Key Points
- Periods of market volatility expose firms managing private funds to increased scrutiny from government agencies, regardless of the existence of any actual misconduct.
- Government agencies may open an investigation based on investor losses, perceived misconduct, or a generalized desire to increase policing of the financial industry.
- To reduce the risk or limit the impact of a government investigation, firms can take proactive measures including assessing policies and procedures regarding risk management, valuation, liquidity management and disclosures, and maintaining adequate supervision and oversight of traders.
For many private fund managers, periods of market volatility and economic downturns are doubly burdensome: Not only must they minimize economic losses while balancing margin calls and redemptions, they also must brace for the possibility of government investigations. The recent market volatility is unlikely to be any different. Remembering how and why government investigations commenced in prior periods of volatility will help firms take steps to fend off and limit the impact of such investigations.
Market-Induced Stressors Can Make Firms Vulnerable to Government Investigations
Economic booms create conditions by which some firms can make more aggressive decisions and take riskier actions, often resulting in increased returns. But when market volatility is followed by investor losses, the Department of Justice (DOJ), Securities and Exchange Commission (SEC) and other federal and state agencies can react by opening an investigation. Where a government investigation appears predicated on evidence of fraud, such scrutiny may be warranted. As the saying goes: “Only when the tide goes out do you learn who has been swimming naked.”
Examples in the past 20 years are plenty. Bernie Madoff’s Ponzi scheme was exposed as the 2008 financial crisis metastasized and investors sought redemptions.1 During the COVID pandemic, the market selloff exposed aggressive and undisclosed risk,2 fraudulent valuations3 and manipulative trading by firms managing private funds.4 These investigations led to criminal and civil actions that resulted in convictions, settlements, and substantial fines in the form of penalties and restitution.
Investigations Not Predicated on Evidence of Fraud
Even for firms that are honest actors, the impact of market volatility on a fund or product can draw unwanted government interest. Government investigations may begin without evidence of misconduct, triggered by a headline, a period of aberrational performance or simply steep market losses. Additionally, investigations that begin focused in one area can morph into investigations into unrelated alleged misconduct. For example, after investigations relating to the causes behind the 2008 financial crisis failed to produce prosecutions, the DOJ and SEC continued to focus on the markets for structured products at the root of the crisis and, in the following years, have brought dozens of high-profile actions relating to the sale, trading and valuation of these products.
Steps To Prepare
Even where there is no misconduct, an investigation itself can have dire consequences, particularly when a firm is working to survive a volatile period. Firms should be mindful of their own vulnerabilities — and the government’s perception of them — and should understand what steps they can take to reduce the risk of adding a government investigation to the list of stresses.
For instance, firms that emphasize risk management that can cabin downside risk should fully understand the limits of their hedging, the investment team’s compliance with risk management strategies and limits, and whether disclosures fairly capture this state of play.
And firms that trade complex or structured products should assess the processes and policies surrounding valuation, including dealings with third-party pricing services on model assumptions and the challenge process, the availability of adequate liquidity in various scenarios, and the supervision and monitoring of traders who work in opaque markets.
Instead of reacting to government suspicions and investigations, proactive firms will be better prepared to navigate scrutiny during periods of market volatility.
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1 Federal Bureau of Investigation, “Bernie Madoff Case: Inside History’s Biggest Financial Crime.”
2 See, e.g., Press Release, DOJ, “Allianz Global Investors U.S. Sentenced in Connection with Multibillion-Dollar Fraud Scheme” (July 12, 2023).
3 See, e.g., Press Release, DOJ, “Founder And Former Chief Investment Officer Of Infinity Q Sentenced To 15 Years In Prison” (Apr. 10, 2023).
4 See, e.g., Reuters, “Archegos Margin Call Share Dump Ripples Across Markets” (Mar. 29, 2021).
This memorandum is provided by Skadden, Arps, Slate, Meagher & Flom LLP and its affiliates for educational and informational purposes only and is not intended and should not be construed as legal advice. This memorandum is considered advertising under applicable state laws.