Three Key Considerations For Fund Sponsors When Participating In Bankruptcy Proceedings – Finance and Banking

We anticipate a more assertive regulatory enforcement program
under the Biden administration, particularly focused on fund
managers’ conflicts of interest, advisers’ codes of ethics,
and related policies and procedures relating to material nonpublic
information. These concerns may be heightened for fund managers
participating in bankruptcy proceedings, where competing fiduciary
obligations arise, particularly in the context of serving on
creditors committees. Outlined below are three primary
concerns.

1. Fiduciary Concerns

Members of an unsecured creditors committee or other committee
in bankruptcy proceedings have fiduciary obligations to other
bankruptcy creditors. Because of this, members of bankruptcy
committees face greater risks of being charged with fraud. Wherever
a fiduciary duty exists, a breach of such duty in connection with a
securities transaction may form the basis for criminal charges by
the DOJ or an enforcement action by the SEC. The antifraud
provisions of the securities laws prohibit devices, schemes, and
artifices to defraud in the offer or sale, or in connection with
the purchase or sale, of securities. The DOJ can prosecute similar
theories under mail fraud, wire fraud, other specific securities fraud statutes or bankruptcy-specific statutes. A breach of a
duty, particularly a fiduciary duty, can provide the hook for
securities fraud charges under a scheme liability theory;
e.g., when an individual acts for personal gain contrary
to his or her fiduciary obligation to others.

This situation came to the fore in a matter prosecuted last
year, where the portfolio manager of a fund allegedly exploited his
position as a co-chair of the unsecured creditors committee in
Neiman Marcus’s bankruptcy proceedings. As a representative of
the unsecured creditors, the portfolio manager had fiduciary
obligations to all unsecured creditors, not just the interests of
his fund. The DOJ and SEC alleged that the fund manager used his
position to attempt to suppress another bidder for securities he
sought to acquire for the fund he managed, acting to his own
benefit and to the detriment of the other unsecured creditors to
whom he owed a duty. This was an extreme case, but one that
highlights the importance of, and risks arising from, fiduciary
obligations.

2. Conflicts – Different Parts of Capital
   Structure

Conflicts of interest can arise when a fund manager has separate
funds that invest in different parts of a single company’s
capital structure. Such conflicts are more likely to arise in
connection with a bankruptcy proceeding where a fund manager may
find itself in a position where a forced liquidation or some other
bankruptcy action may serve its interest as a creditor, but may
disadvantage its position as an equity holder. Taking any action
that disproportionately disadvantages one fund while benefiting
another can potentially result in a breach of fiduciary
obligations. These obligations are heightened when the decision
maker manages one fund with debt interests as well as another fund
with equity interests in the same company. If a fund manager does
not have a separate decision-making structure for each fund (as
well as information barriers), it might not be able to take action
without risking its fiduciary obligations. Managing the conflicts
that accompany investments across a capital structure is an
important consideration in the bankruptcy context.

3. Potential Misuse of Material Non-Public Information
   (“MNPI”)

During bankruptcy proceedings, circumstances exist that that
could give rise to potential claims of insider trading or other
misuse of MNPI. When fund manager representatives serve on a
creditors committee, the firm typically creates a wall between the
person who serves on the committee and others who may make trading
decisions. However, breakdowns in controls may lead to misuse of
that information and potential liability. A number of years ago the
SEC successfully brought an action alleging
that a representative on various creditors committees engaged in a
pattern of insider trading of fixed-income securities using
information he obtained through those committees.

A separate but related question is whether a fund manager’s
existing compliance policies are effectively implemented to prevent
misuse of information. Registered investment advisers are subject
to Rule 204A of the Investment Advisers Act, which requires them to
establish, maintain, and enforce written policies and procedures to
prevent the misuse of MNPI, particularly in circumstances where the
risk of obtaining MNPI is heightened – such as when a fund manager
representative is a committee member. The SEC continues to pursue
actions against investment advisers for failures to maintain robust
policies and procedures relating to the handling of MNPI. The
effectiveness of information barriers is an area on which
regulators are likely to focus, particularly as they increase
scrutiny of private fund managers.

Three Key Considerations For Fund Sponsors When
Participating In Bankruptcy Proceedings

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.