In his recent remarks at the Securities Regulation Institute, SEC Chairman Jay Clayton had some stern words for market professionals, especially lawyers, involved in initial coin offerings (ICOs).  He expressed concern that lawyers in the space “can do better” in their role as gatekeepers to the securities markets, particularly in advising clients whether the “coin” being offered is a security requiring registration.

In particular, he noted situations where lawyers may have helped to structure an ICO with many of the hallmarks of a securities offering, but have taken the position that the coin is not a security.  Second, he noted situations where attorneys have apparently stepped back and provided “equivocal advice” rather than counseling clients that the ICO being promoted would likely require registration.  In his view, these approaches are inappropriate in light of SEC guidance indicating that ICOs are likely to qualify as securities under the long-standing Howey test for investment contracts.

Chairman Clayton noted that he had instructed the SEC staff “to be on high alert” for these situations.  These comments follow his unscripted remarks during a PLI speech in November that “I have yet to see an ICO that doesn’t have a sufficient number of hallmarks of a security.”  We understand that many of the roughly two dozen enforcement attorneys in the SEC’s new Cyber Unit are focused on ICO and blockchain-related investigations, with more cases in the pipeline.

With the SEC’s assertion of jurisdiction over ICOs as securities, and the CFTC’s recent release indicating that it would regulate and monitor cryptocurrency futures contracts, registration and compliance issues are paramount.  If a violation renders a security defective, transactions involving cryptocurrencies or ICOs may also be called into question as either void (automatically unwound) or voidable (unwound at the wronged party’s discretion).  Fund managers with investments in or exposure to ICOs and, more broadly speaking, cryptocurrencies should prepare for increasing regulatory scrutiny and enforcement spillover.

With the public equity markets at an all-time high and private equity fund raising setting new records, it might seem counterintuitive to forecast litigation and regulatory risks.  The opposite is true.  Disputes typically follow capital, and the steeper the growth curve, the greater the risk of litigation and regulatory scrutiny.  With that backdrop, we are pleased to present our Top Ten Regulatory and Litigation Risks for Private Funds in 2018.

1. Regulatory Scrutiny Involving Cryptocurrencies and ICOs

Cryptocurrencies and other instruments based on blockchain technology – such as Initial Coin Offerings (ICOs) – are in the regulators’ sights.  The SEC has asserted jurisdiction over products structured as ICOs and is pursuing violations of the anti-fraud provisions and registration violations involving ICOs and cryptocurrencies.  A number of enforcement attorneys in the SEC’s new Cyber Unit are focused on ICO and cryptocurrency investigations, with more cases in the pipeline.  In addition, the CFTC has declared virtual currencies to be “commodities” subject to its oversight under the Commodity Exchange Act and has brought a number of actions under the anti-fraud provisions of the CEA against industry participants.  Fund managers with investments in or exposure to these areas should prepare for questions about disclosures and increasing regulatory scrutiny and spillover relating to those investments. 

2. Bitcoin Bubble: Related Private Litigation 

The cryptocurrency and ICO mania has been wildly profitable for some, but also has some classic signs of a bubble.  If values collapse, disputes will follow.  For example, if a violation occurs in the chain of distribution, transactions involving that security may be set aside as void or voidable.  Section 29(b) of the Exchange Act provides that a contract made in violation of certain registration requirements “shall be void” as to the violator, and Section 12(a)(1) of the Securities Act gives purchasers a right of rescission for violations of Section 5’s registration provisions.  Private funds and others involved in ICOs or crypto-related technology should also be wary of clawback actions by a court-appointed receiver or bankruptcy trustee if a particular instrument fails or is halted.  Fund managers should also be prepared for disputes with investors, in light of their obligations to appropriately manage and/or disclose material risks.

3. Unicorns: Potential Disputes Spoil the Magic

Unicorns continue to be an area of high risk for private investment funds.  While the IPO markets seem to be opening, rich valuations continue to constrain opportunities for liquidity and future funding rounds.  Looking ahead, exits or funding rounds that are below recent valuations could lead to disputes and SEC scrutiny.  Meanwhile, recent experience – most prominently with Theranos – suggests that the failure of one or more unicorns is likely to attract both regulatory scrutiny and private litigation given the magnitude of investor losses.

