Asset management quarterly - North America

Developments and market trends in North America

Global Publication October 2016

SEC enforcement action signals focus on private equity managers’ brokerage activities

Authors Michael Flamenbaum and Darius Ravangard

In a significant recent enforcement action, the SEC has for the first time charged a private equity fund manager for failing to register as a broker due to receiving transaction-based compensation with respect to its fund portfolio companies. As is common practice in the private equity industry, Blackstreet Capital Management LLC provided services with respect to the acquisition and disposition of its funds’ portfolio companies and received transaction fees. However, the SEC order does not indicate whether management fees for the Blackstreet funds were subject to any transaction fee offset. For this reason, the status of prior SEC Staff comments that a 100 per cent management fee offset avoids the need for broker-dealer registration is unclear. As a result, private equity fund managers that are not registered as a broker-dealer should review their transaction fee practices with outside counsel to consider the implications of the Blackstreet order.

In a significant enforcement action, the SEC has for the first time charged a registered investment adviser for failing to register as a broker due to receiving transaction-based compensation with respect to its fund portfolio companies. In June 2016 the SEC accepted a settlement offer from Blackstreet Capital Management LLC (Blackstreet) and its principal owner and managing member Murry N. Gunty. Blackstreet received over US$1.8 million of transaction and brokerage fees with respect to the acquisition and disposition of portfolio companies, including the purchase and sale of securities. The services included soliciting deals, identifying buyers or sellers, arranging financing and negotiating and executing transactions. These fees were disclosed in and permitted under the funds’ governing documents. However, Blackstreet was never registered as a broker. The SEC found these activities to be in violation of the broker-dealer registration requirements of the US Securities Exchange Act of 1934, as amended, and the settlement included disgorgement of the fees along with interest and a civil penalty. Blackstreet and Mr Gunty were also found to have engaged in certain conflict of interest transactions, improperly used fund assets and failed to adequately disclose certain fees and expenses that were charged to its funds and portfolio companies.

The SEC underscored the importance of its position in a press release in which Andrew, J. Ceresney, Director of the SEC Enforcement Division, stated that: “The rules are clear: before a firm provides brokerage services and receives compensation in return, it must be properly registered within the regulatory framework that protects investors and informs our markets. Blacksteet clearly acted as a broker without fulfilling its registration obligations.”

This issue first arose in 2013 when David Blass, then Chief Counsel of the SEC’s Division of Trading and Markets, suggested that private equity advisers might be considered to be engaging in broker activity by reason of the receipt of transaction fees from portfolio companies. However, Blass stated that if such transaction fees offset the fund’s management fee, the fees could be viewed as a method of paying the management fee and, as a result, there would not be any broker-dealer registration concerns.

On January 31, 2014 the SEC’s Division of Trading and Markets issued a no action letter issued that granted relief to “M&A Brokers” from registering as broker-dealer when engaging in certain activities, including change in control transactions of private companies. The SEC defined “M&A Brokers” as persons engaged in the business of effecting securities transactions solely in connection with the transfer of ownership and control of private companies. While private equity asset managers generally do not fit squarely within this definition and do not technically satisfy all of the conditions contained in the no-action letter, there was hope in the industry that private equity managers could receive transaction fees from portfolio companies without brokerdealer registration pursuant to the presumed policy judgment underlying the no-action letter that brokerage activities in connection with change in control transactions of private companies do not require brokerdealer registration. The Blackstreet action and subsequent SEC statements have confirmed that the relief granted under the no action letter will not extend to private equity managers.

Accordingly, it appears that the SEC may not see any distinction between private equity managers’ activities and those of persons formally engaged in the business of effecting securities transactions, and may subject private equity managers to traditional brokerdealer analysis when assessing brokerdealer registration questions.

