The Capital Commitment

Proskauer on Private Fund Litigation

Cryptocurrencies and Other Digital Assets: A New Regime

Cryptocurrencies and digital assets will continue to be an area of intense regulatory focus, but a new administration may bring new regulations. SEC Chairman Gensler has extensive experience with cryptocurrencies and blockchain, including a teaching stint at MIT. However, Gensler has alternated between censure and praise, referring to cryptocurrencies and blockchain both as an “innovative irritant” and as a “catalyst for change” while noting that crypto markets have been “rife with scams, fraud, hacks and manipulation.” Nonetheless, the main area of focus will likely remain whether, and which, digital assets are subject to SEC regulation as securities.

The SEC’s recent action against Ripple Labs Inc. may illustrate the next wave of regulatory disputes. Liability in Ripple hinges on whether or not XRP (which Ripple describes as a digital asset built for payments) can be considered a security under the “Howey Test”; i.e., whether it is an investment in a common enterprise “with the expectation of profits derived solely from the efforts of others.” The dispute over XRP illustrates the “grey area” into which some digital assets may fall.  Ripple argues that it created a fully-functioning currency, while the SEC can argue that investors were seeking to profit through the issuer’s efforts to manage and develop the market for that asset. Gensler stated in 2018 that there was a “strong case” that both XRP and Etherium (a decentralized cryptocurrency) were securities, but the cryptocurrency landscape has undergone sweeping changes since that time.

Fund managers should also consider how active the CFTC has been in this space, regulating derivatives linked to crypto as well as exercising its authority to prosecute fraud and manipulation in crypto spot markets. The Department of Treasury’s Financial Crimes Enforcement Network is also active (e.g., for anti-money laundering purposes). Meanwhile, participants in these markets would do well to proceed with caution, not simply because of market factors but also due to a dynamic and uncertain regulatory landscape.

Second Circuit Upholds Insider Trading Conviction, Finding Sufficient Confidentiality Duty and Personal Benefit

Last week, the Second Circuit upheld a criminal conviction for insider trading, holding that signing a Non-Disclosure Agreement (NDA) with a target company created a sufficient duty of trust and confidence to support a conviction. The defendant in United States v. Chow, an executive at a foreign private equity firm, was convicted for tipping a business acquaintance with material non-public information about an impending acquisition, and is a reminder of heightened MNPI risks that arise that once an NDA is signed.

Read the full post on Proskauer’s Corporate Defense and Disputes blog.

New Focus and Compliance Approach Needed for Privacy and Cybersecurity

In 2020, we saw an increased regulatory focus on cybersecurity. Though former SEC Chairman Clayton largely took the view that existing statutes and regulations were sufficient, the Division of Examinations increased exam activities in the space while agencies like FinCEN increased enforcement against violators. We can expect to see a continued focus on cybersecurity going forward as a persistent long-term trend, but it is unclear whether it will remain among the top priorities of the SEC this year. As discussed in Risk #1, we believe that the Chairman, Gary Gensler, will take a more active approach generally and, as part of that, we expect a heightened focus on cybersecurity. Sponsors are a theoretically high value target for attack because even relatively small sponsors often control billions of dollars (whether directly or indirectly) and have highly confidential information concerning their investors and partners. It is important that sponsors’ commitment to, and investment in, cybersecurity systems, policies, and procedures is commensurate with their risks and profile in fact.

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Portfolio Companies Continue to be a Source of Litigation Risk

A significant ownership stake in a portfolio company has always raised the specter of claims against funds, sponsors, and sponsor-appointed board designees, if for no other reason than they are perceived by the plaintiffs’ bar to be deep pockets.  This risk has only increased in recent years, as it has become less taboo – indeed, it is becoming commonplace – for founders, management, significant shareholders, and even other sponsors to sue private fund sponsors in connection with change of control transactions. Every significant transaction produces relative winners and losers, even those that are perceived by the market as homeruns such as a unicorn IPO or merger with a SPAC. Fund sponsors, and especially those that hold board seats, should therefore use extra caution and remember that more control comes with greater risk of liability.

