Whistleblower Describes How Private Equity Firms Flagrantly Violate SEC Broker-Dealer Requirements

Last week, Crain’s Business Daily and Fortune reported that a whistleblower has provided the SEC with evidence of massive, ongoing violations of securities laws, specifically, the Securities Exchange Act of 1934, by several unnamed private equity firms.

The violations result from the long-established practice of PE firms charging “transaction fees” to investors in their funds when the PE firms, as managers of various funds, buy and sell of portfolio companies. They also levy transaction fees when portfolio companies issue debt or equity securities. Bear in mind that these fees are not in lieu of fees paid to investment bankers and brokers; they are additional charges, on top of both those third party fees and the private equity firm’s management fee, the famed “2 and 20” (2% annual management fee, 20% of the gains, although the management fee is lower for the very large funds). And these transaction fees are typically comparable in size to the fees paid to investment bankers.

This controversial practice has been going on for decades, and it is no secret. The PE firms collectively have reaped billions of dollars through this ruse. Dozens, if not hundreds, of articles have been written about it. Typically, these stories depict these transaction fees as an abuse of both the portfolio companies and the private equity fund investors, since portfolio company revenues are diverted into the pockets of private equity managers. For instance, a account about the whistleblower published last week by the usually pro-industry CNBC, where the headline itself described transaction fees as “private equity’s ‘crack cocaine.’

But as scandalous as this ongoing looting ought to be, the whistleblower focuses on another glaring problem with the private equity firm transaction fees: the private equity firms are not registered broker-dealers.

Anyone who has been in the securities industry will know how big a deal being a broker-dealer is. Even as a small firm consultant, I’d take care with how my engagements were defined so that there was no way they’d be considered to be securities dealing and hence oblige me to register my firm as a broker-dealer. Being a broker-dealer involves not just registering with the SEC but complying with a long list of requirements to make sure you are dealing with customers fairly, including:

Becoming a member of a self-regulatory organization (usually FINRA)

Training and licensing principals and staff

Obeying state securities laws

Being subject to SEC inspections and disciplinary actions

Complying with customer protection and commission disclosure rules, recordkeeping, financial reporting requirements, and Treasury anti-money laundering requirements

See this Davis Polk discussion for more detail.

So what is surprising isn’t that the whistleblower is making these charges, but that are about twenty years overdue. These filings are simply pointing out what should have been obvious to everyone all along: most of the PE industry stands flagrantly non-compliant with fundamental law regulating the duties of investment managers when they take “transaction-based compensation” in connection with the purchase or sale of securities on behalf of their clients.

The reaction of the PE industry flacks to these allegations has been all too familiar indignation resulting from an overweening sense of entitlement: how can anyone dare to question their fee skimming prerogatives? Legally, they have nothing to stand on. In a courtroom, even the best lawyers money can buy would find it well nigh impossible to defeat the clear language of the statue and decades of supporting decisions. However, the SEC is a very different forum than a court. The PE industry has a strong political hand there, as their lawyers marshal the only arguments they have, which are self-serving palaver dressed up as public policy claims for why the SEC should treat private equity differently than all other investment asset classes.

At their core, the industry arguments are an attempt to dismiss the issue as a mere “technical violation.” This is hard to stomach from firms that fetishize the clever use of contracts, financial engineering, and arcane tax and legal structures to rip out more profits and while insulating themselves from liability when things go awry. For example, when Bain Capital bought Gymboree, it did so through an intermediary called “Giraffe Holdings, Inc.,” and when it bought Dunkin Donuts, it was through “BCT Coffee Acquisition, Inc”. Bain would scream bloody murder if a court didn’t respect the separate legal existence of these purely shell entities.

The PR industry’s pious claims that “technicalities don’t matter when complying with them is inconvenient and costly” is a repeat of the posture of the mortgage securitization professionals, where the entire industry was founded on meticulous compliance with complex contractual provisions so as to satisfy multiple legal requirements. But when deal sponsors and servicers decided it would be cheaper to blow off these carefully crafted provisions that were fundamental to achieving highly desired legal outcomes, suddenly mortgage and foreclosure frauds were rebranded as “paperwork problems”. You can easily substitute “private equity” in this discussion by Georgetown law professor Adam Levitin of the securitization industry’s efforts to trivialize its abject disregard for the law:

To raise the “it’s just paperwork” argument in the context of securitization, however, is unreal. Securitization is all about legal fictions and paperwork. Why on earth would anyone every bother with the complex legal structures of securitization (typically involving two shell entities) other than to take advantage of legal fictions?

