1. Rule 3a4-1 Safe Harbor Exemption from Broker Registration

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1 Chapter 10 Avoiding Broker Registration 10.1 Securities Exchange Act of 1934 The Exchange Act generally defines a broker as a person engaged in the business of effecting transactions in securities for the accounts of others 1 and generally defines a dealer as a person engaged in the business of buying and selling securities for that person s own account, through a broker or otherwise. 2 The general partner of a hedge fund must consider whether it is required to register as a broker or dealer by virtue of the role it plays in offering and selling interests in and buying and selling securities on behalf of the hedge fund. 1. Rule 3a4-1 Safe Harbor Exemption from Broker Registration Exchange Act section 15 3 provides generally that it is unlawful for any broker to use the mails or any means or instrumentality of interstate commerce to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security, unless that broker is registered as such with the SEC. Rule 3a4-1 4 under the Exchange Act provides a safe harbor exemption from the broker registration requirements for any associated person of an issuer if that person meets conditions specified in the rule. Associated person of an issuer includes any general partner of an issuer and any natural person who is an employee, officer, director or partner of a corporate general partner of a limited partnership that is the issuer. Presumably, although no definitive authority has been published, natural persons who are managers of a limited liability company that is the general partner of an issuer are also associated persons of the issuer. An investment adviser, as the general partner of a hedge fund, and its managers and employees who solicit investors for the hedge fund, may qualify for the Rule 3a4-1 exemption from broker registration if they (a) are not subject to a statutory disqualification, as that term is defined in Exchange Act section 3(a)(39), 5 (b) do not receive any compensation related to the amount of hedge fund interests sold (whether by commission or otherwise), (c) primarily perform or intend primarily to perform at the end of the offering substantial duties (other than in connection with the offering) for or on behalf of the hedge fund, (d) are not associated with a broker or dealer, (e) were not employed by a broker or dealer within the preceding twelve months, and (f) do not participate in an offering of securities (other than in certain limited circumstances) more than once every twelve months. A person is subject to statutory disqualification if such person: (a) has been and is expelled or suspended from membership or participation in, or barred or suspended from being associated with a member of, any selfregulatory organization, non-u.s. equivalent of a self-regulatory organization, non-u.s. or Exchange Act 3(a)(4), 15 U.S.C. 78c(a)(4). Exchange Act 3(a)(5), 15 U.S.C. 78c(a)(5). 15 U.S.C. 78o. 17 C.F.R a U.S.C. 78c(a)(39).

2 international securities exchange, contract market designated pursuant to CEA section 5, 6 or any substantially equivalent non-u.s. statute or regulation or futures association registered under CEA section 17, 7 or any substantially non-u.s. statute or regulation, or has been and is denied trading privileges on any such contract market or non-u.s. equivalent; (b) is subject to (1) an order of the SEC, other appropriate regulatory agency, or non-u.s. financial regulatory authority (i) denying, suspending for a period not exceeding twelve months, or revoking his registration as a broker, dealer, municipal securities dealer, government securities broker, or government securities dealer or limiting his activities as a non-u.s. person performing a function substantially equivalent to any of the above; or (ii) barring or suspending for a period not exceeding twelve months his being associated with a broker, dealer, municipal securities dealer, government securities broker, or government securities dealer, or non-u.s. person performing a function substantially equivalent to any of the above; under the CEA; 8 or (2) an order of the CFTC denying, suspending, or revoking his registration (3) an order by a non-u.s. financial regulatory authority denying, suspending, or revoking the person s authority to engage in transactions in contracts of sale of a commodity for future delivery or other instruments traded on or subject to the rules of a contract market, board of trade, or non-u.s. equivalent thereof; (c) by his conduct while associated with a broker, dealer, municipal securities dealer, government securities broker, or government securities dealer, or while associated with an entity or person required to be registered under the CEA, 9 has been found to be a cause of any effective suspension, expulsion, or order of the character described in clause (a) or (b) above, and in entering such a suspension, expulsion, or order, the SEC, an appropriate regulatory agency, or self-regulatory organization has jurisdiction to find whether or not any person was a cause thereof; (d) by his conduct while associated with any broker, dealer, municipal securities dealer, government securities broker, government securities dealer, or any other entity engaged in transactions in securities, or while associated with an entity engaged in transactions in contracts of sale of a commodity for future delivery or other instruments traded on or subject to the rules of a contract market, board of trade, or non-u.s. equivalent thereof, has been found to be a cause of any effective suspension, expulsion, or order by a non-u.s. or international securities exchange or non-u.s. financial regulatory authority empowered by a non-u.s U.S.C U.S.C U.S.C. 1 et seq. Id. 2

