Hedge Fund Bits and Pieces for April 14, 2017

Happy Friday.  Markets are closed today for the holiday and it is tax day this Tuesday.  Enjoy the weekend!

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SEC Brings Actions Against Authors on Investment Article Platforms – platforms like Seeking Alpha and SumZero have been popular places for investment managers to post articles about their investment ideas.  Managers post for a number of reasons including to hone their own investment thesis, hear counterarguments and to generally be part of a community actively involved in the discussion of ideas.  We routinely work with managers who are posting articles on these platforms and help them think about the compliance obligations they have with respect to any postings.

The SEC just announced a major series of enforcement actions against 27 individuals for posting fake and fraudulent articles on these platforms.  Settlements have already ranged from $2,200 to almost $3 million.  While the standard hedge fund manager we deal with is unlikely to be involved in the creation of fake or fraudulent articles (or using these platforms to manipulate positions), these enforcement actions show that the SEC is actively looking at information posted on the internet as a way to find persons involved in securities violations.   Most registered managers will already have social media policies in place that should deal with situations like this, including how to document the posting, but we also recommend that managers discuss articles with their attorneys or compliance personnel before posting.  We believe that (to the extent it has not already happened) the SEC will be closely scrutinizing internet postings during routine manager examinations and that managers need to make sure any such actions are not manipulating the markets (in addition to making sure there is no appearance of manipulation).

FINRA 360 Announced – FINRA just announced a new initiative to “evaluate various aspects of its operations and programs to identify opportunities to more effectively further its mission.”  The initiative is was announced as FINRA 360 in Regulatory Notice 17-14 and focuses on the following, in addition to other FINRA rules: CAB Rules, Funding Portal Rules, Numerous FINRA rules and the Trading Activity Fee.  The goal of FINRA 360 is to ”increase efficiency and reduce unnecessary burdens on the capital-raising process without compromising important protections for issuers and investors” which we think is a step in the right direction.  However, we have previously discussed two FINRA initiatives (here re CABs and here re scrapping the 7) as perhaps a bit misguided.  In any event, we think FINRA is taking a great step here and we also believe that this provides an opportunity for the industry to provide FINRA with meaningful feedback and ideas.  All are encouraged to comment and comments are due by May 30, 2017.

Greyline Solutions Expands Compliance Offering to Broker-Dealers – the regulatory compliance consulting company Greyline Solutions (editors note: I am a minority owner in this business) announced the upcoming acquisition of Vista Compliance which will add significant broker-dealer expertise to its RIA offerings.  For more information, please see the press release.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP and focuses his legal practice on the investment management industry. He can be reached directly at 415-868-5345.

Greyline Solutions Continues Expansion

Regulatory Compliance Consulting Company Adds Significant Broker-Dealer Practice

Below is a press release from Greyline Solutions, one of the premier regulatory consulting groups (editors note: I have an ownership interest in this company and have worked with the acquired company, Vista Compliance, and Talia Brandt for a number of years).  I’d like to send my congratulations to all on the Greyline team!

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Greyline Solutions Expands with Addition of Vista Compliance

Greyline Solutions announces partnership with Vista Compliance. Talia Brandt to lead broker-dealer practice for Greyline.

San Francisco, Calif. – April 13, 2017 – Greyline Solutions, LLC, a premier financial regulatory and
compliance consulting firm headquartered in San Francisco, is partnering with Vista Compliance, a national compliance consulting firm based in San Francisco. The transaction, which is expected to close on May 1, 2017, will expand Greyline’s presence to the East Coast. It will also create a broker-dealer practice, which will be led by Talia Brandt, Vista’s founder.

Brandt and her team of senior consultants – who each have more than 10 years of industry experience, including experience at regulators – will reinforce Greyline’s ability to support alternative asset managers and traditional investment advisers in their compliance efforts.

“For the past nine years, Vista has been steadily growing our business by servicing investment advisers and broker dealers with a client-centric orientation and a commitment to partner with our clients to meet their compliance needs. In joining forces with Greyline, we are excited to leverage our offering by expanding our presence in other markets,” says Brandt.

“Vista’s success is impressive. Its depth of SEC and FINRA compliance experience, including experience working at regulators, has made it a top choice for managers looking for high-touch, institutional-quality services,” says Matthew Okolita, chief executive officer of Greyline. “Vista’s commitment to sustainable quality services aligns perfectly with our mission, and this partnership will allow us continue our efforts to expand nationally across all spectrums of the asset management industry.”

