What does it mean for a hedge fund to have an affiliated broker-dealer?
Definition of Broker-Dealer
We will start off by defining a broker-dealer. Basically a broker-dealer is the term used in the investment management industry for a firm which executes securities trades. The trades may be executed by these firms through an agency relationship (commission) with the client or through dealer (mark up) relationship with a customer. Some firms act in only one capacity and some act in both capacities depending on the securities traded.
While a broker in securities and a dealer in securities are technically different, each is registered as a “broker-dealer” with FINRA and one or several state securities commissions. To be registered as a broker-dealer a firm will need to have 2 owners who each have a current Series 7 exam license and a current Series 63 exam license (pursuant to state law). Additionally, one owner will need to be the financial operations principal which means they are in charge of making sure all of the financial filings are made to FINRA. The financial operations principal (FinOp for short) will also need to have a Series 24 exam license and a Series 27 exam license.
Answer to the Question
An affiliated broker-dealer is an entity which is registered as a broker-dealer which has some sort of affiliation with the hedge fund. Generally this will be through some sort of common ownership (i.e. principals of the hedge fund management company will work at or own a piece of a broker-dealer). Many large hedge fund platforms, and plenty of mid-sized and smaller hedge funds, have affiliated broker-dealers. The broker-dealers do not need to be the large national brokerage houses and oftentimes they are BDs which have either a regional or other focus (for example, OTC bond issues).
Where does this Question Arise?
This question is on the Form ADV which a hedge fund manager completes if the management company registers as an investment advisor with the SEC or state securities commission. This question may also be on a due diligence check-list.
Generally if there is an affiliated BD this will be described in the hedge fund’s offering documents. The hedge fund attorney should have discussed this issue with the manager prior to drafting the offering documents. Obviously, if there is a affiliate relationship, all information regarding the relationship should be disclosed in the private placement memorandum. If the investment program contemplates any trading through the broker-dealer, or any soft dollar placements, the relationship should be described thoroughly in the PPM. The disclosure will probably be in a few places, depending on the relationship, and certainly should be discussed in the ‘conflicts of interest’ section of the PPM.
This question may also arise if the hedge fund plans to invest in new issues. The owners or employees of the broker-dealer may be deemed to be “restricted persons” for the purpose of the new issue rule and thus they would not be able to realize the full amount of profits from the disposition of any new issue.
If you have any questions on this topic, please feel free to contact us and we will get back to you as soon as possible. Other related hedge fund law articles include: