A little-known lawsuit advancing in federal court has the potential to change the moral and legal balance of power between private equity and the public good. But analysts say it may take the Occupy Movement to bring about needed regulatory reforms.
The secretive industry of private equity, mostly lauded in press in the 1990s and mid-2000s for executing daring buyout deals of ever-increasing proportions, is facing enormous skepticism these days.The fact that the Republican Party has chosen to nominate a co-founder of one of America’s largest and most controversial PE firms as its presidential candidate, in the midst of the most severe economic downturn since The Great Depression, is an obvious cause of some of the increased attention. Even so, private equity’s record was a story long overdue to be told.
Besides this raft of media attention, including some serious journalistic scoops, there are more serious investigations into the morally and legally dubious activities of companies like Bain Capital that could have reverberating impacts on the industry’s future. What’s interesting about recent government and shareholder investigations is that in years past, these parties mostly looked the other way, or even cooperated through inaction, allowing PE firms to literally commit crimes, or at least to conduct their business in morally dubious ways, unabashedly preying on the wealth of public companies, less powerful investors and local communities.The lack of moral sanction, and the near absence of law enforcement action, only served to reinforce private equity’s greed.
Now, however, one lawsuit has partly pried open the black box of private equity. The case has the potential to not only provide yet unseen data and documents recording some of PE’s biggest possible crimes, but also to set the stage for the taming of finance capital’s most aggressive and destructive creatures. It’s a moon shot of a chance, and will take popular political pressure and aggressive regulatory and legal action to capitalize on, say lawyers and experts watching the proceedings. Even so the case is worth following.
The story begins in 2006 when the Department of Justice (DOJ) let it be known that it was conducting an investigation into possible antitrust violations within the private equity industry. While the DOJ has prosecuted private equity companies before under antitrust laws, these cases tend to apply to instances where a particular buyout deal would result in the monopolistic concentration of ownership within a market. For example, in 2008, federal prosecutors argued that if Bain Capital had been allowed to purchase a controlling stake in the media giant Clear Channel Communications then, “competition in the sale and provision of advertising on radio stations in [certain] markets would be substantially lessened or eliminated.” This was pretty standard antitrust litigation for Justice Department lawyers. It did little to slow private equity’s debt-financed takeovers and value extraction. Bain ended up buying Clear Channel in a club deal that included Thomas H. Lee Partners later that year.
What was different about the DOJ’s 2006 investigation into private equity was that federal prosecutors were said to be surveying the fundamental business practices of the entire industry with an eye to how virtually every other leveraged buyout was cheating shareholders, manipulating securities markets and illegally extracting value from public corporations.
It was rumored to be an investigation of sweeping scope into the industry’s cartel-like organization through so-called club deals. The PE industry was worried; elite defense lawyers were mobilized to prepare a defense if necessary. After two years of rumors, but no suit announced, many observers began to conclude that the investigation was coming up short of the overwhelming evidence federal prosecutors often seek. Even so, counsel friendly to private equity advocated cosmetic changes to the industry.
“Although it would be difficult for the DOJ to prove anticompetitive behavior, the recent inquiry should serve as a signal to private equity firms, such as KKR, to make changes,” opined Jessica Jackson, a legal scholar sympathetic to the industry, in a 2008 Florida Law Review article. To defuse potential DOJ action, Jackson advocated greater transparency, written consortium agreements and lobbying and public relations investments to boost private equity’s reputation, concluding that, “whatever the outcome, the DOJ probe might actually spur changes for the better.”
Private equity’s biggest firms breathed a collective sigh of relief when after several years no government action was filed and the investigation seemed to fizzle out. With the exception of increased public relations expenditures to combat bad press – the PE industry founded the Private Equity Growth Council, an industry lobbying association, in 2007 – mild changes advocated by reform proponents like Jackson were mostly set aside.
One can only speculate about why the DOJ investigation evaporated. It’s no secret that private equity firms, and the investment banks the industry is closely interwoven with, are among the largest donors to both parties, and that key White House, regulatory and Congressional posts are routinely filled with financial industry executives. Long-time critics of private equity don’t see any cloak and dagger intrigue behind the DOJ’s disappearing investigation, but it’s widely understood that any regulatory or legal campaign against the private equity industry nevertheless faces huge political obstacles.
“At the same time private equity companies became dangerous, they also became extremely wealthy,” said Daniel Greenberg, a law professor at Hofstra University. “We have a PE guy running for president. It’s hard to talk about reform when you have a political system that runs on big cash donations. It’s hard to expect them to take on this industry.”