About Greyline Solutions

Headquartered in San Francisco, Greyline Solutions is a national compliance consulting firm offering comprehensive compliance solutions for businesses in the securities industry. Greyline prides itself on tailoring compliance management solutions to the unique needs its clients, which include private equity, venture capital, hedge fund managers, commodity pool operators and other investment managers, as well as businesses ranging from entrepreneurial start-ups to multi-billion dollar international institutions. Custom technology and experienced staff are two of the hallmarks of Greyline’s offerings. The firm is comprised of securities industry
professionals with decades of experience in the financial and regulatory industries. Its mission is to simplify the process, minimize risk, and lower costs, with the core goal of helping clients focus on building and enhancing their businesses.

Contact Information
Matthew Okolita
Greyline Solutions LLC
http://www.greylinesolutions.com
415.604.9527

Hedge Fund Bits and Pieces for April 7, 2017

Happy Masters Friday!

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End Game of Mini-Prime Consolidation? – earlier this week Cowen announced the acquisition of Convergex.  For Cowen, this is the second introducing prime (mini-prime) acquisition in the last two years, the earlier coming when they acquired Concept Capital in July of 2015.

There are a number of interesting things about this transaction – first, it appears that final consolidation of the introducing prime space has occurred (Cowen and BTIG).  Given the reluctance for any major prime to accept new introducing business, it seems unlikely we would see another group try to get into this space, at least in the current environment.  Second, Cowen has been very active and aggressive with its expansion activities and its efforts to rebrand.  Just last week Cowen announced it received a $100M investment from China Energy Company Limited along with a promise to provide up to $175M in debt financing (presumably this capital was for the purchase of Convergex).  Additionally, we have heard small rumors that Cowen is in the process of rebranding their Ramius division to more align with the Cowen name.

FINRA Blockchain Report Comments Posted – in January FINRA published a report entitled Distributed Ledger Technology: Implications of Blockchain for the Securities Industry.  The report provides an overview of blockchain technology and discusses, among other items, the regulatory considerations for groups who are implementing this technology in certain areas of the securities industry.  FINRA asked for comments on the report and that comment period ended last Friday.  There were a number of interesting comments from both regulatory groups as well as market participants.  In the coming weeks we are planning to provide more analysis on FINRA and other regulatory body efforts in this space.  An overview of the report and links to the comment letters can be found here.

Capital Acquisition Broker (CAB) rules effective April 14, 2017 – in our opinion, there have been a number of misguided attempts by FINRA to modernize and ease certain regulatory frameworks (see our earlier post on the proposal to scrap the Series 7 exam).  Late last year the SEC approved a new category of broker-dealer called a Capital Acquisition Broker which could engage in certain private placement, investment banking and capital raising activities and be subject to a separate set of broker-dealer rules and regulations.  In theory this might be a good thing, but there are a couple of issues with these new rules.  First, the subset of potential groups these rules apply to are very limited (only firms raising money from very large institutions and qualified purchasers can be CABs).  Second, the CAB rules really aren’t that different from the normal FINRA rules applicable to broker-dealers.  The real issue is that FINRA does not have staff who are appropriately trained to understand all the various business models that broker-dealers may have.  We do note that we (and many others) have brought these concerns to FINRA’s attention and we believe the new FINRA president is working to make this better.

In any event, the CAB rules will be effective next Friday and more information on CABs can be found here for those who are interested.  We have not heard of any groups decided to go the CAB route instead of the traditional broker-dealer route, and we will be interested to hear if this changes in the future.

SEC Increases Crowdfunding Limits – pursuant to the requirements under the Dodd-Frank Act that the SEC increase the limits proscribed in the crowdfunding regulations, the SEC increased certain limits under those regulations.  Among other increases, the maximum aggregate amount an issuer can sell in a 12-month period increases to $1,070,000 from $1,000,000 and the maximum amount that can be sold to an investor in a 12-month period increases to $107,000 from $100,000.  More information on the adjustments can be found in the SEC press release on this topic.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP and focuses his legal practice on the investment management industry.  He can be reached directly at 415-868-5345.

Hedge Fund Bits and Pieces for March 31, 2017

Happy Friday and congrats to everyone on making it though the first quarter!  Our firm will be sending out a 2017 first quarter update sometime in the next couple of weeks – if you are not on the distribution list and would like to be, please contact us.  We will also post the update to this blog.

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Annual ADV Updatedue TODAY by 11pm ET (when IARD system shuts down).  The ADV annual updates are due today.  Most firms have submitted their updates by now but if you have not done so, please call your legal or compliance professional immediately.  Additionally, fund managers generally will have their audits completed by today and those should be sent to investors as per the firm’s compliance procedures.

Another Bitcoin Trust Rejected by SEC – on Tuesday the SEC rejected an application by NYSE Arca to list shares of SolidX Bitcoin Trust.  The trust was set to a publicly traded vehicle designed to track the price of bitcoins as measured by an index of unregulated bitcoin exchanges (Bitfinex, Bitstamp, GDAX, itBit, and OKCoin International).  In rejecting the application, the SEC stated that it believes that the bitcoin markets are unregulated.  This is the second rejected listing of a bitcoin product for retail investors (see earlier post discussing the rejection of the Winklevoss bitcoin ETF).