Importantly, the SEC order did not indicate whether the Blackstreet transaction fees were subject to any management fee offset. Thus, it is unclear whether prior SEC staff comments that a 100 per cent management fee offset would eliminate the need for broker-dealer registration creates reflects the current position of the SEC Staff. As a result, private equity fund managers that are not registered as a broker-dealer should review their transaction fee practices with outside counsel to consider the implications of the Blackstreet order.

The appointment of federal administrative law judges and the US Constitution

Author Steven Howard

Five federal courts are grappling with the Constitutional question: Do federal administrative law judges (ALJs) have to be appointed by the President of the United States? The DC Circuit Court recently said no, but the issue is far from resolved. Hanging in the balance are thousands of ALJ cases that have been decided by ALJs who may not have been properly appointed.

There is a significant constitutional controversy currently in the US courts concerning the appointment process for federal administrative law judges (ALJs). There are about 1,700 federal ALJs in the US who preside over thousands of trials and adjudicate cases each year in 35 federal administrative agencies, including the SEC, Departments of Justice, Labor, Transportation, Veterans Affairs, the National Labor Relations Board and the Social Security Administration.

The pending controversy concerns whether Article II, Section 2, Clause 2 of the US Constitution (the Appointments Clause) requires ALJs to be appointed by the President of the United States or by commissions or governing boards of federal agencies that are appointed by the President, as opposed to federal administrative agents, boards or departments that are not appointed by the President.

The Appointments Clause provides that the President:

“shall nominate, and by and with the Advice and Consent of the Senate, shall appoint … Officers of the United States, whose Appointments are not herein otherwise provided for, and which shall be established by Law: but the Congress may by Law vest the Appointment of such inferior Officers as they think proper, in the President alone, in the Courts of Law, or in the Heads of Departments.”

The Appointments Clause requires “Officers of the United States” to be appointed by the President. This includes not only executive officers but also judicial officers and officers of administrative agencies. Thus, the central question that is currently pending before five federal courts: Are ALJs “officers” for purposes of the Appointments Clause? If ALJs are “officers”, they are constitutionally required to be appointed by the President or by officers appointed by the President.

Recently, the US Court of Appeals for the District of Columbia decided that ALJs who adjudicate enforcement cases for the Securities and Exchange Commission (SEC) are not “officers” for purposes of the Appointments Clause. Lucia Companies v SEC, US Court of Appeals, DC, No. 15-1345, decided August 9, 2016 (the Lucia decision). SEC ALJs are not appointed by the President, they are hired by the Office of Personnel Management which is not itself appointed by the President.

The DC Circuit Court found that SEC ALJs do not exercise “significant authority” as the Court so defined in two prior cases that applied a three part definition. The DC Circuit Court stated that the main criteria for drawing the line between officers on the one hand, and employees on the other hand, who are not covered by the Appointments Clause are: (1) the significance of the matters resolved by the officials; (2) the discretion they exercise in reaching their decisions; and (3) the finality of those decisions. The DC Circuit Court decided on narrow grounds that ALJs are employees because they do not issue final decisions because the SEC has statutory authority to review, approve, modify or disapprove every decision made by each SEC ALJ. The DC Circuit Court’s ruling in the Lucia decision is particularly important because the Circuit Court has statutory authority to review SEC cases and, as a consequence, has accumulated significant SEC and federal administrative agency expertise to which the other federal appellate courts frequently defer.

Thus far, there is not a “split” in the Circuit Courts – that is, an appellate court decision that has found ALJs to be officers that require Presidential appointment. There are, however, several federal district court cases that could create a circuit split which would in turn increase the likelihood that the US Supreme Court would review the DC Circuit holding in its Lucia decision.

A great deal is at stake if a federal court decides that ALJs are officers requiring Presidential appointments. While some federal administrative agencies have their ALJs appointed by governing boards and commissioners who have been appointed by the President, numerous federal agencies, like the SEC, have not provided for their ALJs to receive Presidential appointments. If a federal court finds that ALJs exercise “significant authority” and are therefore officers, thousands of previously adjudicated cases may become voidable. The retroactive application of such a federal court finding could have profound consequences for the federal agency adjudicatory process.