“President Obama is in bed with the PE industry,” said Eileen Appelbaum, an economist with the Center for Economic and Policy Research. “They also own the Congress,” she added, referring to the huge campaign contributions and lobbying expenditures of private equity managers and their firms.
Private equity expends tens of millions each election cycle to fund candidates, and party committees, and spends millions more each year lobbying lawmakers and regulators. Private equity firms are practical players seeking universal influence and access, not beholden to a specific party; PE executives and companies tend to lavish funds on Democrats and Republicans, but usually gauge which way the wind is blowing, and then get behind a strong gust. In 2006 and 2008 private equity firms favored Democrats who were obviously ascendant with reformist notions in mind.
This year PE is funding Republicans by a margin of almost three to one in federal races, but still handing over big sums to key Democrats.
This wasn’t the end of the inquiry, however. As is with many DOJ investigations, aggrieved individuals and plaintiff’s lawyers took note that federal prosecutors were retreating, and therefore assembled their own case against the industry. In 2007 several individual investors filed suit against collusive clubs of private equity firms composed of Goldman Sachs Capital Partners, the Carlyle Group, Blackstone, TPG, and Permira Advisers.These firms are alleged to have stolen millions from shareholders in the leveraged buyouts of Freescale, a semiconductor manufacturer, and Kinder Morgan, a pipeline company.
In 2008 the Detroit Police and Fire Retirement System filed its own lawsuit against the same firms, and other private equity titans, that together allegedly colluded in deals to privatize Neiman Marcus, Michaels Stores, the hospital corporation HCA, food services company Aramark, software designer SunGard, and PanAmSat, a satellite operator. These cases were quickly consolidated into what has become one of the most important federal antitrust class actions to advance in recent years, Dahl v. Bain Capital Partners.
In 2010 the judge hearing Dahl v. Bain, Edward F. Harrington of the Federal District Court in Massachusetts, allowed for a major expansion of the buyout deals being subjected to investigation and discovery, from 17 to 27. The plaintiffs recently concluded their survey of records of famous buyout deals produced by the industry’s biggest players – more than 5 million documents according to a lawyer close to the case. Buyouts subject to investigation include Toys “R” Us, Harrah’s Entertainment and the second largest buyout ever – the 2007 purchase of TXU for $44 billion – and even the Clear Channel deal mentioned above. The buyouts in question are nothing less than the crown jewels of private equity’s corporate raids during the bull market of the mid-2000s.
Dahl v. Bain targets a dozen private equity groups as conspirators, including the giants of the industry, TPG, Blackstone, KKR, Goldman Sachs PIA, and Carlyle, which are in respective order the top-five largest PE firms, holding $221 billion under combined management.
The main allegation made in Dahl v. Bain is that through a routine practice of buying out public corporations through so-called “club deals,” private equity firms have conspired to depress the prices at which they purchase the controlling shares of corporations they’re taking private. Club deals are basically leveraged buyouts of public corporations by teams of private equity firms and investment banks as opposed to a single private equity firm undertaking a deal. It’s a very similar case, focusing on the same practices, as the aborted DOJ probe.
Plaintiffs in Dahl v. Bain allege, “bidding clubs restrain competition because they limit the available number of competitors to bid on deals, which artificially depresses buyout prices, thereby harming the shareholders of publicly-traded companies.” Dahl v. Bain’s summary of criminal allegations reads like an annotated playbook of strategic deal structures designed to maximize the value private equity can squeeze from company shareholders on the front-end of a buyout.
“The wrongdoing by these financial institutions is devastating for shareholders,” said David R. Scott, a lawyer representing the Plaintiffs.
The strategic power of private equity to manipulate the terms of a buyout is rooted in the financial industry’s consolidation around a mere handful of investment banks, and the existence of just a few dozen major private equity firms with the capital and connections to be part of the club scene. If what is alleged in Dahl v. Bain is true, then much of the private equity industry’s profits reaped in the 2000s depended on the ability and willingness of a few dozen big firms to constrain genuine competition in markets, to use their outsized power and influence through collusion, and to rig securities prices favorably downward on the opening end of their takeover deals.
“This sort of abusive practice is precisely the kind of conduct that evidences the core pandemic of greed that ultimately has led to our country’s current financial crisis,” said Scott.
The alleged conspiracy was facilitated by the close personal and business relationships linking private equity managers to one another, Plaintiffs claim in their lawsuit. Managers at the largest firms can often be found serving together on corporate and government advisory boards, belonging to the same social clubs, and mixing their money across shared investment platforms. These close-knit ties are features of what has never actually been an industry in the real sense of the word, but rather an elite investors club that has jealously guarded its secrecy, power and privilege.
