A n SEC enforcement order from July 2018 (the “Order”) offers hedge fund managers a sharp reminder of the need to remain alert to legal issues that may arise when their investment posture toward a public company moves from passive to active.1 The Order concerns the efforts of a fund manager to place one of its employees on the board of a public portfolio company, and the conflict of interest spawned by that employee’s undisclosed financial relationship with the company’s CEO. As discussed more fully below, key lessons from the Order include the following: Schedule 13G filers must remain vigilant about the possible need to switch to Schedule 13D as their investment intentions evolve. A fund manager that initially reports greater-than-5% beneficial ownership on Schedule 13G needs to review its investment posture regularly. If an originally passive approach evolves toward one indicating control intent—that is, an intent to influence the issuer’s strategic direction, operations, board or management composition or similar matters—a prompt switch to a Schedule 13D containing the relevant disclosure may be necessary. Public company director candidates should treat the director-vetting process seriously, not least because it feeds into the issuer’s public disclosures. When a fund manager seeks to place one of its employees on a public company board, the manager and the candidate must take seriously the issuer’s process for vetting prospective directors. In part, this is because the information the candidate provides to the issuer will, if the candidate joins the board, be reflected in various public disclosures the issuer will make under federal securities law. In addition, the vetting process is a valuable opportunity for the fund manager and the candidate to consider whether the candidate has potential conflicts of interest that could affect his or her suitability for a board seat. A manager that is adopting a more activist strategy should make sure its compliance policies and training activities keep pace. If a fund manager’s investment strategy is newly edging into activist territory, the firm may need to adapt its compliance policies accordingly. Policies concerning the identification and evaluation of conflicts of interest are especially ripe for updating in this context. Even if the manager’s written policies themselves do not need revision, it may be advisable to provide intensified employee training around activismrelated compliance topics. THE ORDER The respondents in the Order were an SEC-registered investment adviser (the “Adviser”) and its portfolio manager for oil and gas investments (the “PM”). The Order centers on the Adviser’s substantial investment in the common stock of Energy XXI Ltd. (the “Issuer”), and the relationship of the PM with the Issuer’s CEO and directors around the time the PM was seeking to join the Issuer’s board. At the time of the conduct described in the Order, the Issuer was Nasdaq-listed and one of the largest oil and gas producers on the Gulf of Mexico shelf. Alleged Facts The relevant facts alleged by the Order may be summarized as follows: In late 2009, the Adviser filed a Schedule 13G to report its 8.2% beneficial ownership of the Issuer’s common stock. The Adviser filed amendments to its Schedule 13G through February 2012. As required by Schedule 13G, the Adviser certified in each filing that it did not hold its shares “for the purpose of or with the effect of changing or influencing the control” of the Issuer. The Schedule 13G remained on file until December 2014, when the Adviser supplanted it with a Schedule 13D. The Adviser had only sporadic contact with the Issuer during the four-plus years following the initial Schedule 13G filing. In mid-2014, however, the Adviser focused anew on its investment after the Issuer reported disappointing earnings and completed an acquisition that the market viewed unfavorably. By August 2014, the Adviser was holding internal discussions about the prospect of the PM seeking a seat on the Issuer’s board of directors, and the PM began meeting with the Issuer’s management to press for operational changes. The PM spent October 9, 2014 meeting with the Issuer’s top executives. In a private conversation at day’s end, the CEO asked the PM for a $3 million personal loan to help fund a margin call on an account collateralized with the CEO’s shares of Issuer stock. On October 10, the PM agreed to the CEO’s loan request and wired him $3 million from the PM’s personal bank account. The PM and the CEO did not disclose the loan to the Issuer or the Adviser. During October 2014, the PM continued to make detailed recommendations to the Issuer’s management with the aim of spurring layoffs, the replacement of the chief financial officer and the enlargement of the board. By mid-month, the CEO considered the PM to be an official independent director candidate. At this time the PM began undergoing the Issuer’s standard vetting process for prospective board members, including interviews with the lead independent director. Throughout November 2014, the PM—though not yet a director—deepened his interactions with the Issuer to such a degree that the Order characterized him as a “de facto board member” during this period. The PM began attending board meetings; sent a list of recommended operational changes and cost-reduction steps to the lead director and the CEO; prompted the board to create a special committee to consider proposals for cost-cutting, capital allocation and oil well development; and participated in that