We will keep you informed of these significant judicial developments as they unfold.

The US Department of Labor issues a broad, new definition of fiduciary investment advice

Author Steven Howard

Recently, the US Department of Labor issued its final rule expanding the “investment advice fiduciary” definition under the Employee Retirement Income Security Act of 1974 (ERISA), with respect to pension plans covered by ERISA and individual retirement accounts. This is the first major revision to the fiduciary definition since ERISA was enacted in 1974 and is a key part of the President’s “middle-class economics” initiative.

Recently, the US Department of Labor (DOL) issued its final rule (the Rule) expanding the “investment advice fiduciary” definition under the Employee Retirement Income Security Act of 1974 (ERISA), with respect to pension plans covered by ERISA and individual retirement accounts (IRAs). The new Rule will significantly affect many aspects of the US investor marketplace which totals more than US$12 trillion in pension plan, IRA and 401k assets.

This is the first major revision to the fiduciary definition since ERISA was enacted in 1974 and is a key part of the President’s “middle-class economics” initiative. The DOL’s motivation for the Rule is to “level the playing field” and to ensure that investment advice given to investors is in their best interest. To do so, the DOL seeks to mitigate conflicts of interest that exist among broker-dealers, banks, investment advisers, and their clients and to address concerns that broker-dealers and advisers are incentivized to recommend investment products or services that may not be in the best interest of the customer.

The new fiduciary definition

Section 3(21) of ERISA defines a fiduciary to a plan or IRA as a person who

  • Has discretionary authority or control regarding management of a plan or exercises authority or control respecting the management or disposition of its assets.
  • Renders investment advice for a fee or other compensation with respect to money or assets of the plan.
  • Has discretionary authority or responsibility regarding the administration of the plan.

ERISA safeguards plan participants by imposing trust law standards of care and undivided loyalty on plan fiduciaries, and by holding fiduciaries accountable when they breach those obligations. In addition, fiduciaries to plans and IRAs are not permitted to engage in “prohibited transactions,” which pose special dangers to the security of retirement plans because of fiduciaries’ conflicts of interest with respect to those transactions.

The new Rule broadens the application of the traditional fiduciary standard of acting in the customer’s best interest to include the activities of broker-dealers, insurance agents, plan consultants and other intermediaries not previously covered as fiduciaries by ERISA.

Covered Investment Advice

Covered Investment Advice is defined as a recommendation to a plan, plan fiduciary, plan participant and beneficiary or IRA owner for a fee or other compensation, direct or indirect, as to the advisability of buying, holding, selling or exchanging securities or other investment property, including recommendations as to the investment of securities or other property after the securities or other property are rolled over, transferred or distributed from a plan or IRA.

  • Covered Investment Advice also includes recommendations as to the management of securities or other investment property, including, among other things, recommendations concerning investment policies or strategies, portfolio composition, selection of other persons to provide investment advice or investment management services, selection of investment account arrangements (e.g. brokerage versus advisory); or recommendations with respect to rollovers, transfers, or distributions from a plan or IRA, including whether, in what amount, in what form, and to what destination such a rollover, transfer, or distribution should be made.
  • The fundamental threshold element in establishing the existence of fiduciary investment advice is whether a “recommendation” occurred. A “recommendation” is a communication that, based on its content, context, and presentation, would reasonably be viewed as a suggestion that the recipient engage in or refrain from taking a particular course of action. The more individually tailored the communication is to a specific recipient or recipients, the more likely the communication will be viewed as a recommendation.
  • The types of relationships that must exist for such recommendations to give rise to fiduciary investment advice responsibilities include recommendations made either directly or indirectly (e.g. through or together with any affiliate), by a person who
    • Represents or acknowledges that they are acting as a fiduciary within the meaning of ERISA or the Internal Revenue Code.
    • Renders advice pursuant to a written or verbal agreement, arrangement or understanding that the advice is based on the particular investment needs of the advice recipient.
    • Directs the advice to a specific recipient or recipients regarding the advisability of a particular investment or management decision with respect to securities or other investment property of the plan or IRA.
    • In order for a recommendation to constitute fiduciary investment advice, it must be rendered for a “fee or other compensation.” “Fee or other compensation, direct or indirect” means any explicit fee or compensation for the advice received by the person (or by an affiliate) from any source, and any other fee or compensation received from any source in connection with or as a result of the recommended purchase or sale of a security or the provision of investment advice services including, though not limited to, such things as commissions, loads, finder’s fees, and revenue sharing payments. A fee or compensation is paid “in connection with or as a result of” such transaction or service if the fee or compensation would not have been paid but for the transaction or service or if eligibility for or the amount of the fee or compensation is based in whole or in part on the transaction or service.

