Funds Talk: April 2018
Topics covered in this issue include:
- SEC Goes Mining: Launches Cryptocurrency Industry Sweep In the latest development in the regulator’s growing oversight of virtual currency transactions, the SEC has indicated that enforcement action may be expected.
- The Rise of Direct Lending Across Europe Direct lending in the EU is catching up to the U.S. market, with investment funds and insurance companies leading the way with the assistance of recent regulatory inducements.
- Small Business Credit Availability Act Becomes Law On March 23, 2018, President Donald Trump signed into law the Consolidated Appropriations Act of 2018, which contains as Title VIII thereof the Small Business Credit Availability Act. The Small Business Credit Availability Act, among other things, significantly increases the amount of debt that business development companies (BDCs) may incur..
- Paying the Price for Reps and Warranties Breaches Because the law grants courts substantial latitude in crafting damages awards in litigation resulting from breaches of representations and warranties, economists and other experts are exploring new ways of calculating the damages in such disputes — which will become more common as M&A activity accelerates.
- DOJ Criminal Division to Use FCPA Corporate Enforcement Policy as Nonbinding Guidance
On March 1, 2018, John P. Cronan, the acting head of the Department of Justice’s Criminal Division, and Benjamin Singer, chief of the Fraud Section’s Securities and Financial Fraud Unit, announced at the American Bar Association’s 32nd Annual National Institute on White Collar Crime that the Criminal Division will use the Foreign Corrupt Practices Act corporate enforcement policy as nonbinding guidance in criminal cases outside the FCPA context.
The SEC Goes Mining: Launches Cryptocurrency Industry Sweep
After months of steadily increasing supervisory activity in regard to the emerging cryptocurrency sector, it now appears that U.S. financial market regulators may have switched gears and entered the enforcement stage.
The Securities and Exchange Commission (SEC) recently launched an industry sweep, serving a series of subpoenas and information requests to investment funds, advisers and technology companies participating in virtual currency transactions, such as initial coin offerings (ICOs), The Wall Street Journal reports. Moreover, officials have indicated they expect more to come. The New York Times has reported that the subpoenas demanded “a wide array of information about the virtual currencies they have sold, including the information used to market the digital tokens and the identity of the investors who bought them.” Other sources have estimated that as many as 80 companies and individuals were served with subpoenas or otherwise contacted as part of the SEC probe, and the move prompted several companies to pause their offerings after the agency raised questions regarding the transactions. The SEC itself has not publicly commented on the specifics of the subpoenas.
Industry sweeps typically occur when the SEC believes that the practices of a given industry may violate the securities laws. In an industry sweep, SEC enforcement staff may subpoena broad swaths of information designed to determine if the subpoenaed entity, a competitor or the industry more broadly has committed securities violations. As is the case with other large government investigations, industry sweeps, in particular, are organic; they can focus on different targets at different times, making sucessful navigation of them challenging. Industry sweeps can also graduate, if warranted, from regulatory inquiries to criminal investigations. While SEC officials have previously said that some cryptocurrency offerings qualify as securities transactions and therefore must comply with all relevant regulations, the financial markets regulator has not issued formal guidance on the matter.
The SEC’s enforcement sweep is the latest development in a pattern of escalating regulatory interest in virtual currencies and ICOs. For months, the SEC has publicly reiterated its interest in regulating ICOs specifically and the cryptocurrency markets in general. For example, on Feb. 6, 2018, SEC Chairman Jay Clayton and CFTC Chairman Christopher Giancarlo jointly testified before the Senate Banking Committee to discuss the regulatory oversight of cryptocurrencies, where they highlighted their efforts to identify the proper balance between protecting investors against manipulation and fraud while also encouraging innovation in the rapidly growing sector. During that hearing, Chairman Clayton explained that although no ICOs had registered with the SEC, “I believe every ICO I’ve seen is a security ... You can call it a coin, but if it functions as a security, it is a security.”
This was not Chairman Clayton’s first shot across the bow. During a speech in January, he explained that “Market professionals, especially gatekeepers, need to act responsibly and hold themselves to high standards. To be blunt, from what I have seen recently, particularly in the initial coin offering (ICO) space, they can do better.” He further criticized the actions of certain gatekeepers as “contrary to the spirit of our securities laws and the professional obligations of the U.S. securities bar,” later adding that “[t]hose who engage in semantic gymnastics or elaborate re-structuring exercises in an effort to avoid having a coin be a security are squarely in the crosshairs of our enforcement provision.”