committee’s discussions with management. In early December 2014, as the Issuer prepared for a board vote on the PM’s director candidacy, the Issuer’s lawyer sent the PM a D&O questionnaire to complete and submit prior to the vote. The lawyer also gave the PM a draft of the Form 8-K the Issuer planned to file if he were named a director. This draft included a statement that “[t]here are no understandings or arrangements between [the PM] and any other person” that would compromise the PM’s independence as a director. The PM did not complete and submit the questionnaire. Nor did he comment on the draft Form 8-K or otherwise mention the loan to the Issuer. On December 15, 2014, the Issuer’s directors voted the PM onto the board and the Issuer filed the Form 8-K. On December 22, 2014, the Adviser replaced its Schedule 13G with a Schedule 13D disclosing that the PM had become a director. In March 2015, the PM finally revealed the loan to the Adviser and the Issuer. They in turn alerted the SEC. Findings of Liability The Order’s findings of liability included the following: The Adviser did not timely switch to reporting on Schedule 13D. According to the Order, by late October 2014 the Adviser had taken “a series of steps in furtherance of a plan” to place the PM on the Issuer’s board, and therefore no longer could certify that it held its Issuer shares without a control purpose or effect—the prerequisite for the Adviser to continue reporting its beneficial ownership on Schedule 13G. The Order concluded that by not filing its Schedule 13D until late December 2014, the Adviser violated Rule 13d-1 under the Exchange Act, which requires a Schedule 13G filer to switch to Schedule 13D within 10 days of coming to hold issuer securities with a control purpose or effect. The PM caused the Issuer to file a misleading Form 8-K. The Order found that the PM caused the Issuer to violate Rule 12b-20 under the Exchange Act, which requires an issuer to file complete and accurate Exchange Act reports.2 According to the Order, the PM knew the Issuer would state in its Form 8-K that there were no understandings or arrangements between the PM and others at the Issuer that would undermine the PM’s independence as a board member; and, by failing to tell the Issuer of the loan, the PM effectively caused the Form 8-K to be misleading by allowing the filing to create a public impression of the PM’s independence, “even though his independence was compromised by [the CEO] owing him $3 million.” The Adviser had deficient compliance policies concerning conflicts of interest. The Order found that while the Adviser’s compliance policies and procedures alerted employees to classic conflict-ofinterest areas like personal trading, outside activities and gifts and entertainment, they did not prompt employees broadly to recognize other possible problem areas. “For example, there was nothing generally in the [Adviser’s] policies and procedures that would advise an employee that a transaction such as a personal loan to a senior officer of a portfolio company gives rise to serious conflicts of interest.” The Order concluded that the Adviser, by not adequately identifying and addressing conflicts of interest, violated Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder, which require a registered investment adviser to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act by the adviser and its supervised persons. The Order subjected the PM and the Adviser to ceaseand-desist orders, censured the Adviser and levied civil fines of $100,000 and $160,000 on the PM and the Adviser, respectively.3 LESSONS FOR FUND MANAGERS The facts alleged in the Order are certainly unusual—it is not every day that a portfolio manager overseeing an adviser’s position in a public company makes a secret multi-million dollar loan to the CEO and then joins the board. However, there are important larger lessons that fund managers should take from the Order. Remain Alert to Changes in Investment Posture that Could Cause Loss of Schedule 13G Eligibility An investor that wishes to eschew reporting on Schedule 13D in favor of the less detailed Schedule 13G must be able to make the “no control purpose or effect” certification required by Item 10 of Schedule 13G.4 That certification must remain true at all times the investor’s Schedule 13G (including any amendments) is in effect. If the investor undergoes a change of investment intent that renders the Item 10 certification inaccurate—i.e., if the investor begins to hold its issuer securities with a control purpose or effect—the investor must file a Schedule 13D within 10 days following the change.5 An investor generally will be deemed to hold issuer securities with a control purpose or effect if the investor has a “plan or proposal” of the sort enumerated in Item 4 of Schedule 13D. Among the plans or proposals encompassed by Item 4 are those relating to: an extraordinary corporate transaction such as a merger or reorganization; a sale of a material amount of the issuer’s assets; any change in the issuer’s current board of directors, including changing the number of directors or filling an open board seat; or any other material change in the issuer’s management, business or corporate structure. To the extent an investor reporting on Schedule 13G develops a plan or proposal to produce an Item 4 result—including a plan to obtain a board seat—the investor must switch to reporting on Schedule 13D. Of course, a careful facts-and-circumstances analysis often is needed to determine exactly when