Solving Private Equity's Broker-Dealer Compliance Challenge


Legal experts from Dorsey, Dechert, Goodwin and Katten Muchin come together to debate and analyze a SEC crackdown on private equity firms acting as unregistered brokers, and guide asset managers on their compliance paths moving forward.

Click here for a copy of the slides.

-Transcript; November 1, 2016 - 

Nicholas Donato: Hi folks, welcome to the latest roundtable in Navatar's Compliance Series. Today, we'll be talking about what's become one of the thorniest areas of compliance for the private equity world. That is of course, broker-dealer registration. I'm Navatar's Nick Donato, and I'll be your moderator today. Shortly, I'm going to introduce you to four of the leading legal experts on this topic, who together, I think can help us solve some of the more tricky issues that this broker-dealer registration challenge is presenting the sector. But first, why are we here today? What led to today's, conversation?

Well, we all remember, the David Blass case in 2013. For the uninitiated, David Blass was this SEC official who began questioning private equity firms that were collecting transaction fees. But they weren't registered as brokers. And what made it so scary is that transaction fees are a pretty regular feature of the private equity business model. So, Blass' speech sent a strong ripple effect throughout the industry, and that resulted in a lot of speculation. Lawyers were fielding calls from concerned private equity clients. The trade press, which I was a part of, went on to dissect the ramifications of broker-dealer registration from every angle. At the time it felt like what Blass was wondering about openly could eventually become official SEC policy.

Then for the next, about, three years, nothing really happened. There weren't any more speeches; the SEC wasn't really flagging the issue during its examinations. There was some speculation that the private equity industry could get a special exemption, but that didn't quite happen either, so people stopped talking about it. It seemed like the issue had lost all its momentum and sort of just died out. Well, at least that's what we thought, because in June, as many of you I'm sure are aware, the SEC rocked the private equity world when it slapped Blackstreet Capital Management with a $3.1 million settlement for engaging in brokerage activity without registering.

So what's going on here? Well, to find out, Navatar assembled some of the best legal minds on the issue, to find out. But before that, some quick housekeeping. The first thing I want to say is that a recording of this webinar will be emailed to everyone, including the slides, after the broadcast is finished. So, check that in your inbox later this week. Secondly, I encourage you to submit any questions, using that, GoToWebinar tool on your screen there. I'm going to reserve some time near the end of our broadcast to relay your questions to our legal panel, and because I'm not the one who has to answer them. I say the harder, the better. And I promise to preserve your confidentiality.

Now, how does Navatar fit into the picture? Well, we are a cloud provider, and one that is fully dedicated to the financial services industry. What we do is provide private equity firms and others, the industry's first connected growth platform, which is a way to combine your relationship management, fundraising, deal management, secure document exchange, and certain other workflows together onto one shared system. The platform is built on top of Salesforce, but it's been customized for your industry. And we have a support team that specializes in private equity and other sectors. So, without further ado, let's meet today's roundtable. Dan, lets start with you, if you could provide our audience the background of you, and what makes you a thought leader on our broker-dealer topic?

Daniel Baich: Thank you very much Nicholas. My name is Dan Baich, I am Of Counsel at Dorsey & Whitney. I've been practicing in the broker-dealer regulation space since 1999. And spent time at FINRA, and at several leading law firms.

Susan Grafton: I'll jump in here. I'm Susan Grafton, I'm a partner, at Dechert. I began my career in the SEC's division of trading and markets, although that was 1987, so at the time it was Market Regulation. Since then, I've worked in-house, as well as at a number of law firms representing private equity firms, as well as broker-dealers and advising on fee structures, fee payments, employment agreements, largely to try to avoid the broker-dealer registration issues. And I'm also an active member of The ADA's Trading and Market Subcommittee, where David Blass made the remarks that started the ball rolling. I'll turn it over to Peter.

Peter LaVigne: Hi, this is Peter LaVigne. I'm a partner at Goodwin. My practice is mainly broker-dealer and securities regulatory. And I advise not just existing broker-dealers, but also people who are wondering, whether they need to be registered as brokers. Our firm has a strong practice in private equity funds, as well as venture capital, real estate, and hedge funds, so, I field a lot of questions in this area, on a regular basis. Like Susan, I have a background with a regulator, in my case it was the New York State Attorney General's Office. And I just recently finished a three-year term as the Chair of the New York State Bar Association Securities Regulation Committee.