In addition to Chairman Clayton’s comments, the transactions were highlighted when both the SEC and the Financial Industry Regulatory Authority (FINRA) released their respective examination priorities for 2018. This came after the virtual currency market grew exponentially in 2017, when all-time cumulative ICO funding surged from $295.45 million to $5.86 billion by the end of 2017. Inevitably, this growth prompted global regulators to take tentative steps to adapt to the unique challenges created by virtual currencies, which previously largely existed and operated outside the traditional financial systems.
Funds and advisers taking part in cryptocurrency transactions should take note of the SEC’s enforcement sweep. After news of the industry sweep broke, SEC Enforcement Division Co-director Stephanie Avakian added that the SEC is “very active, and I would just expect to see more and more.” And with a personal promise from Chairman Clayton that “[t]he SEC is devoting a significant portion of its resources to the ICO market,” the SEC has made it abundantly clear that the issuance of subpoenas and information requests is a sign that the SEC is ratcheting up its already active enforcement of the growing ICO market.
As is the case with other enforcement reviews, it is almost certain that the SEC’s inquiry will be rigorous and lengthy and is something that this burgeoning industry will have to reckon with for the foreseeable future.
Direct Lending in the EU: New Regulations on Loan Origination Create High-Return Opportunities for Asset Managers
In the post-crisis landscape, stringent regulations and stricter capital requirements led banks to reduce their lending volumes. As a result, the “originate to distribute” model of corporate financing is declining, even in Europe where intermediated finance is still prevalent. Non-bank institutions such as investment funds and insurance companies are increasingly taking advantage of regulatory changes regarding direct lending across European jurisdictions, and EU direct lending is catching up to the U.S. market.
Midmarket deals are booming across Europe. Deloitte recorded an impressive 15% increase in alternative lending deals in 2017. In Q3 2017 alone, approximately 82 funds targeted commitments amounting to $41 billion. The U.K. (120 deals from Q3 2016 to Q3 2017) and France (70 deals from Q3 2016 to Q3 2017) are the leading markets in Europe.
Institutional investors such as Allianz, AIMCO, Standard Life and M&G have recently entered the origination business, which was originally captured by a few experienced asset managers. In France, managers such as Idinvest and Tikehau are consolidating their positions as major players.
An attractive opportunity for both LPs and borrowers
Direct lending offers borrowers flexibility (covenant-lite structures, cash sweeps, CAPEX facilities which are crucial for LBOs, etc.) and speed of execution (thanks to the simplified decision-making processes of alternative lenders compared to traditional banks) with little to no equity dilution. They are mostly used in LBOs, bolt-on acquisitions and growth capital for SMEs that are struggling to obtain traditional bank loans and can’t tap public markets. Some large-cap corporations are also choosing direct lending over syndicated bank loans for the speed of execution and flexibility it offers.
On the supply side, direct lenders are able to attract return-hungry LPs with IRR between 5% and 10% thanks to the 600-1500bps margins on the loans they originate (i.e., at least 200 bps over benchmark syndicated loan rates). The most common LPs are institutional investors such as insurance or pension funds, banks, and private wealth funds. Sovereign funds (European Investment Fund, European Investment Bank, Bpifrance, etc.) are increasingly investing in debt funds as a part of the EU’s policy for SME financing.
New regulations on loan origination
Over the past few years, many EU jurisdictions have implemented new regulations in order to allow alternative lenders to originate loans directly to nonfinancial companies.
A new regulation applicable across all EU Member States since Dec. 2015 introduced the European Long-Term Investment Fund (ELTIF), a pan-European label granted to alternative investment funds (AIFs) by national market authorities, which allows them to originate loans in all EU jurisdictions if they meet certain conditions (such as assets eligibility criteria, diversification rules, limitations on leverage and derivatives, etc.).