SEC Focus on FinTech – it is abundantly clear that technology is beginning to change the capital markets in profound ways.  As practitioners, we are working with our clients to figure out how new ways of investing fit within the current regulatory structures applicable to both products and managers.  As these changes take deeper root, there will be growing pains and the SEC realizes this – below are recent remarks made on Monday in Washington by acting SEC Chairman Michael Piwowar about the FinTech industry and how the SEC will be working in the space in the future.  The full speech, made at the beginning of the SEC’s 27th Annual International Institute for Securities Market Growth and Development, can be found here.

Financial technology (“FinTech”) is also revolutionizing our industry. FinTech can bring tremendous benefits – streamlined market operations and more affordable ways to raise capital and advise clients.  Fifty-nine percent of all adults in developing nations do not have a bank account – but this is changing fast. With cell phones now in the pockets of many individuals in even the poorest of nations, mobile technology has greatly cut down on barriers to accessing capital. In Kenya, for example, I saw firsthand the transformative power of FinTech. Sixty-eight percent of Kenyan adults use their mobile phones for monetary transactions. In 2013, over 25% of the Kenyan GNP was transferred via M-PESA, the leading mobile money transfer service in the country. Services like M-PESA are not only for the transfer of money, but also can be used to take out micro-loans that would have been previously unavailable to small businesses.  The question for us regulators is how can we encourage this innovation and all the potential benefits that it promises, while also managing the risks? At the SEC, we started a FinTech working group. Not surprisingly, FinTech firms report that their greatest struggle is navigating a complex regulatory environment. The SEC, and other securities regulators, should take the leading role in working with the FinTech community to adapt longstanding laws and regulations to newfangled technology. (footnotes omitted)

Other Items:

  • CFTC Announces Committee Meeting on Cybersecurity – the CFTC just announced that the Market Risk Advisory Committee (MRAC) will meet on April 25, 2017 to discuss a number of important issues related to the futures and commodities markets.  A central focus of this meeting will be focused on cybersecurity trends in the futures markets.  The discussion will also cover “how well the derivatives markets are currently functioning, including the impact and implications of the evolving structure of these markets on the movement of risk across market participants” – we anticipate that some part of the discussion will focus on certain new instruments like cryptocurrencies and the emerging derivate products linked to such instruments.  The MRAC’s meeting will be public and be held at the CFTC’s Washington, DC, headquarters.
  • Adidas Trademark Issue – while not directly related to the investment management industry, this blog post (produced by our Of Counsel trademark attorney Bill Samuels) highlights the technical nature of the enforcement of trademarks.  It also highlights the strength of a registered mark (the sale of only two hats, which contain a trademarked phrase, are enough to implicate interstate commerce and allow a trademarked phrase to be protected under the trademark laws).  It is important for managers with questions on their trademarks and other intellectual property to discuss these matters with counsel.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP and focuses his legal practice on the investment management industry. He can be reached directly at 415-868-5345.

Hedge Fund Bits and Pieces for March 24, 2017

Happy Friday from rainy San Francisco. As a reminder, there is one week left for investment advisers to complete the annual ADV update.

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Notes on cryptocurrency and blockchain – earlier this week Coinbase added a new margin product for leveraged trading in certain leading cryptocurrencies including Bitcoin. We believe that a product like this would be subject to CFTC jurisdiction and certain registration (or exemption) requirements. As we’ve had more discussions with groups in this space over the last couple of weeks we are seeing both the difficulties of running a fund strategy in this space (hard to find banks willing to support crypto managers; lack of audit firms able to audit these strategies) and the possibilities of blockchain technology (potentially uses for compliance in the hedge fund space).  These discussions have come in the wake of significant client interest in this are and our article on bitcoin hedge funds.

Cannabis Investment Management Conference – continuing on our earlier discussion of the rise of investment opportunities in the cannabis space, MedMen and IMN are putting on The Institutional Capital & Cannabis Conference next week in San Jose. The conference will take place on March 28-29 and will include a number of funds and allocators in the cannabis space.

Regulations and Tax – not as much news this week on the regulatory front applicable to hedge funds – we expect to begin hearing more next week (after the Health Care Bill vote) when/if the discussion of tax reform begins. If Trump keeps his word to eliminate the “carried interest loophole”, we may see more discussion of the issue like we did back in 2011 and 2009.

Other Items:

  • SEC Compliance Seminars – the SEC announced compliance seminars in a number of cities. Please see the release here.
  • Connecticut Reminder to Exempt IAs – the Connecticut Department of Banking sent out a regulatory reminder about managers who utilize the Connecticut IA registration exemption (more information in our post about the Connecticut ERA filing) in the state. The release can be found here.
  • SEC Adopts T+2 – the settlement cycle for securities transactions gets shorter by one day on September 5, 2017. We expect to hear more from the brokerage firms about this change in the next couple of months as systems become integrated with the new requirements. The announcement can be found here.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP and focuses his legal practice on the investment management industry. He can be reached directly at 415-868-5345.

