Cole-Frieman & Mallon 2019 Third Quarter Update

Below is our quarterly newsletter. If you would like to be added to our distribution list, please contact us.

Clients, Friends, Associates:

We hope you had an enjoyable summer. Typically, the third quarter is quieter than the second quarter from a compliance perspective, however we continue to see meaningful enforcement actions taken by regulatory authorities and rapid developments in the digital asset space. Entering the fourth quarter, we would like to highlight some items we hope will help you stay on top of the business and regulatory landscape in the coming months.  But first, a couple of items of firm news:

  • CoinAlts Fund Symposium. In September, In September, founding sponsor CFM broke new ground to host its fourth successful Symposium in Chicago. An impressive line-up of speakers addressed pressing issues for institutions in the digital asset ecosystem, including legal and operational concerns for fund managers, recent trends and innovations in blockchain, and raising capital from institutional allocators.
    • Cole-Frieman & Mallon’s Anniversary. On September 17th CFM celebrated with family, friends, colleagues and clients 10 years of successful growth to become the largest hedge fund practice in the West Coast. We very much appreciate the continued support from our clients and friends in the industry and look forward to the next decade of success.

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Privacy Regulations

Cayman Islands Data Protection Law Effective September 30, 2019. The Cayman Islands Data Protection Law, 2017 (“DPL”) became effective on September 30, 2019 and applies to all investment advisers providing investment advice to Cayman Islands funds. Under the DPL, Cayman investment funds are considered “data controllers” whether or not they are registered with the Cayman Islands Monetary Authority and investment advisers to such funds are considered “data processors.” The DPL requires data controllers to update their Cayman fund’s subscription agreements to include language specific to the DPL and otherwise provide investors with an updated DPL-compliant privacy notice. There is no specific deadline to provide investors with such privacy notice. Fund administrators must also ensure that they are DPL-compliant and updates to the fund’s administration agreement may be required.

California Consumer Privacy Act to be Effective January 1, 2020. The California Consumer Privacy Act (the “Act”) was passed into California law on June 28, 2018 and will be effective on January 1, 2020. The Act will not apply to most fund managers and will generally only impact managers that serve California residents and have at least $25 million in annual gross revenue, have personal data on at least 50,000 Californians, or receive over half their revenues from the sale of personal data of California residents. The Act does not apply to current client data and, on October 11, 2019, Governor Newsom signed seven amendments into law that generally limit the Act’s reach even further. If the Act were to apply to a fund manager, to be in compliance, such fund manager should post a privacy policy on its website disclosing its collection of personal information, maintain an organized data collection process, and provide investors information regarding the use of their information and the right to opt-out of the sale and request the deletion of such information.

New York SHIELD Act Heightens the State’s Privacy Regulations. On July 25, 2019, the Stop Hacks and Improve Electronic Data Security Act (the “SHIELD Act”) was signed into New York law and amends the State’s data breach notification law. The SHIELD Act, which is set to take effect in March 2020, requires certain businesses or individuals implement safeguards to protect the security, confidentiality and integrity of information. The SHIELD Act broadens the definition of “private information” to include credit card or debit card numbers, usernames and passwords (or security questions and answers) used to access an individual’s online accounts, and biometric information, like fingerprints. The SHIELD Act also expands the definition of “breach”, from unauthorized acquisition of private information to include unauthorized access to private information, as well as the scope of the breach notification requirement to include any person or business that owns or licenses private information of a New York resident. This means the law is no longer limited to those conducting business in New York, but could affect managers who, for example, only store a New York investor’s private information. Because of the broad scope of the SHIELD Act, managers who own private information of a New York resident should review the updated security requirements the Act imposes on them, including the need to implement a data security program, as more specifically discussed in the SHIELD Act.

SEC Matters

SEC Publishes Risk Alert on Principal and Agency Cross Trading Compliance Issues. On September 4, 2019, the Securities and Exchange Commission (“SEC”) published a Risk Alert advising readers on common compliance issues identified in investment adviser examinations, related to principal and agency cross transactions under Section 206(3) of the Investment Advisers Act of 1940, as amended (the “Advisers Act”). These transactions occur when investment advisers execute client transactions as a broker or dealer, either acting as a broker or dealer for its advisory client or doing so for both its advisory client and its brokerage client on the other end of the same transaction. The examinations the SEC conducted showed advisers either did not know they had engaged in principal trades or did not disclose or obtain the required consent before completing the transactions. With respect to agency cross transactions, the examinations also showed advisers often engaged in agency cross transactions without properly disclosing this to clients or could not show proof they had complied with the applicable consent or disclosure requirements. The Risk Alert also expressed concern that many advisers engaging in these transactions either did not have proper compliance policies and procedures or failed to follow the policies and procedures that had been established. Advisers should look closely at potential transactions to determine whether they qualify as either principal trades or agency cross transactions and if so, what actions need to be taken to comply with the respective requirements.

SEC Charged RIA for Nondisclosure of Conflicts Arising from Revenue Sharing. On August 1, 2019, the SEC  charged an SEC RIA for failure to disclose conflicts of interest relating to a revenue sharing agreement with the broker used by most of its clients. The revenue sharing agreement provided that, if the adviser invested its client assets in certain classes of mutual funds that paid the broker to be listed on its platform, the adviser would receive a portion of those payments. The adviser received over $100 million from the broker from July 2014 to December 2018 because of this arrangement. However, the adviser never disclosed to its clients that there were other mutual fund investments less expensive than the investments subject to the revenue sharing agreement. The SEC considered these to be material omissions and determined the adviser’s clients did not make these investments with full knowledge of the adviser’s incentives. Fund managers should ensure that all pertinent conflicts of interest, including those related to the receipt of compensation from third parties, are properly disclosed to their clients.

FINRA Matters

FINRA Proposes Changes to Restricted Person and Spinning Provisions.  On July 26, 2019, FINRA, along with the SEC, proposed certain amendments to FINRA Rules 5130 and 5131. One of the amendments would exempt certain additional persons and certain types of offerings from the scope of the rules. Among other changes (eight total), the proposals would (i) include the definitions of “family member” and “family client” as defined under the Advisers Act in the definition of “family investment vehicle” under Rule 5130, (ii) exempt foreign employee retirement benefit plans that meet certain conditions from Rules 5130 and 5131 and (iii) exclude unaffiliated charitable organizations from the definition of “covered non-public company” in Rule 5131. If these changes are approved and become effective, fund managers can expect further regulatory consistency and clarity to result.

Digital Asset Matters

Bakkt Announces that it’s “Cleared to Launch” Bitcoin Futures. Bakkt, a bitcoin futures exchange and digital assets platform founded by the Intercontinental Exchange (“ICE”), announced in mid-August that the CFTC gave its go-ahead for Bakkt’s futures contracts. The announcement discussed that Bakkt’s bitcoin futures would be exchange-traded on ICE Futures U.S. and cleared on ICE Clear US, both of which are regulated by the CFTC. Bakkt further announced that it acquired a New York state trust charter through the New York State Department of Financial Services, and that this approval to create Bakkt Trust Company, a qualified custodian, would allow the Bakkt Warehouse, which is part of Bakkt Trust Company, to provide bitcoin custodial services for physically delivered futures. On September 23, 2019, Bakkt launched its custody and physically-settled bitcoin futures contracts products. Many disagree whether the launch, which had a trade volume during the first seven days of $5.8 million, was successful or not, and certain researchers speculate the launch was partially why bitcoin’s price has recently decreased. Despite this, the news of the launch can potentially benefit fund managers as Bakkt aims to provide access to this market and address issues that have slowed institutional participation in this market in the past.

SEC Delays Decision on Three Bitcoin ETFs. On August 12, 2019, the SEC once again delayed a decision on three bitcoin ETF proposals.  As of yet, the SEC has not approved a bitcoin ETF. In previous decisions, the SEC expressed concerns with market manipulation, market surveillance and a possible divergence with futures trading. One of the entities proposing a bitcoin ETF published reports addressing these concerns and indicating that the actual bitcoin market is more regulated and surveilled than expected. This ETF proposal received support from a number of well-known individuals in the industry. In fact, Cole-Frieman & Mallon submitted a comment to the SEC with respect to this ETF proposal in June. Unfortunately, on October 9, 2019, this ETF proposal was rejected as the proposal reportedly did not meet the legal requirements necessary to prevent market manipulation or other fraudulent activities. As another of the entities proposing a bitcoin ETF recently withdrew its proposal from SEC review, there remains only one bitcoin ETF proposal sitting before the SEC. Fund managers interested in the digital asset space should stay apprised of future developments regarding this ETF proposal and others that may follow.

FINRA Approves Membership of Placement Agent for Privately Placed Digital Securities. On August 7, 2019, FINRA approved the membership application of a placement agent for privately placed, digital securities on a permissioned blockchain platform developed by its parent company. It took the placement agent 18 months to get approved, which is longer than what is typically seen, as it had to prove to FINRA that it met regulatory requirements. The approval allows the placement agent to issue securities, provide services as a broker for digital securities, and potentially enter the secondary trading business. This approval stands out as many applications have been waiting to hear back from FINRA for months, and sometimes more than a year. Specifically, this approval will expand investment opportunities for investors and provide fund managers with a streamlined tool to utilize in its investment processes.

SEC Freezes $8 Million in Assets Related to Fraudulent Scheme to Sell Digital Securities to Investors. On August 12, 2019, the SEC froze $8 million in assets raised by an individual and two companies he owns. Allegedly, the parties sold their own token on the internet and induced investors to invest in the token based on material misrepresentations and omissions. The complaint also alleged that the individual manipulated the token price and transferred a significant amount of investor assets to his own personal account. The SEC charged the parties with violating the registration and antifraud provisions of the Federal securities laws and further charged the individual for violating antifraud provisions by manipulating the price of tokens. While this digital asset age has certainly shown promise and innovation, fund managers should be on alert for fraudulent schemes such as this.

SEC Charges Group Operating Unregistered Digital Asset Exchange. On August 29, 2019, the SEC settled charges with a company and its founders who created and sold unregistered tokens to more than 13,000 investors. The founders allegedly falsely claimed each token provided an interest in the company’s cryptocurrency mining facility using below-market rate electricity. In reality, the mining facility did not exist. The company and its founders also allegedly illegally operated an unregistered national security exchange to trade the single token. As new and exciting opportunities in the digital asset space continue to emerge, investors should proceed with caution and should conduct ample due diligence prior to moving forward with such opportunities.

IRS Targets Cryptocurrency Investors with Educational Letter about Back Taxes. In July, the IRS began sending educational letters to taxpayers who have purchased or sold cryptocurrencies but either did not report the income entirely or did not report the income correctly. There are three variations of this letter that more than 10,000 taxpayers will receive, depending on how or if the transactions were reported: Letter 6173, 6174 and 6174-A. In mid-August, the IRS began sending a second round of letters to relevant taxpayers. This notice, which the IRS calls CP2000, is aimed at taxpayers that the IRS has actual records of, showing that there is a discrepancy between the trading profits or losses reported by the taxpayer and what third parties (like exchanges) report to the IRS. The notice includes an amount that each recipient taxpayer is expected to pay in 30 days, with interest. Taxpayers trading cryptocurrency can expect the IRS to ramp up these types of letters and notices and should properly report their transactions to the IRS when filing tax returns to avoid penalties.

SEC Approves First-Ever Reg A+ Token Offering. On July 12, 2019, Blockstack became the first company in history to receive SEC approval for a public securities offering where investors would receive tokens, in this case, called “Stacks”. Blockstack raised a total of $23 million from more than 4,500 investors. $15.5 million was raised through a Reg A+ sale in the United States and the other $7.6 million was raised through a Reg S offering in Asia. Blockstack is working with international exchanges to list Stacks tokens potentially as soon as October 2019. While the full effects of this approval are not yet determined, the SEC’s approval has potential to create a new regulatory roadmap for public token offerings.

FINRA and SEC Issue Joint Statement on Custody of Digital Assets by Broker-Dealers. On July 8, 2019, FINRA and the SEC issued a statement expressing the challenges facing broker-dealer’s custody of digital assets. The statement discussed that a broker-dealer seeking to custody such assets must, like all broker-dealers, comply with the SEC’s Customer Protection Rule. This rule protects customer securities and funds held by broker-dealers by requiring broker-dealers to keep customer assets separate from their firm’s assets, making it more likely that customers’ securities and assets can be returned to them in the case of a broker-dealer’s failure. Many unregistered entities and registered broker-dealers that want to engage in activities involving digital asset securities have been submitting applications to FINRA in the hope that FINRA will allow them to engage in such activities. How these entities could custody digital asset securities while complying with the Customer Protection Rule is still under discussion, but as a start, broker-dealers would need to put in place significant technological enhancements unique to digital asset securities.

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Compliance Calendar.