Likewise, France is opening up its “banking monopoly,” a cornerstone regulation that used to exclude non-banks from direct lending. Since 2016, securitization vehicles and some AIFs (namely, specialized investment funds and PE funds) are allowed to originate loans, either under the ELTIF label or under the specific conditions set out in a Decree. More recently, French regulators pushed further for the development of direct lending with a Decree introducing a new category of French AIFs called specialized financing vehicles (SFVs) that are well-suited for direct lending thanks to the great flexibility they offer to asset managers and thanks to their preferential regulatory treatment. (SFVs will, for example, be allowed to issue bonds, benefit from simple receivable transfer mechanisms and be shielded from insolvency proceedings.)
What asset managers need to know
- First lien structures (either senior secured or plain-vanilla unitranche) are the most popular with direct lending, representing 85% of transactions in 2017. Alternative lenders also originate Euro Private Placements (Euro PP), through loans or bond structures (mostly senior unsecured), which are popular with French insurers and pension funds. Loans originated by alternative lenders are usually non-amortizing with a maturity between three to eight years.
- Cross-border deals are fairly common. Most funds are opting for either a global or pan-European strategy in order to improve portfolio diversification.
- Some direct lenders are teaming up to access larger deals.
- Management fees usually amount to approximately 1% and are sometimes coupled with a performance fee.
- Most funds have a 10-year maturity with an investment period of three to five years. While buy-and-hold strategies are the norm for direct lending, most EU jurisdictions do not strictly prevent asset managers from transferring loans they originated before the loans' maturity date. Some funds have included these arbitrage opportunities in their management strategy in order to improve their risk management and increase their returns.
- In a post-Brexit environment, U.K.-based assets managers will likely have to relocate within the EU27 to access the European direct lending market. Paris, Frankfurt and Dublin have emerged as the main destinations in this regard.
Direct lending constitutes a unique opportunity for asset managers, both in a short-term perspective (attractive risk/return profiles in a low-yield environment) and a long-term perspective (disintermediation of European finance coupled with the anticipated post-Brexit changes).
To benefit from those opportunities, asset managers should seek to develop their credit expertise and closely monitor new regulations, since being up to date on those regulatory changes (e.g., the new SFV regime in France) may constitute a key advantage in a very competitive market.
 Banks account for 80% of long-term corporate lending in Europe, compared with 20% in the U.S.
 Regulation (EU) 2015/760 of the European Parliament and of the Council of April 29, 2015
 “organismes de titrisation”
 “fonds professionnels spécialisés”
 “fonds professionnels de capital investissement”
 Decree No. 2016-1587 dated Nov. 24, 2016
 Decree No. 2017-1432 dated Oct. 4, 2017
 “organismes de financement spécialisé”
 Law Decree No. 18/2016 dated February 14, 2014
 “UCITS V Implementation Act” dated February 5, 2016
Small Business Credit Availability Act Becomes Law, Allowing BDCs to Incur Significantly More Debt
On March 23, 2018, President Trump signed into law the Consolidated Appropriations Act of 2018, which contains as Title VIII thereof the Small Business Credit Availability Act. The Small Business Credit Availability Act, among other things, significantly increases the amount of debt that business development companies (BDCs) may incur. Prior to the enactment of the Small Business Credit Availability Act, a BDC could generally incur debt only if after giving effect thereto its ratio (the Asset Coverage Ratio) of (i) total assets less liabilities other than debt to (ii) total debt, would be at least two times.
The Small Business Credit Availability Act reduces the Asset Coverage Ratio to 1.5 times if the following conditions are met:
- Not later than five business days following the applicable approval referred to below, the BDC discloses such approval and the effective date of the approval in a filing submitted to the Securities and Exchange Commission under Sections 13(a) or 15(d) of the Securities Exchange Act of 1934 and in a notice on the website of the BDC.