Hedge Fund Bits and Pieces for March 17, 2017

Happy Friday. This week’s updates below.

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Bitcoin ETF Rejected by SEC – an application to establish an ETF which would be based on a basket of Bitcoins was rejected by the SEC on March 10. The Winklevoss brothers, noted Bitcoin investorss, were the sponsors of the vehicle which was to be called the Winklevoss Bitcoin Trust. In rejecting the proposal, the SEC stated that the Bitcoin markets are unregulated and that the exchange the ETF would be traded on (Bats BZX Exchange) would not be able to enter into “surveillance-sharing” agreements that would be able combat fraudulent or manipulative acts and practices in the Bitcoin market. We expect that there will be future ETF proposals submitted to the SEC and that as the cryptocurrency industry (and specifically the exchanges hosting Bitcoin exchange) becomes more developed, a Bitcoin ETF will at some time be approved for trading. The SEC release can be found here.

Bitcoin Hedge Funds Article – we recently wrote about Bitcoin/ AltCurrency / Cryptocurrency hedge funds.  We believe that this is a burgeoning asset class and we will begin to see more private fund products launched in this space in the coming months.

FINRA Proposal to Scrap Series 7 – last week FINRA filed a proposed rule change with the SEC that would eliminate the Series 7 exam in favor of a more “streamlined” representative-level qualification exam that would include a general knowledge exam and specialized knowledge exam. We have strong thoughts about FINRA’s use of their time to create a new regulatory structure for exams when there has been no specific mandate for this update (no one is asking for this and we don’t know what problem this complete revamp is solving). We also (personally) believe that FINRA could better spend its time focused on matters that its member firms are asking to be addressed. While we are all for streamlining at Federal Agencies and self-regulatory organizations, we believe that streamlining should be reasonable and should serve a purpose – I am not sure if there was a purpose to this, but I also have not read through the entire 619 page FINRA submission to the SEC.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP and focuses his legal practice on the investment management industry. He can be reached directly at 415-868-5345.

Bitcoin Hedge Funds (Cryptocurrency / AltCurrency Funds)

Overview of Blockchain Based Digital Currency Investment Fund Structures

Bitcoin has recently been in the news again due to strong results over the last couple of months. Bitcoin and other digital currencies have been a bit of a fringe phenomenon in the investment management industry since inception. However, the power of the idea of distributed computing/ledgers has been evangelized in various parts of the tech industry and has attracted a significant amount of institutional investment into various digital currencies, and related infrastructure. It is not surprising then to see asset managers beginning to explore this space either through dedicated fund products, or through side pocket investments separate from more traditional products. This post discusses the various structural, regulatory, and operational issues that arise for managers who invest in these instruments.

Foundational Items – Definition

For purposes of this article, we make references to the term Bitcoin and digital currencies. These references will generally mean references to other blockchain-based currencies and/or digital tokens, which are sometimes referred to as cryptocurrencies or altcurrencies. There are various governmental agencies looking into how to define and regulate this space, and the CFTC has specifically defined the term “Bitcoin” in the following way:

Bitcoin is a “virtual currency,” defined here as a digital representation of value that functions as a medium of change, a unit of account, and/or a store of value, but does not have legal tender status in any jurisdiction. Bitcoin and other virtual currencies are distinct from “real” currencies, which are the coin and paper money of the United States or another country that are designated as legal tender, circulate, and are customarily used and accepted as a medium of exchange in the country of issuance. [See note 2 of the CFTC order discussed below.]

Another foundational item of this post is whether Bitcoin is a “security” under securities laws, or a currency under commodities laws, or both, or something else. We will discuss this issue in greater depth below under regulations, but for the general purposes of this article, we will take the position that Bitcoin is not a security regulated by the SEC nor state securities regulators. We will also take the position that Bitcoin is likely a currency that is subject (in some instances) to regulation by the CFTC.

Structural Considerations for Fund Formation

Although there are unique qualities of Bitcoin (it does not act like a security and it is debatable whether it acts like a commodity/currency), the big picture structural considerations for a fund manager in this space will not be significantly different than for a traditional hedge fund investing in securities and/or commodities.

Hedge Fund or Private Equity Strategy. For the Bitcoin funds we have worked with, the strategies tend to be more hedge fund styled than private equity styled. This generally makes sense given the relatively “liquid” nature of the instrument. If a fund invests directly into operating companies in the digital currency ecosystem, or if a fund sets up operations to mine for Bitcoin, there may be the need for side-pocket private equity style sleeves within a larger liquid framework.

