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 utilises 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 20181 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 activities2. The volatility of various cryptocurrencies, including the rapid decline of bitcoin (as we predicted in our 2018 Top Ten3), 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 20194. 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 overvalued5. These valuation issues and the risks they create for private investment funds6 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 litigation7. In addition to private litigation claims, the SEC and DOJ have made it clear with Theranos and others8 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 apps9 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 laws10. Furthermore, securities regulators may focus on the use of big data sets, particularly where they suspect potential material non-public 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 scrutinise 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 utilisation 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 commented11, “[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 maximise 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 RiseIndicia 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 institutionalisation of the fund industry, increasing competition, and litigation funding.
This article is provided as a general informational service and it should not be construed as imparting legal advice on any specific matter.
Timothy Mungovan serves as chair of the Firm’s Litigation Department, co-head of the Private Equity and Hedge Fund Litigation team and co-head of the Private Credit Litigation team. His practice is focused on solving complex business disputes in a variety of areas including securities, asset management, corporate governance, fiduciary obligations, capital markets, financial services, bankruptcy and insolvency. A significant portion of Tim’s practice involves disputes and risk management for private investment funds (private equity, venture capital and hedge funds) and private credit vehicles. Tim devotes time to improving the community by serving on the board of Greater Boston Legal Services, which provides civil legal assistance to thousands of low-income people and families each year. Tim is also the lead editor of Proskauer’s blog on Private Equity litigation, The Capital Commitment.
Joshua Newville is a partner in the Litigation Department in New York and a member of Proskauer's White Collar Defense & Investigations Group, Private Equity and Hedge Fund Litigation team and the Private Credit Litigation team. Josh handles securities litigation, enforcement and regulatory matters, representing corporations and senior executives in civil and criminal investigations. In addition, Josh advises registered investment advisers and private fund managers on regulatory compliance, SEC exams and related risks. Before joining Proskauer, Josh was senior counsel in the U.S. Securities and Exchange Commission’s Division of Enforcement, where he investigated and prosecuted violations of the federal securities laws. Josh served in the Enforcement Division’s Asset Management Unit, a specialized unit focusing on investment advisers and the asset management industry. His prior experience with the SEC provides a unique perspective to help private investment funds and their advisers manage risk and handle regulatory issues.
Sam Waldon is a partner in Proskauer’s Litigation Department and a member of the firm’s Private Equity and Hedge Fund Litigation team, Private Credit Litigation team, Securities Litigation Group, and White Collar Defense & Investigations Group. Sam advises private funds and their managers on litigation, enforcement and regulatory matters, including exams and investigations. Before joining Proskauer, Sam served as Assistant Chief Counsel in the SEC’s Division of Enforcement for eight years. In that role, Sam helped develop and implement many of the Division’s policies and procedures, and advised the Division’s senior leadership, investigative staff and trial unit attorneys on a wide range of legal and policy issues. Sam also worked closely with staff in other Divisions and Offices throughout the SEC on enforcement related issues, including playing a key role in the drafting of the rules establishing the SEC’s whistleblower program.
Michael Hackett is a senior counsel in the Litigation Department and a member of the Private Equity and Hedge Fund Litigation team and the Private Credit Litigation team. His practice focuses on disputes and regulation involving private funds, including private equity, venture capital, hedge, real estate and private credit funds, as well as other limited partnerships, where he regularly advises funds, fund sponsors, investment advisers and institutional and individual investors. Mike’s experience representing private fund clients runs the gamut, from control contests within advisers, to disputes between limited partners and general partners, to representation of investment advisers in connection with regulatory examinations, investigations and enforcement matters. Mike also routinely represents fund sponsors and their portfolio companies, including in significant post-closing disputes.
Tony Drenzek is special regulatory counsel in the Corporate Department and a member of the Private Investment Funds Group and the Private Equity and Hedge Fund Litigation team. His practice focuses on advising U.S. and offshore private fund managers on all aspects of federal, state and SRO organizational and operational compliance, with a specific emphasis on the Investment Advisers Act of 1940. Tony assists U.S. and offshore private fund clients in registering with the SEC as investment advisers, or reporting as exempt reporting advisers, and complying with CFTC and various U.S. state registration and notice-filing requirements. He also assists on structuring fundraising transactions to comply with the U.S. offering exemptions available under Regulation D and Regulation S.
Will Dalsen is an associate in the Litigation Department, a member of Proskauer’s Patent Law Group, Intellectual Property Group, Private Equity and Hedge Fund Litigation team and the Private Credit Litigation team. Will practices in the area of complex intellectual property disputes, with a primary focus on patent infringement matters. He has litigated several high-profile patent infringement cases for some of the world's leading technology companies, including Panasonic, Philips, Sony, Mitsubishi and Zenith Electronics. His practice also includes complex commercial and securities litigation matters, in particular those involving private equity, venture capital and hedge funds. He has represented public and private corporations in contractual disputes, business tort cases, and government investigations. In addition, he advises funds, fund sponsors, investment advisers, and institutional and individual investors.
Brian Hooven is an associate in the Litigation Department, and a member of the Private Equity and Hedge Fund litigation team and the White Collar Defense & Investigations Group. Brian has represented clients in both state and federal courts in all phases of litigation, and in a variety of alternative dispute resolution proceedings. Brian’s practice is focused on resolving complex commercial disputes in a variety of areas including contracts, securities, corporate governance, fiduciary obligations, capital markets, financial services, antitrust, and bankruptcy litigations. In addition, Brian regularly represents corporations and individuals in connection with regulatory and criminal investigations. Brian also maintains an active pro bono practice, representing individual clients in criminal, family and immigration proceedings.
Alexandra Bargoot is an associate in the Litigation Department and a member of the Private Equity and Hedge Fund Litigation team. Her practice includes a variety of complex commercial litigation matters, with a focus on private investments funds, involving both private disputes and regulatory issues. Alexandra assists clients on matters involving SEC investigations, pay to play violations, private actions, sales of investments, investigations of aiding and abetting, arbitration award enforcement, among other areas of expertise.
Lucy Wolf is an associate in the Litigation Department and a member of the Private Funds Group and Private Equity and Hedge Fund Litigation team.
Hena Vora is an associate in the Litigation Department and a member of the Private Funds Group and Private Equity and Hedge Fund Litigation team.
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