What is not covered investment advice under the rule

Not all communications with financial advisers will be covered fiduciary investment advice. As a threshold issue, if the communications do not meet the definition of “recommendations” as described above, the communications will be considered non-fiduciary. The Rule also includes some specific examples of other communications that would not constitute a fiduciary investment advice communication, including

  • Education
  • General communications
  • Platform providers
  • Transactions with independent plan fiduciaries with financial expertise
  • Swap and security-based swap transactions.

The BIC exemption

The DOL’s Best Interest Contract Exemption (which some refer to as the “BIC” or “BICE”) requires retirement investors to be provided advice that is in their best interest while also allowing advisers to continue receiving commission-based compensation. Under ERISA and the Internal Revenue Code, individuals providing fiduciary investment advice to plan sponsors, plan participants, and IRA owners are not permitted to receive payments creating conflicts of interest without a prohibited transaction exemption (PTE). ERISA authorizes the Secretary of Labor to grant PTEs.

The BIC Exemption permits firms to continue to rely on many current compensation and fee practices, as long as they meet specific conditions intended to ensure that financial institutions mitigate conflicts of interest, and that they, and their individual advisers, provide investment advice that is in the best interests of their customers. Specifically, in order to align the adviser’s interests with those of the plan or IRA customer, the exemption requires the financial institution to acknowledge fiduciary status for itself and its advisers. The financial institution and advisers must adhere to basic standards of impartial conduct, including giving prudent advice that is in the customer’s best interest, avoiding making misleading statements, and receiving no more than reasonable compensation. The financial institution also must have policies and procedures designed to mitigate harmful impacts of conflicts of interest and must disclose basic information about their conflicts of interest and the cost of their advice. Importantly, the financial institution may not give its advisers financial incentives to make recommendations that are not in the customer’s best interest.

Impact of the rule

The impact of the Rule will be felt by firms across the financial services industry. The Rule fundamentally expands who is deemed to be a fiduciary by widening the range of activities covered by the standard.

The Rule imposes significant operational, compliance and supervisory burdens for broker-dealers, wealth managers, registered investment advisers, bank trust/ wealth platforms, retirement services platforms, plan record-keepers, and plan administrators. The Rule requires all institutions to begin to implement compliance structures around the new requirements. The financial institution must also provide a detailed list of web-based disclosures, updated at least quarterly, relating to the terms of its model contract, the fees charged, any third party payments it receives, the services it renders, and its policies for avoiding material conflicts.

Issues to watch

  • Court challenges from industry groups to try to derail the Rule are likely. An injunction could push the implementation date further down the road into the next administration, which would allow those new agency officials to decide the remaining details of the Rule’s implementation.
  • House Republicans have already passed congressional resolutions to kill the Rule, but President Barack Obama has pledged to stop those with a veto, and opponents do not appear to have sufficient support to override a veto.
  • A financial institution relying on the BIC Exemption may face challenges from class action litigants who allege that a recommendation was improperly motivated, and may have to restore to the plan or IRA any losses that ensue from its recommendation, plus the economic value of any opportunities that were foregone by the investor by reason of following the improper recommendation instead of making an alternative investment.
  • Finally,the Rule is increasing the pressure on the SEC to approve a uniform fiduciary standard. SEC Chairwoman Mary Jo White has previously indicated that she supports a securities law Fiduciary definition.