Fund Terms. Normally we see standard hedge fund style terms; as well as expenses and fees that are generally similar to standard securities type fund programs (if anything, there may be greater management and performance fees because of the novel strategy / managers tend to have deep backgrounds in cryptography, mathematics and coding). Contribution provisions will also be standard. However, we tend to see greater attempts to limit withdrawals. Such measures could include longer withdrawal periods with longer notice provisions (60-90 days), and the use of investor level or fund level gates. Custody is a big issue, and valuation has the potential to be an issue as well. The use of leverage does not tend to be a major part of this investment strategy.

Onshore / Offshore Structures. As with other non-traditional hedge funds, the structure will be influenced by the taxation of the underlying investments and the nature of the investors. As of right now, we are not aware of any adverse tax consequences with respect to digital currencies for U.S. based investors; therefore, a standard domestic Delaware limited partnership structure should be sufficient. If the fund will have U.S. tax exempt investors, the domestic structure should be sufficient if the fund does not utilize leverage. To the extent the tax code changes in the future to tax digital currencies specifically, the structural considerations may change.

If the fund complex intends to have non-U.S. investors, the manager will choose between a mini-master structure or a master-feeder structure. Jurisdiction of any offshore structure will likely be the Cayman Islands or the British Virgin Islands. We have not seen and do not necessarily believe there would be a reason for a fund complex to introduce SPV structures to accommodate digital currency investment, but if that occurred, such structuring discussions would be based on normal factors like jurisdiction of the underlying asset, corporate necessity, etc.

Regulatory and Other Considerations for Bitcoin Investment Managers

There are a number of instrument-related issues which arise for fund managers who are investing in this space. Because of the relatively nascent stage of these instruments, managers and service providers are working out the below issues, and the way these issues are handled should become more standardized in the near future.

Federal & State Regulatory System.

SEC – Bitcoin and other digital currencies are most likely not securities; but, the SEC is currently examining how to deal with Bitcoin and other digital currencies. The biggest question is whether these instruments are securities or some other kind of asset subject to (or not subject to) regulation. If these digital currencies are securities, then the SEC will have jurisdiction to regulate the instruments, as well as the transfer of such instruments (including the regulation of any exchange facilitating such transfer). Because the SEC has not released any definitive guidance on the issue, Coinbase, a large Bitcoin wallet and exchange platform, has released the following discussion about how digital currencies fit into the SEC regulatory landscape (see Securities Law Framework for Bitcoin). Until we receive definitive guidance, or even informal guidance, from the SEC, the Coinbase framework discussion is probably the best reference material with respect to this particular issue.

CFTC – While it is clear that Bitcoin is fundamentally different from normal currencies traded on the Interbank or forex markets, what is less clear is whether and to what extent the CFTC has jurisdiction over the instrument and the exchanges on which they are traded on. Unfortunately, the answer is not exactly clear and the uncertainty, in part, comes from parts of the Dodd-Frank Act which provided the CFTC with new jurisdiction over parts of the currency trading systems in place in the United States. Because of certain the technical aspects of trading currencies both on the spot (interbank) and futures markets, and how those technical aspects inform the jurisdictional reach of the CFTC post Dodd-Frank, some part of this discussion is theoretical (what is delivery of a digital currency? what is custody of a digital currency and is this different from custody of a password?). While our law firm is currently in discussion with the CFTC as to whether a straight digital currency (as opposed to a digital currency forward or future) is a contract subject to CFTC jurisdiction, we currently believe that a private fund’s purchase of a Bitcoin or similar digital currency would not be subject to CFTC oversight (which would require the private fund manager to register as a CPO and CTA, or fit within exemptions). Notwithstanding the above, some types of instruments involving Bitcoin are commodities subject to CFTC oversight—please see Coinflip CFTC Order. In this order, there were a number of issues that led to the finding of regulatory oversight (products were deemed to be swaps; CFTC specifically mentioned OTC Bitcoin forward contracts as other contracts which may be subject to CFTC jurisdiction, see note 4).

CFTC and SEC? – In the future, it is likely that we will begin to see products linked to and based on Bitcoin, which have both the characteristics of a security and a futures product, thus subjecting such future instruments potentially to both CFTC and SEC jurisdiction. We would expect to see future legislation enacted both to define the nature of digital currencies, and any derivatives thereon, and also to define the scope of the CFTC and SEC’s jurisdiction over such products.

State – We have not heard of any state orders, actions or interpretations involving Bitcoin. We would expect the regulation of such assets to be driven by federal authorities, but we do not discount the fact that many state securities regulators (especially on the west coast) can take aggressive positions regarding new products.

