The Capital Commitment

Proskauer on Private Equity Litigation

DC Circuit Opinion Reaffirms Fiduciary and Disclosure Obligations of Advisers While Rejecting SEC Finding of “Willful” Violations

The DC Circuit recently released an opinion addressing the SEC’s administrative findings against registered investment adviser The Robare Group (TRG) for failure to disclose alleged conflicts of interest. Although the court affirmed the SEC’s finding of a violation of Section 206(2) of the Advisers Act, it held that Commission could not find willful violations under Section 207 based on the same negligent conduct.

The court’s analysis of 206(2) of the Advisers Act, the key negligence-based antifraud provision for investment advisers, is instructive. The court affirmed that, as a fiduciary to its clients, the adviser was required to make full and fair disclosure of all material facts, including conflicts of interest. Continue Reading

Rent the Runway Walks into the Litigation Spotlight

There’s a new unicorn in town, and this time, it isn’t just another tech company. Rent the Runway, also known as RTR, is now officially valued at over $1 billion after its most recent funding round which raised $125 million.

The high-end rental clothing brand was launched in 2009 by female founders, including co-founder and CEO Jennifer Hyman. Rent the Runway’s third and largest round of funding took place during Hyman’s ninth month of her pregnancy term – a fact that surprises some and empowers all. The company has been sky-rocketing in value since it introduced its subscription rental service which now makes up 60% of the company’s revenues. One of the best parts – the consumer base is 100% female.

Of course, with success comes attention, and not always welcome attention.  The same week Rent the Runway reached unicorn status, LA startup FashionPass filed a lawsuit accusing Rent the Runway of monopolizing the high-end clothing rental market. In its lawsuit, FashionPass alleges that RTR conspired with other labels to demand exclusivity in the rental relationship. FashionPass’s complaint alleges in “excess of $3 million” in damages and claims it is entitled to recover treble damages. Continue Reading

Fraud Claims Against Startup Founder Involving Secondary Market Sales Demonstrate SEC Focus on Privately-Held Companies

Last week the SEC announced a settlement of fraud claims against the founder of Jumio, Inc, a private mobile payments company, for misstating the company’s financial results and using those financials to sell his company shares on the secondary market.  This case is a reminder that privately negotiated securities transactions and private, VC-funded companies are not exempt from regulatory scrutiny.  As we observed in a number of settlements last year, the SEC will pursue suspected investor fraud involving privately-held companies, whether in fundraising or sales by insiders, or even in disclosures to a company’s own employees in connection with stock options.

The SEC settlement involving Jumio alleged a variety of misconduct by the founder, such as entering into round-trip transactions designed to inflate revenue.   Interestingly, the alleged scheme was apparently designed so that the founder could sell shares on the secondary market in privately negotiated transactions, rather than in a funding round.

According to the SEC press release, Jumio’s founder agreed to a settlement ordering him to disgorge profits from the sales as well as to pay a penalty, and agreed to be barred from serving as an officer or director of a publicly traded company in the U.S.  The SEC also negotiated a settlement with Jumio’s former CFO/General Counsel for failure to exercise reasonable care in connection with the matter.  Jumio itself filed for bankruptcy in 2016 after the company restated its financial results.

Looking ahead, we see this type of case as a microcosm of what may be in store when the next economic downturn hits the current stable of unicorns.  Misconduct involving privately held companies, or even exits that are below recent valuations, may give rise to similar disputes.  Meanwhile, recent experience – most prominently with Theranos – suggests that the failure of one or more unicorns is likely to attract both regulatory scrutiny and private litigation.

Delaware Chancery Declines Post-Filing Use of Section 220 Books and Records Inspection Request

A recent decision by the Delaware Chancery Court suggests that a litigant might forego the ability to file a books and records request if it waits to do so until after the lawsuit is filed. Last month the Delaware Chancery Court dismissed just such an action, characterizing the request for a books and records inspection after the filing of a lawsuit as “inherently contradictory” and an improper attempt to “sue first, ask questions later.”