Richard Marshall: And my name is Rick Marshall. I'm a partner in Katten Muchin Rosenman in their New York office. Many years ago, I worked at the SEC for several years in various capacities. I guess, on this particular subject, I believe our firm had the first client alert on the Blackstreet case. It was less than 24 hours after the case was published. I worked very heavily on that. I also wrote an article about the case in the B&A Securities and Commodities Law Reporter, which was critical of the ambiguous message, though really lack of the message of the case, and I counsel private equity firms on these issues regularly.

Nicholas Donato: Thanks everyone. So, let's quickly lay out today's agenda. Four main themes that I want to touch upon. First, we want to get an understanding of how the SEC approaches this issue today, and how that might change following next week's election. We also want to give firms a sense of what the main red flags are when it comes to figuring out whether they should register. And then of course, once we give firms a sense of that, what that compliance path looks like moving forward. Lastly, as I mentioned, I'm going to reserve some time at the end here to broadcast some audience questions. Okay, so let's begin. I want to start by gauging all of your reactions to something that we heard when the Blackstreet settlement case was announced. An SEC official said in their press release, and I quote here, "The rules are clear. Before a firm provides brokerage services, and receives compensation in return, it must be properly registered with the regulatory framework that protects investors and informs our markets." Which to me is a pretty strong statement. Do you agree, what are your thoughts?

Peter LaVigne: This is where the transcript would indicate laughter, because, I don't think that they're at all clear, and they're not clear for a large number of reasons. One of the reasons is that we're not exactly sure. Blackstreet capital did not identify the particular fees that they were saying were brokerage fees. The order is sufficient in that it doesn't talk about that. In addition, Blackstreet Capital didn't talk about whether or not they should've been able to use the M&A broker exemption letter, which we can talk about later. But I think there are a lot of open issues that need to be talked about before we really understand what that case means.

Susan Grafton: And I think also because it's a negotiated settlement, and even if you ever have that, there are a lot of factors behind the scene that somehow resolved in a case that now, we're all looking to for the law, but it also could be just the result of negotiations between the respondent and the SEC. And I think that with Peter, in addition to his points, I think also there was disclosure that sounded very clearly that they provided services that were almost explicitly like a brokerage-dealer services. So that's a bad fact that you don't normally have with most private equity firms.

Richard Marshall: The article I wrote was called the 'Perils of Regulation by Prosecution,' and my point was that trying to develop the law by bringing settled enforcement cases is a terrible way to give guidance to people on what they can and can't do. And we heard some reasons for that, and why the Blackstreet case is not clear. We're probably going to hear more of that. We don't know exactly what makes the compensation that's received transaction-based compensation. We don't know exactly what activities a private equity firm can engage in, that cause it to need a brokerage-dealer licenses. And in fact, a lot of what private equity firms do, which is to acquire a company, manage it, and then ultimately sell it, is an advisory function, not a brokerage function. And it's not exactly clear, which of those activities sort of goes over the line. So, I think that it's very unfortunate that the SEC views this kind of a settled enforcement case, as the way to make clear law, it does not do that.

Nicholas Donato: Now would it be likely that the SEC does come out with some more industry-specific guidance to offer this clarity? Or is the more likely outcome that they continue using enforcement cases to make their point?

Richard Marshall: I think it depends on the leadership. We're going to talk about the election. The current leadership at the SEC has focused more on using enforcement actions to clarify the standards. We're not talking about here today, but we could talk about the whistle-blower area, where they're doing it by case. There are other areas, and I think it just depends on the direction that the new leadership wants to take people. I don't think that people in the private equity industry are going to willfully violate the law, if they're given clear guidance they'll follow it. The problem is, they don't have clear guidance.

Susan Grafton: And I think, to some extent, the staff believes that there is guidance out there. I'm not agreeing with that point, but I think to a large extent they believe that there is guidance. There's a whole litany of cases, and no action letters that define, who does have to register as a broker-dealer. So I do think that to a large extent, they feel like the law is clear, and everybody needs to figure it out.