Especially in today’s uncertain market landscape, it is imperative that fund sponsors and their board designees familiarize themselves with the risks associated with portfolio company disputes. For example, sponsors should ensure that GPs who serve on boards are aware of possible conflicts of interest that come from their dual fiduciary duties to the portfolio company and the fund, and should carefully evaluate change of control and/or liquidity events and consider whether procedural safeguards regarding process and price are necessary or prudent.

Insurance coverage, including D&O insurance, plays a critical role as a risk management tool.

Read more of our Top Ten Regulatory and Litigation Risks for Private Funds in 2021.

Valuation in Times of Market Disruption

Valuation practices will continue to be the subject of disputes. Particularly in times of economic disruption and market volatility, buyers and sellers are more likely to have substantial differences of opinions on valuation, which often lead to the use of earn-outs and resulting post-closing disputes. Use of a cost basis for recently acquired assets may also lead to disputes regarding valuation, because using cost alone may be incompatible with the concept of fair value, which should take into account recent changed circumstances. We also expect increased scrutiny on valuations in connection with Manager/GP-led secondary transactions where the Manager/GP is often conflicted by virtue on being on both sides of the transaction.

From a regulatory perspective, valuation is a perennial SEC priority for private fund managers, and this year will be no different. The SEC Division of Examinations’ June 2020 Risk Alert for private fund managers (and a later risk alert) noted common adviser deficiencies in valuing assets in accordance with stated valuation processes or as disclosed to clients, potentially leading to inflated fees and carried interest. With the SEC’s recent adoption of a new regulatory framework for valuation practices for registered funds and BDCs, the SEC may want to test and validate compliance with the new principles. The SEC has also shown over the last year (see here and here) that it will pursue enforcement actions focused on valuation against credit managers, as well as private equity fund managers. Fund sponsors should be prepared for SEC investigations or enforcement actions related to the valuation of portfolio companies (particularly when interim values are used in fundraising) as well as follow-on inquiries from or disputes with unsatisfied fund investors.

Read more of our Top Ten Regulatory and Litigation Risks for Private Funds in 2021.

FinCEN’s $390 Million case against Capital One – And What it Means for AML Enforcement

As the financial services industry prepares for expanded criminal and civil enforcement under the Bank Secrecy Act (“BSA”) with the passage of the Anti-Money Laundering Act of 2020, FinCEN’s recent case against Capital One shows how FinCEN’s approach to AML enforcement is evolving. Continue Reading

The Ripples Behind the SPAC Wave

The past year saw a burst in popularity of SPACs. More than half of companies that went public in 2020 did so using a SPAC on their way to raising over $80 billion in proceeds, and so far in 2021 SPAC offerings far outpace traditional IPOs. SPACs allow companies to go public with greater speed and with fewer hurdles than a traditional IPO. These innovations combined with unprecedented deal volume may signal an increased risk for disputes, especially where the SPAC process and structure can present unique pitfalls.

For example, SPACs must issue registration statements and proxies in advance of acquiring a target company, which require compliance with Sections 11 and 14(a) of the Securities Exchange Act.  But unlike in traditional IPOs, SPAC target companies may disclose projections of future performance before shareholders vote on whether to move forward with a merger, and failure to meet those projections could lead to litigation by shareholders or the SEC. The SEC has issued guidance on the types of disclosures that SPACs specifically should keep in mind, including disclosures pertaining to sponsors’, officers’ and directors’ financial incentives, prior SPAC experience, and conflicts of interest with other entities to which they owe fiduciary duties.  SPACs also often raise money through PIPE (private offering in public equity) transactions, which allow for private investment on special terms, but those require separate disclosures and result in an additional set of shareholders who could later bring claims. By their nature, SPACs also present a number of other regulatory risks, including risks relating to MNPI, valuation, and conflicts of interest. Continue Reading

Increased Regulatory Scrutiny of Private Funds

President Biden has signaled a shift to a more assertive SEC Enforcement program with the nomination, and expected confirmation, of Gary Gensler as the next Chair of the SEC.  Mr. Gensler previously served as the Chairman of the CFTC from 2009 to 2014, where he established a reputation as a forceful regulator. This reputation suggests that we should expect a significant increase in enforcement actions against private fund managers.

