The U.S. Securities and Exchange Commission (“SEC”) recently approved a Financial Industry Regulatory Authority (“FINRA”) proposal to adopt a new regime for the regulation of electing broker-dealer firms that meet the definition of a “capital acquisition broker” (“CAB”).¹

The new rules are designed to relieve CABs from certain compliance burdens applicable to other FINRA members and may be useful for private fund advisers who wish to accept or pay to affiliated persons transaction-based compensation in connection with fundraising activities and portfolio transactions. However, in light of certain resource-intensive requirements that remain applicable to CABs, it is unclear to what extent the new regime will be embraced by private fund advisers.

Background

The Securities Exchange Act of 1934 (the “1934 Act”) defines a broker as “any person engaged in the business of effecting transactions in securities for the account of others.” In determining whether a person is a broker, the SEC focuses on whether the person receives transaction-based compensation and participates in certain key elements of securities transactions, such as negotiations with investors. A person engaging in such activities is generally required to register with the SEC as a broker-dealer and become a member of FINRA.

Over the past several years, private fund sponsors have found themselves subject to increasing regulatory scrutiny with respect to certain longstanding practices that the SEC has indicated could require broker-dealer registration.

The current discussion of potential unregistered broker-dealer activity in the private fund space went mainstream in 2013 with a now-famous speech by David Blass, then Chief Counsel of the SEC’s Division of Trading and Markets.² In his remarks, Mr. Blass specifically highlighted potential issues with respect to transaction-based compensation paid (i) in connection with the marketing and sale of interests in a fund (i.e., as placement fees) and (ii) in connection with portfolio acquisitions and dispositions (i.e., as transaction fees).

The SEC has in recent years announced settlements in enforcement actions taken against private fund advisers with respect to both fundraising activities and portfolio transactions:

• In 2013, the SEC settled with private equity firm Ranieri Partners (“Ranieri”), which had engaged an unregistered “finder” who solicited capital commitments from institutional investors in exchange for a fee equal to 1% of the commitments he facilitated.³ Ranieri agreed to pay a penalty of $375,000, a former Ranieri executive agreed to pay $75,000 and to be suspended for nine months from acting in a supervisory capacity at an investment adviser or broker-dealer, and the finder agreed to be barred from the securities industry.
• Earlier this year, the SEC settled with private equity fund adviser Blackstreet Capital Management (“Blackstreet”), which the SEC alleged had (in addition to certain Investment Advisers Act violations) provided brokerage services and received transaction-based compensation in connection with the acquisition and disposition of its portfolio companies.⁴ Blackstreet agreed to disgorge its transaction fees, with interest, and to pay a penalty of $500,000.

In 2014, the SEC issued a no-action letter⁵ (the “M&A Letter”) that provided limited relief for certain unregistered merger and acquisition brokers (“M&A Brokers”) who facilitate, and receive transaction-based compensation in connection with, transactions involving the transfer of ownership and control of privately held companies. Though certain conditions imposed on the relief provided in the M&A Letter limit its practical utility to most private fund advisers, it was viewed by some commentators at the time as a step toward more favorable SEC guidance with respect to certain private equity industry practices. Thus far, no such guidance has materialized.

In the absence of helpful guidance from the SEC, private fund advisers have generally sought to mitigate regulatory risk by (i) foregoing the receipt of portfolio-level transaction fees (or agreeing to 100% management fee offsets with respect to any such fees),6 (ii) avoiding the payment of placement fees and transaction fees to persons other than registered broker-dealers and their registered representatives, and/or (iii) registering an entity affiliated with the adviser as a broker-dealer and member of FINRA. Each of these approaches involves potentially significant costs to the adviser.

Capital Acquisition Broker Rules

Under the new FINRA rules, a CAB would be permitted to advise an issuer, including a private fund, concerning its securities offerings, and may engage in qualifying, identifying, soliciting or acting as a placement agent or finder on behalf of an issuer, including a private fund, in connection with a sale of newly-issued, unregistered securities to “institutional investors.”

