The Capital Commitment

Proskauer on Private Fund Litigation

SPACs: Sure, Proceedings Are Coming

Proskauer’s Asset Management Litigation partner Dorothy Murray recently authored an article on litigation risks of SPACs.

Dorothy details why the recent popularity of this latest incarnation of so-called “blank cheque” companies will inevitably lead to disputes, and the reasons are all connected to the very features that make SPACs so attractive in the first place. Like all investment vehicles, SPACs carry risks for the unwary but this is acerbated by their particular combination of public and private capital, and unique structure, stakeholder roles and process. She identifies five key issues: conflicts, the regulatory context, the need for additional capital, ongoing governance and increasing complexity in de-SPACing.

Read the full article on ICLG: Commercial Dispute Resolution.

The Portfolio Company Playbook – Chapter 3: Navigating Risk from Company Employee Claims

Another source of litigation risk for fund sponsors are claims brought by portfolio company employees.  Sponsors should be aware of these risks, particularly when the portfolio company is in distress or is considering a sale or other transaction affecting the disposition of shares in the company.  We have set forth below just a few examples of litigation that can be brought against the fund, sponsor, and board designees by portfolio company employees, likely triggering at least indemnity considerations (which need to be evaluated in connection with insurance and indemnity at the portfolio company level), and might also affect the value of the portfolio company and in turn the value of the fund’s assets. Continue Reading

Navigating Brexit: What Funds Should Look Out for as the Dust Begins to Settle

As a result of Brexit, UK-regulated firms will already have grappled with loss of passporting and equivalence measures, and the need to navigate national regimes and relocate staff. As of today, EU firms operating in the UK have a temporary permissions regime with the UK having set out its approach to equivalence, but this remains a one-way street and the EU has made it clear that it will decide its own approach in its own time. 2021 will begin to reveal the full extent of market fragmentation and the resulting impact on liquidity. As of 2021, EU law no longer applies in the UK (save for where elements of it have been expressly incorporated into national law). We can therefore expect divergence in approaches between the EU and the UK in terms of legislation and regulation, especially as the EU’s Market Abuse Regulation (MAR) and Market in Financial Instruments Directive (MiFID II) will be updated over the next few years. Funds can therefore expect the regulatory burden to increase. Continue Reading

Private Credit Lenders Should Remain Vigilant in 2021

Private credit lenders began 2020 facing the dual challenges of an increased risk of defaults and a lack of strong financial covenants, and the pandemic sparked a significant increase in defaults to 8.1% in Q2. However, borrower defaults in Q3 and Q4 were lower than anticipated following the COVID-fueled spike in Q2, due in part to cash infusions into distressed borrowers by private equity sponsors and federal stimulus measures. Despite the continued economic headwinds from the pandemic through 2020 and into 2021, default rates have remained low and are expected to remain low, and private credit lenders and private equity sponsors have huge amounts of liquidity to invest.

Another significant development involved continued jockeying between lender groups, which we predicted in 2020. Several disputes came to a head with significant inter-lender litigation arising from liability-management transactions by lead lenders, and we expect those disputes to continue through 2021. In part, cash infusions by private equity sponsors in response to the pandemic have helped temporarily pushed the battle lines for private credit lenders from potential disputes with borrowers to inter-lender disputes. Two leadings examples are the Serta and Boardriders cases.

In 2021, it will be important for private credit lenders to remain vigilant of the risk of borrower defaults, and to freshly consider their approach to inter-lender disputes.

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

Focus on ESG Will Continue to Grow Under Biden Administration

In 2021, the global impact of environmental, social and corporate governance (“ESG”) investing will continue to grow, with key implications for the asset management industry. The new European regime on sustainability-related disclosures in the financial sector will roll out in March 2021, affecting both European and non-European asset managers alike. In the U.S., where there is no dedicated ESG-related regulatory structure in place, investor demand for ESG-focused strategies is driving fund managers to provide additional resources in the area. In addition, the Biden administration’s early focus on the environment will likely lead to greater scrutiny by the SEC. The SEC’s Division of Examinations is prioritizing exams of ESG-focused strategies, and will use the U.S.’s existing regulatory framework to review ESG-related disclosures.

On February 1, 2021, the SEC announced that Satyam Khanna will serve as Senior Policy Advisor for Climate and ESG in the office of Acting SEC Chair Allison Herren Lee. In this new role, Mr. Khanna will advise the agency on ESG matters and advance related new initiatives across its offices and divisions. In the coming year, the SEC will likely be increasingly focused on whether asset managers have adequate policies in place to support disclosures regarding ESG strategies and performance. With this in mind, fund managers should seek to avoid “greenwashing” – the practice of taking credit for an environmental impact that may not be warranted – as the SEC could view this as having implications under the anti-fraud rules. To stay in compliance, fund managers should continue to build robust ESG focused policies that support disclosures regarding ESG strategies and process.

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

Return to Civil and Criminal Collaboration in White Collar under Biden Administration

Under the Biden Administration, we expect the Department of Justice to reinvigorate the policies aimed at increasing coordination between the criminal and civil divisions.  In a 2015 Memorandum – the “Yates Memo” – former Deputy Attorney General Sally Yates pushed for “early and regular communication” between civil and criminal division attorneys in their pursuit of corporate investigations.  Current conditions, including the government’s COVID-19 response under the Coronavirus Aid, Relief, and Economic Security Act and additional pandemic relief packages, have set the stage for renewed focus on this collaborative policy outlined by Yates.  In the private funds space, this strategy could create a potential multi-pronged risk to portfolio companies—and their private equity owners and creditors—who have received funding from federal relief programs.

In 2021, we expect these federal relief program investigations to move beyond the low hanging fruit of brazen criminal fraud, into areas with more difficult proof issues, including those posed by ambiguous or shifting program requirements, especially as they relate to eligibility.  Even in the absence of adequate proof of criminal intent, some circumstances may be ripe for False Claims Act and other civil fraud enforcement alternatives where the government faces a lower evidentiary burden to establish financial liability, both as to corporate recipients and derivatively to their private equity backers.

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

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.

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

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.

Continue Reading

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.

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