The Capital Commitment

Proskauer on Private Fund Litigation

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.

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. Continue Reading

Three Critical Questions That Will (Hopefully) be Answered by the SEC’s Lawsuit against Ripple

Late last year, the SEC filed a litigated action in the U.S. District Court for the Southern District of New York against Ripple Labs Inc. and two of its executive officers (collectively, “Ripple”), alleging that Ripple raised over $1.3 billion in unregistered offerings of the digital asset known as XRP. Ripple opted not to file a motion to dismiss the complaint, and based on recent filings it appears that the parties do not believe a pre-trial settlement is likely. Continue Reading

2020 Proskauer Annual Review and Outlook for Hedge Funds, Private Equity Funds and Other Funds

Proskauer’s Private Investment Funds Group released its 2020 Annual Review. The yearly report provides a summary of some of the significant changes and developments that occurred in the past year in the private equity and hedge fund spaces, as well as certain recommended practices that investment advisers should consider when preparing for 2021.

Read the full report here.

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. Continue Reading

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