For purposes of the CAB rules, the term “institutional investor” is based on the definition of the same term in FINRA Rule 2210, with the noteworthy addition of “qualified purchasers,” as that term is defined for purposes of the Investment Company Act of 1940 (the “1940 Act”). Accordingly, a CAB may act as a placement agent and receive transaction-based compensation with respect to offerings of interests in private funds able to rely on the exemption from the definition of “investment company” found in Section 3(c)(7) of the 1940 Act. However, because the definition of “institutional investor” in the CAB rules does not include “accredited investors” as defined for purposes of Regulation D under the Securities Act of 1933, a CAB would be limited in its ability to act in the same capacity for private funds relying solely on the exemption from the definition of “investment company” found in Section 3(c)(1) of the 1940 Act.

Under the new FINRA rules, a CAB would also be permitted to advise a company regarding its purchase or sale of a business or assets or regarding its corporate restructuring, including a going-private transaction, divestiture or merger, as well as to effect securities transactions in connection with the transfer of ownership and control of a privately-held company to an active buyer, in accordance with the terms and conditions of the M&A Letter.

CABs will generally be subject to the same securities laws and rules applicable to other broker-dealers, though certain FINRA rules applicable to other members (such as the prohibition against predictions and projections of investment performance) will be eliminated for CABs, and CABs will operate under relaxed supervision requirements. CABs will not be exempted from rules requiring net capital compliance, the annual preparation of audited financial statements or the payment of SIPC dues.

Conclusion

The CAB rules may be useful for certain private fund advisers who wish to raise capital through an affiliated registered entity or to accept transaction-based compensation in connection with portfolio transactions. The rules may also be useful for certain unregistered M&A advisors who currently rely on the M&A Letter to avoid federal broker-dealer registration but either face state broker-dealer registration requirements7 or wish to expand their activities beyond those covered by the M&A Letter. However, it is important to note that even under the new CAB rules the registration and operation of a broker-dealer will continue to be a resource-intensive undertaking. Additionally, in light of the narrow scope of activities permitted for CABs and the substantial degree of overlap between the FINRA rules applicable to CABs and those applicable to traditional broker-dealers, it is not yet clear whether registering under the CAB rules will prove to be an attractive option.

Fund advisers and others considering registration as CABs should consult with legal counsel to help weigh the costs and benefits of registration as well as possible alternative options.

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¹ See SEC Release No. 34-78617; File No. SR-FINRA-2015-054, Order Approving Rule Change as modified by Amendment Nos. 1 and 2 to Adopt FINRA Capital Acquisition Broker Rules (Aug. 18, 2016); available HERE. See also FINRA Notice of Proposed Rule Change to Create a Separate Rule Set that would Apply to Firms that Meet the Definition of Capital Acquisition Broker and Elect to be Governed by this Rule Set (December 4, 2015); available HERE.

²A Few Observations in the Private Fund Space, April 5, 2013, David W. Blass, Chief Counsel and Associate Director, Division of Trading and Markets, Securities and Exchange Commission.

³In the Matter of Ranieri Partners LLC and Donald W. Phillips, Securities Exchange Act Release No. 69091 (March 8, 2013); available HERE.

⁴In the Matter of Blackstreet Capital Management, LLC, Securities Exchange Act Release No. 77959 (June 1, 2016); available HERE.

⁵ Letter dated January 31, 2014 [revised February 4, 2014], from David W. Blass, Chief Counsel and Associate Director, Division of Trading and Markets, Securities and Exchange Commission, to Faith Colish, Martin A. Hewitt, Eden L. Rohrer, Linda Lerner, Ethan L. Silver and Stacy E. Nathanson. See our related e-alert HERE.

⁶ However, in light of the reasoning in the Blackstreet settlement announcement, certain commentators have questioned whether an adviser that collects fees in connection with portfolio transactions might still be required to register as a broker-dealer, even where such fees are subject to a 100% offset.

⁷ We note, however, that some states, including Texas, have adopted exemptions from state broker-dealer registration that generally correspond to the terms and conditions of the M&A Letter. See our prior e-alert on this topic HERE.