Under former Chairman Clayton, private fund advisers benefited indirectly from the SEC’s focus on ”Main Street” investors.  More of the SEC’s limited resources were devoted to addressing retail fraud, leaving fewer resources available to focus on private funds.  As former Enforcement Director Stephanie Avakian explained recently, the SEC relied more heavily on exams by OCIE (recently renamed the “Division of Examinations”)  – through deficiency notices and remediation, rather than enforcement actions – to address perceived private fund compliance violations.  Whether the SEC returns to the more assertive “broken windows” approach to regulation under prior administrations remains to be seen. Continue Reading

Top Ten Regulatory and Litigation Risks for Private Funds in 2021

The regulatory and litigation risks for private funds are greater than at any time since the financial crisis in 2008. Just a few examples prove the point: the pandemic (which caused extraordinary volatility in revenues and valuations for most asset categories); a new administration in Washington D.C. (with a more muscular regulatory agenda); continued proliferation of digital assets (and increased valuations in various cryptocurrencies); unprecedented activity in SPACs (many of which are merging with PE-backed portfolio companies) and PIPEs; and continued extraordinary growth in AUM in private equity and private credit strategies (making private funds nearly ubiquitous in the capital markets). Any one of these factors would materially increase risks for litigation and regulatory enforcement but taken together they present an enormous challenge for the private fund industry. Insurance companies seem to be anticipating a changed environment as well, as premiums for many types of coverage have increased substantially.

Based on a variety of events and factors, we have developed this list of Top 10 Regulatory and Litigation Risks for Private Funds in 2021 to assist sponsors and managers to assess their own risks and take steps to mitigate their risk profile. We will be publishing a series of posts on each of these topics in the weeks ahead.

    1. Increased Regulatory Scrutiny of Private Funds
    2. The Ripples Behind the SPAC Wave
    3. Valuation in Times of Market Disruption
    4. Portfolio Companies Continue to be a Source of Litigation Risk
    5. New Focus and Compliance Approach Needed for Privacy and Cybersecurity
    6. Cryptocurrencies and Other Digital Assets: A New Regime
    7. Return to Civil and Criminal Collaboration in White Collar under Biden Administration
    8. Focus on ESG Will Continue to Grow Under Biden Administration
    9. Private Credit Lenders Should Remain Vigilant in 2021
    10. Navigating Brexit: What Funds Should Look Out for as the Dust Begins to Settle

SEC Division of Examinations Announces its Examination Priorities for 2021

On March 3, 2021, the SEC’s Division of Examinations announced its examination priorities for 2021. Compared to last year, this year’s edition contains an expanded section specifically addressed to private funds. For private fund managers, the exam staff states that it will target a list of issues, including:

  • Preferential treatment of certain investors by advisers to private funds that have experienced issues with liquidity, including imposing gates or suspensions on fund withdrawals;
  • Portfolio valuations and the resulting impact on management fees;
  • Adequacy of disclosure and compliance relating to cross trades, principal investments, or distressed sales;
  • Conflicts around liquidity, such as adviser led fund restructurings or stapled secondary transactions;
  • Risks surrounding non-performing loans and defaults for funds that have a higher concentration of structured products, such as collateralized loan obligations and mortgage backed securities;
  • The impact of recent economic conditions on portfolio companies owned by private funds (e.g., real estate related investments).

Read the full client alert here.