Peter LaVigne: And a lot of us in the broker-dealer community have been talking to the SEC on and off about whether we could get a no-action letter or some kind of guidance. And one of the responses that we've gotten from them is, I mean it's discouraging, it's basically, be careful what you ask for because you might not like the answer. So there's been a disinclination to try to push the SEC at this point to come out with further guidance.

Nicholas Donato: So it seems like some of this will depend on who the country elects next week. Let's talk about that. Where does this issue go if Trump becomes president? Let’s start with a Trump administration and then go to Hillary.

Peter LaVigne: Look, the statistical models right now indicate that Mr. Trump has a likelihood of somewhere between 5 percent and 15 percent of winning the election, but it seems clear that if he actually won the election, it's highly likely that he would also get both houses. He'd have the Senate and the House of Representatives on his side. On the other hand, he's also been at war with Republicans right now, so it's not clear who is going to want to serve in his administration, and how well he's going to cooperate with people. But, there's a likelihood that of course, there are going to be more conservatives in his administration, but the SEC, and Susan maybe able to speak to this, and Rick, but SEC over the years, even in conservative administrations has tended to be highly investor protection minded. So, it's not clear that change would come from the agency, it might have to come from legislation.

Susan Grafton: And it might also depend on to the extent that there are more initiative like we've seen with the JOBS Act and crowdfunding. And those types of initiatives that might look at some of these broker-dealer registration issues as barriers to entry and impediments in terms of raising money. To me, it seems the most widely scenario, if Trump were to win where we might see some guidance and relief. But again, I think it's viewed as an independent agency that's charged with investor protection, so, whether or not it would be pushed to act and whether it would act quickly is an open issue.

Daniel Baich: It's an open issue, but I could see that any commissioners appointed by Mr. Trump would be likely more business-friendly than those appointed by a Democratic administration.

Richard Marshall: I think that it's actually more interesting to look at it from the other perspective, because as one of the speakers point out, it looks like Hillary Clinton is going to win. To me, the most unfortunate aspect of the lead up to that is the Elizabeth Warren letter to President Obama asking him to fire Mary Jo White as Chairman. That, I think is virtually unprecedented, and it signals that within the Democratic party, there is going to be, which Elizabeth Warren has been very explicitly saying, a push for a much more industry-hostile pro-enforcement SEC than what we have now. If President Obama did fire Mary Jo White, I guess Kara Stein would be the new Chairman. She is, I guess, I've been told a friend of Elizabeth Warren, and perhaps the signal was that what we want to have are highly politicized liberals, who don't have any particular desire to work with the business community, who're in fact, very hostile to the business community, and I think that direction might actually make things far worse.

Susan Grafton: And I was absolutely astonished to read a story that I read this morning that basically said that both parties had asked for... indicated that they would like for her to stay on at least for an interim period. So, I think that all this emphasizes that this is just completely up in the air.

Nicholas Donato: Which takes us back to another point that despite some SEC officials saying that the rules are clear, they are clearly not, and this is going to change even further depending on who does win that election. So, let's get into some of the specifics here then, about how people can identify what the red flags would be, as they're operating in this compliance haze we can call it. What are the SEC's concerns on the sale of private fund interests with respect to investor relation staff? When in your view, does this become a compliance risk?

Peter LaVigne: There's actually a Safe Harbor rule that people always use as a touch down 3a4-1, which is sometimes called the issuer exemption, although it's an exemption for employees and officers of the issuer. But there are some key things that are important in that rule. One of those things is that, the people who are selling interest have to have substantial other duties besides simply marketing, and the other one is that they can't be paid special compensation for marketing. So, questions always arise as to whether somebody can get a bonus and if the bonus can be based on how much they bring in. And I think generally practitioners say, "Look, a bonus is okay, if it's based on the person's overall performance, not just marketing, and taking into account how well the firm or the enterprise is doing." On the issue of substantial other duties, a very hard question that practitioners have to answer is, "What if those duties are investor relations?" You know, there are some companies, for whom investor relations is a legitimate and important role, and other places where investor relations is just another aspect of marketing." So, that's a problematic issue.