Regulation of Management Company. Depending on where the manager fits within the regulatory spectrum discussed above, the manager may be subject to oversight and regulation. If the manager is deemed to be an investment adviser, or CTA and/or CPO, based on the above, the manager would be subject to the normal registration and compliance frameworks associated therewith. Managers who invest in other Bitcoin or cryptocurrency funds are definitely investing in securities (a private fund is a security), so a bitcoin fund of funds manager is deemed to be an investment adviser and would need to be registered (or fall within an exemption from registration) with the SEC or state securities commission. While we have seen some significant investment into the space, we acknowledge that the sector is still in its infancy and that we will probably begin to see more institutionalization among managers in this space.

Custody. Perhaps the biggest issue with respect to these instruments is how and where they are custodied, and also how and where the passwords, keys or other information related to the proof ownership are custodied. We believe that each manager needs to develop their own methods to deal with the custody issue, and that these methods will need to address the associated risks of ownership or the particular currency (as discussed in the Securities Law Framework for Bitcoin, each instrument has unique characteristics). In addition to the managers we have worked with, we have heard anecdotal stories about the many different ways managers store and protect the fund’s ownership and evidence of ownership of the digital currencies, including the use of thumb drives and bank safety deposit boxes.

Risks. A fund in this space will need to focus of the normal risks inherent for any private investment vehicle, but there are additional risks to consider related to the strategy, including: general risk of digital currencies, liquidity, ability to hedge, volatility, loss of private keys, technology and security issues, risk of exchanges (e.g. Mt. Gox), lack of FIDC or SIPC protection.

Service Providers. The typical service providers in this space (lawyers, administrators and auditors) have been working together to figure out how to deal with the novel and unique issues presented from these instruments.

Other Issues. There are a host of other issues which arise in this space that will continue to be flushed out over time. These include IT infrastructure for managers and general security over passwords. Valuation has the potential to be an issue depending on the exact nature of the digital currency, and whether the currency is fungible and traded on different exchanges that have different pricing. Valuation also may be an issue if it is determined that there is no public market or exchange for the instrument. Taxation of the gains on these instruments may also change in the future (right now, they presumably are taxed under IRC Section 988). Additionally, there may be capacity constraints as a large number of investors begin to pile into these investments, including when the derivatives markets take hold.

Conclusion

We have worked with a number of groups in this space over the past two years, and have seen an uptick in interest in managing a private fund to invest in Bitcoin and digital currencies. We believe the interest stems from the strong returns of Bitcoin, as well as the public’s growing acceptance of alternative currencies. We also think that a general increase in exposure of Bitcoin has contributed to an interest in being able to invest in digital currencies. As these investments become more standardized and regulated, we believe we will continue to see growth in this area.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon has been instrumental in structuring the launches of some of the first digital currency-focused hedge funds. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.

Hedge Fund / Investment Adviser Updates for March 10, 2017

Happy Friday.  Below are some recent updates that we thought were relevant and/or interesting.  Please contact us if you have any questions on the below.

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IA Annual Update – a reminder to investment advisers that the annual ADV update will be due in 3 weeks.  If you have not already begun the process, you should start working with your fund attorney or compliance consultant to finish the update which is due by March 31, 2017.  Please see our earlier post on the IA update process for more information.

Cybersecurity watch for fund managers – the SEC recently sent a note out to EDGAR users about a phishing email scam.  Emails were purportedly sent from the SEC about changes to the Form 10-K; the emails in fact were part a phishing scam.  A reminder for all to be vigilant with inbound emails.  For the release from the SEC, please click here.

DOL Fiduciary Rule – whether the Department of Labor’s new fiduciary rule will be enacted has been subject to constant speculation since the election of President Trump.  Speculation continues in the wake of the March 2nd notice by the DOL asking for comments on whether to delay application of the rule by 60 days (the rule is/was supposed to be applicable as of April 10, 2017).  Interestingly enough, the request for comments on whether to delay the application of the rule comes from pressure from the current administration; as specifically noted by the DOL in the Federal Register:

The President by Memorandum to the Secretary of Labor, dated February 3, 2017, directed the Department of Labor to examine whether the final fiduciary rule may adversely affect the ability of Americans to gain access to retirement information and financial advice, and to prepare an updated economic and legal analysis concerning the likely impact of the final rule as part of that examination.

Comments on the proposal to delay the rule are due to the DOL by March 17, 2017.   Expect to see a number of stories on this topic over the next couple of weeks.  For more information, see the notice in the Federal Register.

Marijuana / Cannabis Hedge Funds – we recently wrote a post about the legal and operational issues for hedge fund managers in the cannabis space.  We think there will be a lot of stories about this sector in the next few months as the Trump administration sorts out whether and how to enforce federal prohibitions against marijuana.

Other items of interest – we think there will continue to be interesting stories that affect the investment management industry, especially with respect to regulations and taxes (we’re hoping for more news on tax cuts, instead of news related to “closing the carried interest loophole”).  Always of interest are discussions related to the decrease of hedge fund management and performance fees – I’m sure we’ll see more stories and anecdotes likes these.

