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Reform advocates accuse GPs of widespread broker-dealer violations

  • Advocacy group nudges SEC for more action on broker-dealer registration
  • Any changes should go through public comment, says critic
  • Managers aren’t brokers, says lobby group

A coalition of advocacy groups is working to keep alive a controversy that private equity firms might have hoped was put to rest.

In an open letter to the Securities and Exchange Commission, Americans for Financial Reform alleges that broker-dealer violations pervade the industry, calling out two firms in particular: Thomas H. Lee Partners and Silver Lake.

According to the Aug. 2 letter, regulatory filings indicate that both firms regularly charge transaction fees despite having no registered broker-dealer affiliate.

The Washington group contends this practice “appears identical to the activities in the recent case that were determined to constitute unregistered broker-dealer activity,” namely the SEC’s June 1 settlement with Blackstreet Capital Management.

And the problem isn’t limited to a handful of firms. “While we applaud one such recent enforcement action,” AFR writes, “we remain concerned that such violations continue at many U.S. buyout firms, and we believe that unregistered broker-dealer activity directly harms investors.”

‘Iniquitous raid on private equity’

Thomas H. Lee and Silver Lake declined to comment on AFR’s letter. A spokesman for Silver Lake referenced a June 29 op-ed in The Wall Street Journal by Norm Champ, former director of the SEC’s Division of Investment Management, titled “An Iniquitous Raid on Private Equity.”

Calling the penalty imposed on Blackstreet “particularly egregious,” Champ argued that such a significant policy shift as requiring fund managers to register as broker-dealers “should be pursued through a proposed rule or guidance allowing the public to comment — not opaque enforcement action.” He added that the change would do nothing to better protect investors. Champ is now a partner at Kirkland & Ellis.

In settling with the SEC, Blackstreet neither admitted nor denied wrongdoing. It agreed to a censure. The Chevy Chase, Maryland, firm and its owner, Murry Gunty, agreed to disgorge more than $2.3 million, including more than $500,000 to be distributed back to affected clients.  They also agreed to pay more than $280,000 in interest and a $500,000 penalty. 

The broker-dealer issue has been on the regulatory radar for several years. In 2013, a person said to be “a senior private-equity insider” filed a complaint with the SEC, arguing that transaction fees represented a breach of federal securities law by firms acting as unregistered brokers.

The would-be whistleblower’s attorney told Crain’s Business Daily that “the widespread, systematic and flagrant nature of these violations is likely to be deeply troubling to the new, more aggressive SEC under Chairman Mary Jo White’s leadership.” Had his client’s submission led to SEC penalties, the unnamed insider would have received as much as 30 percent of the PE firms’ payments.

Although SEC attorney David Blass put the industry on notice in an April 2013 speech on the issue, no major enforcement actions followed. The recent settlement with Blackstreet, a minor player, gave AFR an opportunity to revive the broker-dealer question with respect to larger firms.

AFR is a nonpartisan and nonprofit alliance of more than 200 consumer, civil rights, labor, and other groups, formed in 2009 to push for Wall Street reform. According to Elizabeth Warren, the organization was instrumental in getting the Consumer Financial Protection Bureau passed into law as part of the Dodd-Frank Act.

Eileen Appelbaum, senior economist at the Center for Economic Policy Research, said “the significance of the broker-dealer regulations is that they protect investors against self-dealing by companies that they invest with.”

Appelbaum, who serves on AFR’s private equity task force, described a hypothetical scenario in which a struggling firm buys a company only to collect transaction fees, which “flow directly into the pockets of the partners.”

“I’m not saying that this is common,” Appelbaum explained. “This is what we need to protect against. If you register as a broker-dealer, then you have the SEC looking over your shoulder. If you’re not doing any self-dealing, then what would be the reason for not registering?”

AFR’s letter suggests one possible answer: “If they registered, private equity firms would be required to receive approval for any fee amounts that they or their affiliates might receive for transacting on behalf of their funds. As a result, the amounts of such fees would be reflected in fund books and records, which investors would generally have a contractual right to access.”

Currently, disclosing these fee amounts is optional. As registered broker-dealers, firms would also have to join a self-regulatory organization, such as the Financial Industry Regulation Authority, and would be subject to additional layers of compliance.

AIC objects to SEC view

The American Investment Council, a PE lobbying group, maintains that “private equity investment advisers are not broker-dealers and should not have to register as such.”

On its website the AIC lists several objections such as “PE investment advisers are ‘invested’; brokers ordinarily act exclusively as intermediaries”; and “a broker’s job is to sell; a PE investment advisor’s job is to provide guidance.” (Of course they also buy and sell, the basis of transaction fees.)

In addition to broker-dealer violations, AFR’s letter highlights abuses involving undisclosed fees, which it says have been met with “extremely selective and slow” SEC enforcement actions. For instance, only Blackstone Group has been penalized for collecting undisclosed “termination-of-monitoring” fees, even though other firms that were co-investors in the deals in question did the same.

Asked why enforcement has been so selective, Appelbaum said, “I don’t know how the SEC makes those decisions. I think basically the SEC has identified the issues where they think investors are most vulnerable. And they want to make a public statement that this is behavior that is not acceptable.”

Appelbaum said the broker-dealer charges against Blackstreet were “very welcome” but she added: “If there’s just one little enforcement against one little company that no one’s ever heard of, I think that’s not sufficient.”

Action Item: AFR’s letter:

Sen. Elizabeth Warren (D.-Mass.) speaks during the first session at the Democratic National Convention in Philadelphia on July 25, 2016. Photo courtesy Reuters/Mark Kauzlarich