The Capital Commitment

Proskauer on Private Equity Litigation

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.

 1. Increasing Sophistication of OCIE

OCIE continues to function as an important referral pipeline to the SEC’s Division of Enforcement.  OCIE’s role in Enforcement referrals is due, in large part, to the industry-specific knowledge and sophistication of the OCIE exam staff, particularly with respect to the structural and operational aspects of private fund advisers.  This developing subject matter expertise has resulted in OCIE examining 17% of registered advisers in fiscal year 2018 and progressively more detailed requests for information and documents from OCIE staff in targeted areas.  OCIE also continues to allocate a portion of its resources to ERA oversight, including recent inquiries evaluating investment activities involving virtual currencies.  Advisers have always been appropriately attuned to an OCIE exam.  However, given OCIE’s increased understanding of the private funds industry, and the correlation between exams and Enforcement referrals, advisers should treat every exam request as an inquiry that could lead to further regulatory scrutiny.

2. Disclosure of Fees, Expenses, and Conflicts of Interest in Enforcement

OCIE and the Division of Enforcement will continue to focus on complete and accurate disclosure of fees, expenses, and conflicts of interest.  OCIE made this point clear in a recent Risk Alert discussing the most frequent fee and expense compliance issues identified in recent OCIE exams.  The SEC’s focus on timely disclosure is part of a multi-year trend dating back to at least May 2016 when Andrew Ceresney, then-Director of the Division of Enforcement, stated that it was “critically important that [private equity fund] advisers disclose all material information, including conflicts of interest, to investors at the time their capital is committed.”  Accordingly, disclosure of existing conflicts after a capital commitment generally will be insufficient, especially in the illiquid fund space where investors may be subject to extended commitment periods and have limited options for liquidity outside of the secondary markets.  Where pre-capital commitment disclosures either were not made or would have been impracticable, private fund advisers should consider what curative actions, if any, may be appropriate, including whether to refrain from taking an action that presents a potential conflict, or to disclose the conflict and obtain consent from an LPAC or the limited partners in accordance with the terms of the LPA.  Just as failing to adequately disclose carries risk, corrective actions that fall short of adequate disclosure or consent carry risk as well.

3. Blockchain-Related Investments (cryptocurrencies, ICOs, bitcoin)

Regulatory scrutiny surrounding blockchain-based technology—such as cryptocurrencies and Initial Coin Offerings—has increased over the last year, and will likely continue to build.  The SEC continues to pursue antifraud and registration violations involving ICOs and cryptocurrencies, and has more recently broadened its focus to include related activities, as illustrated by several celebrities who found themselves facing liability for improper ICO promotional activities.  The volatility of various cryptocurrencies, including the rapid decline of bitcoin (as we predicted in our 2018 Top Ten), also continues to be a fertile ground for private disputes.  While Section 29(b) of the Exchange Act and Section 12(a)(1) of the Securities Act both provide mechanisms to unwind securities transactions, such disputes can be quite costly if the proper precautions are not taken.  Coupling these risks with increasing regulatory scrutiny, fund managers should carefully consider their investment choices and prepare for varying degrees of legal scrutiny between those choices.

4. Cybersecurity, Privacy and Data Security

We expect this year will bring a continuation of the SEC’s heightened focus on private fund cybersecurity, both from OCIE and Enforcement.  OCIE has already stated that cybersecurity is one of its top exam priorities for 2019.  For Enforcement, the Division’s Cyber Unit has been up and running for over a year.  To date, much of the Unit’s cybersecurity focus has been on public companies, but there is good reason to expect that its focus will expand to include private funds as well.  Registered investment advisers are subject to Regulation S-P, which requires that firms adopt written policies and procedures designed to prevent and detect cyber breaches.  Given the SEC’s continued focus on this area and the widespread prevalence of increasingly creative cyber-attacks, private fund managers should consider beginning the year with a careful review of their cybersecurity policies and procedures – and take steps to ensure operational compliance.

5. Unicorns: Overvaluations leading to conflicts

A study published in 2018 confirmed what many have been speculating for years – that some unicorns may have been substantially overvalued.  These valuation issues and the risks they create for private investment funds will become difficult to ignore as investors’ expectations for liquidity increases in 2019.  The successful liquidity of certain high-profile unicorns will likely encourage others to follow suit, ready or not.  Disappointing outcomes may cause investors and employee shareholders to pursue litigation.  In addition to private litigation claims, the SEC and DOJ have made it clear with Theranos and others that they will step in when a unicorn’s actions amount to fraud or other regulatory violations.  Funds – and particularly those with a heavy concentration in unicorns (or directors on unicorn boards) – should be paying careful attention to these inquiries, and in the meantime should be reviewing their insurance coverage program.