Please note the following important dates as you plan your regulatory compliance timeline for the coming months:

Deadline Filing
October 10, 2019 Form 13H amendment due if there were changes during Q3
October 15, 2019 Quarterly Form PF due for Large Liquidity Fund Advisers
October 15, 2019 Extended deadline to file Reports of Foreign Bank and Financial Accounts (FBAR)
October 30, 2019 Registered investment advisers must collect access persons’ personal securities transactions
November 1, 2019 Registered investment advisers that seek to withdraw registration with the SEC may begin to submit Form ADV-W‘s, which must be dated 12/31/19
November 11, 2019 Firm may view, print and pay preliminary notice filings (RIA) with all appropriate states
November 14, 2019 Form 13F is due for certain institutional investment managers
November 14, 2019 Form PR filings for registered CTAs that msut file for Q3 within 45 days of the end of Q3 2019
November 29, 2019 Form PF filings for Large Hedge Fund Advisers with December 31 fiscal year-ends filing
November 29, 2019 Large registered CPOs must submit a pool quarterly report (CPO-PQR)
December 16, 2019 Deadline for paying annual IARD charges and state renewal fees
December 31, 2019 Small and mid-sized registered CPOs must submit a pool quarterly report (CPO-PQR)
December 31, 2019 Cayman funds regulated by CIMA that intend to de-register (i.e. wind down or continue as an exempted fund) should do so before this date in order to avoid 2020 CIMA fees
January 1, 2020 California Consumer Privacy Act goes into effect
Periodic Fund managers should perform “Bad Actor” certifications annually
Periodic Amendment due on or before anniversary date of prior Form D and blue sky filing(s), as applicable, or for material changes
Periodic CPO/CTA Annual Questionnaires must be submitted annually, and promptly upon material information changes

 

Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP.  Mr. Mallon can be reached directly at 415-868-5345.

Cole-Frieman & Mallon 2019 Second Quarter Update

Below is our quarterly newsletter. If you would like to be added to our distribution list, please contact us.

Clients, Friends, Associates:

We hope you are enjoying the start of summer.  Typically the second quarter is quieter than the first quarter from a compliance perspective, however we continue to see meaningful enforcement actions taken by regulatory authorities and rapid developments in the digital asset space.  Entering the third quarter, we would like to highlight some items we hope will help you stay on top of the business and regulatory landscape in the coming months.

First, though, we’d like to announce a few exciting updates regarding Cole-Frieman & Mallon LLP. Scott E. Kitchens has joined the firm as a partner and will be leading the firm’s new Denver office.  Our firm is once again a founding sponsor of the quickly approaching CoinAlts Fund Symposium. The event will be held in Chicago on September 26th and the founding sponsors will be hosting a pre-conference cocktail hour in Chicago on July 18th.  We look forward to seeing many of you there.

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SEC Matters

SEC Adopts New Regulation Best Interest.  On June 5, 2019, the SEC adopted a package of rules and interpretations to bring a new level of transparency between retail investors, investment advisers and broker-dealers, including the new Regulation Best Interest rule and the Form CRS Relationship Summary.  The new Regulation Best Interest requires broker-dealers to act in the “best interest of retail customers when making a recommendation,” whereas previously broker-dealers were only required to recommend “suitable” investments. Broker-dealers are also required to establish and enforce policies designed to comply with this rule.  The Form CRS Relationship Summary, which will become the new Form ADV Part 3, will require RIAs to provide retail investors with “easy-to-understand information about the nature of their relationship with their financial professional,” including information on services, fees, conflicts, their legal standard of conduct, and prior disciplinary history.  The Form CRS, will be a standardized question-and-answer format and must be presented to retail investors at the beginning of their relationship.  The rules are effective 60 days after their publication in the Federal Register, however broker-dealers and investment advisers are given until June 30, 2020 to ensure compliance.

Individual Liable Under Rule 10b-5 for Knowingly Disseminating False or Misleading Statements Made by Another Person.  On March 27, 2019, the Supreme Court ruled that an individual violated Rule 10b-5 by disseminating statements he knew to be false to potential investors, even though he didn’t “make” the statements himself.  The individual sent an email to potential investors stating the assets of a company seeking investment was $10 million at the direction of his boss, who supplied the content and approved the email, while the individual knew the total assets were worth less than $400,000.  The case may result in an expansion of personal liability for those who transmit false or misleading statements that were made by another.  Managers should ensure that their supervised persons are not repeating false statements even if those statements were made by a superior.

SEC’s Office of Compliance Inspections and Examinations (“OCIE”) Issues Risk Alert.  On May 23, 2019, the OCIE issued a risk alert regarding the safeguarding of customer records and information network storage.  The OCIE observed that many firms did not always use their storage solution’s security features to prevent unauthorized access, including failing to use encryption or password protection.  The OCIE identified the following concerns that may give rise to compliance issues: (i) misconfigured network storage solutions; (ii) inadequate oversight of vendor-provided network storage solutions; and (iii) insufficient data classification policies and procedures. The OCIE encourages registered broker-dealers and investment advisers to evaluate their storage of customer information and consider whether security improvements are necessary.

RIA Settles with SEC for $5 Million for Failing to Implement Compliance Policies Reasonably Designed to Prevent Inaccurate Valuations.  On June 4, 2019, the SEC settled charges and instituted cease-and-desist proceedings against an RIA for failing to adopt compliance policies reasonably designed to prevent the risk that its traders were undervaluing securities by failing to maximize relevant observable inputs, such as trade prices. The RIA’s traders were accused of intentionally marking their bond prices below market value to maximize yield and allow them to sell for a profit when needed, in violation of GAAP.  While the RIA did not admit fault, the SEC alleged that the firm’s policies failed to address how their valuations would be conformed with GAAP, and further, that the adviser failed to implement its existing policy.  The SEC stressed the importance of valuation of client assets in the administrative proceeding, calling it “critically important.”

SEC Imposes Cease-And-Desist Order and Remedial Sanctions Against an RIA for “Cherry-Picking” Trades and Misusing Soft-Dollars.  On May 16, 2019, the SEC imposed a cease-and-desist order and remedial sanctions against an RIA for “cherry-picking” trades and misusing soft-dollars.  The RIA disproportionally allocated profitable trades to hedge funds of which the RIA’s portfolio manager was personally invested, while allocating less profitable trades to other clients, including a charitable foundation.  Further, the RIA allegedly used soft-dollar credits in a manner not disclosed to clients, including use in a principal’s divorce settlement, rent paid to a principal owned company, and maintenance fees on a principal’s personal timeshare.  In addition to disgorgement for both the RIA and portfolio manager, the portfolio manager has been banned from the industry.  This case is a reminder for investment advisers to only use soft-dollar credit to pay for disclosed expenses.

SEC Charges RIA Firm and COO for Cross Trades that Defrauded Client.  On March 15, 2019, the SEC charged a fund manager (an RIA) and its chief operating officer with breaching its fiduciary duties, including the obligation to seek the maximum price for an asset to be sold.  The RIA solicited two unwilling buyers to participate in a real estate auction under the promise that they would not win in order to artificially depress the price and allow a second private fund managed by the RIA to purchase it at a discount.  The RIA later resold the asset from the second private fund for a significant profit and received associated performance fees.  With the SEC’s continued focus on cross trades, fund managers should ensure their cross trade policies effectively identify and manage conflicts of interest.

SEC Proposals to Address Cross-Border Application of Security-Based Swap Requirements.  On May 10, 2019, the SEC proposed a series of rule amendments and guidance with the intention of improving the regulatory framework governing cross-border security-based swaps.  The proposals address the application of security-based swap transaction requirements to non-U.S. entities with U.S. personnel involved in “arranging, negotiating or executing the swaps,” and is intended to align the SEC’s regulatory regime with that of the Commodity Futures Trading Commission.  The SEC sought public comment on the proposed amendments and guidance, with comments due July 2, 2019.

CFTC Matters 

CFTC Approves Final Rule to Provide Exception to Annual Privacy Notice Requirement.  On April 25, 2019, the CFTC approved a final rule to remove the requirement that commodity pool operators and commodity trading advisers, among others, provide annual privacy policy notices to customers when certain conditions are met.  The new rule provides an exception to such annual notice when a financial institution (i) does not share nonpublic personal information except in accordance with certain exceptions adopted by the CFTC and (ii) has not changed its policies and practices with regard to disclosing nonpublic personal information from those policies and practices that the institution most recently disclosed.

CFTC Publishes Public Enforcement Manual.  On May 8, 2019, the CFTC’s Division of Enforcement published its Enforcement Manual for the first time, providing clarity on the CFTC’s investigations and pursuit of violations processes.  In addition to increasing predictability of CFTC enforcement actions, the guide underscores the CFTC’s intention to incentivize self-reporting and cooperation, noting that the value of cooperation with the CFTC will be considered in deciding what charges and sanctions to impose and whether an individual or entity is eligible for a non-prosecution agreement or deferred prosecution agreement. The manual also provides a summary of prohibited conduct subject to investigation, which in addition to traditional enforcement action such as fraud, includes misappropriation of material non-public information and disruptive trading practices. The Enforcement Manual promises to provide meaningful information to advisers who suspect they may have committed a violation.

FINRA Matters 

FINRA Begins Effort to Simplify Firms’ Digital Experience.  On May 14, 2019, FINRA announced the launching of its Digital Experience Transformation, with the goal of simplifying digital interactions between firms and FINRA to create more efficient and effective compliance programs. The transformation is set to be implemented in stages through 2022, focusing on six solution areas identified as priorities by FINRA member firms, including enhanced interaction with FINRA staff and a simplified experience for users.

FINRA Introduces Peer-2-Peer Compliance Library.  FINRA launched its Peer-2-Peer Compliance Library providing a resource for member firms in locating templates, checklists and other materials to supplement FINRA provided materials. The library includes documents provided by FINRA registered firms on six compliance topics: (i) Customer Information, (ii) Cybersecurity, (iii) New Product Review, (iv) Outside Business Activities, (v) Outsourcing & Vendor Management, and (vi) Supervision.  The Library promises to be a useful resource for FINRA registered firms.

Digital Asset Matters

SEC Delays Decision on Two Bitcoin ETFs.  On May 14 and May 20, 2019, the SEC again delayed a decision on two bitcoin ETFs.  The SEC has yet to approve a bitcoin ETF, and is again seeking public comment on the ETF proposals.  The SEC will ultimately need to make a final decision by mid-October.  Cole-Frieman & Mallon LLP submitted a comment in support of approval, arguing it is in the best interest of the bitcoin market that the ETF be approved as it will allow the continued expansion of the digital asset industry and the related ecosystems.

SEC Publishes First Framework in Determining if an ICO Constitutes a Security.  On April 3, 2019, the SEC published its first framework for analyzing whether U.S. securities laws apply to an initial coin offering.  The SEC has confirmed their view that the Howey test should be used to determine if an “investment contract” exists with respect to the sale of a digital asset, thus requiring the sale to either be registered or qualify for an exemption from registration.  The framework gives insight on each of the prongs of the Howey test, which states that an “investment contract exists when there is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.”  The framework gives examples of several characteristics that are indicative of an investment contract, which promises to provide helpful guidance for those seeking to raise funds through an initial coin offering.

SEC Publishes First No-Action Letter for Cryptocurrency Token Sale. On April 3, 2019, the SEC published the first no-action letter for the offer and sale of tokens by a jet leasing business.  The SEC stated that their no-action position was based on (i) the tokens being fully operational at the time of sale, (ii) the business selling the tokens for $1 each and redeeming each token for $1 of air charter services per token with the business only repurchasing tokens at a discount to face value, and (iii) the restriction on transfer of the tokens to external wallets.  Taken together, the SEC appears to have been satisfied that any purchase of the token would not be for investment purposes.

SEC Sues Online Messaging Application for Conducting $100 Million Unregistered Securities Offering of Digital Tokens.  On June 4, 2019, the SEC sued a Canadian company running a messaging app with conducting an illegal securities offering for raising over $100 million through an initial coin offering without registering the offer and sale as required under securities law.  The complaint alleges that the company advertised the tokens as an investment opportunity and promised to work to promote demand of the token through company efforts, including incorporating the tokens on their messaging app. This case underscores the importance of complying with securities laws when attempting to raise money through coin offerings, as the SEC will seek to enforce such laws if they deem the ICO a securities offering.

IRS Commissioner Announces Cryptocurrency Tax Guidance to be Released Soon.  On May 30, 2019, IRS Commissioner Charles Rettig stated in a letter to congressman Tom Emmer that cryptocurrency tax guidance is a priority of the IRS and should be released “soon.” The Commissioner stated that the IRS is considering several issues, including: (i) acceptable methods for calculating cost basis; (ii) acceptable methods of cost basis assignment; and (iii) tax treatment of forks.  Guidance promises to be welcome by crypto investors as the IRS last issued guidance in 2014, which left several key questions unanswered.  The cryptocurrency market has also seen itself become increasingly complicated since that time with the emergence of forks, airdrops and staking.