- The BDC discloses, in each periodic filing required under Section 13(a) of the Securities Exchange Act of 1934, the following:
- The aggregate outstanding principal amount of debt and liquidation preference of preferred stock issued by the BDC and the Asset Coverage Ratio as of the date of the BDC’s most recent financial statements included in that filing
- That the BDC has approved a 1.5 times the Asset Coverage Ratio
- The effective date of such approval
- With respect to a BDC that is an issuer of public common equity securities, each periodic filing of the BDC required under Section 13(a) of the Securities Exchange Act of 1934 includes disclosures that are reasonably designed to ensure that shareholders are informed of:
- The amount of debt and the Asset Coverage Ratio of the BDC determined as of the date of the most recent financial statements of the BDC included in that filing
- The principal risk factors associated with its debt
- If the BDC approves the 1.5 times the Asset Coverage Ratio by its board and not its shareholders, the reduction in the Asset Coverage Ratio from two times to 1.5 times cannot become effective until one year after the date of the board approval.
- If the BDC obtains shareholder approval, the reduced Asset Coverage Ratio may become effective on the first day after the date of the approval.
- If the BDC is not an issuer of common equity securities that are listed on a national securities exchange, it must extend to each person that is a shareholder as of the date of approval of the opportunity (which may include a tender offer) to sell the securities held by that shareholder as of the applicable approval date, with 25 percent of those securities to be repurchased in each of the four calendar quarters following the calendar quarter in which that applicable approval date takes place.
This change in law may have a significant impact in the non-bank direct lending market, as BDCs are a common vehicle used by non-bank lenders. BDCs will now be able to increase their assets by up to one-third with additional debt and no new equity raised.
Paying the Price for Reps and Warranties Breaches
In the purchase agreement for the typical M&A transaction, the seller gives the buyer representations and warranties concerning key questions affecting the value of the target company. The representations can cover, for example, the target company’s compliance with applicable law, the accuracy of its financial statements and the operating condition of its physical assets. It has been estimated that in roughly 15 percent of these transactions, the buyer will assert a claim after closing that one of the representations and warranties has been breached.
In the ensuing litigation, the essential legal rules governing the determination of liability are well-established. Representations and warranties are like other contract provisions, and the claimant will have to prove both that a representation was breached and that the breach caused damages. There are thousands of court decisions analyzing the nuances of contract breaches and causation.
But there is surprisingly little law governing calculations of the amount of damages. Many cases are decided in arbitration, and those that go to court typically settle before trial. As a result, the courts rarely address issues in the calculation of damages. Most of the law on damages comes down to a few basic principles, including that the victim of the breach will be “made whole” — that is, the claimant will be put in the same position it would have been in had the breach not occurred. This is known as giving the claimant the “benefit of its bargain.” When the breach is of a contractual representation relating to the value of an asset, the measure of damages will be the difference between the value of the asset as represented and the value of the asset as delivered. Thus the measure of damages will be the extent to which the breach has caused a “diminution of value” in the purchased asset. And proof of both breach and causation must be reasonably certain, but proof of the amount of the resulting damages is allowed to be more speculative. In other words, as between a victim and a defendant who has been held to be liable, the wrongdoer will bear the risk of any uncertainty in the proof of damages. This principle provides the courts with great latitude in crafting damages awards.
With only these general principles to draw on for guidance, the courts have not agreed on precise rules for measuring the diminution in the value of the purchased business. Although the courts have not spoken definitively, economists and other experts on damages have begun to agree on approaches to this issue. They focus on two core questions: To what extent has the breach caused a reduction in the earnings of the company? And if there has been a reduction in earnings, is it temporary or is it recurring?
An example shows how the analysis proceeds. Assume that the target company is a manufacturer of building supplies and the target operates a fleet of trucks that deliver the supplies to retail sellers. Assume further that some of the trucks were not working properly at the time of closing on the sale, and this breached the seller’s representation that all of its assets were in good operating condition and repair. The trucks that are not operable will require repairs, and the costs of those repairs will be the “dollar-for-dollar” measure of damages for the breach. If those trucks were not needed to fill orders, then the dollar-for-dollar measure is likely to be the only damage from the breach. But if the failures of the trucks cause the company to be unable to fulfill an order, which caused a loss of company earnings, then the damages include both the repair costs and the lost earnings on that contract. And if the failure of the trucks causes the company to lose multiple customers and earnings over a long term, then the loss of earnings is long-term (and may be permanent), which can reduce the value of the company substantially, and will yield far more in damages.