4. Privacy and Data Security Risks Continue to Increase

After years of warnings by the SEC, this could be the year that one or more private fund advisers suffer a public cybersecurity breach. Given that highly sophisticated entities – including those that specialize in data protection – have fallen prey to cyber-attacks, private fund advisers are in no better position to deter these very real threats. It may be difficult or even impossible to thwart an attack, but private fund advisers must have in place robust and proactive policies and procedures to limit damage should an attack occur. Given all the warnings and events in the market, the absence of a cybersecurity policy that includes emergency remedial measures may lead to regulatory scrutiny and possible enforcement action.

5. Big data: Big Risks Involving Alternative Data Vendors

Fund managers are increasingly using alternative data sources or “big data” to inform investment decisions, including geolocation data, web scraping, satellite data and aggregate credit card transactions.  Use of large data sets can potentially lead to liability under a host of U.S. privacy and data security laws.  Securities regulators may focus on the use of big data sets, particularly where they suspect potential material nonpublic information is being hacked, used or shared.  Was access to information obtained legitimately?  Was there any deception or misrepresentation in the collection of the data?  If so, liability could arise under the anti-fraud provisions.  Data vendors may be more focused on technological advances and may have high levels of “acceptable” risk tolerance.  Fund managers may risk potential liability under agency theories, in addition to regulatory scrutiny and adverse publicity.

6. Litigation Funding: Fueling Private Fund Disputes

Historically, limited partners have shied away from initiating litigation – in part because their primary objective is to maximize their investment and litigation is viewed as a certain cost with an uncertain return.  This is especially true for government pension plans.  In addition, sponsors 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, whose business strategy is to invest in claims by covering the expenses of litigation in exchange for a share in the recovery.  We expect to see more LP-driven litigation backed by litigation funding, as well as the revelation that litigation funders have already been active in this space behind the scenes.

7. Fund Performance Marketing: A Continuing Area of Examination Focus

Sponsors of private investment funds are acutely aware of the importance of their performance presentations when marketing their funds to existing and potential investors.  While the SEC has always seen performance marketing as an area of regulatory focus, recent amendments to the Investment Advisers Act of 1940, the release of a risk alert from the agency’s National Examination Program, and recent enforcement activity in this area reflect a recommitted emphasis to the issues surrounding performance marketing.  We expect this trend to continue in 2018 and beyond.  As the private fund industry becomes ever more competitive, and marketing pressures intensify, sponsors must ensure that any performance presentations comport with the applicable regulatory compliance requirements.

8. Regulatory and LP Focus on the Use of Subscription Credit Facilities

Sponsors of private investment funds have continually sought to optimize the capital structures of their funds with a goal of enhancing returns for their investors.  While mechanisms such as subscription credit lines allow sponsors to swiftly and smoothly execute portfolio investment opportunities, fund sponsors should reevaluate disclosures to investors of credit line utilization and potential effects on fund performance calculations.  As both the SEC and limited partners further evaluate the use of fund credit facilities, sponsors should be prepared to explain the commensurate benefits and potential conflicts involved.

9. Private Credit Industry Likely to See Rise in Disputes

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.

10. Portfolio Companies Continue to be a Source of Litigation Risk

There are seemingly countless ways that ownership and sale of a portfolio company can expose sponsors to litigation.  As we have previously discussed, there is a growing trend by plaintiffs’ lawyers to name sponsors and their board-designees as defendants in traditional portfolio company litigation – it’s never too early to perform a robust review of insurance policies and indemnity rights and obligations.  Sponsors (and their principals) also are common targets when a portfolio company fails post-sale and a creditors’ committee comes knocking to pursue recoveries.  Finally, we have seen a steady uptick in something that once was viewed as taboo in the industry – sponsors suing other sponsors related to sales of portfolio companies.  This trend is likely to continue.

On Tuesday, February 13th, the Securities and Exchange Commission (SEC) announced the opening of registration for its 2018 national compliance outreach seminar for investment companies and investment advisers. The event is intended to help Chief Compliance Officers (CCOs) and other senior personnel at investment companies and investment advisory firms to enhance their compliance programs.  The SEC’s Office of Compliance Inspections and Examinations (OCIE), Division of Investment Management (IM), and the Asset Management Unit (AMU) of the Division of Enforcement jointly sponsor the compliance outreach program.  The national seminar will be held on April 12th at the SEC’s Washington, D.C., headquarters from 8:30 a.m. to 5:30 p.m. ET.  While in-person attendance will be limited to 500 attendees, the event will also be made available via live webcast, and also via an archived audio webcast, at www.sec.gov.