SEC Hosts Public Forum to Discuss Distributed Ledger Technology and Digital Assets.  The SEC held a public forum to discuss digital assets on May 31, 2019.  As the second forum on digital assets held by the SEC, it aimed to facilitate greater communication on digital assets between industry, academia, and regulators.  SEC staff moderated panels with fintech insiders covering capital formations, trading and markets, investment management, and distributed ledger technology industry trends.  The SEC also announced at the forum a new program for visiting scholars, seeking qualified professors or PhDs with expertise in blockchain to assists the SEC for one year with their oversight and regulatory processes.  The forum is available to view online.

FinCEN Takes First Enforcement Action Against a Virtual Currency Exchanger.  On April 18, 2019, the Financial Crimes Enforcement Network (“FinCEN”) assessed a $35,350 penalty against a peer-to-peer exchanger of bitcoin for the willful violation of the Bank Secrecy Act’s registration and reporting requirements.  FinCEN found the exchanger was not merely a “user” of virtual currency, but a “money transmitter,” and thus was required to register as a money services business and comply with regulatory requirements applicable to them, including having an effective written AML program, filing SARs on transactions they “know, suspect, or have reason to suspect” are suspicious, and filing currency transaction reports on transactions over $10,000.  Exchangers of virtual currency must be aware they are considered money transmitters and must comply with the Bank Secrecy Act’s regulations or risk monetary penalties and a ban from the industry by FinCEN.  FinCEN has indicated that they will continue to seek enforcement action against exchangers who fail to register as money services businesses.

CFM Summarizes Blockstack Regulation A+ Offering.  We have provided a summary of Blockstack’s Regulation A+ “Tier 2” offering to the SEC.  While Regulation A+ has previously been discussed as a potential avenue for blockchain groups to raise capital, it had been untested until now.  The post summarizes many of the legal and regulatory aspects of Blockstack’s offering, and also highlights interesting business aspects that were revealed.  As Blockstack’s offering was just “qualified” by the SEC, their offering circular promises to work as a guide for future blockchain token projects seeking to raise capital through Regulation A+.

Offshore Matters 

Cayman Islands Announce No Penalties for Delayed Filings.  On April 9, 2019, Cayman Islands announced that while the deadline for Cayman Financial Institutions’ to satisfy their CRS/FATCA reporting obligations was May 31, 2019.  Financial Institutions that report by July 31, 2019 will not be subject to enforcement measures or penalties.

Bermuda Proposes Legislation Exempting Non-Tax Residents from Economic Substance Requirements.  On June 28, 2019, Bermuda’s Economic Substance Amendment Act 2019 became law.  The Amendment creates an exemption from Economic Substance requirements for ‘non-resident entities,’ which is an entity which is a resident for tax purposes in a jurisdiction outside Bermuda, not including those countries in Annex 1 to the EU list of non-cooperative jurisdiction (the so called “black list”).  The change brings Bermuda’s regulations in line with the regulations of the British Virgin Islands and the Cayman Islands, both of which exclude non-resident entities from their substance requirements.

Other Matters 

IRS Issues Qualified Opportunity Fund Guidance.  On April 17, 2019, the IRS issued additional guidance for the deferral of capital gains through investment in qualified opportunity funds.  Crucially, the IRS clarified the “substantially all” requirement for the holding period and use of tangible business property.  Under the regulations, property can qualify as “qualified opportunity zone business property” if substantially all of the use of the property is in a qualified opportunity zone for substantially all of the qualified opportunity fund’s holding period of such property.  The IRS has clarified that the threshold for “substantially all” is (i) 70% with respect to the use of the property; and (ii) 90% with respect to the qualified opportunity fund’s holding period of such property.

IRS Issues Proposed Regulations for Determining Global Intangible Low-Taxed Income.  On  June 14, 2019, the IRS published proposed regulations that provide taxpayers with guidance for determining the amount of global intangible low-taxed income (“GILTI”) to include in gross income.  Importantly for fund managers, the proposed regulations change how the GILTI regime applies to domestic partnerships, adopting an aggregate approach where GILTI is computed at the partner level rather than the entity level.  As the regulations are retroactive to 2018, fund managers who paid GILTI should discuss with their tax advisers if filing an amended tax return is advisable.

Legislature Presented with Two Bills Reforming Cannabis Banking.  Two bills are being considered by Congress that attempt to provide cannabis-related businesses and service providers with access to the banking and financial markets. On March 28, 2019, the House of Representatives Financial Services Committee approved the Secure and Fair Enforcement Banking Act (“SAFE Act”), which would prohibit federal banking and financial regulators and law enforcement from taking action against institutions solely because they provide financial services to cannabis-related businesses and also excludes legitimate cannabis related business from being deemed proceeds from unlawful activity under anti-money laundering laws. On April 4, 2019, the Strengthening the Tenth Amendment Through Entrusting States Act (“STATES Act”) was re-introduced in both the House and the Senate.  The STATES Act would remove state-legal marijuana-related activity from the Controlled Substances Act, significantly restricting federal enforcement abilities of cannabis.  Both bills would significantly alter the cannabis industry, allowing them to access and interact with the economy in ways previously denied to them.

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Compliance Calendar.

 

Please note the following important dates as you plan your regulatory compliance timeline for the coming months:

Deadline Filing
June 29, 2019 Delivery of audited financial statements to investors (private fund managers to fund of funds, including SEC, State, and CFTC registrants)
June 30, 2019 Deadline for Cayman Island registered funds with a fiscal year end of December 31 to file the Fund Annual Return and audited financial statements with Cayman Islands Monetary Authority
June 30, 2019 Deadline for making available AIFMD annual report for funds in or advertising in the EU (Alternative Investment Funds with a financial year ending on December 31)
June 30, 2019 Review holdings to determine Form PF filing requirements
July 10, 2019 Review transactions and assess whether Form 13H needs to be amended
July 15, 2019 Quarterly Form PF due for large liquidity fund advisers
July 30, 2019 Quarterly account statements due (Commodity Pool Operators (“CPOs”) claiming the 4.7 exemption)
July 31, 2019 Cayman Islands CRS and US FATCA reporting deadline without adverse consequences (for those who missed the initial May 31, 2018 deadline)
August 14, 2019 Form 13F filing (advisers managing $100 million in 13F Securities)
August 14, 2019 CTA-PR filing with NFA
August 29, 2019 Quarterly Form PF due for large hedge fund advisers
August 29, 2019 CPO-PQR filing with NFA
September 30, 2019 Review transactions and assess whether Form 13H needs to be amended
September 30, 2019 Deadline to designate a MLRO, DMLRO, and AMLCO for Cayman Islands AML compliance
October 15, 2019 Quarterly Form PF due for large liquidity fund advisers
October 15, 2019 Annual Foreign Bank and Financial Accounts Report deadline (for those who missed the April 17 deadline

Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP.  Mr. Mallon can be reached directly at 415-868-5345.

Blockstack Regulation A+ Token Offering

Overview of the Regulation A+ Offering Circular for Crypto Tokens

By Bart Mallon
Co-Managing Partner, Cole-Frieman & Mallon LLP

It is generally accepted that the initial coin offering (ICO) from mid-2017 is dead and that firms raising money for their blockchain or token projects will need to do so in a way that is compliant with SEC laws and regulations.  For many groups, this means raising money through general private placements or various SAFTs (simple agreement for future tokens)  and SAFEs (simple agreement for future equity).  However, raising money in this manner does not put the seller’s tokens in the hands of a mass audience which is an important element for groups who are trying to obtain network effects for their project.  One alternative to traditional private offerings for token projects is the Regulation A+ public offering of tokens for up to $50M in proceeds.  Although Regulation A+ has been a potential avenue for a number of blockchain groups, it has been an untested and it was unclear what the time or costs would be to complete such an offering.  This all changed with the Blockstack public offering of tokens pursuant to Reg A+.

Through considerable time and cost, Blockstack submitted its Regulation A+ “Tier 2” offering to the SEC for “qualification” to publicly sell its tokens (Stacks Tokens) on April 11 2019.  We have reviewed all 203 dense pages of Blockstack’s Offering Circular (which is estimated to cost $1.8M in legal and accounting fees to produce) and take this opportunity to discuss the unique characteristics of the the offering which any token project will need to address in the future.  While we can see that this will be the first step in standardizing token offerings under Regulation A+, we also see that there are a number of legal, business and operational issues that any token sponsor will need to address in what will inevitably be a “not as easy as advertised” process with the SEC.

What is Blockstack & the Stacks Token?

Blockstack is a blockchain platform with a goal of “sponsoring and commercializing an open-source peer-to-peer network using blockchain technologies to ultimately build a new network for decentralized applications.”  The platform has been designed to do a number of things that current blockchains and centralized working solutions (i.e. Google Docs) do, but with a focus on decentralization and a high level of privacy.  Blockstack is introducing use cases which include a browser, universal user accounts and personal data lockers which are all designed to give users control over their personal data.  Eventually the blockchain will allow for more decentralized apps and a smart contract platform with a new smart contract language and more clarity on costs for use of the language.

The Stacks Tokens on the Blockstack network, which are being sold in the offering, will ultimately be used as fuel for running the smart contracts on the blockchain (the tokens will be burned).  The Stacks Tokens will also be used by consumers as payments for the decentralized applications that will live on the network.  Tokens will also be used for polling purposes and other incentives.  In general, the platform looks very similar to other smart contract platforms with some technical differences.  The project sponsored is Blockstack PBC, a Delaware public benefit corporation,  a company with a number of well-healed and well known investors.  For more information on the Stacks Token and project as a whole, you can see their sales deck for the token offering.

$50M Regulation A+ Raise

The proceeds from the raise will be generated through two different programs – the cash program and the app-mining program.  Together the programs will raise $50M in consideration over the 12 months following the “qualification” of the offering.

Cash Program

In the cash program, there are two different sales prices for the tokens based on whether the tokens are sold in exchange for vouchers (to persons who indicated interest to Blockstack in November and December of 2017) or if they are sold in the general offering.  The price is $0.12 per token (up to 215M tokens) for investors who participated in the voucher program and $0.30 (up to 40M tokens, but can be modified to be up to 62M tokens) for investors who participate through the general offering.  The total consideration amount from the cash program (vocher and general offerings) will not exceed $38M, but the total amounts are subject to the tokens ultimately distributed through the app mining program, which is variable.

App Mining Program

Blockstack is offering tokens as rewards to certain developers of applications on its blockchain.  [Include more here.]  These token rewards are being included as part of the Reg A+ offering because they may be deemed to be investment contracts and/or as part of the offering.  Pursuant to this program, all gifted tokens will be deemed to be work $0.30 per token for the first three months after the qualification of the offering, and then based on current market prices for the tokens.  The idea is that Blockstack is getting consideration in-kind with work provided on its blockchain and is paying for that work with tokens.

Other Aspects of the Offering and Business

There are a number of other interesting legal and business items which were discussed throughout the offering circular.  Many of these items are unique to Blockstack’s business, but many will have general applicability to future Reg A+ digital asset offerings.

  • Finalizing tokens offered in program – as previously discussed, the total amount of tokens sold through the offering is not set in stone.  Directly after the SEC deems the offering “qualified”, Blockstack will finalize the allocation of tokens between the cash and app mining programs.  A sale of the tokens will open 28 days after the SEC deems the offering to be “qualified”.
  • Tier 2 investor qualification – the offering is a “Tier 2” offering which means both accredited and unaccredited investors will be allowed to invest.  Because it is a Tier 2 offering, the unaccredited investors are limited to invest 10% of the greater of annual income or net worth.
  • Concurrent Reg S offering – Blockstack is raising additional capital from non-US persons in a concurrent offering.  The tokens sold in the Regulation S offering will be subject to a 1 year lockup (investors cannot use during the lockup period) and are being sold at $0.25 per token.
  • Tokens subject to a time-lock – for many reasons Blockstack has chosen that the purchased tokens will be introduced to the platform over time, with full distribution of all sold tokens 2 years after the qualification of the offering.  Blockstack will release 1/24th of the sold tokens at inception, then will release 1/24th of the sold tokens once a month thereafter (every 4,320 blocks on the bitcoin blockchain).
  • No restriction on transfers of tokens – this offering is not of restricted securities (see our earlier post about token distribution issues / restricted securities) and are free usable and tradable (on a registered exchange or ATS) upon release from the time-lock; however, Blockstack believes the Stacks Tokens will not initially trade on any crypto exchanges and this will make it hard to sell the tokens.
  • “Cap Table” – there was much information presented about the current token float (the genesis block created 1.32B tokens) and the amount of tokens sold in previous offerings (various private placements and SAFTs).  After all the offerings and various distributions, there will be 116M tokens unallocated that Blockstack will control and can utilize however they wish.  Many of the issued tokens have been or are being provided to related entities to compensate employees, similar to stock option grants.
  • Use of proceeds – as is the case with most all offerings, there is a discussion of how the sponsors will use the cash proceeds from the sale.  Blockstack also discusses the use of the cash proceeds under different levels of total subscription (25%, 50%, 75% and 100%).
  • Milestones – through a previous funding round, Blockstack was provided with capital if they met certain milestones with respect to the development and adoption of the Blockstack network.  While they easily met the first milestone (technical implementation of certain features of the blockchain), it is unclear if they will meet the second milestone (dealing with adoption of the network).  They will be required to “return a significant amount of capital that Blockstack currently intends to use in the development of the Blockstack network.”  The milestone is 1M verified users by the end of January 2020.  Blockstack specifically says that at current growth rates it will not achieve the second milestone.
  • Hard Fork from Bitcoin – Blockstack currently runs as a virtual blockchain on the bitcoin network.  It will ultimately transition over to its own blockchain when it has a large enough network to maintain security.  This will involve a “hard fork” to the Blockstack network and its associated risks.
  • Risk Factors – as with any public or private placement, there are attendant risks which are disclosed to potential investors.  These include normal investment risks (operations, catastrophic events, etc) and general risks related to digital/crypto (loss of token, irreversible, loss of keys, various hacks, forks, volatility, uncertain tax treatment, etc), however, there were a number of interesting Blockstack specific risks including: risk of not attracting both users and developers to the platform, the time-lock risk, regulatory risk (does not have New York BitLicense, is not a money transmitter or money services business, potential violation of Regulation M with respect to its activities in its own tokens, etc).

