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
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.
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
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
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.
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.
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
The Portfolio Company Playbook – Chapter 2: Navigating Risk from Conflicts of Interest
Private funds frequently negotiate for special rights when making an investment in a portfolio company, such as the right to appoint one or more board directors, voting rights, and liquidation preferences. Fund sponsors often focus solely on the positive aspects of these special rights, such as increased control, without considering fully other implications. As the Peter Parker principle reminds us, with great power comes great responsibility. In the fund context, sponsors should remember the portfolio company corollary: with greater control comes greater exposure to liability.
Portfolio Company Insolvency: Risk Mitigation Strategies for Fund Sponsors and Board Designees
COVID-19 continues to disrupt normal business operations, creating liquidity problems and negative working capital for many companies. As fund sponsors take actions to help their portfolio companies navigate through this time, they should also sensitize directors to insolvency issues and the associated litigation risks. As we have previously highlighted, both funds and fund managers may face increased risks of litigation exposure when a portfolio company is running low on cash and faces the possibility of restructuring or reorganizing. The COVID-19 pandemic and the havoc it has wrought in its wake has amplified these risks, as companies scramble to shore up their cash positions. These litigation risks are also magnified when fund managers serve as directors of the distressed portfolio company, given the heightened risk of conflicting fiduciary duties inherent in such dual roles.
The Portfolio Company Playbook – Chapter 1: A Fund Sponsor’s Guide to Navigating Risks, Conflicts, and Regulatory Concerns Arising from Portfolio Companies
Over the last few years, we have seen an uptick in litigation claims against sponsors and funds arising out of their interests in portfolio companies. A fund sponsor’s participation on a portfolio company board, in particular, is a risk factor for the entire investment structure (the GP, the Management Company, individual members of the GP and Management Company, and the Fund) due to conflicts of interest, whether real or perceived, and related competing fiduciary duties. There are, however, steps that fund sponsors can take to manage and reduce their risks. The first step is to develop a full understanding of where, and why, risks lie in the investment structure. With that understanding, sponsors can develop and implement practices to manage and reduce those risks.