Hedge Fund Lawsuit Financing Poised for SEC Enforcement Scrutiny

The SEC’s enforcement lawyers and examiners are moving closer to gathering data on investments hedge funds make in support of litigation, as the financing arrangements grow in popularity.

The US Securities and Exchange Commission Aug. 10 proposed requiring private funds to report confidentially to the agency about their spending on litigation finance. The funding, which litigants and law firms use to cover their costs, has reached billions of dollars.

The potential reporting is part of a broader hedge fund transparency push by SEC Chair Gary Gensler, who said his agency is trying to better protect investors and monitor systemic risk to the US economy. The SEC can bring cases against hedge funds for false or misleading disclosures.

“They’ll use it as a tool in their toolbox to aid their enforcement and their exam program,” Scott Mascianica, a Holland & Knight partner and former SEC lawyer, said about the prospective litigation finance disclosure requirements.

The agency’s interest in litigation finance disclosures comes after major growth in the funding market. As of 2019, it had $39 billion in global assets, according to law firm Brown Rudnick.

‘Light Touch’

The extent of hedge fund investments in litigation finance is opaque, despite the involvement of D.E. Shaw & Co., Elliott Management Corp. and other major firms. Hedge funds can avoid making specific disclosures about litigation finance under current SEC rules.

Private funds would have to report certain statistics about their investment strategies under the agency’s proposal, which also would apply to those registered with the Commodity Futures Trading Commission.

Funds generally would be required to disclose the percentage of their money that goes toward litigation finance, as part of a net asset value calculation that excludes liabilities.

Small funds also could disclose the percentage of their capital invested in lawsuits under the plan, but an earlier SEC proposal would require the information from large funds.

None of the disclosures to the SEC or CFTC would be made public.

“It’s a very light-touch regulation as far as regulation goes,” said Maya Steinitz, a University of Iowa law professor who studies litigation finance.

Disclosure Fight

Still, Republicans and hedge funds have raised concerns with the proposal. Managed Funds Association CEO Bryan Corbet said the proposed disclosures would have “dubious utility.”

Hedge funds may balk at providing more information on what assets make up their investments. Litigation funders in general have been averse to disclosing the specific lawsuits they’ve backed. The industry has been successful fighting against any national disclosure rules. Some individual courts, including the New Jersey federal court, have required litigants to disclose whether they’ve received funding.

Hester Peirce and Mark Uyeda, the SEC’s Republican commissioners, voted against releasing the agency’s proposal to boost the transparency of funds’ strategies for litigation finance and other investments, including cryptocurrency. More granular information is unnecessary for the agency to police the industry, they said.

The bigger the investments, the more likely the SEC is to seek granular data on them, Mascianica said.

“This space has grown exponentially,” Mascianica said.

—Roy Strom contributed to this report.