Legal Issues Presented

In addition to the description of many of the business issues related to the creation of the blockchain, there are a number of novel legal issues presented and addressed in the offering circular.  Below we have identified the most interesting of these issues and have included how Blockstack has addressed them.

  • Are the tokens securities?  Blockstack believes that the current tokens (non-sufficiently decentralized) are a type of security called an investment contract and are not equity or debt securities:

We do not believe that the Stacks Tokens should be characterized as either debt or equity under the securities laws.  We believe that these tokens should currently be characterized as investment contracts.  Holders will not receive a right to any repayment of principal or interest, as might be expected under a traditional debt instrument; nor will they receive an interest in the profits or losses of any Blockstack affiliate, any rights to distributions from any Blockstack affiliate, or any legal or contractual right to exercise control over the operations or continued development of any Blockstack affiliate, as might be expected for a traditional equity instrument.

  • When will the tokens be “sufficiently decentralized” so they are no longer securities?  This is one of the most important questions of the offering and essentially addresses the question of when the SEC will lose jurisdiction over the tokens in the offering and when/how Blockstack can issue, sell or otherwise use the tokens as rewards for certain activity on its blockchain.

The board of directors of Blockstack PBC will be responsible for regularly considering and ultimately determining whether the Stacks Tokens no longer constitute securities issued by us under the federal and state securities laws of the United States.  In making this determination, the board will refer to the relevant legal and regulatory standards for such determination in effect at the time of such determination, will consult with legal counsel and will, if possible and appropriate, seek consultation with relevant regulatory authorities including, we expect, the Commission.  At the present time, based on the guidance cited above, we expect this determination to turn the SEC’s recent guidance on the application of the test under SEC v. W. J. Howey Co. (the “Howey test”) to digital assets set forth in its release “Framework for ‘Investment Contract’ Analysis of Digital Assets,” and specifically on whether the Blockstack network is sufficiently decentralized, which will, in turn, depend on whether purchasers of Stacks Tokens reasonably expect Blockstack to carry out essential managerial or entrepreneurial efforts, and whether Blockstack retains a degree of power over the governance of the network such that its material non-public information may be of special relevance to the future of the Blockstack network, as compared to other network participants. Under current guidance, Blockstack would expect to take the position that if the answers to these questions are that purchasers do not and Blockstack does not, the Stacks Tokens will no longer constitute a security under the federal and state securities laws of the United States. The board of directors of Blockstack PBC may also assess other criteria for making this determination, including any criteria based on additional guidance we receive from U.S. regulators.   …

In the event that the board of directors of Blockstack PBC determines that the Stacks Tokens are no longer a security issued by Blockstack Token LLC, Blockstack will make a public announcement of its determination at least six months prior to taking any actions based on this determination, such as filing an exit report on Form 1-Z terminating its reporting obligations with respect to the Stacks Tokens under Regulation A.

  • Are any actors related to Blockstack or its blockchain required to be registered in any way?  Here, Blockstack addresses the issue of whether certain actors are required to be transfer or clearing agents because of their relationship to the blockchain and creation or distribution of the tokens:

We have taken the position that Blockstack, the miners on the network, and the network’s blockchain are not required to register as transfer agents, both because the Stacks Tokens are not currently securities registered under Section 12 of the Exchange Act, and because none of the activities Blockstack, the miners, or the blockchain is involved in are described in the definition of a transfer agent.  In addition, to the extent that certain activities that meet the definition of a transfer agent are performed automatically on the blockchain, the blockchain is not a “person” that would be required to register.  …

We have taken the position that Blockstack, the miners and the blockchain are not clearing agencies under the Exchange Act because the types of activities they engage in are not those described in the definition of a clearing agency.  To the extent that these activities occur on the blockchain, the blockchain is not a “person” that would be required to register.

Blockstack has included similar discussions related to questions on whether it or any related actor is an investment company, broker-dealer, money transmitter, money services business, or subject to New York BitLicense requirements.  All of these discussions conclude that the way the current blockchain works, and pursuant to the current interpretation of the securities laws, Blockstack and related actors would not be required to register as any of the above.  It is possible that the SEC or the various state securities regulators could disagree with conclusions presented in the offering circular.

  • Is the Blockstack Network or the browser an ATS?  The issue of what actors may be deemed to be an ATS is an open one and will eventually be an important issue when the SEC provides FINRA and the digital asset industry with future guidance.  (HFLB note: SEC and FINRA just recently released a joint statement on digital asset custody which we will be reviewing shortly.)

We have taken the position that neither the network nor the Browser should be viewed as an exchange or an ATS because neither will “bring together” anyone by sorting or organizing orders in the Stacks Tokens in a consolidated way or by receiving orders for processing and execution of transactions in the Stacks Tokens.  Instead, each proposed transaction involving Stacks Tokens on the network will by individually negotiated and implemented. For example, transactions by users (such as developers or users of Decentralized Applications) will be posted on an individual basis. In addition, we will be the only “seller” of Stacks Tokens when we distribute them as rewards on the network. …

We also take the position that payments on the network and the Browser for services do not involve “orders” of securities, because they are not primarily purchases of securities. Instead, these payments are commercial sales of access to Decentralized Applications or of items bought through in-app purchases.

Conclusion

It is clear that Blockstack has carefully thought through the business and legal issues involved in launching a Regulation A+ capital raise in order to expand a blockchain and token network.  While the offering circular provides thoughtful analysis, it also highlights the many unresolved issues that plague the digital asset space.  The digital asset industry in the US is starved for clarity on many of these issues and, if this offering is ultimately qualified, it will be a large step forward in solidifying how token sponsors should proceed with capital raises.  Blockstack spent a lot of money to produce the offering circular and we must hope that this filing, or a filing similar to this, can become the template for blockchain token projects of the future.

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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.

Bitcoin ETF – Bitwise Asset Management

Cole-Frieman & Mallon Comment Letter to SEC

On June 12, 2019 our law firm submitted a comment letter to the SEC with respect to the Bitwise Bitcoin ETF application.  In our comment we stated that we believe it is in the best interest of the bitcoin market that the Bitwise ETF be approved.  We made this statement based on our firm’s experience with asset managers generally, and specifically with asset managers in the digital asset space.  We also believe that the various Bitwise presentations and research prepared for the staff (here, here, and here) present strong arguments for the approval of the Bitwise ETF.

The Bitwise ETF application was originally submitted to the SEC by the listing Exchange (NYSE Arca) on January 28, 2019 and has subsequently under gone two statutory extensions (see here) as the SEC tries to figure out how they are going to regulate the digital asset industry.  Ultimately the SEC will need to make a final decision (accept or reject) by mid-October.  The various comment letters (found here) show overall support for the Bitwise ETF and generally implore the SEC to approve the application.

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For more information on this topic, please see our collection of cryptocurrency fund legal and operational posts.

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 cryptocurrency focused hedge funds. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.

Cole-Frieman & Mallon LLP Announces New Partner Scott E. Kitchens

Firm Adds New Denver Office to Expand Practice

Cole-Frieman & Mallon LLP, a leading boutique investment management law firm, is pleased to announce Scott Kitchens has joined the firm as a partner. He will be opening the firm’s new Denver office and will focus his practice on advising private funds and investment advisers in relation to structure, formation and ongoing operational needs. Mr. Kitchens previously worked in the investment management practice group of a large international law firm. He has deep ties to the Colorado investment management community and is committed to growing the firm’s local practice.

“I am excited to welcome Scott to the firm and build out the Denver office together” said Karl Cole-Frieman, co-founder of the firm. “We also know that Scott’s reputation in the Denver community is exceptional, and we believe Scott will propel our firm to be the leading investment fund practice in Denver.” Matthew Stover, CEO of Denver based fund administration firm MG Stover & Co. noted that “the alternative fund industry in Colorado is growing and we believe that Cole-Frieman & Mallon will be a strong addition to the community. We also know that Scott will bring great experience to the new office.”

Mr. Kitchens’ background includes notable experience with venture capital, private equity, and similar closed-end fund structures. “I am very excited to join Cole-Frieman & Mallon and launch its Denver office,” said Mr. Kitchens. “I have known the attorneys at the firm for many years and am confident that we will continue our strong expansion in the investment management space.”

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About Cole-Frieman & Mallon LLP

Cole-Frieman & Mallon LLP is a premier boutique investment management law firm, providing top-tier, responsive and cost-effective legal solutions for financial services matters. Headquartered in San Francisco, with offices in Atlanta and Denver, Cole-Frieman & Mallon LLP has an international practice that services both start-up investment managers, as well as multi-billion dollar firms. The firm provides a full complement of legal services to the investment management community, including: hedge fund, private equity fund and venture capital fund formation, adviser registration, counterparty documentation, SEC, CFTC, NFA and FINRA matters, seed deals, hedge fund due diligence, employment and compensation matters, and routine business matters. Cole-Frieman & Mallon LLP is also a recognized leader in the burgeoning cryptocurrency fund formation space. The firm publishes the prominent Hedge Fund Law Blog which focuses on legal issues that impact the hedge fund community. For more information please visit us at: colefrieman.com.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP and the founder/editor of the Hedge Fund Law Blog.  Mr. Mallon directly at 415-868-5345.

Crypto Headlines from Week of April 26 – Bitfinex/Tether & SeedInvest

There were two big announcements in the crypto space this week and we anticipate that both will shape the dialogue in crypto circles over the course of the next few months.

NY AG Order re Bitfinex and Tether – the New York Attorney General announced an order requiring Bitfinex to provide certain information on its corporate activities to New York in connection with an investigation into Tether.  The central issue is whether Bitfinex used Tether funds to “hide the apparent loss of $850 million dollars of [Bitfinex] co-mingled client and corporate funds.”  The order was announced yesterday and sent the entire crypto market down 10%.  Bitfinex has released a statement in response to the order saying that Bitfinex and Tether are “financially strong – full stop.”  We anticipate this will be a major story over the next couple of weeks.

SeedInvest Receives ATS License – ever since the SEC released the DAO report in July 2017, firms have been trying to secure a broker-dealer with an Alternative Trading System.  A broker-dealer with an ATS designation would allow a digital asset trading platform to legally provide an exchange/trading service in the US.  SeedInvest (which was recently bought by Circle), through its affiliated broker-dealer SI Securities, just received the ATS designation (see here on page 11 – “The Firm operates an alternative trading system to facilitate the trading of securities previously purchased in private placement transactions through SI Securities.”).  The ATS designation in this instance allows the firm to have a trading system/platform for previously issues equity securities (private placements) and not for tokens; however, it is generally viewed that this is the first step toward FINRA ultimately allowing for the ATS designation to apply to a token platform.  We will see how this plays out with other platforms in the near future but this is certainly a sign that regulators are moving in the right direction.

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For more information on this topic, please see our collection of cryptocurrency fund legal and operational posts.

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 cryptocurrency focused hedge funds. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.

Cole-Frieman & Mallon 2019 First Quarter Update

Below is our quarterly newsletter. If you would like to be added to our distribution list, please contact us.

Clients, Friends, Associates:

The first quarter of each year is typically a busy time for both investment managers and services providers.  The first quarter of 2019 was no exception.  Now that many of the filing deadlines have passed, and audit work should be completed (or nearly so), we enter the second quarter of 2019 with regulatory changes and developments on the horizon.  Below is a brief overview of some items that we hope will help you stay on top of the business and regulatory landscape in the coming months.