Whenever the breach causes a longer-term reduction in earnings, the damages analysis will require a formal valuation of the business as it was delivered to the buyer. The measure of damages will be the difference between the purchase price and the current valuation. To make that valuation, the analyst usually will perform a discounted cash flow (DCF) or other recognized method of valuation, such as a comparable company analysis. Each of these valuation methods has inherent problems. The DCF method relies heavily on a projection of future financial performance, which requires the analyst to make estimates based on assumptions that always will be subject to attack. A comparable company approach requires the analyst to select the companies that appear to be most comparable, and that selection always raises issues as to whether the selected companies are genuinely comparable to the target.
One question that the courts have not answered definitively is whether a buyer’s damages for breach of a representation will be calculated “at the multiple” — that is, as a multiple of the lost earnings of the target company. Buyers often advocate for damages at the multiple because that approach tends to yield larger amounts in damages. In urging a court to accept the multiple, the buyer will say that its own valuation of the target company was based on a multiple of earnings, and since the parties agreed to the purchase price, that is the most current and accurate measure of the target’s value. Sellers will say that the multiple is only one measure of value and that the buyer may have paid more than the fair market value of the company. For example, the buyer may have anticipated synergies with other portfolio companies that would have prompted the buyer to pay more than a DCF valuation would suggest was the fair market value of the company. In resolving the dispute between buyers and sellers on this issue, the facts of the transaction are likely to matter. In some transactions the parties expressly premise the purchase price on a multiple of earnings. In others, the multiple may have been used only for the parties’ internal financial modeling and there was no negotiation or agreement between buyer and seller on the correct multiple. In the absence of an express agreement on the multiple at the time of the transaction, there will be room during the litigation for both sides to make their arguments. As the number of private M&A transactions increases, these issues will be contested more often.[*]
[*] These issues were the subject of a panel discussion titled, “Measuring Loss: How Damages Can Be Calculated,” at the AON Transaction Solutions Symposium, on February 13, 2018. Arthur Aufses was a member of that panel.
DOJ Criminal Division Announces FCPA Corporate Enforcement Policy Provides Nonbinding Guidance for All Criminal Cases
On March 1, 2018, John P. Cronan, the acting head of the Department of Justice’s Criminal Division, and Benjamin Singer, Chief of the Fraud Section’s Securities and Financial Fraud Unit, announced at the American Bar Association’s 32nd Annual National Institute on White Collar Crime that the Criminal Division will use the Foreign Corrupt Practices Act Corporate Enforcement Policy as nonbinding guidance in criminal cases outside the FCPA context.
The FCPA Corporate Enforcement Policy, announced by Deputy Attorney General Rod J. Rosenstein on Nov. 29, 2017, and incorporated in the U.S. Attorneys’ Manual, provides guidance to prosecutors regarding how to handle corporate resolutions in FCPA cases. It states, in relevant part, that “[w]hen a company has voluntarily self-disclosed misconduct in an FCPA matter, fully cooperated, and timely and appropriately remediated, . . . there will be a presumption that the company will receive a declination absent aggravating circumstances involving the seriousness of the offense or the nature of the offender.” To qualify for the benefits of the policy, the company must “pay all disgorgement, forfeiture, and/or restitution resulting from the misconduct at issue.”
The presumption of declination can be overcome by aggravating circumstances, which include the “involvement by executive management of the company in the misconduct; a significant profit to the company from the misconduct; pervasiveness of the misconduct within the company; and criminal recidivism.” Even if a criminal resolution is warranted, however, the company is eligible for a 50% reduction off the low end of the U.S. Sentencing Guidelines fine range, except in the case of a criminal recidivist. And if the company has implemented an effective compliance program, appointment of a monitor generally will not be required. Furthermore, even if a company does not voluntarily self-report misconduct, as long as it cooperates with the DOJ and timely and appropriately remediates, it will be eligible for up to a 25% reduction off the low end of the Guidelines fine range.
The policy intends to incentivize companies to come forward when they discover wrongdoing and “reduce cynicism about enforcement.” The policy also underscores the Department’s commitment to hold individuals accountable for criminal misconduct.