As I’ve noted in other venues, securitization is the legal apotheosis of form over substance, and the basis on which this is legally tolerated is the punctilious observance of formalities. Failure to do so can result in a securitization failing to be bankruptcy remote or to lose its off-balance sheet accounting status or lose its pass-thru tax status, any of which are disasterous. Securitization deals were so heavily lawyered precisely because the paperwork matters. They aren’t like a sale of a used sofa over Craigslist.

Whether private equity fund investors have been cheated out of brokerage fees is a difficult question. By not registering, PE firms have evaded the requirement of registered broker-dealers to provide investors with brokerage commission reports. Investors can’t tell whether they have been cheated out of portions of transaction fees that were supposed to be rebated to them because they never got the information they would need in order to know. It’s much like the NSA before Snowden arguing that nobody could prove illegal spying because the fact of the spying was itself a secret.

How has the SEC missed this flagrant violation of the 1934 Exchange Act for so long? The answer is very simple, and has a surreal Catch-22 quality. Basically, the SEC limits its surveillance for security law violations almost exclusively to those who volunteer to be examined, either as “investment advisers” or “broker-dealers”. Other than shutting down flagrant Ponzi schemes run by two bit hustlers, the SEC does very little even to look for securities law violations among investment firms that don’t comply with requirements to self-register as broker-dealers or investment advisers. Almost all PE firms chose to keep the SEC entirely out of their houses by ignoring the requirement to register as broker-dealers. To the SEC, the private equity industry, and its illegal broker-dealer practices, simply didn’t exist. And Dodd Frank’s registration requirements don’t address this issue. Private equity firms are now required to register as investment advisors, but that regime covers different activities than that of broker dealers, and thus is not relevant to the transaction fee abuse. But, natch, the SEC firms are arguing otherwise: the SEC is already supervising [part of] what they do, so that should be more than enough.

In fact, the SEC’s failure to supervise all relevant securities-related activities was the heart of the Madoff fraud. Madoff had two businesses: a basically legitimate broker-dealer unit that was registered with the SEC and therefore regularly audited by it, and an unregistered investment adviser that was running the massive Ponzi fund. The SEC dutifully oversaw the broker dealer while essentially pretending that Madoff’s investment adviser unit didn’t exist. So the PE funds are arguing we should just trust them with the mirror image of Madoff’s supervision.

We’re going to continue to probe this topic. There’s lot’s of interesting evidence available in the public domain showing how PE firms have carried on their shenanigans, and we are going to examine it. We are also going to look at the political efforts of the industry to influence the SEC, and also ask some questions about how such a nakedly illegal securities practice has managed to hide in plain sight for so long.

Print Friendly, PDF & Email


  1. ltr

    Please do continue the analysis of both problems, I at least was not aware of either of the problems and both seem quite important. I will read your essay again now.

    1. sgt_doom

      Thanks, I always believed this to be the case as there really “is nothing new under the sun” — as Louis Brandeis detailed in his classic work, Other People’s Money and How the Bankers Use It, the ussuance of securities can frequently be simply a stealthy way of shifting ownership, such as when the Blackstone Group puts for a securities issue for AXA Holdings, which is partially purchased by Bank of America, and State Street Corporation, therefore having AXA Holdings owning a portion of BofA stocks, while BofA owns a portion of AXA, and they both, and vice-versa, own a hefty portion of State Street Corporation’s stocks.

      Cross stock ownership? Thought that was supposed to be illegal, after all…….

  2. TomDority

    Can anyone say “Money Trusts”

    A quick reading of the 1919 publication of
    “Other People’s Money’
    by: Louis Dembitz Brandeis

    Would shed light on this whole bit a fraudulent activity and the accompanying influence by Investment Bankers and how their shackles were re-removed by repeals of Glass Stegal and others that were enacted because of the dangers of the Money Trust

  3. Ulysses

    The greed and shameless selfishness of most folks in the financial sector is breathtaking. Even the slightest limits on their looting behavior are laughed at and ignored.

    “Other than shutting down flagrant Ponzi schemes run by two bit hustlers, the SEC does very little even to look for securities law violations among investment firms that don’t comply with requirements to self-register as broker-dealers or investment advisers.”

