By Jacob Navon
Managers of alternatives firms may be ignoring an unexpected regulatory pitfall to their potential detriment. In a talk to the American Bar Association earlier this year, David Blass, the U.S. Securities and Exchange Commission's chief counsel of the division of trading and markets, highlighted the question of whether marketers employed, or engaged, by hedge funds and private equity firms might come under the broker-dealer registration requirements of the Securities Exchange Act of 1934.
Registering as a broker-dealer can add onerous costs and layers of managerial complexity, as well as additional regulatory oversight to an alternatives investment manager. Most important, the prospect of falling afoul of the SEC on these issues generates reputational risks that can be very consequential to a firm.
Four possible industry developments might be motivating this newfound interest in looking at broker-dealer registration requirements. First, the Dodd Frank legislation has brought most of the alternatives world under the requirements of the 1940 Investment Advisers Act. Consider that many personnel involved in distributing traditional 1940 act products, such as mutual funds, require broker-dealer registration, so why not distribution staff at hedge funds and private equity firms?
Second, the JOBS Act has liberalized funding through crowdsourcing portals, relaxing registration requirements for such entities. But paradoxically this may motivate regulators to look more carefully at the question of who should be registered as well as who might be exempt.
Third, the trend of offering so-called liquid alternatives, as well as the proposal to remove the ban on public advertising, will increasingly bring hedge fund type strategies to Main Street investors. Historically the SEC did not focus as much on alternatives firms because their clients, high-net-worth individuals and institutional investors, were presumed to be able to fend for themselves. Yet the closer an entity gets to retail investors, the more government protection may be deemed necessary.
Last, the alternatives segment has grown exceedingly large, becoming a very significant part of the investment universe. Again, the more significant a segment becomes the closer scrutiny it likely invites.
The tests for broker/dealer registration are broad and depend on the specific activities a person might perform. In general, any employee of, or adviser to, a fund whose main role is to market securities (which includes interests in hedge or private equity funds), to solicit or negotiate such securities transactions, or to handle customer funds and/or securities; may well require registration. The pressure to register is heightened when such an employee receives compensation that is based on the outcome of these activities, otherwise known as transaction based compensation. Any investment firm that raises capital by selling interests in commingled funds through a dedicated sales force paid on commission, for example, could fall under this very broad definition.
Many hedge fund managers have assumed that they can get around broker-dealer registration requirements by paying their marketing staff a subjective bonus rather than an explicit commission, presuming that the subjectivity of the bonus avoids the transaction based compensation designation. Alternatively they have assumed that the issuer exemption in the 1934 Act protects them.
Unfortunately neither assumption may exempt a firm from having to register as a broker-dealer. The criteria for registration do not necessarily apply only when there is transaction based compensation. And, even if it is subjective, how the bonus is determined may well matter a lot. After all, is it fair to presume that the bonus will be larger in years when sales are more plentiful? Even absent an explicit, documented, direct linkage to sales (such as a commission), the mere fact that the bonus is higher in good sales years may cause such an incentive to be considered transaction based compensation. And the issuer exemption, as currently formulated, only very narrowly applies to employees of issuers--those whose main role is not marketing and who are involved in providing information to broker dealers that are marketing their issuance. This exemption hardly applies to private fund marketers who talk directly to investors. Consider, also, that often the fund is a separate legal entity from the general partner and the general partner's personnel thus may not be working for the issuer itself. Many hedge funds employ their distribution personnel under a broader umbrella of “investor relations,” a role that includes maintaining relationships with existing investors as well as soliciting new ones. It is not clear whether this combination avoids these issues; if a firm came under scrutiny, it is possible the SEC might try to parse what proportion of an employee's time is accorded to their different responsibilities.
The foregoing matters a lot. Blass cited enforcement actions by the SEC that have meted severe consequences to both individuals, and their related firms, when they were found to be operating without necessary registration. This happened even in the absence of fraud or other harm to their investors. To be sure, this does not imply that every alternative investment firm is necessarily in violation of the rules. Yet in our legal system ignorance of the law, or simply applying it incorrectly (even when you intend to be in compliance), does not protect you from adverse outcomes--especially in cases that involve shaping public policy.
In more recent comments, Blass reiterated that the policy around broker/dealer registration requirements in the alternatives sector is unclear at best. He noted, moreover, that SEC staff are engaging with industry participants to try and clarify when registration might be required and when not. He explained that the intent here is not necessarily to require broker-dealer registration by all. But he also suggested that given other priorities, it is unlikely that the SEC will act formally and issue transparent guidelines for all to see. The simple point here is that until and unless the rules are relaxed explicitly, firms should not ignore the requirements of the 1934 Securities Exchange Commission Act even as they are paying all this attention to ensuring compliance with the requirements of the Dodd Frank Act and ensuing regulation.
At the very least, firms should engage with appropriate advisers to review, and perhaps modify, their sales compensation schemes. For added security, they can converse with SEC staff directly to get informal guidance about their own situation. As Blass commented, he is raising these issues so that investment entities do not get into trouble when the SEC inevitably descends on them for one of their “random” reviews. This is definitely one issue where an ounce of prevention may avoid tons of consequences.
Jacob Navon is a partner at Westwood Partners, an executive recruiting firm in New York that focuses on clients in the Investment Management, Wealth Management, Hedge Fund and Investment Banking segments.