Richard Marshall: This issue has been around for a long time. When a hedge fund tries to raise money, it faces this issue. If you think about it, the interests in the private equity fund, the hedge fund, are securities. And so, are you affecting transactions and securities for the account of others. And that is an issue that has been well developed through 3a4-1 and a line of no action letters, which were sort of commonly known as the Finder's No Action letters. And, there are permissible activities that can be engaged in without the need for a broker's license, but I think the two touchstones are, number one, that there not be by the individual, the receipt of transaction-based compensation, and number two, that the frequency and extensiveness of the activity, and the sales effort be limited. It would not be something the person does all the time, as their sole activity, and they wouldn't go out and basically do hard sell sale pitches and then help the person fill out the documentation, and close the deal. So, there is well developed law in this area, but it's not unique to private equity.

I believe they brought a case, against a firm, about three years ago, for selling interest and not having a broker's license. I think that was in the private equity space, and that did attract a lot of attention. The good news for private equity is that they tend to do a new fund, not all the time, but every once in a while. There are some very large firms that might be constantly offering a new fund, but for most private equity firms, they're not offering a new fund every day of the week. So, there is a possibility of structuring either under 3a4-1 or the Finders No Action Letters, to avoid registration, if you're prepared to not pay transaction-based compensation to the sales force.

Daniel BaichThat's right, and then, if you do want to pay transaction-based compensation to a sales force, then you have to look into the possibility of creating a broker dealer or a captive broker dealer, and registering all the sales persons.

Susan Grafton: Or you could enter into an arrangement with a firm that basically will provide all the broker dealer, supervisory, and compliance functions to the sales force, and so, the sales team would be dual hatted and the broker dealer registration issues would be taken care of through this other entity.

Nicholas Donato: I wonder too, if you were to have a captive group, what kind of operational and logistical challenges does that present? Whether it's the chain of command, where it's job titles, whether it's the employment agreement… is that a big undertaking?

Susan Grafton: Well, from the broker-dealer perspective, they would all be registered with a third party broker dealer, who would be responsible for supervising them, and whether they have the authority to hire or fire, set compensation, but only with respect to the broker-dealer. So they can say, "Look, I don't want Joe to work with me anymore at this broker-dealer," and then it would be up to the private equity firm to decide on whether they wanted to keep him on, if they're thinking of that. If that was your question from sort of the reporting lines, and so, there could be two different sort of streams of compensation. One would be determined with respect to the sales activity, and one would be determined with respect to any other activities.

Daniel Baich: For a third party, for a captive broker-dealer, I think the compliance challenges are similar, but different in a way, because the private equity or hedge fund would be directly responsible for compliance with their captive broker-dealer.

Susan Grafton: Right, and I think one of the challenges you often see there is that you have sometimes a more junior person, who is put in charge of the broker-dealer functions, if you're going to have a captive broker-dealer. And so, how do you enforce the supervisory chain of control and make it look like the folks who have the regulatory risk at the broker-dealer really have the supervisor responsibility versus, say, the more senior people who are just performing the private equity functions.

Peter LaVigne: That's right. Nick, I think we're going to talk about registering a broker dealer a little bit later, but the fact is that when people are thinking about this process, they can't simply think about it as going through the registration process, and then they have a broker. But if ongoing compliance is a real burden, and it's something that has to be taken seriously, because there are compliance risks that arise if you get examined by the SEC or FINRA or somebody else, and they find deficiencies. It's just another thing to worry about on a regular basis, and to pay people to take care of.

Richard Marshall: Well, I know we're going to be talking about having a registered captive broker-dealer. If you have your individuals licensed at an independent third party broker-dealer, which is perfectly legal. So you have salesmen who work for you, but they're also registered reps of a completely independent firm that's a registered broker-dealer. In that context, I find that there's a few issues that the private equity firm has that make them resistant. One is, it costs money. Part of the compensation has to be paid to that independent third party. Number two, there's a loss of control. That broker-dealer sometimes says, "No, you can't do this. I don't like this issue, I don't like the way you're handling this." That is something people are bothered with. There's also, frankly, sometimes difficulty in finding the right firm. If you're marketing to world-class institutions, you want to have people who are licensed at a world-class institution, and frankly, the firms that will carry the licenses have become more reluctant to just take that on. So, it can sometimes be difficult to find a place for your people to get licensed, if you were being consistent with the way you want to present your firm to the world. So, those are the three issues that I see with that formula, but it works as a legal method.