Section 220 of the Delaware General Corporation Law allows stockholders to inspect books and records of a Delaware corporation for any proper purpose and to compel inspection if such inspection is refused. Section 220 is typically used prior to the filing of a lawsuit as a means to develop information to support a plaintiff’s claims before it has access to discovery rules.  The corollaries to a Section 220 demand in the limited partnership and limited liability company contexts are known as a Section 17-305 demand and a Section 18-305 demand, respectively. Continue Reading

The Top Ten Regulatory and Litigation Risks for Private Funds in 2019

An increasingly sophisticated and active OCIE division, innovative market disruptors, a maturing credit cycle, and a philosophical change in how the private fund industry views and utilizes litigation are likely to lead to increased regulatory scrutiny and litigation risk for advisers (and their funds) in 2019.  With that backdrop, we are pleased to present our Top Ten Regulatory and Litigation Risks for Private Funds in 2019. Continue Reading

SEC Staff Announces 2019 OCIE Examination Priorities

The SEC’s Office of Compliance Inspections and Examinations has released its annual priorities publication for 2019.  Containing both a look back at the program’s accomplishments for fiscal year 2018 and a look forward into its initiatives for 2019, this annual report sets out important guidance for private fund managers in administering their compliance programs and preparing for an SEC examination.  For additional guidance, please read our full client alert on this topic.

Valuation of Illiquid Securities as a Focus of Recent Enforcement Actions

While the SEC consistently announces that valuation is a “key area of focus,” it is uncommon for regulators to “second guess” valuation determinations in the absence of other potential violations. However, recent actions would suggest that the SEC is particularly interested in the valuations and methodologies behind illiquid securities. As we have noted here before, although valuation can be more art than science, there are heightened regulatory risks in the following areas around valuation:

(1) breakdowns in controls/policies/procedures;

(2) violations of Generally Accepted Accounting Principles (GAAP); and

(3) incomplete or inaccurate disclosures to fund investors and auditors.

The September 2018 settled action against LendingClub Asset Management (LCA) is a prime example of regulatory focus on valuation. The SEC alleged, among other things, that the manager improperly valued asset-backed securities (ABS) held by its funds. LCA disclosed that the relevant funds exclusively owned ABS backed by consumer credit loans, and that it would periodically determine a fair market value for those assets using Level 3 inputs under GAAP. As is typical for Level 3 assets, they lacked observable market inputs and were valued based on management estimates or pricing models. LCA used a discounted cash flow (DCF) model to predict the future performance of the loans discounted to present value.

However, the SEC took issue with two categories of adjustments made by LCA to the model. First, the SEC alleged that the manager improperly incorporated a “floor” for monthly returns that was not based on supportable assumptions. Second, the SEC alleged that the manager made an unjustified change to the discount rate used for its DCF model, which had the result of increasing fund returns. Although LCA later took a series of remedial measures, including outsourcing its monthly valuation to an independent third party, recalculating fund returns and reimbursing investors, the SEC ultimately determined to pursue an enforcement action against LCA and certain individuals affiliated with it.

Similarly, the SEC’s March 2017 case against hedge fund manager Covenant Financial Services illustrates a typical SEC valuation action. Here, the SEC focused on the application of an otherwise GAAP-compliant valuation policy, ultimately finding that the failure to properly apply the valuation policy (by using Level 3 inputs when Level 2 inputs were available, and inconsistent with the Level 3 inputs) resulted in violations of the anti-fraud provisions of the Investment Advisers Act.

An example of a more nuanced valuation action is that which the SEC brought against Enviso Capital in July 2017. The SEC alleged that Enviso Capital failed to use reasonable assumptions and estimation of future cash flows when preparing a DCF model, which resulted in overvaluing a loan (and consequently the fund) where it was probable that the full value would not be collected. As a result of these valuation issues, the SEC asserted that the fund’s performance was overstated and that its financial statements were not GAAP-compliant.

What does this mean? Two things: (1) valuation policies must be carefully analyzed for GAAP compliance and must be accurately disclosed to investors, and (2) valuation policies must be properly and consistently applied over time.

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