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.