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SEC Matters

SEC Publishes Examination Priorities for 2019.  On December 20, 2018, the SEC announced its Examination Priorities for this year.  In 2019, the SEC intends to place emphasis on matters concerning digital assets, cybersecurity, and matters of importance to retail investors, including fees, expenses, and conflicts of interest.  Specifically, the SEC will focus on (i) compliance and risks in critical market infrastructure; (ii) retail investors, including seniors and those saving for retirement; (iii) FINRA and MSRB; (iv) cybersecurity; and (v) anti-money laundering programs.  We recommend speaking with your compliance firm to ensure your books and records as well as operations are in compliance with the securities rules.

SEC Adopts Final Rules Allowing Exchange Act Reporting Companies to Use Regulation A.  Regulation A provides an exemption from registration under the Securities Act for offerings of securities up to $50 million within a 12-month period.  On December 19, 2018, the SEC amended Regulation A to enable companies that are subject to the reporting requirements of Section 13 or 15(d) of the Securities Exchange to use Regulation A.  The amendments also permit such reporting companies to meet their Regulation A ongoing reporting obligations through their Securities Exchange Act reports.

SEC Proposes Rule Changes for Fund of Fund Arrangements.  On December 19, 2018, the SEC voted to propose a new rule and related amendments designed to streamline and enhance the regulatory framework for fund of fund arrangements.  The SEC’s proposal would allow a fund to acquire the shares of another fund in excess of the limits of Section 12(d)(1) of the Investment Company Act without obtaining an individual exemptive order from the SEC.  To rely on the rule, funds must comply with conditions designed to enhance investor protection, including conditions restricting the ability of funds to improperly influence other funds, charge excessive fees, or create overly complex fund of fund structures.

SEC Takes Action Against Robo-Advisers.  On December 21, 2018, the SEC settled proceedings against two robo-advisers for making false statements about investment products and publishing misleading advertising.  The proceedings were the SEC’s first enforcement actions against robo-advisers, which provide automated, software-based portfolio management services.

SEC Opens Registration in Compliance Outreach Seminar. The SEC will be sponsoring a seminar on May 16, 2019 as part of its compliance outreach program. The program seeks to aid chief compliance officers and other investment adviser or investment company personnel in the development of their compliance programs. The seminar will be held in Pittsburgh, Pennsylvania, and the topics include 2019 exam and enforcement priorities, common deficiencies, cybersecurity, and what to expect in an examination. Those interested in attending the seminar may register here.

CFTC Matters 

CFTC Releases a Primer about Smart Contracts. On December 11, 2018, LabCFTC, the CFTC’s hub for engagements with the FinTech innovation community, released a primer to help explain smart contract technology and related risks and challenges. The primer looks to provide a definition for smart contracts by looking at smart contract history, characteristics, and potential application in daily life.

NFA Adopts Proficiency Requirements for Swap-Related Associated Persons. On March 25, 2019, the NFA adopted an interpretive notice regarding its amendments to NFA Bylaw 301 and NFA Compliance Rule 2-24 which will implement changes to the NFA’s Swaps Proficiency Requirements. These new rules will go into effect on January 1, 2020 and will require all Associated Persons who engage in, or supervise activities involving, swaps at futures commission merchants, introducing brokers, commodity pool operators, commodity trading advisers, swap dealers, and major swap participants to take and pass a proficiency exam. The exam tests both market knowledge and knowledge of regulatory requirements, and there is no grandfathering provision within the new requirements. The new rules provide for two tracks of testing: the Long Track for swap dealers and the Short Track for all others. The NFA’s Swaps Proficiency Requirements must be completed by January 31, 2021.

NFA Amends its Interpretive Notice on Information Systems Security Programs. In March 2016, the NFA issued an interpretive notice requiring each member to adopt a written information systems security program (ISSP) to combat and effectively respond to unauthorized access of their information technology systems. On January 7, 2019, the NFA announced that it amended the notice to provide more clarification on ISSP approval and the corresponding training requirements for members. Additionally, the amended notice now requires NFA members (other than FCMs) to notify the NFA when certain cybersecurity incidents occur. The amendments to the March 2016 notice became effective April 1, 2019.

NFA Adopts Interpretive Notice Regarding CPO Internal Controls Systems. On April 1, 2019 the NFA adopted an interpretive notice applicable to CPO NFA members that have the ability to control customer funds. The notice specifically requires these CPO NFA members to implement an internal controls framework meant to protect customer funds and provide reasonable assurance that the CPO is in compliance with all CFTC and NFA rules, especially rules regarding maintenance of books and records for each commodity pool.

CFTC Announces 2019 Examination Priorities. On February 12, 2019, the CFTC announced its 2019 examination priorities–the first time the CFTC has done so in its history. In the announcement, the Division of Market Oversight (DMO), the Division of Swap Dealer and Intermediary Oversight, and the Division of Clearing and Risk each summarized their respective priorities. Of note, one of the DMO’s 2019 priorities include cryptocurrency surveillance practices.

Digital Asset Matters

SEC Commissioner Discusses Regulatory Considerations Concerning Digital Assets.  On February 8, 2019, SEC Commissioner Hester Peirce provided remarks concerning regulation and innovation.  Commissioner Peirce stated that digital asset tokens sold for use in a functioning network, rather than as investment contracts, fall outside the definition of securities.  Commissioner Peirce also acknowledged the uncertainty of the regulatory environment concerning digital assets as well as the novel challenges presented by digital asset trading platforms.  Additionally, Commissioner Peirce suggested that there will be further development of the digital asset regulatory environment in 2019.

SEC Issues a Public Statement on Digital Assets as Investment Contracts. On April 3, 2019, the SEC released a public statement discussing whether digital assets are considered securities by virtue of being offered and sold as investment contracts. The public statement references both a published framework of analysis by FinHub and a response to a no-action request by the Division of Corporation Finance. FinHub’s published framework identifies the relevant factors in determining whether a digital asset is offered or sold as an investment contract. Further, the no-action letter demonstrates the type of digital asset that the Division of Corporation Finance would not consider an investment contact or, accordingly, a security.

District Court Reconsiders Previous Ruling, Grants SEC Preliminary Injunction.  Last November, in what was seen as a victory for ICO issuers, a District Court denied the SEC’s attempt to obtain a preliminary injunction against a digital asset company, holding that the SEC failed to prove the company’s token was a security.  On February 14, 2019, the District Court reversed its position and granted a preliminary injunction to the SEC, holding that the contents of the company’s website, whitepaper, and social media posts concerning the company’s ICO constituted an offer of securities.

CFTC is Seeking Comments on Digital Asset Mechanics and Markets.  On December 11, 2018, the CFTC announced it is seeking public comment and feedback to better inform the CFTC’s understanding of the underlying technology, opportunities, risks, mechanics, use cases, and markets for virtual currencies beyond Bitcoin, namely Ether and its use on the Ethereum Network.  The CFTC is seeking to understand the similarities and distinctions between Ether and Bitcoin, as well as Ether-specific opportunities, challenges, and risks.

ICO Issuer Settles Unregistered ICO Charges After Self-Reporting to the SEC. On February 20, 2019, the SEC announced a settlement regarding an unregistered ICO by a company that raised over $12 million in digital assets in late 2017 to finance its operations. In the summer of 2018, the company self-reported to the SEC and cooperated with the SEC’s investigation. The SEC stated that it did not impose a penalty on the company because the company self-reported, agreed to compensate investors, and will register the tokens in compliance with securities laws.

Although the company conducted an ICO after the SEC released the DAO Report on July 25, 2017, the SEC’s decision to forgo fining the company suggests the SEC’s approach to the digital asset space is to focus on fraudulent conduct rather than stifling innovation in the space.

Nasdaq Offers Bitcoin and Ethereum Liquid Indices.  As of February 25, 2019, Nasdaq is offering spot Bitcoin and Ethereum indices, quoted in USD, based on real-time prices.  This move by Nasdaq, which lists over 3,300 companies and carries out approximately 1.8 billion trades per day, could serve as a step towards mainstream adoption of digital assets.

Florida Court Rules Direct Sales of Bitcoin Constituted Money Transmission.  On January 30, 2019, the Third District Court of Appeals in Florida held that an individual’s sale of Bitcoin for cash constituted money transmission and the sale of a payment instrument.  The Court held that since the seller was not licensed to act as a money services business, he could be charged with engaging in unlawful money transmitter services in connection with sales of Bitcoin for cash.

JPMorgan Creates Digital Asset Payment Coin.  On February 14, 2019, JPMorgan announced that it is the first U.S. bank to create and successfully test a digital coin representing a fiat currency, JPM Coin.  JPMorgan claims the JPM Coin will be used to make instantaneous payments using blockchain technology.  While JPMorgan claims that the JPM Coin is designed for institutional use and not for public investment, the company hopes to further develop JPM Coin’s utility in the future.

Other Matters 

FINRA Issues Panel Decision Regarding Transaction-Based Compensation. On January 29, 2019, FINRA’s Department of Enforcement released its decision in an enforcement hearing involving transaction-based compensation. In the decision, FINRA found that the respondent violated such  rules by paying compensation to (i) an unregistered finder’s non-member, unregistered entity and (ii) non-member, unregistered entities owned by its brokers. Additionally, FINRA held that the respondent failed to reasonably supervise its business and had inadequate written supervisory procedures that neither prevented nor detected deficiencies.

Atlanta Panel.  On April 24, 2019, Cole-Frieman & Mallon will be co-hosting a panel with Harneys and Trident Fund Services at Atlanta Tech Village.  The panel will cover developing topics in the investment management space including developments in the digital asset space, the rise of cannabis, and qualified opportunity zone funds.

Qualified Opportunity Zones.  This continues to be a hot topic:

Qualified Opportunity Fund Panel.  In February, Cole-Frieman & Mallon and Anderson Tax hosted a panel regarding qualified opportunity zone funds.  The panel addressed the tax and legal considerations that investment managers and investors should be aware of when creating or investing in a qualified opportunity zone fund.

IRS Holds a Public Hearing on Qualified Opportunity Funds.  On February 14, 2019, the IRS held a public hearing seeking input related to the first round of proposed rulemaking it issued in October 2018.  In the next round of proposed rules, the IRS is expected to provide (i) clarity on the definition of qualified opportunity zone business; (ii) data reporting requirements; (iii) clarity on interactions with other tax incentives; and (iv) guidance on interim gain reinvestment.  Further rule clarifications are expected in Spring 2019.

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Compliance Calendar.

 

Please note the following important dates as you plan your regulatory compliance timeline for the coming months:

Deadline Filing
March 31, 2019 Deadline to update and file Form ADV Parts 1 & 2
April 10, 2019 Amendment to Form 13H due if necessary
April 15, 2019 1st Quarter 2019 Form PF filing for quarterly filers (Large Liquidity Fund Advisers)
April 30, 2019 Collect quarterly reports from access persons for their personal securities transactions
April 30, 2019 Distribute code of ethics and compliance manuals to employees.  Require acknowledgement form to be executed in connection with such delivery
April 30, 2019 Annual Privacy Notice sent to all clients or fund investors (for Advisers with Fiscal Year ending December 31)
April 30, 2019 Distribute audited financial statements to private fund investors that have not invested in fund of funds
April 30, 2019 Distribute Form ADV Part 2 to clients
April 30, 2019 Quarterly NAV Report (registered commodity pool operators claiming the 4.7 exemption)
April 30, 2019 Annual Form PF due date for annual filers (Large Private Equity Fund Advisers and Smaller Private Fund Advisers)
May 15, 2019 Quarterly Commodity Trading Advisor Form PR filing
May 15, 2019 File Form 13F for first quarter 2019
May 31, 2019 First deadline for Cayman Islands Financial Institutions to submit their CRS returns to the Cayman Islands Tax Authority
May 31, 2019 Third reporting deadline (full reporting) for Cayman Islands Financial Institutions with reporting obligations under the Cayman FATCA regulatory framework to report their U.S. Reportable Accounts to the Cayman Islands Tax Authority
June 29, 2019 Distribute audited financial statements to private fund investors that have invested in fund of funds
Variable Distribute copies of K-1 to fund investors
Periodic Filings Form D and Blue Sky filings should be current

Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP.  Mr. Mallon can be reached directly at 415-868-5345.

Cole-Frieman & Mallon 2018 End of Year Update

Below is our quarterly newsletter. If you would like to be added to our distribution list, please contact us.

Clients, Friends, Associates:

As we prepare for a new year, we also reflect on an eventful 2018 that included developments impacting both traditional hedge fund managers as well as those in the digital asset space. Regardless of these developments, year-end administrative upkeep and 2019 planning are always particularly important, especially for general counsels, Chief Compliance Officers (“CCOs”), and key operations personnel. As we head into 2019, we have put together this checklist and update to help managers stay on top of the business and regulatory landscape for the coming year.