Have a great weekend!

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP and focuses his legal practice on the investment management industry.  He can be reached directly at 415-868-5345.

Cannabis Hedge Funds

Overview of Private Fund Investment in the Marijuana Industry

After the elections of 2016, eight states and the District of Columbia have laws allowing for the recreational use of marijuana. Many other states have decriminalized the use of marijuana and most allow the use of medical marijuana. From the standpoint of the investment management industry, the expansion of the market for cannabis has created a new category of potential investments. Private investment funds that focus on this industry (so called marijuana or cannabis hedge funds) are still relatively rare but we anticipate that they are in the early stages of developing into a strong sector strategy moving forward. This post is designed to provide an overview of the structure and regulatory considerations for these vehicles.

Structural Considerations

In general, the structure of a cannabis hedge fund will be substantially the same as a standard hedge fund, with some minor items to keep in mind. Structurally, managers will focus on the type of strategy they will deploy, the investment terms for that strategy and whether to use offshore structures.

Hedge Funds or Private Equity Strategy. Each manager in the space will have their own idea of what would make an attractive investment in this space. If a manager is planning to make investments in companies that are publicly traded, then the fund structure will be the same as a traditional hedge fund (more liquidity, annual performance allocation). If a manager is interested in making investments directly into companies that are not publicly traded, then the fund structure will likely be private equity style (no liquidity, distributions only on disposition events). Many managers will find that their industry expertise will help them find attractive opportunities in both spaces and so these managers will most likely do some sort of combination structure—essentially a hedge fund with side pockets.

Fund Terms. Whichever structure is used, the terms are going to be substantially similar to other hedge funds and managers will need to determine what contribution schedule, redemption schedule, leverage amount, if any, and what other investment terms will work for their fund. Because of the industry focus, we’ve seen some groups form advisory boards. We’ve also seen groups who have decided to create SPV structures under the fund to facilitate direct investments, to navigate the regulatory landscape, or to create greater shields from liability.

Onshore / Offshore Structures. Whether to use an offshore structure will be determined mostly by the jurisdiction of investors in the fund. Like a normal private fund, if there are no offshore investors, then a standard domestic fund will usually be sufficient; if there will be offshore investors or if manager intends to use leverage and have IRA or 401k investors, an offshore structure will normally be utilized. If an offshore structure is used, the choice will generally be between the mini-master structure  and the master-feeder structure. In general, the manager will not want to create a standalone offshore structure if they are doing PE-style investments because of the likelihood that such investment would be deemed to be involved in a US trade or business, subject to additional tax planning. In addition to structure, managers will need to decide on offshore counsel and many managers will engage independent directors.  These items will be discussed with counsel during the formation process.

Regulatory and Other Considerations for Marijuana Fund Managers

While structuring of the fund and drafting of the fund documents will be fairly straightforward, there are some other operational issues for cannabis fund managers to keep in mind.

Regulation of Management Company. Like a normal hedge or PE fund manager, the management company to a cannabis fund would be deemed to be an investment adviser because the manager would receive compensation for providing advice regarding investment in securities. As any normal investment adviser, the manager would need to determine whether to register under the state or SEC regimes or whether the manager could utilize an exemption from registration.

Federal Legal Issues. There are two federal laws that impact investment managers in the cannabis industry:

Controlled Substances Act (CSA) – Notwithstanding minor federal action to the contrary (i.e. the “Cole Memos”), marijuana is still deemed to be a Schedule 1 controlled substance under federal law. While unlikely, it is possible that marijuana businesses abiding by state law could be subject to federal action with respect to the manufacturing and dispensing of the product. [Note: the above was accurate during the Obama administration; the Trump administration has indicated that federal action may occur.] Federal sanctions under the CSA are harsh and include jail time and fines.

Bank Secrecy Act (BSA) – Perhaps a bigger issue for the cannabis industry are the issues that arise under the BSA. The BSA provides a framework that banks must follow with respect to certain suspicious activity. Because marijuana is still classified as a Schedule 1 controlled substance, banks are technically required to report the activity of their clients in the cannabis industry to the U.S. Treasury. This sort of red tape, and the potential for liability to the bank for helping to facilitate this activity, makes banks less likely to deal with groups in this space. Although fund managers are a step removed from any growing or selling operations, we have generally found that managers will need to spend time finding a bank that is comfortable with the potential risks of holding the fund’s cash. Ultimately as the industry grows and federal law loosens (if they do), we believe the banking industry will come around. We have recently heard of groups who are trying to work on a bitcoin-type payment system for the cannabis industry.