an investor crosses the line from exploratory considerations of activism to a definitive adoption of “control” intent signaling the loss of Schedule 13G eligibility. We generally counsel a conservative approach to this analysis, in part because any litigation or SEC enforcement action by its nature will view the investor’s behavior and intentions through a hindsight lens. In any case, the larger point is that a fund manager’s legal and compliance staff must remain vigilant about behavior or communications on the part of the firm’s investment professionals that might suggest a change from passive to control posture is underway.6 When Seeking a Board Seat, Respect the Need for Thoughtfulness and Complete Disclosure in the Candidate-Vetting Process When a fund manager seeks to place one of its employees on a public company board, the manager and the candidate must take seriously the issuer’s vetting process for prospective directors, in awareness that the candidate’s statements during the process will inform the issuer’s public disclosures should the candidate join the board. A thorough approach to the candidate-vetting process includes carefully reviewing and thoughtfully responding to the issuer’s D&O questionnaire. These questionnaires are designed, among other purposes, to gauge whether or not the director candidate meets relevant stock exchange and SEC independence standards, is qualified to serve on various board committees (including pursuant to the SEC’s required qualifications for audit committee members), or has any relationships with the issuer, its related persons or other parties that might interfere with the candidate’s exercise of fiduciary duties as a board member. While D&O questionnaires can be tedious to work through, there are at least two major reasons to focus thoroughly on the task, with the assistance of counsel if necessary. The first is that thinking attentively about the questions posed might make it apparent that having the candidate on the board in fact would not serve the manager’s purposes. For example, a conflict or even the appearance of one could necessitate the director’s recusal from important board discussions and votes. Similarly, reviewing the questionnaire might make it clear that the candidate does not meet relevant independence standards or is not qualified to join a board committee on which the manager wants representation.7 The second reason to provide full and accurate questionnaire responses emerges when one considers that a major purpose of the questionnaire is to ascertain whether the candidate will meet relevant independence standards, and that the board’s conclusion that the candidate is independent will be reflected in the issuer’s post-appointment disclosures under federal securities law. Indeed, providing incomplete or misleading information to the issuer on independence-related issues can result—as shown by the Order—in the candidate being liable for the issuer’s own inaccurate disclosure about the candidate’s putative independence. In this regard, it is important to understand that several of the questions in a standard D&O questionnaire are designed to elicit information the issuer needs to fulfill specific Exchange Act disclosure obligations and make mandated corporate governance determinations under stock exchange rules. For instance, when an issuer’s board of directors appoints a new director during the interim between annual meetings, the issuer must file a Form 8-K containing the information specified by Item 4.04(a) of Regulation S-K.8 Item 4.04(a) calls for details of any material related-party transactions or arrangements involving the director. On the stock exchange front, the Nasdaq listed company rules (to which the Issuer was subject) provide that for a director to be deemed independent, the board must determine that the director has no relationship that “would interfere with the exercise of independent judgment in carrying out the responsibilities of a director,” including an absence of specified bright-line relationships that preclude a determination of independence.9 The NYSE’s listed company rules contain similar provisions.10 Ensure that Conflict-of-Interest Policies and Training Keep Up with the Manager’s Changing Investment Strategy Most fund managers have compliance policies and procedures that address classic employee conflicts of interest that could run counter to the manager’s fiduciary duty to its clients. These traditional conflict areas include trading for personal accounts, the misuse of nonpublic information, engaging in outside business activities and the receipt of business gifts and entertainment. Of course, it is necessary for a manager to sensitize its personnel to these widely-recognized potential conflict areas. However, it is equally important for the manager to consider imaginatively whether its particular investment strategies may give rise to potential conflicts that go beyond the standard categories. In particular, a manager that has begun to embark on shareholder activism may need to assess whether its existing compliance policies and procedures encompass potential conflicts that could arise when a portfolio manager is interacting deeply with issuer management or obtains a seat on the issuer’s board. Even if the manager concludes that its existing written policies and procedures remain adequate in light of the strategy evolution, it may be prudent at least to retrain employees with a specific emphasis on conflict issues that the changing investment approach may engender.