This update includes the following:

  • Annual Compliance & Other Items
  • Annual Fund Matters
  • Annual Management Company Matters
  • Regulatory & Other Items from 2018 Compliance Calendar

We are also delighted to announce that effective December 22, 2018 our growing San Francisco team will complete their move to expanded premises at 255 California Street, San Francisco, CA 94111.

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Annual Compliance & Other Items

Annual Privacy Policy Notice. On an annual basis, registered investment advisers (“RIAs”) are required to provide natural person clients with a copy of the firm’s privacy policy if (i) the RIA has disclosed nonpublic personal information other than in the connection with servicing consumer accounts or administering financial products; or (ii) the firm’s privacy policy has changed. The U.S. Securities and Exchange Commission (the “SEC”) has provided a model form and accompanying instructions for firm privacy policies.

Annual Compliance Review. On an annual basis, the CCO of an RIA must conduct a review of the adviser’s compliance policies and procedures. This review should be in writing and presented to senior management. We recommend that firms discuss the annual review with their outside counsel or compliance firm, who can provide guidance about the review process as well as a template for the assessment and documentation. Conversations regarding the annual review may raise sensitive matters, and advisers should ensure that these discussions are protected by attorney-client privilege. CCOs may also want to consider additions to the compliance program. Advisers that are not registered may still wish to review their procedures and/or implement a compliance program as a best practice.

Form ADV Annual Amendment. RIAs or managers filing as exempt reporting advisers (“ERAs”) with the SEC or a state securities authority must file an annual amendment to Form ADV within 90 days of the end of their fiscal year. For most managers, the Form ADV amendment will be due on March 31, 2019. This year, because March 31st falls on a Sunday, we recommend filing annual amendments to the Form ADV on Friday, March 29, 2019, and no later than the first business day following the 90-day deadline (Monday, April 1, 2019). RIAs must provide a copy of the updated Form ADV Part 2A brochure and Part 2B brochure supplement (or a summary of changes with an offer to provide the complete brochure) to each “client”. For SEC RIAs to private investment vehicles, a “client” for these purposes means the vehicle(s) managed by the adviser and not the underlying investors. State-registered advisers need to examine their state’s rules to determine who constitutes a “client”.

Switching to/from SEC Regulation.

SEC RIAs. Managers who no longer qualify for SEC registration as of the time of filing the annual Form ADV amendment must withdraw from SEC registration within 180 days after the end of their fiscal year (June 29, 2019 for most managers) by filing a Form ADV-W. Such managers should consult with legal counsel to determine whether they are required to register or file an exemption from registration in the states in which they conduct business.

ERAs. Managers who no longer meet the definition of an ERA will need to apply for registration with the SEC or the relevant state securities authority, if necessary. Managers who are required to register with the SEC as of the date of their annual amendment must register with the SEC within 90 days of filing the annual amendment (June 29, 2019 for most managers, assuming the annual amendment is filed on March 31, 2019).

Custody Rule and Annual Audits.

SEC RIAs. SEC RIAs must comply with certain custody procedures, including (i) maintaining client funds and securities with a qualified custodian; (ii) having a reasonable basis to believe that the qualified custodian sends an account statement to each advisory client at least quarterly; and (iii) undergoing an annual surprise examination conducted by an independent public accountant. SEC RIAs to pooled investment vehicles may avoid both the quarterly statement and surprise examination requirements by having audited financial statements prepared for each pooled investment vehicle in accordance with generally accepted accounting principles by an independent public accountant registered with the Public Company Accounting Oversight Board (“Auditor”). Statements must be sent to investors in the fund within 120 days after the fund’s fiscal year end. Managers should review their custody procedures to ensure compliance with these rules.

California RIAs. California RIAs (“CA RIAs”) that manage pooled investment vehicles and are deemed to have custody of client assets are also subject to independent party and surprise examinations. However, similarly to SEC RIAs, CA RIAs can avoid these additional requirements by engaging an Auditor to prepare and distribute audited financial statements to all investors of the fund, and to the Commissioner of the California Department of Business Oversight (“DBO”). Those CA RIAs that do not engage an auditor must, among other things, (i) provide notice of such custody on the Form ADV; (ii) maintain client assets with a qualified custodian; (iii) engage an independent party to act in the best interest of investors to review fees, expenses, and withdrawals; and (iv) retain an independent certified public accountant to conduct surprise examinations of client assets.

Other State RIAs. Advisers registered in other states should consult with legal counsel about those states’ custody requirements.

ERAs. Each state has its own requirements for ERAs. CA ERAs must undergo an annual audit and provide the audit to their investors within 120 days after the end of their fiscal year (April 30, 2019 for most managers).

California Minimum Net Worth Requirement and Financial Reports.

RIAs with Custody. Every CA RIA that has custody of client funds or securities must maintain at all times a minimum net worth of $35,000, however, the minimum net worth is $10,000 for a CA RIA (i) deemed to have custody solely because it acts as general partner of a limited partnership, or a comparable position for another type of pooled investment vehicle; and (ii) that otherwise complies with the California custody rule described above (such advisers, “GP RIAs”).

RIAs with Discretion. Every CA RIA that has discretionary authority over client funds or securities, whether or not they have custody, must maintain at all times a net worth of at least $10,000, and preferably $12,000 to avoid certain reporting requirements.

Financial Reports. Every CA RIA that either has custody of, or discretionary authority over, client funds or securities must file an annual financial report with the DBO within 90 days after the adviser’s fiscal year end. The annual financial report must contain a balance sheet, income statement, supporting schedule, and verification form. These financial statements must be audited by an independent certified public accountant or independent public accountant if the adviser has custody of client assets.

Annual Re-Certification of CFTC Exemptions. Commodity pool operators (“CPOs”) and commodity trading advisers (“CTAs”) currently relying on certain exemptions from registration with the U.S. Commodity Futures Trading Commission (“CFTC”) are required to re-certify their eligibility within 60 days of the calendar year end. Such CPOs and CTAs will need to evaluate whether they remain eligible to rely on such exemptions.

CPO and CTA Annual Updates. Registered CPOs and CTAs must prepare and file Annual Questionnaires and Annual Registration Updates with the National Futures Association (“NFA”), as well as submit payment for annual maintenance fees and NFA membership dues. Registered CPOs must also prepare and file their fourth quarter report for each commodity pool on Form CPO-PQR, while CTAs must file their fourth quarter report on Form CTA-PR. For more information on Form CPO-PQR, please see our earlier  post. Unless eligible to claim relief under Regulation 4.7, registered CPOs and CTAs must update their disclosure documents periodically, as they may not use any document dated more than 12 months prior to the date of its intended use. Disclosure documents that are materially inaccurate or incomplete must be corrected promptly, and the corrected version must be distributed promptly to pool participants. Any amended disclosure documents must also be approved by the NFA.

Trade Errors. Managers should make sure that all trade errors are properly addressed pursuant to the manager’s trade errors policies by the end of the year. Documentation of trade errors should be finalized, and if the manager is required to reimburse any of its funds or other clients, it should do so by year end.

Soft Dollars. Managers that participate in soft dollar programs should address any commission balances from the previous year.

Schedule 13G/D and Section 16 Filings. Managers who exercise investment discretion over accounts (including funds and separately managed accounts (“SMAs”)) that are beneficial owners of 5% or more of a registered voting equity security must report these positions on Schedule 13D or 13G. Passive investors are generally eligible to file the short form Schedule 13G, which is updated annually within 45 days of the end of the year. Schedule 13D is required when a manager is ineligible to file Schedule 13G and is due 10 days after acquisition of more than 5% beneficial ownership of a registered voting equity security.

For managers who are also making Section 16 filings, this is an opportune time to review your filings to confirm compliance and anticipate needs for the first quarter. Section 16 filings are required for “corporate insiders” (including beneficial owners of 10% or more of a registered voting equity security). An initial Form 3 is due within 10 days after becoming an “insider”; Form 4 reports ownership changes and is due by the end of the second business day after an ownership change; and Form 5 reports any transactions that should have been reported earlier on a Form 4 or were eligible for deferred reporting and is due within 45 days after the end of each fiscal year.

Form 13F. A manager must file a Form 13F if it exercises investment discretion with respect to $100 million or more in certain “Section 13F securities” within 45 days after the end of the year in which the manager reaches the $100 million filing threshold. The SEC lists the securities subject to 13F reporting on its website.

Form 13H. Managers who meet the SEC’s large trader thresholds (in general, managers whose transactions in exchange-listed securities equal or exceed two million shares or $20 million during any calendar day, or 20 million shares or $200 million during any calendar month) are required to file an initial Form 13H with the SEC within 10 days of crossing the threshold. Large traders also need to amend Form 13H annually within 45 days of the end of the year. In addition, changes to the information on Form 13H will require interim amendments following the calendar quarter in which the change occurred.

Form PF. Managers to private funds that are either registered with the SEC or required to be registered with the SEC and who have at least $150 million in regulatory assets under management (“RAUM”) must file Form PF. Smaller private advisers (fund managers with less than $1.5 billion in RAUM) must file Form PF annually within 120 days of their fiscal year-end. Larger private advisers (fund managers with $1.5 billion or more in RAUM) must file Form PF within 60 days of the end of each fiscal quarter.

Form MA. Investment advisers that provide advice on municipal financial products are considered “municipal advisers” by the SEC, and must file a Form MA annually, within 90 days of their fiscal year end.

SEC Form D. Form D filings for most funds need to be amended on at least an annual basis, on or before the anniversary of the most recently filed Form D. Copies of Form D are publicly available on the SEC’s EDGAR website.

Blue Sky Filings. On an annual basis, fund managers should review their blue sky filings for each state to make sure it has met any initial and renewal filing requirements. Several states impose late fees or reject late filings altogether. Accordingly, it is critical to stay on top of filing deadlines for both new investors and renewals. We also recommend that managers review blue sky filing submission requirements. Many states now permit blue sky filings to be filed electronically through the  Electronic Filing Depository (“EFD”) system, and certain states will now only accept filings through EFD.

IARD Annual Fees. Preliminary annual renewal fees for state-registered advisers, SEC RIAs, and ERAs (that are required to file a Form ADV) are due on December 17, 2018. If you have not already done so, you should submit full payment into your Renewal Account by E-Bill, check, or wire as soon as possible.

Pay-to-Play and Lobbyist Rules. SEC rules disqualify investment advisers, their key personnel, and placement agents acting on their behalf, from seeking to be engaged by a governmental client if they have made certain political contributions. State and local governments have similar rules, including California, which requires internal sales professionals who meet the definition of “placement agents” (people who act for compensation as finders, solicitors, marketers, consultants, brokers, or other intermediaries in connection with offering or selling investment advisory services to a state public retirement system in California) to register with the state as lobbyists and comply with California lobbyist reporting and regulatory requirements. Note that managers offering or selling investment advisory services to local government entities must register as lobbyists in the applicable cities and counties. State laws on lobbyist registration differ widely, so managers should carefully review reporting requirements in the states in which they operate to make sure they are in compliance with the relevant rules.

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Annual Fund Matters

New Issue Status. On an annual basis, managers need to confirm or reconfirm the eligibility of investors that participate in initial public offerings or new issues, pursuant to Financial Industry Regulatory Authority, Inc. (“FINRA”) Rules 5130 and 5131. Most managers reconfirm investor eligibility via negative confirmation (i.e. investors are informed of their status on file with the manager and are asked to inform the manager of any changes), whereby an investor’s failure to respond operates as consent affirmation of the current status.

ERISA Status. Given the significant problems that can occur from not properly tracking ERISA investors in private funds, we recommend that managers confirm or reconfirm on an annual basis the ERISA status of their investors. This is particularly important for managers that track the underlying percentage of ERISA funds for each investor, with respect to each class of interests in a pooled investment vehicle.

Wash Sales. Managers should carefully manage wash sales for year end. Failure to do so could result in book/tax differences for investors. Certain dealers can provide managers with swap strategies to manage wash sales, including basket total return swaps and split strike forward conversions. These strategies should be considered carefully to make sure they are consistent with the investment objectives of the fund.

Redemption Management. Managers with significant redemptions at the end of the year should carefully manage unwinding positions so as to minimize transaction costs in the current year (that could impact performance) and prevent transaction costs from impacting remaining investors in the next year. When closing funds or managed accounts, managers should pay careful attention to the liquidation procedures in the fund constituent documents and the managed account agreement.

NAV Triggers and Waivers. Managers should promptly seek waivers of any applicable termination events set forth in a fund’s ISDA or other counterparty agreement that may be triggered by redemptions, performance, or a combination of both at the end of the year (NAV declines are common counterparty agreement termination events).

Fund Expenses. Managers should wrap up all fund expenses for 2018 if they have not already done so. In particular, managers should contact their outside legal counsel to obtain accurate and up-to-date information about legal expenses for inclusion in the NAV for year-end performance.

