A 12 month analysis of FINRA NMA’s (New member Applications) from July 2016 shows 55% of new BD firms admitted identify as private placement only, while nearly the same number of PP only firms withdrew.
Many in this fast growing cross-section of BD formations are running for cover under rabid disruption by the SEC. The controversy is over SEC’s Blackstreet Capital Management decision June 2016 that left private equity dealers trying to determine how to align with FINRA; should they get in, stay in, or get out.
Private placement firms handle a variety of transactions such as; raising start-up or injection capital, financing debt, and merger or acquisition capital. They work for a tight group of experienced investors. To register as a broker-dealer is an expensive process which subjects them to strict regulatory oversight; not something private equity firms are eager to do. Private fund groups point out that investors in private funds are accredited investors like; banks, insurance companies, and mutual funds who understand the risks. Also, private placement sales are limited to a closed group of 100 investors or less. If the purpose of regulation oversight is to protect investors, then there should be no need for oversight of highly experienced investors, right?
Nonetheless, FINRA and SEC are tightening the reins for private placement companies with a keen position toward transaction fees. The recent action against Blackstreet by the SEC was with regards to fees for “investment banking activities” they conducted for their portfolio companies. Bottom-line, if a private placement firm is charging fees, regardless if the fees are 100% refunded to investors, they are likely related to broker-dealer activities. Fee revenue, regardless of credit against the fees of 80% to 100%, is now under threat of being classified as transaction-based compensation for providing services.
In 2012 the SEC created a special unit to oversee the private placement sector and by 2014 it had flagged an alarming rate of violations in collection of fees and allocation of expenses. In a private equity industry conference, Andrew Bowden, Director of SEC, OCIE said, “we have identified what we believe are violations of law or material weaknesses in controls over 50% of the time.”
The Blackstreet case poses a number of threats and concerns for private placement firm structures.
Identifying when a person stops conducting non-broker activity and crosses over to a violation is still unclear. Many PP only firm violations under the SEC view stem from acting as finders, business brokers, or employees, who are unaware they have crossed the threshold.
Further, SEC enforcement action by unhappy investors can lead to litigation and investors seeking rescission of the contract (illegal contracts are void), not to mention monetary damages. SEC actions may include civil penalties, disgorgement of commissions earned, barring from the industry, and more. This puts private placement firms who are not registered as BD’s under tremendous threat when a deal goes bad. Once broker-dealer activity is established, the penalty can be substantial.
Private Placement only Advisors with the means to do so are likely to go ahead and register as a licensed broker-dealer rather than take the risk. Others stay awake at night wondering if they have somehow crossed the line; hoping tomorrow isn’t the end of the road. Still some wonder if this new action by the SEC is a preview of changes forthcoming, and how soon do PP only firms have to apply for BD registration or change strategy and structure altogether.
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What do you think; is the SEC imposing too much of a restriction on private placement firms that deal only with small groups of experienced investors?
RND Resources has a full suite of FINRA new member application and start-up assistance for private equity firms. We’re happy to work with your investors, attorneys, CPA’s, and other stakeholders to develop a winning strategy for your Private Investment firm.