SEC proposes business continuity rule for advisers

Author Andrew James Lom

On June 28, 2016, the US SEC proposed new rules for investment adviser business continuity and transition plans. The rules to some extent codify existing practice but also raise potential compliance and enforcement issues. Industry participants are particularly concerned by the potential for public disclosure of sensitive succession planning and personnel information.

On June 28, 2016, the US Securities and Exchange Commission (SEC) proposed new Rule 206(4)-4 and related amendments to the recordkeeping requirements of Rule 204-2 (together, the “Proposed Rule”)1 under the US Investment Advisers Act of 1940, as amended (the “Advisers Act”), that would require registered investment advisers to adopt and implement written business continuity and transition plans in an effort to reduce the risks related to a significant disruption in and adviser’s operations and minimize investor harm.2 At the same time, the SEC’s Division of Investment Management issued staff guidance3 to registered investment companies (the “Guidance”) regarding their business continuity obligations under existing Rule 38a-1 (Rule 38a-1) under the US Investment Company Act of 1940, as amended.

Continuity plans

Business continuity plans (BCPs) are not new to the investment management industry. Rule 38a-1 was adopted on December 24, 2003, along with Rule 206(4)-7 under the Advisers Act for registered investment advisers (Rule 206(4)-7), in both cases to require implementation of a number of compliance policies and procedures.4 The SEC indicated in the adopting release for these rules that a registered investment company’s or registered investment adviser’s policies and procedures should include a BCP to the extent relevant.5 Many in the industry view BCPs as relevant to all advisers, and many investors routinely seek to understand an adviser’s BCP as part of the due diligence process before engaging the adviser or investing in a fund managed by the adviser. For example, as early as 2006, the Alternative Investment Management Association (AIMA) published a Guide to Sound Practices for Business Continuity for Hedge Fund Managers6, and the current Managed Funds Association (MFA) Model Due Diligence Questionnaire for Hedge Fund Investors asks managers to explain their plan to recover from business interruptions.7 Both the AIMA guide and the MFA model questionnaire purport to apply to all fund managers, regardless of their SEC registration status. Moreover, a 2009 survey of investment adviser compliance professionals conducted by the Investment Adviser Association8 found that the single largest area of increased compliance testing was in BCPs, indicating that advisers already had BCPs in place. Thus, many industry participants consider the Proposed Rule as merely clarifying existing law and codifying existing best practices.

The SEC staff has previously made efforts to clarify the BCP requirements under Rule 206(4)-7. In 2007, after Hurricane Katrina, the SEC’s Office of Compliance Inspections and Examinations (OCIE) and other SEC staff issued a Compliance Alert9 summarizing their evaluations of registered investment adviser BCPs, noting certain elements of effective BCPs and citing Rule 206(4)-7 as a primary source of relevant law. Then again in 2013, after Hurricane Sandy, nearly a decade following adoption of Rule 206(4)-7, a National Exam Program Risk Alert issued by OCIE10 continued to reinforce the expectation that registered investment advisers have BCPs, also pointing to Rule 206(4)-7 and discussing certain elements of effective BCPs and certain shortcomings. The Proposed Rule’s requirements are strikingly similar to the success elements for registered investment adviser BCPs discussed in these OCIE alerts

  • Maintenance of critical operations and systems, as well as the protection, backup and recovery of data.
  • Alternate physical office locations.
  • Communication plans for clients, employees, vendors and regulators.
  • Assessment of critical third-party service providers.
  • Transition of the registered investment adviser’s business when it winds down or is unable to continue to provide advisory services.

However, while the Proposed Rule may aim to codify existing law and practice, not every registered investment adviser has an adequate, or any, BCP, as noted in the OCIE alerts.