Nicholas Donato: Now to determining whether or not that group should be captive or who should be registered, of course comes down to what types of fees you're charging, so I want to shift the conversation to that. One of the things that we hear or some of the speculation is that fee offsets are one potential escape route, and you'll see that I've listed a number of different types of fees that may trigger some compliance red flags. But let's begin with fee offsets. Is this an escape route?

Peter LaVigne: Alright, so the question is whether you're acting as a broker or dealer, and those are two different things by the way. So, if the fund is engaging in a transaction on its own behalf, it might arguably be a dealer, or it might be acting for its own investment account and not a dealer at all. So the argument is, that when the general partner or the manager of that fund does something on its behalf, it's not acting as a broker at that idea and intermediary, it's acting as the person who actually runs the other party to a transaction. So, if the manager in that case gets a fee, but offsets the fee 100 percent to the fund, then an argument could be made that it is the fund that's receiving the fee and not the manager, and therefore the manager is not being paid compensation for being a broker. Now issues come up about offset, one of the issues being, does the offset have to be 100 percent? And another issue being, what happens if the fees that are owed don't equal the fees that you're getting for acting as an intermediary? What do you do about those situations?

Richard Marshall: Yeah, I laughed because David Blass in that speech from 2013 said that if there was, I guess, 100 percent offset, that he would view that as taking the broker-dealer issue away. The reason appeared to be that there would be no receipt of transaction-based compensation. Basically, it you would be entitled to money, but it would cause you to receive less of typically your advisory fee, so therefore, net-net, you would not have any money coming in. That's all that we really have from the SEC, is one sentence in a speech from three-and-a-half years ago. And people debate this issue, and of course there is the complexity of what if it's less than 100 percent offset? Does that mean that it doesn't really count? We don't know.

Peter LaVigne: Yeah, and offsetting fees can be problematic for other reasons too. There's another case that the SEC brought against WL Ross and Company. And in that situation what was happening is that there was more than one fund that had an investment in a portfolio company, and there were also other investors besides the funds. And what happened there was that the SEC didn't like the way that the manager was offsetting fees with respect to the funds, because it felt that it had used the methodology that resulted in their getting more money than they should have gotten. So, you have to be careful about the offset, especially if there are multiple parties involved.

Nicholas Donato: And we mentioned too, the risk that you may be charging transaction fees that surpass your management fee totals to be offset. And let's just for the sake of argument say that you are doing it at the 100% rate, whether or not we have enough clarity on what happens next.

Richard Marshall: Well, I guess the problem at that point too is, if you've earned a fee that's larger than 100 percent of the offset of some other fee, you are, in fact, making money. You're just making less than you would without the offset. Then the question is, is making a small amount of transaction-based compensation okay? Then you're not acting as a broker, whereas making a big fee makes you a broker. There's no law on that at all that I'm aware of.

Peter LaVigne: That's right. I think it's a mistake to think that the SEC might respect a kind of de minimis analysis, and just to use an analogous point, in the Blackstreet Capital case, a lot of the assets that were being bought and sold were actually not even securities. When they actually did the analysis, I'm told by people who worked on the case, that there were only three transactions that involved securities, so they hoped that the SEC would conclude, "Well, you were good most of the time, and there were only three transactions that involved securities," but the SEC didn't take that position, so I think that you can't count on the fact that you've offset most of the fees, but not all of them, as being a defense.

Daniel Baich: I don't think you could be a little bit pregnant, in this case.

Nicholas Donato: So, I've put up some fees here, on the screen that could potentially be troublesome from the broker-dealer question. We can cherry-pick which fees we want to discuss, because I'm being conscious of time here, but I definitely want to discuss monitoring fees, and about when or where this would become an issue.

Peter LaVigne: I'm going to make the simple statement that monitoring fees become a problem when you accelerate them. You accelerate them in circumstances where you're supposed to be monitoring a portfolio company, for example, over a period of 10 years, but it gets sold, or it has an IPO prior to the end of that period, and there's an acceleration, so that you're getting the monitoring fees that you would've gotten for the last three years right up front.

Susan Grafton: And somehow you convert the monitoring fee into something that looks more transaction-based, which would go again to the acceleration point, but it's somehow geared to the disposition of a portfolio company.