State Laws. For states that now allow the recreational use of marijuana, there generally are a number of laws and regulations that both operating companies and fund managers must keep in mind. The laws and regulations will generally be implemented by a state regulatory body that will have the power to determine the manner in which leaf-based products (including seeds) are brought to market. Non-leaf based products (such as paraphernalia) generally will be subject to lesser or no scrutiny under state law.

Investment Size. Many private companies in the industry are new and subject to the same kinds of operational risks that apply to businesses in other industries. Additionally, these private companies are small and not yet able to deploy capital from large equity investments. In this way, fund projects tend to be on the smaller side because of capital constraints.

Service Providers. Some groups, especially audit firms, may be reticent to provide services to groups who focus on investments into this sector. As mentioned above, banking may be also be an issue for managers in this space. Some groups also may decide that there are specific issues they need to discuss with cannabis legal counsel.

Valuation. As with any private investment fund that deals with investments into non-publicly traded securities, a cannabis fund with investments in private companies may have to deal with valuation issues of the investments. To a certain degree, many issues can be side-stepped if the manager institutes side pockets, but this will be an area where the manager will want to discuss options with fund counsel as well as fund accountants and auditors.

Conclusion

The marijuana/cannabis industry undoubtedly will become huge over time as more states allow recreational use of marijuana. Although currently still in its infancy, the cannabis industry is poised for significant growth and eventually capital will flow towards managers who focus on this space. While we would have predicted that there would be significantly more private funds focused on this area by now, we anticipate that this will be a strong and growing sector over the coming years as more states legalize the recreational use of the drug and the infrastructure around both companies and assets managers in this space becomes more institutionalized.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP and helped establish one of the first cannabis-focused hedge funds. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.

IA Annual Form ADV Update for 2017

Investment Adviser Registration Update Due March 31

Under SEC and state regulations, registered investment advisers and exempt reporting advisers (“ERAs”) must file an annual amendment to Form ADV within 90 days of the end of its fiscal year. For most firms this means that the annual updating amendment is due by March 31, 2017.

Process and Major ADV Update Items

The annual update can be completed through the IARD system either (i) internally by the firm’s CCO or (ii) externally by a firm’s compliance consultant or fund attorney. The process generally will entail a review of the current Form ADV, and Form ADV Part 2 if applicable, to make sure that all information is up to date and accurate. In general, once the review process has begun, the update can be completed in a few days depending on the complexity of firm’s operations and the capacity of the updater to make changes in the system. For many firms whose operations have not changed throughout the year, the update should be fairly straight forward – for private fund managers in this situation, the focus mostly will be on the Schedule D, Item 7.B.(1) items (Private Fund Reporting) which include updates to the following items for each fund:

  • Gross asset value of the private fund as of 12/31/16 (essentially RAUM of the fund, described below)
  • Total number of investors
  • % of the fund owned by the advisor and/or its related persons
  • % of the fund that is owned by fund of funds
  • % of the fund that is owned by non-US persons

Private Fund RAUM

The SEC has defined regulatory assets under management (“RAUM”) in Item 5b of the Form ADV instructions (see Form ADV and Filing Instructions for more information).  Generally, RAUM should include the securities portfolios for which a manager provides continuous and regular supervisory or management services as of the date of filing or update of the Form ADV. Unlike AUM, the RAUM calculation requires managers to report assets managed without the deduction of any outstanding indebtedness or other accrued but unpaid liabilities (including accrued fees or expenses) that remain in a client’s account. A fund manager’s RAUM may be higher than its normally reported AUM because it includes:

  • Cash and cash equivalents (i.e., bank deposits, certificates of deposit, bankers acceptances, and similar bank instruments)
  • Long and short positions (on a gross basis)
  • Leverage
  • Margin
  • Family or proprietary accounts
  • Accounts for which the manager receives no compensation for its services
  • Accounts of clients who are not United States persons

RAUM should be calculated based on the current market value of the assets as determined within 90 days prior to the date of filing the Form ADV.  For private funds, the SEC has stated that a manager may rely on the gross assets as reflected on the fund’s balance sheet, and the manager may assess the value of financial instruments under the applicable accounting standards, which is GAAP in this industry.  We urge managers to reach out to their accounting firm if they are unsure about the treatment of any financial instruments for purposes of the RAUM calculation.

Other Items

While it is important to make sure all parts of the Form ADV are accurate and complete, special attention should also be paid to the Part 2 brochures. Some firms also take this opportunity to review their compliance program but given this update requirement and the audit deadline for pooled investment vehicles, the annual compliance review will often be pushed back until later in the year.  While we are quickly coming up to March 31, there is still plenty of time to complete the update and private fund managers should reach out to us if they would like our assistance preparing the amendment for this year.

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Bart Mallon provides investment adviser registration and compliance services to investment advisers and private fund managers through Cole-Frieman & Mallon LLP.   Mr. Mallon can be reached directly at 415-868-5345.