The staff Guidance, while not directly applicable to registered investment advisers, carries the same BCP themes. It elaborates the expectations for registered investment companies to

  • Periodically evaluate each service provider’s own business continuity plan (and assess backup processes and redundancies).
  • Consider how the business continuity plans of critical service providers may relate to one another in the context of each investment company’s needs and obligations.
  • Understand critical service providers’ cyber-preparedness and monitor their providers for cybersecurity breaches or other disruptions that may affect the operations of the fund complex.
  • Develop a plan related to potential breaches and disruptions at their critical service providers, including protocols for communications internally and with investors, regulators and the press.

These requirements are more pointed than those in the Proposed Rule and highlight a concern that, given the already high barriers to entry in the investment management industry, any new or specific requirements relating to BCPs may be overly prescriptive, irrelevant to certain businesses and/ or awkward to maintain in response to changing circumstances and risks. At the same time, the use of the Guidance for registered investment companies in connection with their BCP obligations under Rule 38a-1 has led some commentators11 to question whether similar guidance for registered investment advisers under Rule 206(4)- 7 would be more effective and efficient at achieving the results sought by the Proposed Rule. There is also some fear that, given the history of Rule 206(4)- 7, a new rule addressing BCPs would lead to confusing and overlapping compliance obligations and potentially duplicative enforcement actions for the same underlying “violation”.

Transition plans

In addition to BCPs, the Proposed Rule would require certain transition planning measures to be addressed by registered investment advisers, including

  • Policies and procedures related to the safeguarding, transfer and/or distribution of client assets during transitions.
  • An inventory of key documents, such as organizational documents, contracts, policies and procedures, including the location of such documents.
  • Details regarding the adviser’s management structure, risk management processes and financial and regulatory reporting requirements.
  • Material financial resources available to the adviser.
  • Policies and procedures relating to the prompt production of client specific information in order to transition client accounts.
  • An assessment of the applicable legal and contractual issues related to a transition.

In this regard, the SEC’s discussion of the Proposed Rule provides for short-term arrangements that seem more in the nature of a BCP and for long-term succession planning.12 To the extent a short-term transition plan overlaps with a BCP or includes protocols for wind-down, the Proposed Rule may have little effect on registered investment advisers. Other transition planning elements may already be covered by the agency nature of the investment advisory relationship, as the SEC notes that “advisers routinely transition client accounts without a significant impact to themselves, their clients, or the financial markets”.13 Likewise, reports by Hedge Fund Research14 show that 904 hedge funds liquidated in 2013, and 1,023 hedge funds liquidated in 2009, in each case with little apparent effect on the market, although there may have been some impact on investors in those funds, and the SEC notes that private fund transitions are also subject to the governing documents of each fund.15

The more problematic aspect is long-term succession planning under the Proposed Rule. Most registered investment advisers are privately-owned small business with fewer than 50 professional employees16 and, as is natural in any industry, view long-term succession planning as an intensely personal human resources or even estate planning matter. Such plans are highly sensitive and strategic, and even writing them down could have detrimental effects on the relationships among an adviser’s own personnel. Moreover, such plans likely are difficult to evaluate in an examination and enforcement context, potentially leading to unfair and disruptive results. Absent clarification, it may not be possible for registered investment advisers, their owners and their human resources departments to comply with a requirement to produce, disclose and annually evaluate their long-term succession plans, and doing so likely is not in the interest of their clients.





81 F.R. at 74716 and 74717.


A Guide to Sound Practices for Business Continuity for Hedge Fund Managers (June 16, 2006), see AIMA press release.



See comments submitted between July 8, 2016 and September 6, 2016, by, among others, AIMA, MFA, the Investment Adviser Association, the Investment Company Institute, and the Securities Industry and Financial Markets Association.


81 F.R. at 43538.


81 F.R. at 43535.


81 F.R. at 43539, footnote 75.

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