“Defendants’ senior executives also invested in each other’s investment funds and businesses,” explained the fourth amended complaint in Dahl v. Bain, “thus benefiting when their competitors entered going-private transactions on favorable terms.” Three examples of these collusive links were redacted from the fourth complaint, however. The fourth complaint did let it be known that “certain managing directors of Bain, Silver Lake and TPG are co-owners of the Boston Celtics,” but again the citation from which this fact was drawn was blocked out.
The contents of Dahl v. Bain until recently have been shrouded in secrecy. The PE industry’s lawyers have aggressively moved to prevent as much information as possible from becoming public record. Even so, we know from extensive sociological research that these sorts of ties among elite business executives extend across public and private corporate boards, government advisory positions, and university boards of trustees, where private equity big shots rub elbows and likely plan their raids with one another.
Now these kinds of collusive links, and the detailed communications proving them, has been released in the fifth amended complaint for Dahl v. Bain. This latest version of the lawsuit – which contains much new material from previous version thanks to the extensive discovery process – was almost put under seal by Judge Harrington, at the behest of the PE industry’s lawyers.
Harrington ordered the fifth amended complaint unsealed on October 10 in response to the New York Times Company, which intervened in the case, arguing that the public has a right to know its basic contents.
Why has the private equity industry been able to carry out an allegedly conspiratorial manipulation of stock prices, stealing untold sums of money in the process and with so little resistance until now? Dahl v. Bain strikes at this problem without necessarily naming it. By targeting the biggest players in the industry, and spelling out in detail how their biggest most lucrative deals were all part of a systematic conspiracy to loot the American economy, the lawsuit indirectly is asking why private equity firms have been allowed to organize themselves and behave in ways that are obviously illegal and immoral – beyond just what is alleged in the case complaint.
According to the legal scholar Daniel Greenwood, “a sort of moral and legal arbitrage” characterizes the entire history of private equity. In a 2008 paper, “Looting: the Puzzle of Private Equity,” Greenwood explains how morality and law are arbitraged – that is, how inconsistencies or contradictions in moral and legal codes are purposefully exploited – by private equity’s lords of finance to extract value from the economy:
Private equity funds are primarily devoted to transferring corporate wealth to private pockets. In the economic jargon they are in the business of extracting rents, transferring wealth from employees, citizens, the government, and future innovation to a handful of highly paid managers. In the grittier language of politics they are engaged in legalized theft.
Greenwood’s main point is that in the world of SEC-regulated corporations and banking, managers are beholden to diluted masses of many shareholders, as well as employees, government and the communities in which they operate. These executives are certainly in charge of deciding where and how to use company assets and credit, and could, and sometimes do, loot their companies and harm other stakeholders by ratcheting up unsustainable debts or executing mass employee layoffs.
However, such blatant theft by managers in this realm is relatively checked by both legal and moral expectations that have been codified in what we understand today as the fiduciary and professional duties of company managers. Real laws and strong moral codes prevent outright looting of the company, and constrain greed within financial markets.
In contrast, private equity was created to escape these legal and moral barriers, to unabashedly pursue strategies of looting. “Part of the whole private equity game is that you take the company out of the SEC’s bailiwick, you take it private so it’s not regulated and you can do things that otherwise can’t be done,” explained Greenwood in an interview.
Greenwood’s paper explains the problem in more depth:
Shareholders – the primary role through which private equity defines itself with respect to the corporation – owe no such fiduciary duties to the corporation; under both law and popular mores, they are ordinarily free to exploit their position in purely self-interested ways. By exiting the legal regime of fiduciary duty, agency and collective responsibility and shifting, instead, to the devil-take-the-hindmost rules of self-interested markets, they transform the moral valence. Corruption, thus, is redefined as normal, even praiseworthy, profit-seeking, shareholder-value maximizing market success.
In spite of several decades of blatant moral violations and questionably legal strategies executed by private equity firms, Greenwood says the legal and regulatory framework has yet to catch up.
“Private equity firms fit themselves into a box, the notion of the shareholder.The shareholders’ interest is deeply embedded in system,” explained Greenwood. “People understand stock trading, and people understand that traders act like purely self-maximizing individuals. The current theory we’re all operating under is that the system, with all its rules and norms, will convert this into something socially advantageous. PE [firms] found a way to fit themselves in this shareholder box, allowing them to act in pure self interest, but their actions have no redeeming social value.”