The agenda for the national seminar will include a discussion of OCIE, IM, and AMU program priorities in 2018, issues related to fees and expenses, portfolio management trends, regulatory hot topics, cybersecurity, compliance, and rulemaking.

Investment adviser and investment company senior officers may register online to attend the event in-person. If registrations exceed capacity, investment company and investment adviser CCOs will be given priority on a first-registered basis.  Registration instructions also will be sent to SEC-registered investment advisers using the e-mail account on the adviser’s most recent Form ADV filing.  For more information, prospective attendees can contact the SEC staff at ComplianceOutreach@sec.gov.

We are pleased to announce that partner Samuel Waldon has joined Proskauer’s Litigation Department in DC, enhancing the Firm’s securities litigation and regulatory enforcement practices.  Among his other areas of focus, Sam will bolster the firm’s Asset Management Litigation team.

“In today’s ever evolving regulatory landscape, Sam’s extensive experience at the SEC and his deep knowledge of federal securities law will be a valuable asset to our clients,” said Tim Mungovan, Chair of Proskauer’s Litigation Department.

Mr. Waldon joins Proskauer from the U.S. Securities and Exchange Commission (SEC), where he served as Assistant Chief Counsel in the Enforcement Division for eight years.  Providing guidance on all types of enforcement matters, his focus included FCPA, asset management, insider trading and financial fraud matters, as well as issues relating to the Freedom of Information, Bank Secrecy, Privacy, Right to Financial Privacy and Electronic Communications Privacy Acts.  Mr. Waldon received his B.A., summa cum laude, from Virginia Tech and his J.D., with honors, from University of Texas School of Law.

On April 12, 2018, the SEC’s Office of Compliance Inspections and Examinations issued a risk alert listing the most common compliance issues concerning fees and expenses charged by SEC-registered investment advisers.  Advisers should review their practices, policies and procedures to ensure compliance with their advisory agreements and representations to clients in light of the fee and expense issues noted in the risk alert.

Here are the top six:

• Fee-Billing Based on Incorrect Account Valuations.
• Billing Fees in Advance or with Improper Frequency.
• Applying Incorrect Fee Rates.
• Omitting Rebates and Applying Discounts Incorrectly.
• Disclosure Issues Involving Advisory Fees.
• Adviser Expense Misallocations.

For additional guidance, please read our full client alert on this topic.

As a sign that the SEC is continuing to actively pursue private equity fund advisers, on April 24, 2018, the SEC announced a settlement with private equity fund adviser WCAS Management Corporation (WCAS) related to allegations of undisclosed conflicts of interest. The specific conflicts resulted from an allegedly undisclosed contractual arrangement whereby a portion of fees received by a group purchasing organization (GPO) for services it provided to WCAS funds’ portfolio companies would be paid to WCAS. In settlement of the allegations, WCAS agreed to disgorgement of $688,819.78 and a civil monetary penalty of $90,000, as well as a cease and desist and censure.

Arrangement with the GPO

According to the SEC’s Order, the GPO was an organization that aggregated certain items of vendor spending, such as office supplies and car rentals, in order to provide group purchasing discounts to participating companies.  At issue were the arrangements entered into between the GPO and WCAS with respect to services rendered to portfolio companies of two WCAS-managed funds formed in 2005 and 2008.

In early 2011, the GPO and a WCAS employee began negotiating a services agreement, whereby WCAS would receive a fee equal to 25% of the net revenue the GPO received from vendors based on the purchasing activity of the portfolio companies owned (and in some cases previously owned) by the WCAS funds. From September 2012 through December 2016, WCAS allegedly received $623,035 pursuant to the WCAS services agreement.  The SEC alleged that WCAS did not disclose its right to receive, or actual receipt of, the GPO fees in its PPM, LPAs, management agreements.

Moreover, while the organizational documents for the two WCAS funds provided that a group of limited partners unaffiliated with WCAS was to approve in advance “any transactions that give rise to potential conflicts of interest,” WCAS allegedly did not seek that prior approval in breach of its fiduciary obligations. The SEC further alleged that WCAS had an undisclosed incentive to recommend the GPO’s services to the funds’ portfolio companies because WCAS stood to receive a share of revenue generated for the GPO.

