It’s gratifying to see that more and more organizations are recognizing the need to make private equity adhere to long-established regulations, their own disclosures, and widely-accepted norms in investment management, such as acting as a fiduciary. The latest example, a letter by Americans for Financial Reform, urging the SEC to take action on long-standing broker-deealer abuses by private equity firm. This document, which we’ve embedded at the end of this post, points out that even though the investors in private equity are typically major institutional investors like public pension funds, these monies are being deployed on behalf of large numbers of individuals of modest means, so this is clearly a matter of public interest.
We’ve written about the peculiar failure of the SEC to target private equity firms for acting as unregistered broker-dealers. The agency finally roused itself in June and fined a tiny firm, Blackstreet Capital Management. Given how selective the agency’s private equity enforcement actions have been, despite senior officials saying they found serious misconduct at half the firms included in its first round of exams, it’s likely that the SEC simply putting the industry on notice. In fact, as the AFR argues, this approach is inadequate in light of other private equity abuses that it describes in considerable. In other words, this is the last group that deserves “Trust me” treatment.
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….
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 AFR letter is short and well-argued; I urge to to read it in full.
It would also be of great help to press key Representatives and Senators. 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 with the AFT letter attached or a link to this article.
Say that you are glad to see the SEC finally engage in long-overdue enforcement by fining unregistered broker-dealers in private equity, but there are much bigger firms engaged in precisely the same conduct. The SEC’s track record of highly selective enforcement suggest the agency will let them off the hook.
Republicans are generally unsympathetic for calls for the SEC to do more. You might point out that this sort non-enforcement is a classic example of the sort of rigged system that has led small business owners to overwhelmingly support Trump. Retail brokers are required to hold securities licenses and comply with the SEC requirements because one of the lessons of the Great Crash was that it took over two decades for investors to regain trust in the stock market after the abuses of the Roaring Twenties. It’s galling for these law-abiding businessmen to see much richer private equity barons thumb their noses at the law.
The time is long overdue for making private equity play by the same rules as everyone else. Tell them you expect them to push the SEC to enforce the law.
Thanks again for your help!