SEC Approves FINRA’s Capital Acquisition Broker Rules

On Aug. 18, 2016, the Securities and Exchange Commission (“SEC”) approved various Financial Industry Regulatory Authority (“FINRA”) rule changes, allowing for the adoption of FINRA’s capital acquisition broker (“CAB”) regime. The CAB regime will become effective no later than Feb. 14, 2017.

The proposed rule changes create a separate set of rules that would apply exclusively to firms that meet the definition of a “capital acquisition broker” and elect to be governed under these rules. This new regulatory regime could assist private fund managers that seek to raise capital for their funds through an affiliated entity or that engage in certain activities such as advising companies on M&A transactions. It is important to note that a broker-dealer that is a CAB would not be able to perform many tasks traditionally connected with broker-dealers, such as acting as an introducing broker, handling customer funds or securities, or participating in proprietary trading of securities or market-making activities.

The CAB rules were designed to acknowledge the relatively limited scope of such participants and exempt them from the more stringent rules FINRA created to govern the activities of traditional broker-dealers.

This disparity in the range of activities performed by firms registered as broker-dealers was highlighted in a recent SEC administrative proceeding against Blackstreet Capital Management and its principal owner, Murry N. Gunty. Among other violations, the enforcement action alleged that Blackstreet violated broker-dealer registration requirements when it performed brokerage services on behalf of fund portfolio companies. Ultimately, Blackstreet and Gunty agreed to pay approximately $3.1 million to settle the proceeding, which demonstrated the SEC’s renewed interest in the receipt of transaction fees by private equity fund advisers as part of a determination of whether such advisers may need to register as broker-dealers.

CAB Rules

To qualify as a capital acquisition broker, a broker must be engaged in one or more of the following:

• Advising an issuer, including a private fund, concerning securities offerings or other capital raising activities;
• Advising a company on the purchase or sale of a business or assets or regarding corporate restructuring, including a going-private transaction, divestiture or merger;
• Advising a company on its selection of an investment banker;
• Assisting in the preparation of offering materials on behalf of an issuer;
• Providing fairness opinions, valuation services, expert testimony, litigation support and negotiation and structuring services;
• Qualifying, identifying, soliciting or acting as a placement agent or finder (i) on behalf of an issuer in connection with a sale of newly issued, unregistered securities to institutional investors, or (ii) on behalf of an issuer or control person in connection with a change of control of a privately held company; or
• Effecting securities transactions solely in connection with the transfer of ownership and control of a privately held company through a transaction involving securities or assets of the company, to a buyer that will actively operate the company in accordance with the terms and conditions of an SEC rule, release, interpretation or “no-action” letter that permits a person to engage in such activities without having to register as a broker or dealer pursuant to Section 15(b) of the Securities Exchange Act of 1934.

With respect to a private fund manager utilizing an affiliated entity to assist in the capital raising activities of the private fund, the CAB regime will be helpful so long as the private fund manager limits the affiliated entity’s capital raising activities to 3(c)(7) funds. This is due to the fact that all of the investors from which the CAB raises capital must be “institutional investors.” An institutional investor includes qualified purchasers but does not include accredited investors. As a result, the CAB regime is effectively only applicable to CABs that raise capital for 3(c)(7) funds and cannot be utilized with respect to 3(c)(1) funds unless all of the investors in the 3(c)(1) fund separately qualify as institutional investors. In addition, private fund managers may be able to use the CAB regime to solve for the concerns arising under the Blackstreet enforcement action, assuming they limit their activities to those in which a CAB may participate and they comply with the obligations imposed on CABs.

In this regard, qualified FINRA members opting to elect CAB status will receive relief from the obligation to comply with a variety of FINRA broker-dealer rules. However, they will be subject to FINRA bylaws “unless the context requires otherwise,” as well as various streamlined rules to accompany CAB status. These include rules governing conduct, supervision and responsibilities related to associated persons, finances and operations, securities offerings and other areas of a firm’s operations.

The CAB regime should alleviate the uncertainty created by the various scope of activities of firms registered as broker-dealers. However, the rules will also impose several limitations on firms that choose to elect CAB status, forcing them to weigh the benefits against the constraints as they review their activities and decide which status is appropriate under the new regime.