Takeaways

In response to this latest settlement, advisers should take note of several key points:

• First, despite its expressed retrenchment with respect to the protection of retail investors, the SEC remains focused on areas of disclosure and potential conflicts of interest in the private fund space.
• Second, private fund advisers must remain vigilant to any activities or arrangements which could be perceived as creating potential conflicts of interest between a management company and its affiliates, and the funds that are advised.
• Third, where such potential conflicts exist, advisers must review their funds’ organizational and governance documents to determine whether:
  • the potential conflict has been adequately disclosed prior to investors’ commitment of capital to the funds;
  • notice of the potential conflict must be provided to the fund and its beneficial owners;
  • consent to engage in the arrangement or activity at issue must be obtained from an advisory board, or the applicable agreement should be amended with the requisite limited partner consent; or
  • the potential conflict is of such a nature that abstention is the most prudent course.

As always, the best way to avoid conflict of interest and related disclosure issues is to adopt and implement written policies and procedures reasonably designed to identify, analyze and address potential conflicts of interest as soon as they arise.

Last week, former CFTC Chairman Gary Gensler explained in remarks at M.I.T. that he believes the second and third most widely used virtual currencies—Ether and Ripple—may have been issued and traded in violation of securities regulations. This comes on the heels of a crackdown on cryptocurrency-related securities by the SEC, which is particularly focused on initial coin offerings (ICOs). For fund managers, we believe the increased regulatory pressure will be felt in some expected, and some not-so-expected, ways. 

ICO enforcement is trending: The SEC’s Cyber Unit has ramped up enforcement pressure, issuing dozens of subpoenas and information requests to technology companies and advisers involved in the ICO market. The requests have sought information about the structure for sales and pre-sales of ICOs.  This uptick in enforcement pressure isn’t surprising, especially given Chairman Clayton’s repeated warnings that participants in the ICO space are not complying with the required securities laws (for example, notably stating that he has yet to see an ICO that “doesn’t have a sufficient number of hallmarks of a security.”)  There are no signs the SEC will slow down its scrutiny of crypto-related assets. The SEC has already indicated that it will devote significant resources to policing the ICO market.

• SEC and CFTC enforcement cases have to date focused on the anti-fraud provisions, involving traditional types of schemes (offering frauds, market manipulation) feeding on interest in new technology.
• Clayton has repeatedly warned attorneys and other advisors involved in structuring ICOs to stop advising their clients that these instruments don’t need to be registered.
• The SEC is looking at potential registration issues for ICOs, under the principle that every offering of securities must be registered or subject to a valid exemption.
• Businesses operating as ICO exchanges or advising on ICO investment decisions may have to consider registration under the Securities Exchange Act of 1934, the Investment Company Act of 1940 or the Investment Advisers Act of 1940.
• The SEC’s Section 21(a) report of investigation regarding The DAO sets out the framework for how the Commission is likely to analyze whether a crypto coin or token is a security.

As such, those who interface with this market in any way should beware that they can face heightened scrutiny merely by virtue of their involvement with these instruments.

OCIE exam focus is also high: The Office of Compliance Inspections and Examinations is following the lead of the Chairman, but with a different focus. It has been publicly reported that the exam staff intends to examine up to 100 fund managers as part of a sweep of crypto-focused funds. However, while SEC examiners could refer any red flags they observe to enforcement investigators, the effort is principally to inform the Commission how to address the new world of cryptocurrency investments.  Two key areas of focus are likely to come to light:

• Have cryptocurrency related risks been adequately disclosed to LPs in offering docs (i.e., potential investment losses, liquidity risks, price volatility, hacker-related frauds, etc.)?
• Are there adequate risk management policies and procedures that have been put in place by firms registered with the Commission given novel issues implicated by crypto-related investments?

To this end, fund managers should be prepared to explain how disclosures to LPs adequately reflect the risks involved in any crypto-related investments. Because of the potential for regulatory spillover, fund managers should satisfy themselves that investments in this space comply with applicable laws and regulation—the question will be asked.

Regulatory uptick has been felt by the market: This increasing regulatory pressure appears to be affecting the market—while the number of ICOs in March dipped only slightly, the gross proceeds were only $795 million—a 45% decrease from the $1.44 billion raised in February.   This decrease may signal a shift to a higher degree of “pre-sale” fundraising, mainly focusing on institutions and accredited investors—often through Simple Agreements for Future Tokens (or SAFTs), which have also garnered significant regulatory attention. However, given the increasing focus on this area (along with crypto-related investments in general), fund managers should be sure to commit the upfront effort to carefully analyze emerging regulatory risks.