Electronic Schedule K-1s. The Internal Revenue Service (“IRS”) authorizes partnerships and limited liability companies taxed as partnerships to issue Schedule K-1s to investors solely by electronic means, provided the partnership or company has received the investor’s affirmative consent. States may have different rules regarding electronic K-1s and partnerships and companies should check with their counsel whether they may still be required to send state K-1s on paper. Partnerships and companies must also provide each investor with specific disclosures that include a description of the hardware and software necessary to access the electronic K-1s, the length of time that the consent is effective, and the procedures for withdrawing the consent. If you would like to send K-1s to your investors electronically, you should discuss your options with your service providers.

“Bad Actor” Recertification Requirement. A security offering cannot rely on the Rule 506 safe harbor from SEC registration if the issuer or its “covered persons” are “bad actors”. Fund managers, and their applicable officers and directors, must determine whether they are subject to the bad actor disqualification any time they are offering or selling securities in reliance on Rule 506. The SEC has advised that an issuer may reasonably rely on a covered person’s agreement to provide notice of a potential or actual bad actor triggering event pursuant to contractual covenants, bylaw requirements, or undertakings in a questionnaire or certification. If an offering is continuous, delayed, or long-lived, however, issuers must update their factual inquiry periodically through bring-down of representations, questionnaires, and certifications, negative consent letters, periodic re-checking of public databases, and other steps, depending on the circumstances. Fund managers should consult with counsel to determine how frequently such an update is required. As a matter of practice, most fund managers should perform such update at least annually.

U.S. FATCA. Funds should monitor their compliance with the U.S. Foreign Account Tax Compliance Act (“FATCA”). FATCA reports are due to the IRS on March 31, 2019 or September 30, 2019, depending on where the fund is domiciled. Reports may be required by an earlier date for jurisdictions that are parties to intergovernmental agreements (“IGAs”) with the U.S. Additionally, the U.S. may require that reports be submitted through the appropriate local tax authority in the applicable IGA jurisdiction, rather than the IRS. Given the varying FATCA requirements applicable to different jurisdictions, managers should review and confirm the specific reporting requirements that may apply. As a reminder, we strongly encourage managers to file the required reports and notifications, even if they already missed previous deadlines. Applicable jurisdictions may be increasing enforcement and monitoring of FATCA reporting and imposing penalties for each day late.

CRS. Funds should also monitor their compliance with the Organisation for Economic Cooperation and Development’s Common Reporting Standard (“CRS”). All “Financial Institutions” in the Cayman Islands and British Virgin Islands are required to register with the respective jurisdiction’s Tax Information Authority and submit returns to the applicable CRS reporting system by May 31, 2019. Managers to funds domiciled in other jurisdictions should also confirm whether any CRS reporting will be required in such jurisdictions. CRS reporting must be completed with the CRS XML v1.0 or a manual entry form on the Automatic Exchange of Information portal. We recommend managers contact their tax advisors to stay informed of FATCA and CRS requirements and avoid potential penalties.

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Annual Management Company Matters

Management Company Expenses. Managers who distribute profits on an annual basis should attempt to address management company expenses in the year they are incurred. If ownership or profit percentages are adjusted at the end of the year, a failure to manage expenses could significantly impact the economics of the partnership or the management company.

Employee Reviews. An effective annual review process is important to reduce the risk of employment-related litigation and protect the management company in the event of such litigation. Moreover, it is an opportunity to provide context for bonuses, compensation adjustments, employee goals, and other employee-related matters at the firm. It is not too late to put an annual review process in place.

Compensation Planning. In the fund industry, and the financial services industry in general, the end of the year is the appropriate time to make adjustments to compensation programs. Since much of a manager’s revenue is tied to annual income from incentive fees, any changes to the management company structure, affiliated partnerships, or any shadow equity programs should be effective on the first of the year. Make sure that partnership agreements and operating agreements are appropriately updated to reflect such changes.

Insurance. If a manager carries Directors & Officers or other liability insurance, the policy should be reviewed on an annual basis to ensure that the manager has provided notice to the carrier of all actual and potential claims. Newly launched funds should also be added to the policy as appropriate.

Other Tax Considerations. Fund managers should assess their overall tax position and consider several steps to optimize tax liability. Managers should also be aware of self-employment taxes, which can potentially be minimized by structuring the investment manager as a limited partnership. Managers can take several steps to optimize their tax liability, including: (i) changing the incentive fee to an incentive allocation; (ii) use of stock-settled stock appreciation rights; (iii) if appropriate, terminating swaps and realizing net losses; (iv) making a Section 481(a) election under the Internal Revenue Code of 1986, as amended (the “Code”); (v) making a Section 475 election under the Code; and (vi) making charitable contributions. Managers should consult legal and tax professionals to evaluate these options.

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Regulatory & Other Items from 2018

SEC Updates.

SEC Annual Enforcement Report. On November 2, 2018, the SEC Division of Enforcement published its Annual Report, which highlighted enforcement efforts protecting “main street investors” through initiatives such as the newly-created SEC Retail Strategy Task Force, disclosures of 12b-1 marketing and distribution fees by mutual funds, required cybersecurity disclosures by public companies, and enforcement efforts regarding Initial Coin Offerings (“ICOs”) and digital assets. In 2018, the SEC brought a total of 821 enforcement actions and obtained monetary judgements totaling $3.95 billion, both of which were increases from 2017 figures.

CFTC and NFA Updates.

NFA Develops New Swaps Proficiency Program and Exam. On June 5, 2018, the NFA  announced  the creation of a new online proficiency and exam program for swaps. The online program and exam are expected to launch in early 2020, and any associated persons engaging in swaps activities will be required to pass the program and exam. Previously, training and examinations had only been required for associated persons engaging in futures or forex activities.

Digital Asset Updates.

SEC Settles Charges Against Digital Asset Hedge Fund Management Company. On December 7, 2018, the SEC settled charges against the management company of a digital asset hedge fund for alleged violations of the general solicitation rules. In the settlement agreement, the SEC alleged that the management company violated the general solicitation rules because they did not have substantive and pre-existing relationships with all investors in their fund, offered securities over a website that was accessible to the general public without a password, failed to take reasonable steps to verify accredited investor status, and engaged in general solicitation via online and in person events. In the settlement, the management company agreed to abide by a cease and desist order and to pay a $50,000 civil penalty

SEC Settles Charges Against Digital Asset Hedge Fund Manager. On September 11, 2018, the SEC announced the settlement of charges against a digital asset hedge fund and its manager. The charges included failing to register the hedge fund as an investment company, and offering and selling unregistered securities. Settlement terms included a cease and desist order against both the fund and fund manager, censure, and a $200,000 penalty. Notably, this is the first action the SEC has taken against a digital asset fund based on violations of the registration requirements of the Investment Company Act of 1940, as amended (the “Investment Company Act”).

SEC Emphasis on ICOs. Throughout 2018, the SEC focused much of its regulatory and enforcement efforts on ICOs. Notable developments included:

  • On February 6, 2018, SEC Chairman Jay Clayton stated at a Senate hearing, “I believe every ICO I have seen is a security”.
  • On September 11, 2018, the SEC settled charges against an ICO platform for operating as an unregistered broker-dealer.
  • On October 11, 2018 the SEC issued an Investor Alert that warned against ICOs claiming SEC approval or impersonating the SEC. Also October 11th, the SEC  obtained an emergency stop order against an ICO company for falsely claiming SEC approval. However, on November 27, 2018, a federal judge denied an SEC motion for a temporary restraining order against the ICO company, ruling that the SEC had not yet proven that the ICO was a security. Further, on October 22, the SEC obtained an order to suspended the trading of a cryptocurrency company for falsely claiming to be an SEC-qualified custodian.
  • On November 16, 2018, the SEC reached two settlements with companies for offering and selling unregistered securities through ICOs, and the companies have agreed to register the tokens from these past ICOs as securities with the SEC as part of the settlement agreements. Additionally, the SEC released a statement taking the position that the federal securities laws apply to ICOs, and that it is not too late for past ICO issuers to comply with these laws.
  • On November 29, 2018, the SEC settled two charges against celebrities for endorsing and promoting several ICOs. Both celebrities failed to disclose to investors that they had been paid to promote the ICOs. The terms of the settlements included disgorgement of profits and civil penalties of $300,000 and $100,000.

NFA Digital Asset Disclosure Rule. On July 20, 2018, the NFA released an Interpretive Notice creating new disclosure requirements for Futures Commission Merchants (FCMs), CPOs, and CTAs engaging in digital asset activities. For more information on this Interpretive Notice, please see our previous  post.

New York Attorney General Releases Report on Digital Asset Exchanges. On September 18, 2018, the Office of the Attorney General of New York (the “OAG”) released  a report summarizing a crypto exchange fact-finding initiative. Based on the digital asset exchanges examined, the OAG outlined three primary areas of concern: potential conflicts of interest, lack of anti-abuse controls, and limited customer fund protection.

SEC Settles Charges Against Founder of Digital Asset Exchange. On November 8, 2018, the SEC settled charges against the founder of a digital asset exchange. The SEC took the position that the digital asset exchange qualified as an “exchange” under the Securities Exchange Act of 1934, as amended, and therefore was required to register with the SEC, which it had not done. The founder agreed to settlement terms including $300,000 in disgorgement, $13,000 for pre-trial interest, and a $75,000 penalty.

Other Updates.

Second Circuit Amends Insider Trading Ruling. On June 25, 2018, the U.S. Court of Appeals for the Second Circuit amended its decision in United States v. Martoma, clarifying tippee liability in insider trading cases. The Second Circuit held that a “meaningfully close personal relationship” is not required for tippee liability, and once again upheld a former portfolio manager’s 2014 conviction for insider trading. For further discussion of the original 2017 decision please see our previous 2017 Third Quarter Update.

Fifth Circuit Vacates DOL Fiduciary Rule. On March 15, 2018, the Fifth Circuit Court of Appeals issued a judgement vacating the Department of Labor (“DOL”) Fiduciary Rule in its entirety, finding that the DOL lacked the authority to enact the rule. The Fiduciary Rule would have expanded the definition of a “fiduciary” to include anyone making a securities or investment property “recommendation” to an employee benefit plan or retirement account. For further discussion please see our previous 2018 Second Quarter Update.

GDPR and Enhanced Data Protection Requirements Effected. On May 25, 2018, the  General Data Protection Regulation (“GDPR”) went into effect as part of the efforts of the European Union (“EU”) to protect personal data. U.S. fund managers with EU resident investors will need to: (i) maintain records of any data processing activities; (ii) obtain EU clients’ affirmative consent to process data; and (iii) provide EU clients with access to the fund’s privacy policy. Managers that have no presence in the EU, but that also have EU resident investors, may be required to appoint an EU local representative. However, such managers may still be excluded from this requirement if they can demonstrate that their data processing is only “occasional”, does not include special categories of EU resident personal data (including criminal) on a large scale, and is unlikely to result in a risk to the rights and freedoms of natural persons. We believe most of our clients generally fall into this exclusion and will not need to appoint an EU representative. For more information on GDPR, including compliance items of particular note for fund managers, please see our earlier  post.

Section 3(c)(1) of the Investment Company Act Amended. President Trump authorized the Economic Growth, Regulatory Relief, and Consumer Protection Act (“Growth Act”) on May 24, 2018. A portion of the Growth Act amends Section 3(c)(1) of the Investment Company Act by increasing the number of investors allowed in a qualifying venture capital fund from 100 to 250 investors. The Growth Act defines a qualifying venture capital fund as one with less than $10 million in aggregate capital contributions and uncalled committed capital.

Qualified Opportunity Zones. The 2017 Tax Cuts and Jobs Act mandated that the IRS create “Qualified Opportunity Zones” (“QOZs”), which are designated low-income areas that will provide certain tax breaks and incentives. Qualified Opportunity Funds (QOFs) that make investments in QOZs may qualify for tax incentives including a tax deferral of capital gains that are re-invested into QOFs and a tax exclusion for capital gains that are reinvested into QOFs and held for ten years. On October 19, the IRS  released proposed regulations and guidance notes that provide clarification on how QOFs can receive capital gain tax deferrals if they are located in QOZs.

Offshore Updates.

The Cayman Islands Monetary Authority (“CIMA”) Provides Anti-Money Laundering (“AML”) Compliance Guidance and Delays the AML Officer Deadline. CIMA released a notice on April 6, 2018 providing guidance on the 2017 revisions to its AML Regulations. The notice discusses the requirement for private funds to appoint an Anti-Money Laundering Compliance Officer (“AMCLO”), Money Laundering Reporting Officer (“MLRO”) and Deputy Money Laundering Reporting Officer (“DMLRO”), and offer guidance on compliance obligations when these duties are outsourced or delegated. Under these new CIMA requirements, investment funds that conduct business in or from the Cayman Islands must appoint individuals to these new AML officer positions. CIMA has delayed certain deadlines for funds that launched prior to June 1, 2018:

  • CIMA-Registered Cayman Funds – registered funds must have appointed the new officers by September 30, 2018, but do not need to confirm the identity of the officers via CIMA’s Regulatory Enhanced Electronic Forms Submission (“REEFS”) portal until December 31, 2018. Managers should confirm that they have appointed individuals to the AML officer positions if they have not already done so.
  • Unregistered Cayman Fund – unregistered funds do not need to appoint the new officers until December 31, 2018, and they do not need to confirm the identity of these officers via the REEFS portal.

