The long-simmering question of whether buyout shops have to register as broker-dealers erupted this month in the form of a Securities and Exchange Commission enforcement action against Blackstreet Capital Management LLC.
In a June 1 order, the SEC found that Blackstreet Capital had violated the Securities Exchange Act of 1934 by performing its own brokerage services — prospecting for new deals, identifying potential sellers for portfolio companies, lining up financing, negotiating transactions — without registering as a broker-dealer. Blackstreet Capital, which specializes in buying and turning around corporate orphans, earned at least $1.88 million in “transaction-based compensation” for these services, the SEC found.
Without admitting or denying the findings, Blackstreet Capital and its owner agreed to pay more than $3.1 million to settle charges that it acted as an unregistered broker-dealer, as well as for other securities-law violations. A spokesman for the Chevy Chase, Maryland, firm declined comment on the findings in the order.
Law firm Katten Muchin Rosenman LLP sent out an advisory to its clients titled, “SEC Enforcement Action Highlights Need for Private Equity Firms to Consider Broker-Dealer Registration,” while compliance consultant ACA Compliance Group (a portfolio company of New Mountain Capital) sent out a similar message to its clients.
It remains to be seen whether the Blackstreet Capital case marks a “one-off enforcement action” or a “wholesale shift” in the SEC’s approach to enforcement, said a source familiar with the work of the Association for Corporate Growth. The source added: “A lot of firms are rattled by it.” ACG’s PE regulatory task force, or PERT, has made broker-dealer issues one of six priorities it is working on.
And with good reason. As registered broker-dealers, firms would have to become members of a self-regulatory organization such as the Financial Industry Regulation Authority. They would have to follow a host of rules and regulations and be subject to exams to test for compliance.
Smaller shops already complying with 1940 Act registration requirements would have a “strong reaction” to an additional layer of regulation, said our source familiar with the ACG. Firms also could face fines for past failure to register as a broker-dealer.
A spokeswoman for the SEC said the agency had no comment beyond the order and a press release.
The issue of broker-dealer registration bleeped onto buyout-shop radars in April 2013. Speaking at a meeting of the American Bar Association, then-chief counsel of the SEC’s division of trading and markets, David W. Blass, discussed two instances in which buyout firms might have to register as broker-dealers. (Blass said he was expressing his own views.)
One is where buyout shops employ staff devoted exclusively to fund marketing or that pay staff transaction-based compensation for selling interests in a fund. Another is where they receive transaction-based compensation for brokerage services provided to portfolio companies — along the lines of what Blackstreet Capital did.
In a bit of good news, Blass said registration wasn’t required if the brokerage fees fully offset management fees, a practice that has become increasingly common. Blass left the agency in August 2014, succeeded by Heather Seidel the following February.
The issue resurfaced a year later when Bloomberg News, citing a person with knowledge of the matter, reported that the agency was considering an exemption to the broker-dealer registration requirement for PE shops. But in an interview with Buyouts, a source with direct knowledge of the situation debunked that story. He even called it “a bit of a head-scratcher how everyone got comfortable with not registering.”
Since then some buyout shops have received deficiency letters in the wake of SEC exams saying that they should be registered as broker-dealers, according to a source at one PE firm. However, our source knows of no one that has registered as a result of those exams.
Instead, he said, they typically told examiners that on advice of counsel they “respectfully disagreed” with their position. Among the reasons is that they don’t market themselves as broker-dealers, they don’t treat investment banking as a business line, and they themselves are the buyer or seller as opposed to being an intermediary between buyers and sellers.
Perhaps the most troubling aspect of the Blackstreet Capital case for PE firms is the broad range of services the SEC tagged as brokerage services, including “soliciting deals.” Most buyout firms solicit deals and many charge closing fees after acquisitions. Also, the SEC evidently wanted to make a statement about broker-dealer registration in announcing the case. It titled its press release: “Private Equity Fund Adviser Acted As Unregistered Broker.”
On the other hand, Blackstreet Capital did not use investment banks or outside broker-dealers on its deals. That is unusual and suggests it went beyond the level of services provided by most buyout firms. Blackstreet Capital also was found to do other things wrong, including using fund assets for political contributions and entertainment expenses without permission from investors. That makes unclear how much weight the SEC assigned to the broker-dealer issues when deciding to bring an enforcement action.
The Blackstreet Capital case on its own isn’t likely to inspire more firms to register as broker-dealers. What it will inspire is more calls for guidance from the SEC. This Tuesday and Wednesday ACG is organizing a series of “fly-in” meetings for private equity CFOs and CCOs with SEC Commissioner Michael Piwowar; the director of the Office of Compliance Inspections and Examinations, Marc Wyatt, and other regulators and legislators. April Evans, partner, CFO and CCO at Monitor Clipper Partners and a member of PERT, said broker-dealer issues would be on the agenda.
“We need to have these conversations because this is a murky, murky area right now from the SEC’s perspective,” Evans said. “From the perspective of industry, it’s very clear. We’re not broker-dealers.”
Action Item: The SEC guide to broker-dealer registration: https://goo.gl/gMIAjX