A recent settled SEC order, In re Arlington Capital Management, Inc. and Joseph F. LoPresti, highlights the potential benefits of voluntarily taking steps to remediate conduct or practices that could run afoul of the SEC’s rules and standards. If done correctly, voluntary remediation can result in meaningful reductions in the sanctions sought by the SEC. But if done incorrectly, remediation can result in wasted time and money – and possibly make matters worse. This post will explore the elements of an effective voluntary remediation plan, as shown by the remediation in Arlington, as well as some of the potential pitfalls of ineffective remediation.

In Arlington, the SEC found that the firm, an investment adviser, and LoPresti, the firm’s owner and CCO, fraudulently advertised the firm’s performance by using inflated, hypothetical, back-tested results and creating the false impression that those results were the firm’s actual performance results. As part of the settlement, Arlington and LoPresti each agreed to the entry of a cease and desist order and a censure, as well as the payment of civil penalties – $125,000 by Arlington and $75,000 by LoPresti. Most notably, however, LoPresti was not barred or suspended from being associated with an investment adviser, a sanction the SEC could have pursued.

In accepting the settlements with Arlington and LoPresti, the SEC specifically emphasized the respondents’ remedial efforts. The Arlington Order suggests that an effective remediation plan should focus on the following:

1. Timing. The firm began its remediation during the SEC investigation – demonstrating that remediation is typically better late than never. However, the SEC will almost always give greater credit to a firm that begins remediation before becoming aware of an SEC investigation.
2. Outside compliance consultant. The firm retained an outside firm to review and revise the firm’s compliance policies and procedures. The SEC will almost always have greater confidence in remedial efforts recommended or implemented by an outside firm, rather than the firm itself. It is common for the SEC to require, as part of a settlement, that a firm retain an independent compliance consultant.
3. Compliance policies and procedures related to the misconduct. The firm revised its policies and procedures relating to advertising, permitting the firm to argue to the SEC that it is unlikely that similar misconduct will occur in the future.
4. Compliance policies and procedures more broadly. The consultant undertook a comprehensive review of Arlington’s entire compliance program, rather than limiting its review to the firm’s policies and procedures regarding advertising. The SEC often views isolated misconduct as potentially evidencing broader legal or compliance failures at a firm. By reviewing and revising its overall compliance program, Arlington was able to demonstrate its commitment to establishing a “culture of compliance ” at the firm.
5. Compliance functions. The firm agreed to separate the CCO function from the management function. LoPresti previously held both functions, but as part of the settlement, the firm agreed to hire a new CCO to replace LoPresti. Also, the firm upgraded its compliance software.
6. Training. LoPresti and the new CCO both received additional training provided by the consultant.

Although not part of the remediation in Arlington, where there are identifiable client losses, an effective remediation plan could also include reimbursement – or at least segregation – of the losses by the adviser. In appropriate cases, disclosure to clients and investors of the underlying misconduct or the remediation may be important. Moreover, it may be appropriate in some cases to discipline or terminate employees involved in the wrongful conduct.

While effective voluntary remediation, as in Arlington, can offer significant benefits, implementing a plan is not without risks. Most notably, a firm engaging in remediation should be mindful that:

• The remedial efforts could be viewed as insufficient. If, in evaluating a proposed settlement, the SEC takes this view, the remediation will have accomplished little more than wasting time and money. As a result, a firm should carefully design its remediation plan with an eye towards anticipating and meeting the SEC’s expectations.
• The remedial efforts could attract attention to an area of concern. The SEC staff (Enforcement staff in an investigation or OCIE staff in an exam) could view the remediation as an acknowledgement by the firm that the conduct at issue was unlawful (or at least problematic) or that its prior policies and procedures were deficient. In developing a remediation plan – especially where the underlying conduct is not definitively violative – a firm should take steps to ensure that the remedial efforts do not have the unintended effect of helping to establish culpability.
• The remedial efforts themselves could create additional disclosure obligations, which could raise concerns with clients. A firm considering a particular remediation effort should carefully consider whether and how to disclose the remedial changes to clients or investors.   Failure to accurately do so may be an additional violation of the securities laws, which the SEC may view as more serious than the underlying compliance matter being remediated.

As Arlington’s efforts demonstrate, voluntary remediation can offer significant benefits if done correctly – particularly in mitigating the sanctions sought by the SEC in an enforcement action. However, voluntary remediation is not without risk, and therefore any remediation plan should be carefully developed and implemented with those risks in mind.

