount of capital available to the fund for investments and increased each other partner’s pro rata share of future capital calls.

The SEC also alleged that Blackstreet failed to establish written policies and procedures reasonably designed to prevent violations of the Advisers Act arising from conflicts of interest, undisclosed fees and improper use of fund assets.

Broker-Dealer Registration

Over the last several years, industry professionals, regulators and commentators have debated the relative value of requiring private fund advisers to register as broker-dealers in order to receive transaction-based compensation for brokerage services.  The Blackstreet action represents the first enforcement action in which the SEC takes the position that fund managers providing such services and charging transaction-based fees are required to register. It also signals the SEC’s intent to enforce the registration requirements of the Exchange Act even under circumstances in which (i) the brokerage services were not performed by a true third party, (i.e., no “issuers exemption” based on the fund’s significant economic stake in the portfolio company) and (ii) the party acting as a broker-dealer was subject to the Advisers Act (i.e., registration as an investment adviser and provision of advisory services does not provide an exemption from registration as a broker-dealer).The order also indicates that the SEC does not apply the “M&A Broker” exemption, provided under the October 13, 2014 no-action letter from the SEC’s Division of Trading and Markets, to investment banking activities by PE fund managers.

Notably, the SEC’s order did not state whether Blackstreet’s transaction fees were used to offset the management fees it received as the investment adviser to the funds.  The former Chief Counsel of the SEC’s Division of Trading and Markets suggested in a 2013 speech[1] that a 100% offset against the management fee might alleviate concerns about whether a fund manager should register as a broker-dealer.  The Blackstreet action appears to leave open the issue of whether a full offset can operate as a safe harbor from registration.

However, because the SEC found several violations of the Advisers Act in addition to the adviser’s failure to register as a broker-dealer under the Exchange Act, the Blackstreet action does not provide clear guidance as to whether the SEC intends to enforce broker-dealer registration requirements against fund managers who otherwise comply with the Advisers Act and Securities Act.  Even so, the SEC’s Press Release plainly prioritizes Blackstreet’s failure to register and includes the following statement by Andrew J. Ceresney, Director of the SEC Enforcement Division:

“The rules are clear: before a firm provides brokerage services and receives compensation in return, it must be properly registered within the regulatory framework that protects investors and informs our markets. Blackstreet clearly acted as a broker without fulfilling its registration obligations.”

As a result, PE fund managers must carefully evaluate the investment banking services they provide to portfolio companies and the fees charged for such services to determine whether registration as a broker-dealer is required.  Failure to register when required could expose both the manager, the fund and the portfolio company to significant risks, including disgorgement of transaction fees, penalties, interest, censure and cease-and-desist orders, temporary injunctions and criminal charges.  Most importantly, a transaction involving an unregistered broker could give rise to a right of rescission for the counterparty in a private action, pursuant to the Exchange Act or under similar state laws.  Also note that if a fund manager decides to register as a broker-dealer, the manager must also become a member of the Financial Industry Regulatory Authority (FINRA) and will be subject to FINRA’s rules regarding investment banking activities and general broker-dealer compliance.

Additional Adviser Act Violations

The Blackstreet action also highlights the SEC’s continued focus on adequate disclosure of fees and expenses, as well as conflicts of interest.  Managers must ensure that fund governing documents specifically enumerate the types of expenses that the fund will bear and the fees that the manager or its affiliates expect to collect in connection with fund activities.  The fund documents should also disclose whether, and the extent to which, those fees and expenses will be used to offset the management fee.

The SEC’s press release is available here and a copy of the SEC’s order is available here.

If you have questions about this issue, please contact a member of Hirschler Fleischer’s Investment Management Team.

[1] David W. Blass, Chief Counsel, Division of Trading and Markets, U.S. Securities and Exchange Commission, “A Few Observations in the Private Fund Space” (April 5, 2013), available at https://www.sec.gov/News/Speech/Detail/Speech/1365171515178.