Richard Marshall: In my view, a simple monitoring fee is not a transaction-based compensation, and it's not a fee for an activity that would normally be treated as one that would require broker registration. It wouldn't be effecting transactions and securities, either for your own account or the account of others. The whole issue of accelerated monitoring fees... You enter in to a 10 year contract with a portfolio company, and the contract provides that if the company is disposed of before the 10 years, the full 10 year fees have to be paid to the private equity firm, at the time of closing. So, let's suppose you have a 10-year contract, and after five years, the company is sold, so the private equity firm gets five years of monitoring fees, but they're not doing any monitoring, and that payment is triggered by the fact that the company is sold. There is absolutely no law on this. In some ways, it has an appearance of transaction-based compensation, but what is the activity? I think, you would also have to have some activity that would be traditionally associated with effecting transactions and securities. Typically, the private equity firm is involved in the disposition of the company, but are they acting as an advisor? Are they acting as a broker? What exactly are they doing? There has never been an enforcement case on this, and there have been plenty of enforcement cases about accelerated monitoring fees, but not saying that it required broker-dealer registration. And this is an intellectually interesting question, but I don't know if any guidance from the SEC that would say that you get an accelerated monitoring fee, you need a broker's license.

Peter LaVigneThis is a good opportunity to talk about what the SEC would look for and how fund managers can protect themselves, because what the SEC is going to be asking is, "What is the fee for? What is the activity for which you're being paid, and if it were an arms-length contract, would somebody else pay you this to do what you are doing?" It's not enough to call things something that don't look suspicious, or that are ordinarily seen in other contacts, like an advisory fee, or a monitoring fee. The SEC will look beyond the name, and they'll ask, "What actually is going on, and why are you being paid? You don't seem to be doing any kind of portfolio monitoring. What you really seem to be doing is introducing people, so that they can have transactions." That's where the problem lies, and that's how fund managers can protect themselves, by being very careful to understand what the fee is for, and if they would like to, they can conduct with the licenses that they have.

Nicholas Donato: I wonder too, given the current noise on the issue from the Blackstreet case, even if there's not been a prior case or prior guidance on it that you may start seeing something like structuring fees resulting from a club deal, start coming under scrutiny, because the examiners are taking orders from the top or they're equally aware of all the noise around it, and are taking a closer look or more skeptical eye on these fees.

Richard Marshall: One of the confusions here is after Blass speech in 2013, there were scores of private equity firms who had inspections and were asked to explain to the SEC why they were not registered as a broker-dealer. It was the finder's issue, the fundraising issue, it was also the deal fee issue, and firms uniformly put in letters saying that they didn't think they needed to be a broker-dealer for reasons A, B, C, D and nothing happened. The SEC has been sensitive to this issue for years, but what we have is one enforcement case.

Nicholas Donato: So, I want to pivot the conversation towards another recent development that may offer firms some relief on this matter. In August, the SEC approved a FINRA proposal for creating a separate set of rules for broker-dealers that must meet the definition of a Capital Acquisition Broker or a CAB. Is this something private equity firms should feel excited about?

Susan Grafton: It doesn't get them out of registering as a broker-dealer, but it does help them in terms of the burdens of being a broker-dealer. So I think that to an extent they have resigned themselves to needing to be a broker-dealer. It certainly is less onerous than the full-fledged broker-dealer registration.

Peter LaVigne: Yeah. I think the jury's still out on the Capital Acquisition Broker. The timing is that the rules will go effective in April of 2017, and you can start applying as early as something like January 3rd of 2017, if you want to be a Capital Acquisition Broker or if you're a regular FINRA member firm by the way, you can switch over to being in a CAB easily. But they're restricted to two main activities. One is private placements to institutional investors, which fortunately, also includes qualified participants, which is kind of people who go into 3C7 funds. And then the second thing that you can do is M&A transactions. And then you can engage in various kinds of investment banking activities, advisory activities, around those two things. But there are also limitations, so that you're not supposed to be able to do secondary transactions, and sometimes it's helpful for somebody who's associated with a fund to be able to help an investor to get out and sell to somebody else, but that at the moment is a restriction.