Potential disputes involving unicorns have been a hot topic for the last several years.  We predicted that would continue this year in in our webinar and related blog post: The Top Ten Regulatory and Litigation Risks for Private Funds in 2018.  In April, the Regional Director of the SEC’s San Francisco office, Jina Choi, confirmed this in her comments during a San Francisco Federal Bar Association panel.  Specifically, Ms. Choi discussed the SEC’s actions against Zenefits, Credit Karma, and Theranos, and reiterated the SEC’s continued commitment to monitoring suspected investor fraud in privately-held companies.  Ms. Choi also highlighted the settlement remedies in Zenefits and Theranos, including specifically that both settlement agreements required the company and individual officers at the company to pay penalties.

We expect to see the SEC continue to focus on unicorns in future investigations and proceedings. Private companies should prepare for increased scrutiny of their investor disclosures, particularly those related to and affecting the company’s valuation.  In addition, they should ensure their disclosures comply with Rule 701(e) of the Securities Act when granting stock options to employees, as the SEC noted in the Credit Karma settlement.  Finally, SEC actions may spark parallel private actions by investors against the company.

During his recent keynote address at the New York City Bar Association’s 7th Annual White Collar Crime Institute, SEC Enforcement Co-Director Steven Peikin imparted a few suggested “do’s and don’ts” for effective communication with the SEC during the Wells process—typically the last opportunity to address potential charges prior to the authorization of a SEC enforcement proceeding.

Read our full summary of his observations on our Corporate Defense and Disputes blog.

On June 4, we posted a summary of SEC Enforcement Co-Director Steven Peikin observations during his recent keynote address at the New York City Bar Association’s 7th Annual White Collar Crime Institute.  Co-Director Peikin imparted a few suggested “do’s and don’ts” for effective communication with the SEC during the Wells process.  Although Co-Director Peikin’s suggestions should serve as helpful guides to defense counsel, we believe a few of the observations bear further consideration.

Read our full summary of his observations on our Corporate Defense and Disputes blog.

The theft of millions of bitcoins and related failure of cryptocurrency exchange Mt. Gox—recently written about in the Wall Street Journal—provides a perfect example of how cryptocurrency-related issues can blossom into one of our Top Ten Regulatory and Litigation Risks.  The WSJ article chronicles the journey of Kim Nilsson—one of the victims of the $400 million bitcoin theft from Mt. Gox in 2014—as he investigates and eventually uncovers the identity of the hacker who stole his bitcoins.  During his investigation, Mr. Nilsson discovered another concern—one potentially ripe for dispute:

Mt. Gox had been concealing bitcoin thefts that occurred as far back as 2011 and had been insolvent since at least 2012—two years before it filed for bankruptcy.

Historically, investors and other transferees could be subject to clawback actions where they profited from “false profits,” which had been paid using proceeds from other harmed investors, during periods of insolvency—as demonstrated in Madoff and other frauds.  Given that Mt. Gox was reportedly insolvent years before its bankruptcy petition in 2014, this may spell trouble for investors that cashed out at values above their initial investment cost during the undisclosed period of bitcoin thefts.   In essence, investors who cashed out during the period of insolvency may have received more money than they were entitled to receive, depending on the applicable law.

Mt. Gox should serve as a warning to investors in cryptocurrencies, as fraud and insolvency involving cryptocurrency-related investments or businesses is unlikely to diminish.  Myriad complex issues will arise with respect to the applicable law and the rights and duties of those involved.  The good news is that in the U.S., the law adapts to new circumstances using historical concepts.  The bad news is that the evolutionary process can be rocky and difficult to predict, making it difficult to risk-weight outcomes.  Thoughtful participants in these sectors should assume that Mt. Gox foreshadows a larger trend of fraudulent conduct and resultant litigation, given cryptocurrencies’ meteoric rise and potentially rapid declines.  More specifically, fund managers and others involved in cryptocurrency-related investments should keep in mind clawback actions, and be prepared for disputes.

Fund managers take note – after over a year of warning, this month the SEC announced a pair of settlement orders with respect to registration requirements for a fund and broker dealer operating in the crypto and digital assets space. It was the agency’s first ever enforcement actions applying the investment company and broker-dealer registration provisions of the securities laws to businesses involved in digital securities. As we’ve written on Proskauer’s Blockchain and the Law blog, we expect to see the SEC continue to expand its oversight of digital assets as securities.

