On April 7, 2024, the United States District Court for the District of Connecticut approved the Securities and Exchange Commission’s request to dismiss its action against a hedge fund manager for the manager’s alleged failure to safeguard material nonpublic information, in violation of § 204A of the Investment Advisers Act of 1940, when it engaged outside counsel to participate on creditors’ committees on its behalf and consult with the firm on related investments. The action was dismissed with prejudice, meaning the Commission cannot refile it.
According to the Complaint in the action, the hedge fund manager invested in bankrupt or distressed companies, a strategy that involved a public side at the firm that traded companies’ debt, and a private side that participated in confidential negotiations over how the same companies could repay their debt. In connection with this strategy, the manager hired outside counsel to serve as its representative on creditors’ committees where such confidential negotiations were had. Furthermore, to ensure its public side would not be restricted from trading a company’s debt while its private side participated on a committee for the same company, the manager established an information barrier between the two sides.
The Commission alleged that the manager’s information barrier policy did not clearly require that outside consultants be subject to the same oversight and controls as private side employees who also participated in such creditors’ committees. According to the Complaint, this “loophole” created a substantial risk that MNPI might leak from the consultant to the manager’s public side, risking misuse of the information or insider trading by the firm. The Complaint offered, as an example, outside counsel’s participation in a bankruptcy mediation involving Puerto Rico’s default on general obligation bonds.
In a release issued on the day that, together with the hedge fund manager, the Commission filed a joint stipulation of dismissal, the Commission stated that its “decision to exercise its discretion to dismiss this enforcement action is based on the specific facts and circumstances of this case and… does not necessarily reflect the Commission’s position in any other case.”
The Commission could have decided to drop this action for a few reasons. As an initial matter, the action was filed on December 20, 2024, in Chair Gensler’s final weeks before the change in administration. It also presents a unique fact pattern that would have created substantial risks for the SEC at trial. After all, the consultant the Commission alleges should have been subject to the manager’s information barrier policies and procedures was an attorney, an expert in bankruptcy law, and well aware of his contractual, ethical, and legal obligations not to disseminate confidential information learned in the course of his participation in creditors’ committees. In other words, the Commission would have had to argue the manager’s information barrier policy was not reasonably designed because outside counsel was not subject to its internal oversight and controls. Finally, the action would have been complicated by the fact that much of the relevant evidence resided with that lawyer who is now deceased.
As illustrated by other recent enforcement actions, investment managers should not take the Commission’s dismissal as an indication that it is no longer committed to investigating and prosecuting § 204A violations.
On September 30, 2024, the Commission brought settled administrative proceedings against a global alternative asset manager for its alleged failure to establish policies and procedures reasonably designed to safeguard MNPI obtained in connection with its participation on ad hoc creditors’ committees. The settled Order centered on interactions between the manager’s analysts and financial advisers to such committees, and took issue with the fact that the manager had no policies or procedures requiring its personnel to conduct diligence on such advisers’ evaluation or handling of MNPI or for obtaining representations from them concerning their MNPI policies and procedures. Without admitting or denying the Commission’s findings, the manager was censured and required to pay a $1.5 million penalty. The § 204A charge against the manager was approved on a 5-0 vote of the Commission, including Commissioners Uyeda and Peirce, in the minority at the time.
On August 26, 2024, the Commission brought settled administrative proceedings against a private fund manager for its alleged failure to establish policies and procedures reasonably designed to safeguard MNPI when trading collateralized loan obligations while participating in ad hoc lenders’ groups. Specifically, the Order found the manager did not have written policies or procedures requiring it to consider the impact of MNPI learned about companies from its participation in lenders’ groups, before trading CLO tranches containing such companies’ loans. Without admitting or denying the Commission’s findings, the manager was censured and required to pay a $1.8 million penalty. The § 204A charge against the manager was approved on a 4-1 vote of the Commission, including Commissioner Uyeda, with Commissioner Peirce not approving.
Insider trading and the effectiveness of policies and procedures to safeguard against insider trading have been and will continue to be a perennial focus area for the Commission. If you have any questions regarding the foregoing, please contact any of the attorneys listed below or your primary Seward & Kissel attorney.
