We’ve been writing for some time about the peculiar failure of the SEC to target private equity firms for acting as unregistered broker-dealers. The agency has finally roused itself and has fined an itty bitty firm, Blackstreet Capital Management. Needless to say, it’s not clear whether the agency is simply putting the industry on notice that it needs to clean up its act and register if they continue to collect transaction fees from portfolio companies, or whether it is warming up for larger enforcement actions.
If the latter, it would be a very big deal, because this is considered to be a serious violation of securities laws and the punishment is therefore hefty: dollar for dollar for the amount of fees impermissibly charged. The SEC applied the classic dollar-for-dollar formula in the case of Blackstreet. If you read the order, the total amount to be disgorged of $2,339,000 is the sum of the transaction fees of $1,877,000 (p. 5), plus the impermissible operating partner fees of $450,000 (p. 5), plus the political contributions of $12,000 (p. 6).
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….
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.
Carlyle acknowledged in its recent 10-K that it is at risk of being fined:
In 2014, the SEC indicated that investment advisers that receive transaction-based compensation for investment banking or acquisition activities relating to fund portfolio companies may be required to register as broker-dealers. Specifically, the Staff has noted that if a firm receives fees from a fund portfolio company in connection with the acquisition, disposition or recapitalization of such portfolio company, such fees could raise broker-dealer concerns under applicable regulations related to broker dealers. To the extent we receive such transaction fees and the SEC takes the position that such activities render us a “broker” under the applicable rules and regulations of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), we could be subject to additional regulation. If receipt of transaction fees from a portfolio company is determined to require a broker-dealer license, receipt of such transaction fees in the past or in the future during any time when we did not or do not have a broker-dealer license could subject us to liability for fines, penalties or damages.
In keeping with the industry tendency to stretch the truth, even in SEC filings, the sentence immediately before this section tried fobbing off the SEC’s rousing itself after decades of as if the SEC had previously signed off on this activity but now had changed its mind. In fact, the broker-dealer regime is a “show up and register” approach. The SEC does not typically go out looking for miscreants; normally, people who’ve been duped by unregistered broker-dealers complain to the agency and then the SEC saddles up.
But the idea that firms could safely take ginormous transaction fees and not have to register was always a huge risk; why their big ticket lawyers didn’t insist that they register long ago is a mystery. Anyone who has spent any time in the securities industry knows the importance of registering as a broker-dealer if you are going to take transaction fees with any regularity. Even in my brief tenure on Wall Street, where I did not stay long enough to get a Series 7 license (required even for investment bankers), I learned of the importance of operating in a licensed operation. As a consultant, I was mindful of the issue in structuring my engagements when advising on transactions. Similarly, even small M&A boutiques register as broker-dealers.
Now it is possible that the Blackstreet fine is a mere shot across the bow, to tell the industry the firm in the industry that charge transactions fees (most but not all) need to register pronto or they will face a Blackstreet-type fate. It’s bizarre to see Carlyle confess in its 10-K for 2015 that it was told by the SEC that the agency was contemplating not just requiring firms to register, but also considering fining firms for past violations. That would seem to be enough of a warning to induce firms to register just to limit the amount of possible fines, which is billions of dollars across the industry.
Were the PE big boys confident that can get their Congresscritters to call the SEC off? If the SEC starts moving up the food chain and fines larger firms, will we hear the bogus argument that paying the fines would put them out of business?
If your Senator or Representative is on one of the Congressional committees overseeing the SEC (the Senate Committee on Banking, Housing and Urban Affairs or the House Financial Services Committee), please drop them a short e-mail linking to the SEC order or press release on the Blackstreet settlement. Say that you are glad to see the SEC finally take a long-overdue step to start enforcing the law by fining unregistered broker-dealers in private equity, but there are much bigger firms engaged in precisely the same conduct, and you expect them to support the agency in taking them on. You could point out that one of the reasons that populist candidates like Sanders and Trump are doing so well is the the public is sick and tired of having completely different legal standards applied to the rich and well connected, as opposed to everyone else. The time is long overdue for making private equity play by well-established rules.
Thanks again for your help!