In an earlier post, we discussed the ongoing violation of SEC broker-dealer regulations by private equity firms when they collect “transaction fees” for buying and selling companies on behalf of the funds they manage. The 1934 Exchange Act mandates that only SEC-registered broker-dealers may collect transaction-based compensation (subject only to limited exceptions which are not germane here ). Very few private equity firms are registered as broker-dealers (and even those are flouting the law in ways we’ll discuss later). This means that almost all PE firms are engaged in ongoing violation of the ’34 Act.
Today, let’s look at a particular transaction that not only illustrates this type of violation, but also contains other egregious mis-statements in order to hide truth.
In May 2007, a fund controlled by Apollo Global Management bought Claire’s Stores, Inc. Those with young daughters may be know this chain of 3,500 stores, which sell mostly hair accessories and very inexpensive jewelry aimed primarily at children. This was a height-of-the-bubble PE deal that barely escaped bankruptcy. Apollo took Claire’s private for a $3.1 billion purchase price and financed the deal by loading Claire’s with $2.4 billion of debt.
The deal was aggressive, not only in its very high leverage ratio, but also in the way Apollo “papered it up.” At the closing, Claire’s executed a “Management Services Agreement” with Apollo, where the company agreed to pay Apollo and its co-investors $3 million a year for ten years as payment for nebulously defined services purportedly to be provided by its PE overlords. In addition, the company agreed to pay Apollo $20 million in the form of what the agreement referred to as a “transaction fee.” (see section 2.3 in the embedded document).
Helpfully for our purposes, the agreement specified the services that Apollo purportedly provided in order to earn the transaction fee, namely “…certain investment banking, management, consulting and financial planning services…” in connection with the acquisition. (see third paragraph of agreement in the embedded document)
Apollo put the noose around its own neck by acknowledging a direct link between the $20 million transaction fee payment and “certain investment banking” services it had provided prior to the buyout (remember, this agreement was executed at the closing). As a widely-used Davis Polk treatise on broker-dealer law notes, “…persons (other than professionals such as lawyers or accountants acting as such) who participate in or otherwise facilitate negotiations in effecting mergers or acquisitions, and receive transaction-based compensation, are required to register as broker-dealers.” However, Apollo did not register as a broker-dealer until 2011, almost four years subsequent to the Claire’s buyout.
The agreement also contains a bizarre and presumably false statement when it says multiple times that Apollo advised Claire’s itself in the company’s buyout and was getting paid, in part, for that service. This is a departure from the usual shell-game claims used to justify transaction fees. Private equity firms typically state that they earned their fee for advising a shell legal entity that they created and controlled for the purpose of the transaction and into which the buyout target is merged. There are multiple reasons why buyouts are usually done in this merger-into-a-shell format, and one of them is that it provides a legal entity, albeit one controlled by the PE firm itself, that the PE firm can claim to have “advised” in order to earn its transaction fee.
For unknown reasons, Apollo dispensed with this well-established legal fiction and instead claimed in the agreement that it had advised Claire’s itself on the company’s response to Apollo’s buyout offer (see the third paragraph and section 2.3 of the embedded document). If this were actually true, which is possible in theory, the Claire’s board of directors would have been guilty of a glaring breach of fiduciary duty by paying for advice about a potential buyout from the prospective buyer.
There is one other whopper of a false statement that was made as part of the deal. In the proxy statement filed by Claire’s filed just prior to the buyout, Claire’s stated:
Section 3.17 Brokers. No broker, finder or investment banker (other than the Financial Advisors [Goldman Sachs and Peter J. Solomon Company, L.P. (together, the “Financial Advisors”)]) is entitled to any brokerage, finder’s or other fee or commission in connection with the transactions contemplated by this Agreement based upon arrangements made by and on behalf of the Company or any of its subsidiaries.
False statements of this type occur in almost all public-to-private proxies. The companies filing the proxies claim that nobody other than the formally-named investment banker(s) is going to earn a fee as part of the buyout, when the PE firm buyer is actually going to receive a transaction fee larger than any of the formal investment banking fees that are disclosed.
Of course, at the time that companies file these proxies, just prior to the deal’s consummation, they are already effectively already under the control of their soon-to-be private equity owners, so they presumably are following orders by making this routine false disclosure. Often, transaction fees are never disclosed, and when they are, it is typically months or years after the buyout closes, so nobody is the wiser.
This should be easy pickings for the SEC.