3 government to administer or enforce its laws relating to financial transactions as described in clause (a) or (b) above; (e) has associated with him any person whom he knows, or in the exercise of reasonable care should know, to be a person described by clause (a), (b), (c) or (d) above; or (f) (1) has committed or omitted any act, or is subject to an order or finding, enumerated in subparagraph (D), (E), (H), or (G) of paragraph (4) of Exchange Act section 15(b), 10 (2) has been convicted of any offense specified in subparagraph (B) of such paragraph (4) or any other felony within ten years of the date of filing an application for membership or participation in, or to become associated with a member of, such self-regulatory organization, (3) is enjoined from any action, conduct, or practice specified in subparagraph (C) of such paragraph (4), (4) has willfully made or caused to be made in any application for membership or participation in, or to become associated with a member of, a self-regulatory organization, report required to be filed with a self-regulatory organization, or proceeding before a self-regulatory organization, any statement which was at the time, and in the light of circumstances under which it was made, false or misleading with respect to any material fact, or (5) has omitted to state in any such application, report, or proceeding any material fact required to be stated therein. Even if the general partner of a hedge fund or its managers or employees fail to satisfy the safe harbor conditions, they might not be required to register as brokers on the grounds that they are not in the business of selling securities, as discussed below in section In such case, however, their activities in offering or selling interests in the hedge fund are more likely to be challenged by regulatory authorities. The SEC staff generally views with suspicion an arrangement under which a person claims to be soliciting investors as no more than a finder. In rare cases, 11 however, the SEC staff has not objected to a finder s participation in private offerings, if the putative finder does no more than introduce investors to the issuers or their promoters. The SEC staff would not agree that a solicitor is a finder, rather than a broker, if the solicitor assists in any other way in selling securities or negotiating or documenting the securities transactions. Except for that limited exception for finders, a person that is not employed by the general partner or that is a corporation or other entity and that assists in the offering of interests in the hedge fund must be registered with the SEC as a broker. The general partner should enter into a written agreement with any finder or broker it engages to assist it in the offering. The agreement should reflect the applicable requirements of the private offering exemption, the Exchange Act, the Advisers Act and state law. The hedge fund s offering circular should disclose the nature and terms of any such relationship or arrangement U.S.C. 78o(b)(4). 11 See, e.g., Paul Anka, SEC No-Action Letter (July 24, 1991) (Paul Anka will provide names of potential investors but will not contact them, solicit them, make any recommendations to them, participate in any negotiations with them or contact them concerning the issuer). 12 See and , supra. 3

4 2. Non-Safe Harbor Cases A general partner of a hedge fund and the general partner s principals may be required to register as brokers or dealers if they do not qualify for the Rule 3a4-1 safe harbor and their securities activities are sufficiently extensive. 13 The SEC examines a number of factors in assessing whether securities activities are extensive: the type of and basis for any compensation received, the extent to which the general partner holds funds or securities for others, the extent of contact with the public, and whether the general partner is engaged in the business of effecting transactions in securities. 14 If a person engages in securities activities often enough to support the inference that those activities are part of the person s business, he or she will be deemed to be engaged in the business. 15 The SEC views receipt of compensation related to sales of securities as an important factor in determining whether a person is acting as a broker. The SEC staff has declined to take a no-action position where a registered investment adviser proposed to assist a broker or dealer with solicitation and to receive transaction-related compensation. 16 In one no-action letter, an investment adviser proposed to assist a brokerage firm in presenting and explaining section 8 housing limited partnerships and other real estate partnerships or oil and gas partnerships to interested persons. For the investment adviser s services, the brokerage firm was to pay the investment adviser a consulting fee based on sales of partnership units to customers. The SEC staff concluded that the proposed activities would require the investment adviser to register as a broker or dealer, or as an associated person of a registered broker or dealer. Even a person that is not paid any commissions or other transaction-related fees may be required to register as a broker if the person proposes to locate issuers, solicit new clients and act as a customers agent in structuring or negotiating transactions. In one SEC no-action letter, 17 an investment adviser requested relief from registering as a broker where it proposed to locate prospective real estate investment trust (REIT) issuers and negotiate the terms of private placements by the REITs. The investment adviser would then attempt to interest its clients in purchasing those REIT securities. No registered broker or dealer would be involved in effecting these transactions. Even though the investment adviser was to be compensated by an annual fee based on the percentage of its assets under management, rather than on a transaction-specific basis, the SEC staff declined to provide no-action relief. In another no-action letter, 18 an investment adviser proposed to engage in three activities: (a) advising both U.S. and non-u.s. clients as to the value of U.S. securities, U.S. mutual funds and American Depositary Receipts; (b) publishing a newsletter, available for a flat subscription fee, containing business and economic information on India, including closing stock prices for Indian stocks and buy/sell/hold recommendations for Indian stocks; and (c) acting as a purchaser s representative by buying and selling securities on behalf of clients. The SEC 13 See, e.g., Boston Advisory Group, SEC No-Action Letter (Aug. 7, 1984); In Touch Global, SEC No-Action Letter (Nov. 14, 1995). 14 InTouch Global, SEC No-Action Letter (Nov. 14, 1995). 15 Id. 16 Boston Advisory Group, SEC No-Action Letter (Aug. 7, 1984) 17 PRA Securities, L.P., SEC No-Action Letter (Mar. 3, 1993). 18 InTouch Global, SEC No-Action Letter (Nov. 14, 1995). 4

5 warned the investment adviser that it might be required to register as a broker or dealer under the Exchange Act. 3. Solicitors The Advisers Act generally prohibits an investment adviser required to be registered under the Advisers Act from paying cash fees directly or indirectly with respect to solicitation of clients, except under arrangements that comply with Advisers Act Rule 206(4)-3 (the solicitors rule ). 19 To comply with the solicitors rule, the investment adviser s agreement with the solicitor must be in writing. The agreement must require the solicitor to provide to each client written disclosure about the solicitor s relationship with the investment adviser (including the compensation arrangement). The client must acknowledge in writing receipt of the written disclosure, and the investment adviser must retain copies of this disclosure and acknowledgement. 20 The investment adviser must make a bona fide effort to ascertain whether the solicitor has complied with the agreement and have a reasonable basis for believing that the solicitor has complied. No such disclosure, however, is required if the solicitor solicits only clients for impersonal advisory services (such as an advisory newsletter). 21 Although a partner, officer, director or employee of an investment adviser is subject to the solicitors rule and must be compensated pursuant to a written agreement and disclose his or her affiliation with the investment adviser, he or she need not disclose his or her compensation for solicitation activities or obtain an acknowledgment from each client solicited. 22 The written disclosure document provided to each prospective client must include the names of the solicitor and the investment adviser, the nature of the relationship (including any affiliation) between the solicitor and the investment adviser, and a statement that the investment adviser will compensate the solicitor for his services. The terms of the compensation arrangement, including a description of the compensation paid or to be paid to the solicitor, must also be disclosed, as well as the amount, if any, that the client will be charged in addition to the advisory fee because of the solicitor s involvement, and any differences among clients in the amount or level of advisory fees charged by the investment adviser that are attributable to any arrangement pursuant to which the investment adviser compensates the solicitor for soliciting clients for, or referring clients to, the investment adviser. The solicitors rule prohibits an SEC-registered investment adviser from paying fees to a solicitor (whether or not an employee and whether or not the solicitation is for impersonal advisory services) who has been convicted within the past ten years of certain felonies or misdemeanors, has violated the federal securities laws, is subject to an SEC order or decree, or is permanently or temporarily enjoined by order, judgment or decree of any court of competent jurisdiction from acting as, or as an affiliated person or employee of, an investment adviser, underwriter, broker, dealer, transfer agent or certain other occupations relating to the purchase or sale of securities. 23 This part of the solicitors rule prevents an SEC-registered investment adviser from hiring as a solicitor a person whom the investment adviser would not be permitted to hire as C.F.R (4)-3. Advisers Act Rule 206(4)-3(b), 17 C.F.R (4)-3(6). See also 8.4.5, supra. Advisers Act Rule 206(4)-3(a)(2)(i), 17 C.F.R (4)-3(a)(2)(i). Advisers Act Rule 206(4)-3(a)(2)(ii), 17 C.F.R (4)-3(a)(2)(i). Advisers Act Rule 206(4)-3(a)(1)(ii), 17 C.F.R (4)-3(a)(1)(ii). 5

