Recent SEC Settlements Serve as Cautionary Tale About the Use of Unregistered Broker-Dealers by Investment Advisers
The Securities and Exchange Commission (SEC) recently announced settlementsinvolving a private equity firm, its former senior managing director, and an individual “finder” who solicited investors as an independent consultant for the firm.1 These settlements serve as a reminder to investment advisers and their principals to tread cautiously when engaging an unregistered “finder” in connection with fundraising efforts. As the settlements illustrate, engaging an unregistered finder risks exposing the investment adviser and its principals to liability for causing and aiding and abetting the unregistered finder’s violations of the federal broker-dealer registration requirements. In addition to this potential liability, engaging an unregistered finder could subject the investment adviser and its funds to potential private placement and disclosure issues, rescission liability, and reputational harm.
Recent SEC Settlements
Background. The SEC’s investigation found that the firm’s senior managing director who led the firm’s capital raising efforts caused the firm to engage the executive’s long-time friend as an independent consultant to find potential investors for the firm’s funds. The consultant was not registered as a broker-dealer or associated with a registered broker-dealer, and was subject to an SEC order barring him from association with any investment adviser. The executive had been “generally aware” of the consultant’s SEC disciplinary history. The firm agreed to pay a transaction-based fee of 1% of the commitments that resulted from the consultant’s efforts.
The executive, who was responsible for coordinating the consultant’s activities, instructed the consultant that his activities were limited to arranging meetings between potential investors and firm principals, and that the consultant was not to discuss his views of an investment in the funds or to circulate to potential investors any of the fund documents that were provided to him by the executive and other firm personnel. Despite these limitations, the consultant:
- engaged in substantive discussions with potential investors regarding their proposed investment in the funds (with and without the executive present);
- urged at least one potential investor to consider adjusting its portfolio allocations to accommodate an investment in the funds;
- provided potential investors with his analysis of the funds’ strategy and performance track record;
- circulated fund documents and due diligence materials to potential investors; and
- provided potential investors with confidential information relating to other potential investors and their proposed commitments.
The SEC noted that the firm received the consultant’s expense reimbursement requests, which reflected “extensive contact” with potential investors, yet the firm “did nothing to monitor or limit” the consultant’s contact with investors. Similarly, the SEC noted that the executive “eventually became aware” that the consultant was having “substantive communications” with potential investors, yet the executive “still failed to do anything to curb” these activities.
The consultant ultimately solicited over $550 million in capital commitments on behalf of the firm’s funds, and in return received approximately $2.4 million in fees. The firm also reimbursed the consultant for travel and entertainment expenses incurred in finding potential investors.
SEC orders and settlements. The SEC found that the consultant violated Section 15(a) of the Securities Exchange Act of 1934, which requires persons engaged in the business of effecting transactions in securities to be registered as a broker or dealer or associated with a registered broker or dealer. The consultant settled with the SEC and agreed to be barred from the securities industry.
The SEC found that the firm caused the consultant’s violations based on the firm’s failure to adequately oversee the consultant’s activities, limit the consultant’s access to key documents, and monitor or limit the consultant’s contact with investors. The firm settled with the SEC and agreed to, among other things, pay a $375,000 civil penalty. In determining to accept the firm’s settlement, the SEC considered the firm’s subsequent remedial measures to modify its policies and procedures to provide that it would not retain a third party, including a finder or marketer, that is not a either a registered broker-dealer or a registered representative of a broker-dealer to market or place any security or investment in any security of any of the firm’s affiliates.
The SEC found that the executive caused and aided and abetted the consultant’s violations by providing him with key fund documents and information, and by failing to monitor and limit the consultant’s activities despite being aware that he was having substantive communications with potential investors. The executive settled with the SEC and agreed to, among other things, pay a $75,000 civil penalty and be suspended from acting in a supervisory capacity of an investment adviser or broker-dealer for nine months.
These recent settlements serve as powerful reminders to investment advisers and their principals that engaging an unregistered broker-dealer may expose them to liability for causing and aiding and abetting the unregistered broker-dealer’s Section 15(a) violations. Given the liability risks, investment advisers seeking to raise funds should strongly consider employing a registered broker-dealer in connection with such efforts where the only alternative is to employ a consultant in purported reliance on the so-called “finders” exemption. In light of the SEC’s presumably favorable consideration of the firm’s modifications to its policies and procedures, investment advisers should consider whether to modify their policies and procedures to require only the use of registered broker-dealers or registered representatives of a broker-dealer in connection with fundraising efforts.
1. See Press Release, SEC Charges Private Equity Firm, Former Executive, and Consultant for Improperly Soliciting Investments (Mar. 11, 2013), available at http://www.sec.gov/news/press/2013/2013-36.htm.