In In the Matter of Crypto Asset Management, a crypto-focused hedge fund manager, Crypto Asset Management LP (“CAM”), held out its fund as the “first regulated crypto asset fund in the United States.” Per the settlement order, CAM’s statements were incorrect because neither CAM nor the fund were registered with the SEC. Finding that the fund invested more than 40% of its assets in securities (i.e., certain crypto/digital assets), the SEC concluded that it was an “investment company” and thus subject to the Investment Company Act. Because the fund was not registered as an investment company and did not qualify for any of the Investment Company Act’s statutory exemptions or exclusions, the SEC charged CAM with causing violations of the registration provisions of the Investment Company Act. Furthermore, the SEC alleged that CAM made negligent misrepresentations in violation of the Securities Act and the Advisers Act by stating that it was “regulated.” CAM and its principal agreed to make rescission offerings to all its affected investors in addition to paying a penalty.

In In the Matter of TokenLot, LLC, the SEC alleged that a self-described “ICO Superstore” operated as an unregistered broker-dealer by offering customers the ability to buy, sell and trade digital assets connected with ICOs. Finding that digital assets issued and traded by TokenLot were securities, the SEC charged TokenLot and its owners with violating broker-dealer registration requirements under the Exchange Act and also alleged that they engaged in unregistered offers and sales of securities in violation of Section 5 of the Securities Act. Per the SEC’s order, TokenLot’s principals agreed to destroy TokenLot’s remaining inventory of digital assets with the help of a qualified third party, in addition to paying disgorgement and penalties. The SEC also imposed industry bars against the principals, with the right to reapply after three years.

TokenLot and CAM are the SEC’s first ever enforcement actions expanding these provisions of the securities laws to digital assets and cryptocurrencies, following the SEC’s issuance of the DAO Report on July 25, 2017, its request to lawyers to knock it off with the unregistered coin offerings, and various other enforcement proceedings over the past year. This pair of orders signals that the SEC believes any grace period with respect to securities law compliance in connection with digital assets is over.

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.

One of the hardest questions to answer is when seeking information through diligent research potentially moves into a gray area of improper material non-public information.  Under current US law, the answer is often: maybe, it depends.  And much of that determination depends on information that a fund analyst may not control or even have access to – for example, whether information was initially shared in violation of some duty of trust or confidence, whether there was a “benefit” to an insider, etc.  While ignorance of the law is not a defense, even experienced securities law practitioners can get tripped up by the complicated patch-work that is the current insider trading law.

Fund managers have an obligation to their clients to make the best investment decisions that they can.  Their job is to make the right investment decisions for their clients, and conducting diligent research is a large part of that job.  With that in mind, we welcome the task force’s efforts to clarify the insider trading laws.  In our experience, when managers have clear guidance on what is and isn’t allowed, they will stay on the right side of the law.

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.

Alternative data sets may conceivably contain material nonpublic information (MNPI), or information that, when aggregated, could be considered MNPI.  Trading while in possession of such information might lead to liability under the securities laws if confidential information has been “misappropriated” in breach of a duty owed to the source of the information. If data has been collected in a manner considered “deceptive,” then there is a risk that trading on that information may be considered part of a fraudulent scheme in violation of the anti-fraud provisions under the securities laws.

Fund managers who use such data need to be careful.  One concern is whether vendors have obtained appropriate consents to both the usage and sharing of the information.  Many smartphone users may not be aware that their phone is sharing location data.   Another concern is heightened risk of the data containing personally identifiable information (PII) or information which can readily be linked to PII.   The vendor highlighted in the WSJ article apparently scrubs location data of personally identifiable information, and most data collectors de-identify or anonymize data that comes from sources that contain PII.  Fund managers who purchase scrubbed data from third parties should check to ensure the information they receive is appropriately de-identified or anonymized and, if not, take steps to remove all identifying information.

Fund managers should also be aware of a host of other potential concerns involving collection and use of alternative data.  For example, the Computer Fraud and Abuse Act (CFAA) prohibits access to information from a computer, website, server or database that is without authorization or in a way that exceeds authorized access.   The Electronic Communications Privacy Act prohibits the collection or use of communications collected in violation of the Act.  Other potential concerns involve claims as varied as copyright to breach of contract.

When using alternative data sets, due diligence and appropriate representations are required in order to minimize risk.

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.

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.

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.

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.

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.