So you're still going to have to comply with SEC rules, because there's been no change in those, and also FinCEN, which controls AML processes. There are a few things about the FINRA CAB rules, which are really helpful. One of which is that there's going to be a much easier suitability standard. Another one is that the communications rule has been shortened down to a few conduct rules, so that you don't have to do filings with FINRA, advertising material and so forth. And in the communications rule, you'll be able to do something that regular FINRA members can't do, and that is to provide reasonable forecasts and projections with respect to offerings. So, PE firms could open a CAB as an affiliate, and use it to number one, sell interest in their funds, and number two, to engage in M&A transactions with portfolio companies and assets.

Susan Grafton: And receive transaction-based compensation, which is definitely the reward at the end of all of this hassle. I would think that some of these requirements that you mentioned, like FinCEN requirements, in many cases the firm doesn't want to do those, even without the CAB requirements.

Nicholas Donato: So the way that we've broken this down then is that there seems to be three options. You can remain unregistered, potentially rely on the M&A broker exemption that we discussed. There's of course, the option of registering, which a percentage of private equity firms have done, and then there is this CAB option that we're talking about. And it's your point Richard, yes, if we could shift in the pros and cons and identify the main areas that a private equity firm should look at to choose which of those three paths is right for their firm.

Richard Marshall: And just to put a fourth option on the table, we talked about it earlier, having a few individuals at the firm, become registered representatives of an independent third party broker-dealer. I think that's a fourth option.

Peter LaVigne: And I was just going to say something from the business point of view that registering as a broker, it could be extremely valuable. Obviously, there are some very successful companies that are brokers, without a doubt. But if you're a PE firm and what you want to be able to do is to have a few individuals marketing your fund once a year or a couple of times a year, and you also might want to get some kind of fees, M&A type fees, it may be that the cost of registering as a broker or a CAB just isn’t... It's just too high relative to the benefits of registration. So, there's going to be a lot of PE funds that may decide that remaining unregistered, but being careful about how they conduct their business is going to be superior. But if on the other hand, you've got a much larger organization, and you can use your broker/dealer in several ways, and there are a lot of opportunities to make fees available to you, then I think you should consider the process.

Richard Marshall: My experience is that many private equity firms resist registration. Some of the very largest ones are registering, but many firms still resist. I think that we've talked about the fact that it is expensive and time consuming to get through the registration process, particularly the FINRA fees. It is not an inconsequential cost to maintaining the broker-dealer of annual audits, periodic filings of this and the other thing. I find that firms are very concerned about the frequency of inspections. FINRA inspects firms very frequently, whereas the SEC inspects advisors relatively infrequently.

And there's a concern that FINRA, when they find minor technical problems, tends to bring an enforcement action. And although the penalties may not be as severe as with the SEC, that is something that firms are concerned about, a little sort of technical footfall that ends up on their record. Frankly, there's also a concern about licensing of individuals. On the advisor's side, there is the state licensing investment advisor/rep thing, but most private equity firms kind of avoid them for a number of reasons, but in the broker-dealer side, people will have to get licenses, which means they'll have to get finger printed, they'll have to take an exam, they'll have to maintain a Form U4, which discloses a lot of information, and is available now on the internet. And there's a lot of concern about that routine.

Susan Grafton: And I agree absolutely with all of those. I think there are also, though, when folks are weighing the decision and the idea of having the third party that we've discussed, there are concerns about having the information sharing that would happen with those third parties – if you're going to have your individual employees licensed though that broker-dealer. And sometimes, I think there's concern that investors might not want their information shared with that third party.

Nicholas Donato: So, in our final minutes here, I'm going to shift this over to audience questions. And one of the first questions that I'm reading has to do with compliance monitoring, and I'm going to take some leeway in paraphrasing this question a little bit differently than it's written, because it's a question that a number of Navatar clients have directed our way. And it's about using a system to monitor who's talking to prospective investors? Who's sending out diligence materials? Who had a marketing meeting? Who might be in any type of business that may give the appearance of affecting a transaction and triggering these broker-dealer compliance concerns? So, the question to the panel would be are firms taking a risk if they don't have a system in place to monitor who's sending out the PPM? Or who's met with any number of investors per quarter, whatever it may be?

Richard Marshall: I certainly think that firms have to monitor their marketing efforts, whether they're doing it through a registered broker-dealer or not, because they have to worry about anti-fraud. They have to worry about the Securities Act of 1933. They have to worry about the state notice filing. We haven't even talked about state registration, but if you're selling securities, you have to worry about whether some state is going to require an individual to get a license in that state. So, somebody who would go out and raise money, this sounds like more like a fundraising, without keeping a close eye on who's doing what, and what legal issues are raised by that, I think that would be very unwise.