As an example of the Criminal Division’s new extension of the FCPA cooperation policy, Messrs. Cronan and Singer cited specifically to the Fraud Section’s Feb. 28, 2018 settlement with Barclays PLC. Barclays self-reported that, through its employees and agents, it had misappropriated confidential information from its client, Hewlett-Packard Co., and engaged in a front-running scheme that involved foreign exchange transactions. The company cooperated with the Fraud Section, providing all known relevant facts about the individuals involved in the misconduct, took steps to enhance its compliance program, agreed to pay $12.9 million in combined restitution to HP and disgorgement of its profits from the front-running scheme, and promised to continue to cooperate with the government. Based on the corporation’s conduct, the Fraud Section declined to prosecute the company. In January 2018, the former head of Barclays Capital Inc.’s New York foreign exchange trading operation was indicted in connection with the misconduct. Messrs. Cronan and Singer contrasted Barclays’ $12.9 million settlement with the $101.5 million in penalties and disgorgement that HSBC Holdings PLC paid after a similar front-running investigation, noting that HSBC did not self-report the wrongdoing and, at least initially, did not fully cooperate with the DOJ.
The DOJ leadership has clearly expressed a commitment to rewarding companies that self-report wrongdoing, fully cooperate and remediate while holding individuals accountable. These policy statements are a welcome development, an acknowledgment that, as Deputy Attorney General Rosenstein noted at the ABA White Collar Institute, corporate prosecutions may “disproportionately punish innocent employees, shareholders, customers, and other stakeholders.” Hopefully, they mark a return to the government’s historical practice of not prosecuting corporations that did the right thing by fully cooperating and remediating, as was for example the case with Salomon Brothers in the Treasury auction bidding practices inquiries and with Kidder Peabody in the insider trading probes.
Even if not formally binding on the individual U.S. Attorneys’ offices, these statements by senior DOJ officials provide a significant basis for defense counsel to argue for declinations or reduced penalties in corporate criminal matters outside the context of the FCPA. Similarly, Deputy Attorney General Rosenstein emphasized that “[c]orporate America is often the first line of defense for detecting and deterring fraud. Meaningful compliance measures help the Department preserve its finite resources.” Therefore, he explained, the DOJ “want[s] to reward companies that invest in strong compliance measures.” He stated that “[w]hen something does go wrong, the greatest consideration should be given to companies that do not just adopt compliance programs, but incorporate them into the corporate culture.” He cautioned, however, that a company that wants to be treated by the Department as a “victim,” should “act like a victim who wants to see the perpetrators held accountable.”
 Rod J. Rosenstein, Deputy Attorney General for the U.S. Dep’t of Justice, Prepared Remarks for the 34th International Conference on the Foreign Corrupt Practices Act (Nov. 29, 2017), available athttps://www.justice.gov/opa/speech/deputy-attorney-general-rosenstein-delivers-remarks-34th-international-conference-foreign.
 See FCPA Corporate Enforcement Policy, U.S. Dep’t of Justice, U.S. Attorneys’ Manual 9‑24.120, available at https://www.justice.gov/usam/usam-9-47000-foreign-corrupt-practices-act-1977#9-47.120.
 Rosenstein, supra note 1.
 See Letter from Benjamin D. Singer, Chief of the Securities and Financial Fraud Unit of the Fraud Section for the U.S. Dep’t of Justice Criminal Division, to Alexander J. Willscher & Joel S. Green, Counsel for Barclays PLC (Feb. 28, 2018), available at https://www.justice.gov/criminal-fraud/file/1039791/download.
 Press Release, U.S. Dep’t of Justice, Former Head of Barclays New York Foreign Exchange Operation Indicted for Orchestrating Multimillion-Dollar Front-Running Scheme (Jan. 16, 2018), available athttps://www.justice.gov/opa/pr/former-head-barclays-new-york-foreign-exchange-operation-indicted-orchestrating-multimillion.
 Rod J. Rosenstein, Deputy Attorney General for the U.S. Dep’t of Justice, Prepared Remarks for the 32nd Annual ABA National Institute on White Collar Crime (Mar. 2, 2018), available athttps://www.justice.gov/opa/speech/deputy-attorney-general-rosenstein-delivers-remarks-32nd-annual-aba-national-institute. Rosenstein added that rather than issuing memoranda to explain new policies and initiatives, under his leadership, the DOJ is endeavoring to “consolidate all existing Department policies in the U.S. Attorney’s Manual.” Id.