Regulatory Review And Litigation Update: Private Funds

Regulatory Review And Litigation Update: Private Funds

A panel discussion on recent updates and trends in the regulatory review and litigation space for private funds.

June 16, 2022

During a panel discussion at the Stout Valuation Summit, Joel Cohen, Managing Director in Stout’s Disputes, Compliance, & Investigations group, led a conversation discussing recent updates and trends in the regulatory review and litigation space for private funds.

The panelists consisted of the following:

  • Brooke Clarkson, partner, Foley & Lardner LLP
  • Nick Morgan, partner, Litigation Department, Paul Hastings LLP
  • Richard Strohmenger, legal Counsel, Värde Partners
  • Jeremiah Williams, Partner, Ropes & Gray

The discussion has been edited for length and clarity.

As the Chairman of the U.S. Securities and Exchange Commission (SEC), Gary Gensler has charted course to prioritize SEC compliance, cryptocurrency regulation, and environmental, social, and governance (ESG) during his time in leadership. What he cannot accomplish in regulatory change he has been accomplishing by enforcement, and while there is a strong, progressive block in Chairman Gensler and Commissioners Allison Lee and Caroline Crenshaw, the SEC may run up against resource and manpower limitations as it attempts to implement some of his goals.

Regulations Around Insider Trading and Material, Non-Public Information (MNPI)

Inside trading can be a fuzzy concept, and seeing what constitutes MNPI can often be far easier in retrospect. Now, firms and their employees should consider how MNPI affects their broader trading decisions.

The lack of a federal statute along with the relative uncertainty around insider trading concepts for private firms has given the SEC a choice in the cases it pursues going forward: Does it take on cases near the edge of legal theory regarding insider trading — pushing the envelope — or does it devote its limited workforce to cases derived from firmly established theory?

In Securities and Exchange Commission v. Matthew Panuwat, the SEC has aggressively pursued insider trading in a novel way, taking a proactive approach regarding MNPI. Panuwat was a former employee of Medivation Inc., a biopharmaceutical company in negotiations to be acquired. According to the SEC’s complaint, Panuwat purchased short-term, out-of-the-money stock options minutes after learning confidential information about the merger.1

However, Panuwat’s stock purchase was not in his own company. Instead, he purchased them in a peer company that saw its stock rise following Medivation’s acquisition. The SEC has brought a case based on this “shadow trading,” arguing for a causal connection between Medivation’s public announcement and the stock increase for the peer company.

The SEC may be floating a premise that an employee cannot use MNPI learned through his or her employer as part of the total mix of information when making investment decisions. This could lead to issues for fund managers and other industry participants who frequently use this sort of data to influence broader trading decisions.

Companies will need to continue to be thoughtful about their restrictive list policy and how their investment professionals and other employees are trained on those policies.

Digital Assets and the Jurisdiction of the SEC

If ambiguity in insider trading law creates opportunities for the current SEC commission to push the boundaries of legal theory, this can be just as true, if not more so, with digital assets. There is, arguably, ambiguity over the limits of the SEC’s jurisdiction regarding digital assets, namely, whether a digital asset can be designed in a way that it does not fall within the SEC jurisdiction, as determined by the Howey Test.

The Howey test, outlined in the Supreme Court Decision in SEC v. W.J. Howey Co., classifies a transaction as an offering of “securities” if it meets four criteria: (1) an investment of money, (2) in a common enterprise, (3) with a reasonable expectation of profit, (4) to be derived from the efforts of others.2

Currently, one of the most active pieces of litigation in this space is the SEC’s case against Ripple Labs Inc. The SEC has alleged that the company (along with two of its executives) raised over $1.3 billion through an unregistered, ongoing digital asset securities offering.3 However, interested parties are watching to see if the court will rule that the particular digital asset is not a security under the Howey Test, and therefore the SEC does not have jurisdiction.

“People are focused on the Ripple litigation because there have been dragged-out fights over nearly everything in the case, including forcing the SEC to answer interrogatories about how the Howey test applies to various assets such as Bitcoin or Ethereum,” said Morgan.

The SEC has also allegedly reached a number of settlements that can still dictate the practices of other players in the digital asset space while simultaneously providing insight into the SEC’s stance on digital assets.

“Some settlements can create bad precedent,” said Clarkson. “People settle for a variety of reasons, so they might be a little less concerned with the language the SEC is using in describing the settlement, whereas the next defendant is now stuck with that language.”

The Importance of Environmental, Social, and Governance Criteria

Environmental, Social, and Governance (ESG) is front of mind for investors, regulators, and many other market participants. The SEC’s has committed to promulgating new ESG disclosure rules,4 and Congress and other agencies are making movements on the ESG front as well.

Gensler has instructed his staff to create ESG disclosure metrics and has had them send out letters to public companies encouraging them to strengthen ESG disclosures and rulemaking. The SEC is also looking beyond issuers, focusing on public companies as well as investment funds and their managers; however, on the fund side, there is not yet a robust regulatory ESG landscape within the United States.5

Even outside of regulation, institution and retail investors view ESG as a high priority, examining companies’ ESG actions and metrics. The SEC is looking at the third parties that produce those metrics, studying how those ratings are calculated and whether they accurately measure a company’s success at fulfilling ESG goals. This can even result in litigation. Albeit without much success, a number of private plaintiffs have allegedly brought claims revolving around a public company failing to pursue certain ESG goals listed out in a governing document.6

The growing importance of ESG criteria, ambiguity regarding the jurisdiction of the SEC over digital assets, and regulations around MNPI present themselves as topics to watch moving forward.

  1. “SEC Charges Biopharmaceutical Company Employee with Insider Trading,” Litigation Release No. 25170, Securities and Exchange Commission v. Matthew Panuwat, U.S. Securities and Exchange Commission, August 17, 2021.
  2. Jay B. Sykes, “Securities Regulation and Initial Coin Offerings: A Legal Primer”, Congressional Research Service, August 31, 2018.
  3. “SEC Charges Ripple and Two Executives with Conducting $1.3 Billion Unregistered Securities Offering,” U.S. Securities and Exchange Commission, press release, December 22, 2020.
  4. “SEC Response to Climate and ESG Risks and Opportunities,” U.S. Securities and Exchange Commission, webpage.
  5. Kit Addleman, et al., “SEC Enforcement Highlights: Fiscal Year 2021,” Haynes Boone, News and Insights, 2021.
  6. Elad L. Roisman, “Can the SEC Make ESG Rules that are Sustainable?” U.S. Securities and Exchange Commission, speech, June 22, 2021, speech.