The Capital Commitment

Proskauer on Private Equity 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.

2018 Annual Review and 2019 Outlook Highlights Private Equity Fund Litigation Risk Areas

In our recently released 2018 Annual Review and 2019 Outlook for Hedge Funds, Private Equity Funds and Other Private Funds, we note that innovative market disruptors, a maturing credit cycle, and a philosophical change in how the industry views and utilizes litigation are likely to lead to increased litigation risk for advisers (and their funds) in 2019. Below we have excerpted the areas that should be on the top of every adviser’s list as we look toward 2019.

The Unicorn Ripple Effect

While the number of IPOs has increased, rich valuations for private companies may constrain opportunities for liquidity and future funding rounds. Ultimately, an uneven IPO outlook for unicorns could lead to disputes. Overly optimistic valuations can lead to inflated expectations, especially among employee shareholders expecting a payout and investors expecting gains. A company with rich valuations may have greater difficulty creating liquidity for shareholders. As more unicorns linger and fall into distress, some may fail, leading to litigation. And as the Theranos case has taught us, the failure of a unicorn is likely to attract not only regulatory scrutiny, but also potential private litigation claims.

Litigation Funding Alters the Landscape

Historically, limited partners have shied away from initiating litigation – in part because their primary objective is to maximize the value of their investment and litigation is viewed as having high costs with an uncertain return. In addition, advisers have an asymmetric advantage in that they often can draw on the fund to cover legal expenses, whereas limited partners must cover their own expenses. Enter litigation funders, who are raising funds and capital at an unprecedented pace and whose business strategy is to invest in claims by covering the expenses of litigation in exchange for a share in the recovery. Litigation funding has the potential to fuel a new wave of LP-driven litigation that, up until recently, had been viewed as a risk that was hard to quantify and seemed unlikely to materialize.

Private Credit Defaults and Workouts

The market for private credit lending (sometimes called alternative finance or private capital) continues to boom, with some experts estimating that it will exceed $1 trillion by 2020. The influx of capital into the private credit industry is altering the landscape for deal types and deal terms. Rising competition, intense deal activity, and the reach for yield have led to more complicated capital structures. This complexity coupled with higher interest rates are signs of a maturing credit cycle – which in turn signals an increased risk of defaults. End of cycle defaults often lead to contentious workouts. Given that disputes tend to follow market trends, the continued growth of the private credit market today could lead to disputes tomorrow.

Portfolio Company Litigation

There are seemingly countless ways that ownership and sale of a portfolio company can expose advisers and their funds to litigation. There is a growing trend by plaintiffs’ lawyers to name advisers, funds and their board-designees as defendants in traditional portfolio company litigation. Advisers (their principals) and their funds also are common targets when a portfolio company fails post-sale and a creditors’ committee comes knocking to pursue recoveries. And there has also been a steady uptick in something that was once viewed as taboo in the industry – advisers and their funds suing other advisers and their funds related to sales of portfolio companies. Each of these trends is likely to continue in 2019 and beyond.

Proskauer Private Investment Funds Group Releases 2018 Annual Review and Outlook

Proskauer’s Private Investment Funds Group today released its 2018 Annual Review and Outlook for Hedge Funds, Private Equity Funds and Other Private Funds.  This yearly publication provides a summary of some of the significant changes and developments that occurred in the past year in the private equity and hedge funds space, as well as certain recommended practices that advisers should consider when preparing for 2019.

Highlights from the annual review include:

  • A summary of SEC examination priorities and enforcement developments impacting the private funds industry, including fees and expenses, allocation of investment opportunities and conflicts of interest;
  • A review of the continued evolution of whistleblower law, including an overview of the Supreme Court’s ruling on the definition of “Whistleblower,” the first overseas whistleblower awards and proposed changes to the SEC’s whistleblower rules;
  • An analysis of the current state of insider trading law, including an analysis of the Second Circuit’s approach to the personal-benefit requirement in United States v. Martoma and the potential for securities fraud liability even without personal benefits or a fiduciary breach;
  • U.S. and U.K. tax updates, including an overview of the comprehensive U.S. tax bill signed into law in December 2017;
  • An extensive review of employment law developments at the federal and state level potentially impacting advisers, including legislation since the beginning of the #MeToo movement aimed at eliminating sexual harassment and abuse in the workplace;
  • A review of big data, web scraping and other issues in data science, including a discussion of the applicability of the Computer Fraud and Abuse Act to data scraping;
  • Developments relating to the regulation of cryptocurrencies, tokens and other digital assets, including the CFTC’s authority to regulate cryptocurrencies and the SEC’s intention to regulate tokens (often referred to as initial coin offerings or ICOs) as securities;
  • Regulatory developments in the European Union, including an update on the still uncertain Brexit process and a review of the Alternative Investment Fund Managers Directive II and the General Data Protection Regulation; and
  • A comprehensive overview of required U.S. regulatory filings across the many agencies overseeing the private funds industry, including a quick reference table for monthly filings in 2019.

WSJ Article on Geolocation Data Highlights Risks for Fund Managers

On Friday, the WSJ published an article detailing how companies are monetizing smartphone location data by selling it to hedge fund clients.  The data vendor featured in the WSJ article obtains geolocation data from about 1,000 apps that fund managers use to predict trends involving public companies.  However, as we’ve noted, the use of alternative data collection for investment research purposes may give rise to a host of potential issues under relevant laws. Continue Reading

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