When asked why this status quo has lingered for so long, causing so much damage, Greenberg again referred to the political power of the industry, adding also that, “Some legal thinkers tend to be conservative and slow to pick up on an innovation.”
Dahl v. Bain is a long way from being decided, but if the plaintiffs prevail in their main allegations, the result could serve to advance a broader indictment of private equity, and help change the stymied legal and moral balance of powers by shifting the way regulators, courts, and other market agents think about and treat private equity.
This is especially true now that the SEC is rumored to be in the midst of its own investigation into the PE industry. The SEC probe is said to focus on another systematic way in which the private equity firms use their power and secrecy to arbitrage profits from the regulated economy – by purposefully mis-stating the value of companies held in their private portfolios, and using manipulative methods to market these companies for re-sale at inflated prices. It’s an allegation that is functionally related to the main claim in Dahl v. Bain; such a practice would further increase the value extracted from companies undergoing a leveraged buyout by manipulating share prices during a private equity firm’s exit.
Regardless of whether the SEC moves to prosecute, Dahl v. Bain has the potential to fundamentally challenge the legal and moral arbitrage by which private equity has been allowed to operate. The case elevates the fiduciary concerns of corporate shareholders and the notion – even if it is just an ideal – of fair and efficient markets over and against private equity’s privilege to extract value.
The conspiracy of the industry to use their secrecy, close ties and financial power to mis-price securities through bid-rigging, and to siphon off the spreads – one of their key looting strategies – is suddenly being subjected to the moral and legal codes that govern most other investors. In subjecting private equity to antitrust laws, indeed by just accepting Dahl v. Bain for trial, the US District Court, District of Massachusetts, reversed the legal status quo that has for so long excluded PE from the securities laws all other investors must abide by.
Some of the trusted law firms that have defended private equity in past suits have busied themselves in recent years issuing advice to their PE clients to prevent these investigations and cases from transforming into threats to the industry’s privileged existence. For example, lawyers with the Paul Hastings firm have advised their PE clients to “avoid meetings, discussions and situations with competitors that may be construed as anticompetitive in nature,” and to remember that, “regardless of the setting, never discuss with an actual or potential competitor your firm’s intentions whether or not to bid on a target.”
Following the DOJ investigation and the filing of Dahl v. Bain, corporate counsel with the White & Case law firm warned their PE clients to “be prepared for antitrust scrutiny.” When the court, to the surprise of the PE industry, ruled against multiple motions to dismiss Dahl v. Bain, White & Case warned their clients that the lawsuit,”refocuses the antitrust spotlight on joint bidding practices for the foreseeable future, encouraging private plaintiffs and possibly federal and state antitrust authorities to bring antitrust claims against deal participants.”
Even with all this pressure, some close observers of private equity remain skeptical of how far the courts alone can push reform. Appelbaum, of the Center for Economic and Policy Research, who is currently writing a book on the private equity industry, said Dahl v. Bain can uncover new facts and bring more scrutiny to bear on the major plays. However, she added, “This alone is definitely not going to bring them down.”
“Consider all the stuff that happened during the financial crisis, and consider the fact that the SEC hasn’t brought any big cases against anybody as a result of that.” Although the industry is on the ropes, Appelbaum thinks it’s still far too strong and influential for just court cases to spur change. “A lot of what these companies do to extract value is still perfectly legal. Private equity, their answer is as long as it’s legal we can do it; if you don’t like it change the laws.”
Greenwood says it’ll probably take popular pressure in the form of a social movement to spur real changes capable of bringing private equity to heel. “Short of some kind of popular uprising, it’s hard to see who would change things. Is Occupy in suspension, or is it over? If it’s suspended and is going to come back, that’s where it is.”
“Let’s see what Occupy can do,” echoed Appelbaum. For anything major to happen on the legal front, Appelbaum thinks the SEC will have to prosecute. “Somebody big would have to go to jail. If it’s just a fine or prohibition, it probably won’t change anything.”
Anything in isolation is probably unlikely to do much to challenge to dominance of finance capital, in particular private equity, over the rest of the economy. Given the current SEC investigation said to be underway, and Dahl v. Bain, there’s more scrutiny of private equity today by regulators and the courts than there has arguably been since the LBO wave of the 1980s.
Add to this the intense microscope the press has put private equity under, especially since Romney’s run for the presidency began, and the broader critique of finance capital articulated through the Occupy Movement, and you have at least the necessary conditions for a real challenge. But a lot depends on how these various threads are pieced together over the next few years, a messy process of litigation, social movement organizing, regulatory action, and politics that has no guaranteed outcome.