    This is indeed disturbing, yet I can’t help feeling that perhaps people already understand we can’t trust these foxes to guard this henhouse, and have moved on to question whether the whole egg-farm of hyper-financialized capitalism should continue to exist at all.

  4. Lambert Strether

    Look, the free market takes care of this stuff. What’s wrong with you?

    I mean, just imagine the reputational damage if this were true. So it can’t be true. I think Crains has been taken over by communists.

  5. Chauncey Gardiner

    Very much appreciate this post. Thank you. The journey to clean up, restructure and aggressively regulate financial intermediaries, their so called “securities”, their skimming and manipulations, and their egregious fee and personal compensation structures, begins with steps like this. I very much hope the steps briefly outlined in the final paragraph of this post bear fruit in influencing our representatives in government to undertake meaningful policy changes relating to this sector.

    I am in full agreement with Ulysses comment above otherwise, including his final sentence. Our society simply can’t continue to bear their costs, including the non-monetary.

    Would also be nice if at least one of the legacy political party candidates for the Presidency at the next big dance in 2016 is not either a finance sector alum or a trojan horse for Wall Street-large corps.

  6. DakotabornKansan

    How will the “new, more aggressive” SEC under Chairman Mary Jo White’s leadership respond?

    “[The Bank of America settlement] does not comport with the most elementary notions of justice and morality. In much of the world, propaganda reigns, and truth is confined to secretive, fearful whispers. Even in our nation, apologists for suppressing or obscuring the truth may always be found. But the S.E.C., of all agencies, has a duty, inherent in its statutory mission, to see that the truth emerges; and if it fails to do so, this Court must not, in the name of deference or convenience, grant judicial enforcement to the agency’s contrivances.” – Federal Judge Rakoff’s rejection of proposed settlements in the fraud investigations of Bank of America and Citigroup opinion

    “When White was nominated, Judge Rakoff told me, he e-mailed her, saying, “Does this mean I have to be nice to the S.E.C.?” “Yes, it does,” she wrote back. I asked White whether she had been influenced by Rakoff’s two harsh opinions, before she arrived, accusing the S.E.C. of letting off Citigroup and Bank of America far too easily. She said, “The S.E.C. has discretion. I’ve thought about this issue for a very long time. . . . Judge Rakoff was a voice in the discussion, but no, I don’t think what he did was a trigger.” She gave a measured account of how the new policy would work: “The change is that in certain kinds of cases that require greater public accountability, we may make a judgment that it’s important to get an admission. Has there been obstructive behavior? Has there been high-level misconduct?”

    “Andrew Ceresney, who was White’s right-hand man at Debevoise & Plimpton before coming to the S.E.C., and who recently remarked to a gathering of lawyers that his goal in his new job was “to help bring the S.E.C.’s swagger back,” told me, “Part of the mission is to protect investors and make sure the markets are fair and efficient. Through enforcement you do that by bringing the actions where the evidence supports it. You punish people to the extent the securities law allows. You try to deter misconduct. Take important actions in important priority areas.”

    “If it turns out to require a lot more than that to prevent another financial calamity, White has yet to prove that she’s going to deliver it.” – Nicholas Lemann, “Street Cop”


  7. jfleni

    RE: whistleblower has provided the SEC with evidence of massive, ongoing violations of securities laws.

    It was always obvious that Madoff only got more than a century in prison, because he more or less came clean about his crimes in response to many complaints and circumstances; SEC and feds did not want to look under any other rocks, to find their good buddies swarming under there.

    Opinion: Madoff should be paroled into custody of some honest former prosecutor (or governor?) who together will start the process of revealing all the sleazy tricks: How front running works; Why SEC always accepts self-serving hucksterism as truth, etc.,etc.

    Then maybe some century-long sentences can attach to other deserving swindlers.

    And no, nobody is holding their breath as long as Barry Bubba is in there.

    1. Ulysses

      Nonetheless, the very important work done by investigators like Yves– in bringing all of this criminality to light– is priceless. We are more likely to challenge the banksters’ grip on power if everyone sees that they don’t even follow the few rules left in the rigged game they play!

  8. Tony Butka

    Great article. If you combine this with the discussion of ‘The Blob’ in Jeff Connaughton’s The Payoff, it’s time to be afraid, very afraid. They are everywhere, and my friends in the Union pension funds are running around signing NDA’s with them in a lemminglike search for yield.


Comments are closed.