6. Alternative Data

Fund managers continue to turn to alternative data sets to inform investment decisions, including geolocation data, web scraping, satellite data, credit card transactions and other data sets commonly referred to as “big data.”  However, alternative data is not without risks.  Recent press articles have highlighted concerns relating to geolocation data pulled from hundreds of smartphone apps that fund managers can purchase to predict trends involving public companies.  This creates a host of potential risks under applicable U.S. privacy and data security laws.  Furthermore, securities regulators may focus on the use of big data sets, particularly where they suspect potential material nonpublic information has been collected in a manner considered “deceptive,” or has been “misappropriated” in breach of a duty owed to the source of the information.  Ongoing diligence on the precise source of the data and collection methods is of paramount importance, particularly under agency theories or when issues may have been raised early in the data collection chain of custody.  Data vendors may have different levels of risk tolerance and may be more focused on technological advances than maintaining low levels of acceptable risk that are tolerable to advisors, which makes it all the more critical that the end-users of this information undertake sufficient due diligence procedures.

7. Performance Marketing and Credit Facilities

Both regulators and private fund investors continue to scrutinize performance information of private fund advisers.  It is routine for OCIE staff to request and closely review private placement memoranda and pitch decks to determine if performance data has the potential to mislead investors.  And as the utilization of subscription credit facilities has increased, OCIE is taking a closer look at the corresponding performance marketing materials.  In certain circumstances examiners have requested a recalculation of private fund performance without application of the subscription line.  Investors are taking notice as well.  As one private equity consultant recently commented, “[U]sage of [financing lines] made it difficult for a simple, straightforward apples-to-apples comparison of managers based on investment returns.  Firms use these lines differently and some don’t use them at all . . . now, stripping out the effects of subscription lines is critical to manager assessment and benchmarking.  Deconstructing investment performance is now more necessary than ever.”  In light of this focus – by both regulatory agencies and investors – advisers should consider whether disclosures are appropriate when communicating performance information that might have been impacted by credit facilities.  Likewise, for the reasons set forth in No. 5 above, advisers should monitor unicorn valuations dynamically if there is a shakeout or volatility develops.

8. Private Credit Industry Primed for Disputes

Private credit lending remains on track to become a $1 trillion industry by 2020.  The landscape for deals is becoming more competitive, with higher leverage and deal terms that are looser or have deteriorated.  In the 1980s and early 1990s, commercial banks assembled dedicated teams and developed sophisticated systems to work-out troubled commercial loans.  It remains to be seen how private credit lenders would respond to a similar situation, but if necessary they would be doing so with substantial resources and many tools at their disposal.

9. Litigation Funding Alters the Landscape

Limited partners are not typically in the business of initiating litigation – in part because their primary objective is to maximize the value of their investment and litigation is viewed as having certain costs with an uncertain return.  At the same time, limited partners – unlike managers who can often rely on indemnification from the fund and other sources – must cover their own legal expenses.  These factors have contributed to relatively low levels of litigation involving private funds.  Enter litigation funders, who are raising 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 – something that could be attractive to limited partners considering litigation alternatives.  Litigation funding therefore has the potential to fuel a new wave of litigation affecting private funds, whether involving disputes at the portfolio company level, the fund, or even the adviser.

10. Portfolio Company Litigation on the Rise

Indicia of control of portfolio companies – through directorships or otherwise – has always been a source of litigation risk for advisers and their funds.  That risk has only increased as it has become more common for plaintiffs to name fund advisers, as well as their funds and board-designees, as defendants in high-stakes litigation matters.  Aggressive plaintiffs’ lawyers view advisers as lucrative targets because of their deep pockets and desire to avoid litigation.  And we continue to see a steady uptick in something that was once viewed as taboo in the industry – advisers and their funds suing other advisers and their funds in post-closing disputes.  We expect this trend to continue in 2019 and beyond, given the institutionalization of the fund industry, increasing competition, and litigation funding.

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

Bharara Task Force on Insider Trading

Former SDNY U.S. Attorney Preet Bharara and SEC Commissioner Jackson recently announced, via NY Times op-ed, the creation of the Bharara Task Force on Insider Trading.  Based on the premise that U.S. insider trading laws are unclear and hopelessly out of date, the task force intends to propose new insider trading reforms to help clarify the laws and protect American investors.

Jackson and Bharara recognize that individuals facing liability should have more clarity about what the law is.  For those of us who regularly advise fund managers on compliance with insider trading rules, more clarity would be a welcome development.

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