Daniel Baich: I agree.

Nicholas Donato: We have a question here coming in that's related to fees. If an advisor to a PE firm receives fees that are contingent on the closing of the transaction, might that raise questions at the SEC?

Susan Grafton: It does because that sends us back to the whole issue of transaction-based compensation. So, if the idea is that the performing services and connection, let's say with a sale of a portfolio company, some other event that is a securities transaction, and the fee is contingent on that closing of that transaction, then that does raise the issue of broker-dealer registration.

Nicholas Donato: We have another question related to fees here, this one for debt investment firms. Would arranging and syndicating private loans for a borrower, and say one to three other lenders, where the borrower pays the investment manager based on the size of the deal, might that require broker-dealer registration?

Peter LaVigne: The whole issue of loans is interesting, because loans can be securities or not securities. It's not like the Howey Test, where you talk about participation interest and securities. This is a family resemblance test, so does something look more like a loan, or does it look more like you're selling securities? And if it looks more like a loan, for example, you have sophisticated institutions that are usually in the business of lending, and that can include hedge funds and BDCs that lend. And, are the loans being syndicated in a way that they're reasonably likely to end up in the hands of other sophisticated people, or are they broken up into pieces that could be sold to the public? And finally, there is some looking at whether there's an alternative regulatory structure, but that's not always decisive. The fact is, that loans can be either, and you have to be very careful to make sure that you're not just syndicating out loans to, for example, individual investors, because that could look more like a security.

Nicholas Donato: Another question coming in related to fees. This has been a fee really under the microscope of the SEC, dead deal expenses. When might they raise broker-dealer registration concerns?

Richard Marshall: I guess I can speak to that. That was one of the issues in one of the enforcement cases: How do you allocate broken deal expenses? In that case, the allegation was that the broken deal expenses were not borne in a manner that was consistent with disclosures, and therefore it raised anti-fraud concerns. There was no question raised about whether or not the broker-dealer fees required expenses, required broker-dealer registration. Normally, when you talk about transaction-based compensation, you're talking about revenue, not expenses. Normally, bearing expenses, and in a broken deal, I guess you pay money and nothing happens, you incur expenses, and then there's no transaction. Normally, that would not be viewed as transaction-based compensation, and the one case that we have talked about how those expenses were born, did not deal with the issue of broker-dealer licensing, so I would say that's probably not a high risk area.

Nicholas Donato: We have time for one last question, and this is going to be a difficult one. We have someone asking if they have seen third party advisors, who'll receive a transaction fee, plus the carried interest allocation, but it's structured through an intermediate entity between the portfolio company and between the PE funds, and it doesn't seem that such deal brokers need one or both of broker-dealer or SEC registration exemptions. Have you seen this in your practice, that intermediate vehicle?

Peter LaVigne: Well, I mean, it's not so much the intermediate vehicle point, but it's just what is the advisor getting a fee for? So there are advisors who are legitimately advising with respect to the assets or portfolio companies, and then there are other advisors whose value added is that they're bringing in investors. And if what you're doing, or if they're introducing two parties who are going to... Like a buyer of an asset and a seller of an asset, if that's what they're doing, just making an introduction or bringing in investors, then it does look like a brokerage transaction.

Richard Marshall: In tax law, in corporate law, frequently you can create structures where you have some entity that's sort of... one entity gates the fee and another entity performs the service, and you don't collapse the two. Under the federal securities laws that generally doesn't work. Each of the federal securities laws says, basically, you can't do indirectly what you couldn't do directly. So, creating different shell companies, and having one company get the fee and another company do the work, normally does not help you, you really have to look at the substance, the economic substance of what's going on.

Nicholas Donato: Well, that is all the time that we do have today. There are a number of other questions coming in, but you'll see contact information for all five of us there, if you would like to follow up with any of the points that you heard here today. I want to thank the roundtable for their valuable thought leadership. As mentioned at the start the webinar, a copy of today's recording will be made available in the coming day or two, so look for that. On behalf of Navatar, I'm Nick Donato, enjoy the rest of your day!