6 an employee because of other provisions in the Advisers Act, and thus it prevents the investment adviser from doing indirectly what it cannot do directly. 24 The solicitors rule is primarily a disclosure rule that reflects the SEC s concern about the potential for clients to be misled or unduly influenced by a solicitor whose arrangement with the investment adviser is not fully disclosed. It is not a safe harbor from any broker registration requirements. Thus, a solicitor who assists an investment adviser in marketing interests in a hedge fund or shares of a mutual fund in full compliance with the solicitors rule is nevertheless likely required to register as a broker. The SEC has stated that an investment adviser that is not registered with the SEC may not rely on the solicitors rule. 25 In addition, the solicitors rule only authorizes the payment of cash referral fees to solicitors. Although no formal SEC statement prohibits the payment of non-cash referral fees to solicitors, the SEC might question the propriety of such payments, particularly absent full disclosure about the arrangement. 26 Any investment adviser, whether or not registered with the SEC, should make at least the disclosures required by the solicitors rule to any potential client that a paid solicitor solicits for the investment adviser. In recent years, the SEC has instituted an increasing number of enforcement actions alleging violations of the solicitors rule and the broker registration requirements by investment advisers and solicitors Dealer Registration Because a hedge fund buys and sells securities for its own account, it might arguably be comprehended by the definition of dealer. The SEC staff has, however, provided no-action relief from dealer registration where the partnership in question did not (1) act as an underwriter or participate in a selling group in any distribution of securities, (2) carry a dealer inventory in securities, (3) quote a market in any security, (4) advertise or otherwise hold itself out to the public as a dealer, or as being willing to buy or sell any security on a continuous basis, (5) render any investment advice, or (6) extend or arrange for the extension of credit on securities or lend any securities. 28 On other occasions, the SEC has also considered whether the person purchases or sells securities as principal to or from customers, runs a book of repurchase and reverse repurchase agreements, uses an interdealer broker for securities transactions, issues or originates any securities, or guarantees contract performance or indemnifies the parties for any loss or liability from the failure of the transaction to be successfully consummated Advisers Act Release No. 688 (Jul. 12, 1979), 44 F.R (Jul. 18, 1979). 25 Id. 26 See 14.2, infra. 27 Advisers Act Release No (Apr. 6, 1994); Advisers Act Release No (June 16, 1995). 28 Davenport Management, Inc., SEC No-Action Letter (Apr. 13, 1993). The SEC staff also provided relief from broker registration for the investment partnership s general partner, based on the requester s assertion that all investments and other decisions of the partnership were controlled by the general partner and the general partner s activities making decisions on behalf the partnership to buy or sell securities were not the activities of a broker, but rather activities necessary to carry out the business of the partnership. See also International Investment Group, Inc., SEC No-Action Letter (July 23, 1987); Acqua Wellington North American Equities Fund, Ltd., SEC No-Action Letter (July 11, 2001). 29 Acqua Wellington North American Equities Fund, Ltd., SEC No-Action Letter (July 11, 2001). 6

7 Other than issuing or originating securities (the interests in the hedge fund), the typical hedge fund does not engage in any of the above activities. Even the fifth factor listed above (rendering investment advice) is not present, because the investment adviser to the hedge fund, not the hedge fund itself, provides investment advice to the partnership. As a result, a hedge fund should not be considered a dealer. No authority provides guidance on whether the general partner of a hedge fund should be considered a dealer. The lack of reported judicial opinions and SEC staff no-action letters, in the face of such a common practice, suggests that the general partner should not be regarded as a dealer. If that is so, it may be because the general partner engages in securities transactions for the account of the hedge fund, not for its own account (disregarding that it may have itself invested in the hedge fund), or because the general partner does not provide investment advice about investing in the hedge fund and is not in any of the other categories described above Avoiding State Registration 1. Generally Definitions of broker and dealer in many state laws are similar to those in the Exchange Act, and many state laws provide similar exemptions from those definitions. 30 A general partner that offers and sells hedge fund interests in a particular state and does not qualify for an exemption from broker or dealer registration under that state s laws would be required either to register as a broker or dealer, or to rely on the position that it is not in the business of selling securities, notwithstanding its activities in offering and selling hedge fund interests. As noted above, although managers of private investment funds frequently maintain this position, it is subject to challenge by securities regulatory authorities or a private plaintiff. For example, California defines broker-dealer as any person engaged in the business of effecting transactions in securities for the accounts of others or his own account 31 and explicitly excludes an issuer and its agents from the registration requirements. Nevertheless, the California Commissioner of Corporations has indicated that an investment adviser and the hedge fund that it manages, if located in California, might be required to register as broker-dealers because they may be deemed to be in the business of effecting transactions in securities Employees as Agents Employees of a hedge fund s general partner may be required to register as agents or salespersons under state law. Many states, however, exclude from their definitions of agent any individual who represents the issuer in selling federally covered securities if no remuneration is paid specifically for selling the securities New York 30 See, e.g., California Corporations Code See , (c), , and 7.4.3, supra. 31 Id. 32 California Blue Sky Letter (9/21/98). 33 See, e.g., California Corporations Code 25003(d); Utah Uniform Securities Act (2). See , (c), , and 7.4.3, supra. 7

8 Unlike most states laws, New York law does not exclude issuers from the definition of broker or dealer. Accordingly, before offering or selling interests in a hedge fund in New York, the general partner must file, among other things, a broker-dealer statement. 34 This statement generally requires information regarding business history for the last five years, criminal record and educational background of the general partner and its partners, officers, directors or other principals. The broker-dealer statement is effective for four years from the date of filing. A general partner that fails to file the broker-dealer statement before offering hedge fund interests in New York could be subject to penalties and other disciplinary action assessed or prosecuted by the New York attorney general. 34 New York GBL 359-e. 8