RIA Compliance Blog
Last month the Securities and Exchange Commission (“SEC”) sanctioned a registered investment adviser and its managing member for violating the Investment Adviser’s Act of 1940 (“Adviser’s Act”) and for acting as an unregistered broker-dealer in connection with the services the adviser provided to a private fund that it managed and the fees charged for those services.
Blackstreet Capital Management, LLC (“Blackstreet”) serves as the manager of two private equity funds (the “Funds”). In the Funds’ governing documents, Blackstreet disclosed to the Funds’ investors that it would charge fees for brokerage services rendered in connection with acquiring portfolio companies. Blackstreet did, in fact, perform brokerage services including soliciting transactions, identifying buyers and sellers, negotiating and structuring transactions, arranging for financing, and executing transactions. In exchange for those services it received over $1.8 million.
In its Order Instituting Administrative Proceedings (the “Order”), to which Blackstreet consented, the SEC found that this conduct violated the Securities Exchange Act of 1934 (“Exchange Act”) in that Blackstreet was operating as an unregistered broker-dealer. The Order also found that Blackstreet had charged certain fees that were not disclosed to the Funds’ investors and were not permitted by the Funds’ governing documents, that it improperly used Funds’ assets to make political and charitable contributions and to pay for entertainment expenses, and that it improperly acquired interests in one of the Funds from investors who desired to sell their interests.
In settling the matter with the SEC, Blackstreet agreed to disgorge the amount of the brokerage fees it had charged and to pay a $500,000 civil penalty. The total required to be paid by the Order, including pre-judgment interest is over $3.1 million.
In some respects, the Blackstreet matter is a continuation of a considerably long line of precedent whereby private equity funds or other hedge funds whose advisers charge transaction-based fees but are not registered as broker-dealers, are sanctioned for violating the registration requirements of the Exchange Act. The receipt of transaction-based fees has always been a critical element in determining whether or not registration is required. Other factors historically noted by the SEC are whether the adviser solicits, negotiates, and executes the investor’s transactions in the fund. Nevertheless, receipt of transaction-based compensation remains the key factor. Transaction-based sanctions consist of commissions or fees that will be paid to the adviser upon the purchase of an interest in the fund by an investor.
The Blackstreet case, however, is somewhat notable because it also focuses upon the receipt by Blackstreet of compensation for acquiring and selling companies within the portfolio. The services Blackstreet offered in exchange for those fees was “operating partner oversight.” But because those fees were not disclosed to the investors, a conflict of interest was created because Blackstreet compensated itself from fund assets without disclosing or receiving investor approval, in violation of the Adviser’s Act.
Parker MacIntyre provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds and issuers of securities, among others. Our regulatory practice group assists financial service providers with complex issues that arise in the course of their business, including complying with federal and state laws and rules. Please visit our website for more information.