Who doesn't love a discount? Who wants to pay full price for anything. So . . . what happens when a law firm offers a discount to its clients? According to a recent Securities and Exchange Commission settlement, the reduced cost wound up costing a helluva a lot more than anyone seems to have contemplated.
Case In Point
Oct. 7, 2015, the Securities and Exchange Commission ("SEC") filed an Order Instituting Proceedings ("OIP") alleging that Blackstone Management entities had breached their fiduciary duties. As more fully set forth in the OIP "Summary"
1. These proceedings arise from inadequate disclosures that involved two distinct breaches of fiduciary duty by private equity fund advisers Blackstone Management Partners L.L.C., Blackstone Management Partners III L.L.C., and Blackstone Management Partners IV L.L.C. (collectively, "Blackstone"). First, from at least 2010 through March 2015, upon either the private sale of a portfolio company or an initial public offering ("IPO"), Blackstone terminated certain portfolio company monitoring agreements and accelerated the payment of future monitoring fees as set forth in the agreements. Although Blackstone disclosed that it may receive monitoring fees from portfolio companies held by the funds it advised, and disclosed the amount of monitoring fees that had been accelerated following the acceleration, Blackstone failed to disclose to its funds, and to the funds' limited partners prior to their commitment of capital, that it may accelerate future monitoring fees upon termination of the monitoring agreements. Second, in late 2007, Blackstone negotiated a single legal services arrangement with its primary outside law firm (the "Law Firm") on behalf of itself and the funds. For the majority of legal services performed by the Law Firm beginning in 2008 and continuing through early 2011, Blackstone received a discount that was substantially greater than the discount received by the funds. The disparate legal fee discounts were not disclosed to the funds or the funds' limited partners until August 2012. Because of its conflict of interest as the recipient of the accelerated monitoring fees and the beneficiary of the disparate legal fee discounts, Blackstone could not effectively consent to either of these practices on behalf of the funds it advised. As a result, Blackstone breached its fiduciary duty to the funds in violation of Section 206(2) of the Advisers Act and also violated Section 206(4) of the Advisers Act and Rule 206(4)-8 thereunder.
2. Blackstone separately violated Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder by failing to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act arising from the undisclosed receipt of fees and conflicts of interest.
In anticipation of the OIP, without admitting or denying the findings, the Blackstone Management Respondents submitted an Offer of Settlement, which the SEC accepted, and, accordingly, the Respondents were ordered to Cease-And-Desist from further Investment Advisers Act violations and to pay a:
In the Matter of Blackstone Management Partners L.L.C., Blackstone Management Partners III L.L.C., and Blackstone Management Partners IV L.L.C. Respondents.(Order Instituting Cease-And-Desist and Making Findings, and Imposing a Cease-And-Desist Order; SEC, Invst. Adv. Act Rel. 4219; Admin. Proc. 3-16887 / October 7, 2015).
We Don't Pay Wholesale
Of note in the OIP, is the discussion concerning the issued of the allegedly improper disclosure by the Respondents of their legal fee arrangements:
C. Disparate Legal Fee Discounts
17. From at least late 2007 through early 2011, the Law Firm performed a substantial volume of legal work for Blackstone and the Funds. During this period, the Funds generated significantly more legal fees than Blackstone.
18. In late 2007, Blackstone negotiated a single legal services arrangement with the Law Firm on behalf of itself and the Funds whereby Blackstone benefited by receiving a discount from the Law Firm that was substantially greater than the discount received by the Funds.
19. Blackstone did not disclose the disparate legal fee discounts the Law Firm provided from 2008 through early 2011 to the Funds, the Funds' LPAC, or the Funds' limited partners. Moreover, because of its conflict of interest as the beneficiary of the disparate legal fee discounts, Blackstone could not effectively consent to the undisclosed practice on behalf of the Funds.
