In late February, Bloomberg stated that the SEC is “considering” forgiving decades of private equity firms acting as unregistered broker-dealers and possibly legalizing the practice going forward. In case you think this is not a big deal, as we explain later in the post, the SEC is in fact vigilant about enforcing these regulations, so this would be an unprecedented waiver of liability. And remember, private equity firms engage top securities law firms, yet as we’ve discussed in past posts, they’ve been remarkably open, one might even say brazen, about their misconduct. In other words, these violations aren’t in a grey area. The firms and their legal advisors knew exactly what they were up to, but apparently figured they’d see how long they could get away with it, and indeed, it has proven to be for quite a long time.
But notice the formulation of the Bloomberg story:
The U.S. Securities and Exchange Commission is considering granting private-equity firms a reprieve after they collected billions of dollars in deal fees without being registered to do so, according to a person with knowledge of the matter.
This article is based on a single source. And it’s very easy to guess who that single source is: one of the people pushing the SEC to treat decades of running roughshod over well-established, well-known securities laws as not even worthy of notice, much the less action. A group of excessively wealthy individuals is pressing for a “get out of our costly arrogance for free” card, when they of all parties can well afford to pay.
This is a classic Washington D.C. trial balloon, where a controversial or indefensible course of action is floated out to the press by an anonymous “knowledgeable insider.” The public relations plant’s purpose is to test whether opponents can muster the strength to make a big fuss, in which case the SEC bureaucrats can climb down from their position in favor of PE without ever having stuck their necks out.
The Bloomberg story acknowledges that the billions in fees collected by the PE industry over decades appear to have been illegal, noting that an SEC official “…signaled in a speech last year that transaction fees the private-equity industry had been taking for decades may have been improper because the firms weren’t registered as broker-dealers.” This official, the chief counsel of the Division of Trading and Markets, now appears to have been thrown under the bus, as his colleagues scramble to find a way to accommodate their PE overlords. Bloomberg makes no bones about the reason for the about-face, titling an entire section of the article “Powerful and Successful Lobby.”
The article quotes industry mouthpieces making the usual intelligence-insulting arguments, including the claim that registering as broker-dealers would be too expensive and that the broker-dealer regime would provide no additional investor protections beyond the status quo, where PE firms are already registered as investment advisers. This latter claim is outright false. Customers who have been harmed by the bad acts of broker-dealers have much stronger rights than investment adviser clients because broker-dealer clients can sue to recover for investment losses. Similarly-situated customers of investment advisers can only seek recovery of fees paid to the adviser, but not recovery of investment losses.
As we’ve amply demonstrated in our past coverage of private equity, investors in PE are almost uniformly asleep at the wheel. There is a raging controversy at the SEC about whether the law is going to be enforced with respect to investor protections to which they, the investors, are legally entitled, and none of them has yet seen fit to rouse themselves and show that they care.
The industry flack also claims that the billions paid in transaction fees were not for broker-dealer services (although the argument is so absurd it doesn’t seem to be made with much enthusiasm). Yes, Washington DC is a generally fact-free zone, but let’s look at the language from an actual transaction agreement:
From the J Crew 2011 buyout by Leonard Green Partners and TPG (emphasis ours):
(c) During the Term, the Managers (or their respective Manager Designees)[Leonard Green and TPG] will advise the Companies in connection with the consummation of any financing or refinancing (equity or debt), dividend, recapitalization, acquisition, disposition and spin-off or split-off transactions involving the Companies or any of their direct or indirect subsidiaries (however structured), and the Companies will pay to the Managers (or their respective Manager Designees) an aggregate fee (the “Subsequent Fee”) in connection with each such transaction equal to customary fees charged by internationally recognized investment banks for serving as a financial advisor in similar transactions, such fee to be due and payable for the foregoing services at the closing of such transaction.
This is broker-dealer activity as clear as day. According to the agreement, TPG and Leonard Green get paid a fee every time J Crew engages in a securities transaction, which the PE firms will advise J Crew on, and the PE firms get paid an amount based on what an investment bank, which is a registered broker-dealer, would charge for such advisory services. There is simply no other side to the argument that, by the very language of the J Crew buyout deal, the PE buyers engaged in broker-dealer activity. We’ve cited almost identical language in other posts on this topic. This formulation is not an aberration. It is absolutely standard in large buyout deals, and literally hundreds of examples of it can be found in SEC filings.
TPG, like a number of the other large PE firms – KKR and Apollo come to mind – have formed internal broker-dealer units in the last few years and are telling the press that they are already in compliance (Leonard Green, by contrast, has no broker-dealer unit). A close examination of TPG’s filings with the SEC, however, reveals that TPG’s compliance is a sham. All broker-dealers are required to file form X-17A-5 annually with the SEC, which shows the balance sheet and income statement of the broker dealer unit. Firms have the option to request confidential treatment of the income statement portion of the filing, meaning that it is not posted on the SEC website, and virtually all broker dealers of any type request and receive such confidential treatment. However, TPG has missed this trick and has neglected ever to request confidential treatment, which means that we can see the revenues of its broker dealer.
For the year 2011 when TPG received its self-described “Transaction Fee” in the amount of $26.25 million for J Crew deal, which closed in March of that year, the TPG broker-dealer unit reported revenues in its SEC filing of just $6,986,446. So, given that the J Crew transaction fee alone was almost four times larger than the broker-dealer unit’s revenues that year, the J Crew transaction fee clearly was never paid to the broker-dealer unit, which is a firm requirement under broker-dealer regulations to ensure that the payment is handled consistent with the disclosure to clients and other unique requirements of broker-dealer fees.
Recent SEC enforcement actions show that, in other contexts, the SEC views it as a grave infraction to not pay broker-dealer fees to the broker-dealer unit of a business. Just last Friday, the SEC fined Credit Suisse $196 million for, among other things, unsupervised broker dealer activities in the U.S. The SEC did not claim that Credit Suisse had no registered broker-dealer unit in the U.S. — the firm has had one for decades. Rather, the SEC based the fine on the fact that Credit Suisse was diverting revenues that should have been credited to the registered broker-dealer unit in order to keep those revenues from being properly regulated.
The private equity overloads clearly believe they are in an even more privileged class than the generally-above-the-law too-big-to-fail banks. Somebody needs to ask Mary Jo White whether she agrees.