20. As the result of an early-2011 internal Blackstone audit, Blackstone voluntarily ended the disparate legal fee arrangement with the Law Firm and adopted a new task-based legal services arrangement pursuant to which Blackstone and the Funds received the same discounts. In August 2012, Blackstone disclosed to all of its Funds' limited partners the disparate legal fee discounts that had been in place from late 2007 through early 2011 and stated that the rate differential generally reflected the different mix of work performed by the Law Firm for the Funds and Blackstone.
Page 5 of the OIP
Gettin' All Warm And Fuzzy
In concocting the various sanctions, it appears that the SEC gave the Respondents considerable concessions as a result of the firms' perceived cooperation and remedial acts. As explained, in part, in the OIP:
BLACKSTONE'S COOPERATION AND REMEDIAL EFFORTS
28. In determining to accept Blackstone's Offer, the Commission considered remedial acts taken by Blackstone prior to contact from Commission staff and cooperation afforded the Commission staff after Blackstone was contacted. In early 2011, Blackstone voluntarily ended its disparate legal fee arrangement with the Law Firm. In 2012, Blackstone disclosed to all limited partners, without any resulting complaints, that historical discounts offered to Blackstone exceeded discounts provided to the Funds.
. . .
30. Throughout the staff's investigation, Blackstone voluntarily and promptly provided documents and information to the staff. Blackstone met with the staff on multiple occasions and provided detailed factual summaries of relevant information. Blackstone was extremely prompt and responsive in addressing staff inquiries.
Page 7 of the OIP
Bill Singer's Commentary
I'm still not quite understanding the legal fee thing. I wish the OIP spelled out with more precision the nature of the "single legal services agreement" at issue. What I understand is that during the relevant period, the Funds apparently incurred far more in the way of billable hours than Blackstone. the single agreement was somehow unfair because "Blackstone benefited by receiving a discount from the Law Firm that was substantially greater than the discount received by the Funds." Ummm . . . meaning what? What constitutes substantially greater?
For example, imagine a law firm that bills at a standard $500 an hour rate, but for over 1,000 hours a month it would offer a 10% discount in the form of a $450 an hour rate. In circumstances where the monthly hours exceed 1,500, the discount would rise to 15%.
If using the above scenario, on a monthly basis Blackstone accounted for 260 hours and the Funds accounted for 1,250 hours, how does the SEC believe the cumulative discount should be disclosed and handled?
Would it be fair to only allow the 10% discount for the Funds and not apportion any reduction for the company because the latter's hours did not surpass the 1,000 hour threshold -- that hardly makes sense. If in adding the two clients' billable together, the law firm is willing to offer both a 15% discount for in excess of 1,500 monthly hours, is the SEC proposing that the clients reject the offer and insist upon a 10% and 15% discount for the company and the Funds respectively? And feel free to manipulate the numbers as you wish: What if the company only used 26 monthly hours and the Funds used 1,500?
What happens if the law firm is the sole source of the discount? And by that I mean what if the law firm is eager to attract business from both the Funds and Blackstone and purely on its own volition says that it will offer a 20% discount. Assume, for purposes of this latter example, that the breakdown in hours is 5% and 95% respectively for the company versus the Funds. How does that get analyzed by the SEC? And what if the law firm, sensing that the power to direct business may actually flow from the company, decides based solely upon its own best interests, to offer the Funds a 20% discount but the company a 25% discount, how would that involve misconduct by the Funds and company if they accepted such a bonus billing arrangement? If the company asks the law firm to give the 25% discount to the Funds and the law firm declines, what would the SEC propose under those facts?
Another issue raised by this settlement is whether an onus is now placed on law firms servicing such financial complexes to warn their clients that any discounted legal fees must be fully disclosed and apportioned pursuant to Blackstone -- except it's not clear to me if mere disclosure redresses the SEC's concerns here because the federal regulator also seem troubled by the bestowal of a benefit upon the company that is, in large part, derived from the legal requirements of the Funds. Does offering a fee discount open a law firm to malpractice charges if the discount is extended without a full discussion with the client of Blackstone?
The reference in the OIP to "disparate" doesn't accomplish much without an accompanying explanation from the SEC as to what constitutes disparate. Merely "different" is not "disparate."