Funds formed on or after June 1, 2018 must have appointed the officers (and confirmed such officers through REEFS for registered funds) at launch. If you have any questions, we recommend fund managers discuss AML compliance with offshore counsel and the fund’s administrator.

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Compliance Calendar

Compliance Calendar. As you plan your regulatory compliance timeline for the coming months, please keep the following dates in mind:

Deadline Filing
December 17, 2018 IARD Preliminary Renewal Statement payments due (submit early to ensure processing by deadline)
December 27, 2018 Last day to submit filings via IARD prior to year end
December 31, 2018 Review RAUM to determine 2019 investment adviser registration and Form PF filing requirements
December 31, 2018 Deadline for CIMA-registered funds formed prior to June 1, 2018 to confirm the identity of new AML officers via REEFS
January 15, 2019 Quarterly Form PF due for large liquidity fund advisers (if applicable)
January 31, 2019 “Annex IV” AIFMD filing
February 14, 2019 Registered CTAs must submit a 2018 year-end report
February 14, 2019 Quarterly Form 13F updates due
February 14, 2019 Annual Form 13H updates due
February 14, 2019 Annual Schedule 13G updates due
March 1, 2019 Deadline for re-certification of CFTC exemptions
March 1, 2019 Quarterly Form PF due for larger hedge fund advisers (if applicable)
March 1, 2019 Large-sized CPOs must submit a quarterly report (CPO-PQR)
March 31, 2019 Deadline to update and file Form ADV Parts 1, 2A & 2B
March 31, 2019 Small and mid-sized registered CPOs must submit a quarterly report (CPO-PQR) for the fourth quarter of 2018
Periodic Fund managers should perform “Bad Actor” certifications annually
Periodic Amendment due on or before anniversary date of prior Form D and blue sky filing(s), as applicable, or for material changes
Periodic CPO/CTA Annual Questionnaires must be submitted annually, and promptly upon material information changes

Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP.  Mr. Mallon can be reached directly at 415-868-5345.

 

Cole-Frieman & Mallon 2018 Third Quarter Update

Below is our quarterly newsletter. If you would like to be added to our distribution list, please contact us.

Clients, Friends, Associates:

We hope that you had an enjoyable summer. The past quarter saw further interest in digital assets from regulators, as well as enforcement actions and indications of possible regulatory changes. In the traditional investment management space, this summer saw a continuation of the bull market. As we move into the fourth quarter, we would like to provide an overview of items we hope will help you stay up-to-date with regulatory developments.

In addition to the discussion below, we would like to announce a couple of firm-related items:

  • CoinAlts Fund Symposium. In September, preceded by a well-attended Women in Crypto networking event sponsored by Coinbase, founding sponsor Cole-Frieman & Mallon hosted its third successful full day Symposium in San Francisco. Speakers including keynote Tim Draper, founder of Draper Associates, DFJ and the Draper Venture Network and Joe Eagan of Polychain Capital explored issues key to fund managers and investors in the digital asset space.
  • CFM San Francisco. We are delighted to announe our overflowing San Francisco team will shortly relocate to expanded premises at 255 California Street.

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SEC Matters

SEC Chairman Hints at Changes in Investor Standards. On August 29, Securities and Exchange Commission (“SEC”) Chairman Jay Clayton spoke at the Nashville 36|86 Entrepreneurship Festival. He discussed issues the SEC is focused on or intends to focus on, including initial coin offerings (“ICOs”), promoting capital formation for public companies or companies considering going public, and rethinking the SEC’s current private offering exemption framework. Of note, Chairman Clayton stated that the SEC should explore how the current private offering exemption landscape could be simplified and streamlined. In particular, the Chairman noted that the SEC should examine the possibility of focusing on factors beyond investor wealth (i.e. accredited investor status), such as investor sophistication or investment amount.

SEC Releases Best Execution Deficiencies Alert. On July 11, the Office of Compliance Inspections and Examinations of the SEC released an alert outlining common deficiencies observed in examinations of advisers’ “best execution” obligations. These requirements come from the Investment Advisers Act of 1940, as amended, and impose a duty on advisers to execute trades so that total costs and proceeds are most favorable to clients. While best execution obligations depend on the facts of each situation, the SEC observed the following common deficiencies:

  • Not Performing Reviews – advisers were unable to provide evidence that they periodically and systematically reviewed the broker-dealers used to execute transactions.
  • Not Considering Materially Relevant Factors in Broker-Dealer Services – advisers did not consider the full range and quality of broker-dealers’ services.
  • Not Seeking Other Broker-Dealers – advisers often used only one broker-dealer for all of their clients without evaluating the services, quality, and costs of others.
  • Not Disclosing Best Execution Practices – advisers did not fully disclose best execution practices to their clients.
  • Not Disclosing Soft Dollar Arrangements – soft dollar arrangements (i.e. commissions in exchange for brokerage and research services) were not fully and fairly disclosed in advisers’ Form ADVs.
  • Not Properly Allocating Mixed Use Products and Services – advisers did not properly allocate the costs of mixed use products or services (i.e. products or services obtained using soft dollars, where that product or service is also used for non-investment purposes, such as accounting or marketing). Additionally, advisers did not properly document the reasons for mixed use product or service allocations.
  • Inadequate Policies and Procedures – advisers lacked policies, had insufficient internal controls, or did not have policies tailored to their investment strategy.
  • Not Following Policies and Procedures – advisers failed to follow their own best execution policies and procedures.

In light of the deficiencies listed above, advisers should review their best execution policies and procedures, and contact legal counsel or a compliance professional with any questions.

Hedge Fund Adviser Charged with Short-and-Distort Scheme. On September 12, the SEC charged a hedge fund advisor with illegally profiting from a “short-and-distort” scheme. The adviser is alleged to have released false information about a public pharmaceutical business after shorting the company. The adviser allegedly used reports, interviews, and social media to spread false claims that, for example, the pharmaceutical company was “teetering on the brink of bankruptcy”. The SEC is seeking a permanent restraining order, disgorgement of ill-gotten gains, and civil penalties.

SEC Charges Adviser for Risky Investments and Secret Commissions. On July 18, the SEC charged an adviser and its CEO with misleading investors by putting their capital in risky investments and secretly pocketing large commissions from such investments. The adviser and CEO are accused of misleading investors about the risks of the investments, overbilling, concealing financial conflicts, and violating the anti-fraud and registration provisions of federal securities laws. The SEC is seeking a permanent injunction, disgorgement of ill-gotten gains and losses avoided plus prejudgment interest, and civil monetary penalties. 

CFTC/NFA Matters 

CFTC Chairman Outlines Increased CFTC Enforcement. On October 2, the Commodities Futures Trading Commission (“CFTC”) Chairman Christopher Giancarlo summarized the CFTC’s increased enforcement efforts from the prior fiscal year in a speech to the Economic Club of Minnesota. These efforts include:

  • Enforcement Actions – in the prior fiscal year, the CFTC filed approximately 25% more enforcement actions than each of the prior three fiscal years.
  • Large-Scale Matters – the CFTC has increased enforcement actions against large-scale matters (i.e. matters that threaten basic market integrity). In the CFTC’s last fiscal year, it brought more than three times the average number of large-scale actions as the previous administration.
  • Manipulative Conduct – the CFTC has brought more than five times the previous average number of actions against manipulative conduct in the past fiscal year. Such conduct includes fraud, spoofing (i.e. bidding with the intent to cancel before execution), and the use of technology to manipulate order books.
  • Accountability – the CFTC has prioritized individual accountability, and approximately 70% of the past fiscal year’s cases involved charges against individuals who committed illegal acts.
  • Partnership with Criminal Enforcement – the CFTC has filed “far more actions in parallel” with criminal law enforcement partners than in any previous year.
  • Whistleblower Awards – with respect to whistleblowers, the CFTC has strengthened protections, granted a record number of awards, and received a record number of tips and complaints.

With these increased enforcement efforts in mind, managers of funds subject to CFTC jurisdiction should ensure they are up-to-date with CFTC filings and regulations.

CTA Associated Person and Introducing Broker Charged with Fraud. On August 10, the CFTC settled charges against an associated person of a commodity trading adviser (“CTA”) and introducing broker. The charges were based on a fraudulent trading scheme where the trader entered unauthorized commodities trades in customers’ accounts, transferred profitable trades to his own account, and left losses in the clients’ accounts. The settlement included a cease and desist order, a permanent ban from engaging in trading with any CFTC-registered entity, and a $100,000 civil monetary penalty.

Digital Asset Matters

Regulators continued to show interest and initiate enforcement actions in the digital asset space. Below is a summary of certain key digital asset items from the third quarter. For a complete review of these and other crypto developments, please consult our Third Quarter Digital Asset Regulatory Items blog post.

SEC Charges Digital Asset Hedge Fund Manager. On September 11, the SEC announced the settlement of charges against a digital asset hedge fund and its manager. The charges include misleading investors, offering and selling unregistered securities, and failing to register the hedge fund as an investment company. After being contacted by the SEC, the fund offered rescission and disclosed its previous misstatements to investors. The settlement included cease-and-desist orders, censure, and a $200,000 penalty. This is the first action the SEC has taken against a digital asset fund based on violations of the investment company registration requirements.

SEC Charges ICO Platform for Operating as Unregistered Broker-Dealer. On September 11, the SEC settled charges against an ICO platform. The business was charged with failing to register as a broker-dealer, as well as offering and selling unregistered securities. This is the SEC’s first charge against an unregistered broker-dealer in the digital asset space following the SEC’s 2017 DAO Report, which cautioned anyone offering or selling digital assets to comply with federal securities laws.

New York Attorney General Releases Report on Digital Asset Exchanges. On September 18, the Office of the Attorney General of New York (the “OAG”) released a report summarizing a crypto exchange fact-finding initiative. Based on the digital asset exchanges examined, the OAG outlined three primary areas of concern: potential conflicts of interest, lack of anti-abuse controls, and limited customer fund protection.

NFA Requires CPOs and CTAs to Disclose Digital Asset Activity. On July 20, the National Futures Association (“NFA”) released a notice that imposed new disclosure requirements on futures commission merchants, commodity pool operators (“CPOs”), and CTAs that are NFA members engaged in certain digital asset activities. The new disclosures cover, for example, the volatility and cybersecurity risks of digital assets. Additional details are available in our recent blog post.

Offshore Matters

Cayman Islands Delays AML Officer Deadline. Under new Cayman Islands requirements, investment funds that conduct business in or from the Cayman Islands must appoint individuals to new anti-money laundering officer positions. The Cayman Islands Monetary Authority (“CIMA”) has delayed certain deadlines for funds that launched prior to June 1, 2018:

  • CIMA-Registered Cayman Funds – registered funds still must have appointed the new officers by September 30, 2018, but now do not need to confirm the identity of the officers via CIMA’s Regulatory Enhanced Electronic Forms Submission (“REEFS”) portal until December 31, 2018.
  • Unregistered Cayman Funds – unregistered funds do not need to appoint the new officers until December 31, 2018, and they do not need to confirm the identity of these officers via the REEFS portal.

Funds formed on or after June 1, 2018 must have appointed the officers (and confirmed such officers through REEFS for registered funds) at launch. The new roles must be filled by individuals, and some service providers may be willing to provide individuals to serve such roles. We recommend fund managers discuss anti-money laundering compliance with offshore counsel and the fund’s administrator.

Other Matters 

FINRA Warns of Regulator Impersonators. On July 13, FINRA issued a warning that persons claiming to be working for FINRA have been calling firms and attempting to obtain confidential information. In particular, FINRA warned that the use of overseas telephone numbers or email addresses indicates a likely scam, as well as emails from suspicious domains that do not end with “@finra.org” and that contain attachments or embedded links. If you have questions about the legitimacy of purported FINRA communications, contact your FINRA Coordinator.

New York Issues Sexual Harassment Compliance Mandate. Managers with operations in New York State and New York City should be aware of recent changes to employers’ obligations with respect to sexual harassment. Effective October 9, 2018, all employers in New York State are required to adopt a sexual harassment prevention policy equal to or greater than the standards of the state-issued model policy. Additionally, New York State employers must provide sexual harassment prevention training annually that is equal to or greater than the state-created model. This training must be completed by current employees by January 1, 2019, and by new hires within 30 days of being hired. Managers that may be subject to these new requirements can learn more on New York State’s Combating Sexual Harassment in the Workplace website. New York City has also implemented similar training requirements for employers with 15 or more employees, which will take effect on April 1, 2019. Additionally, effective September 6, 2018, New York City employers must post a sexual harassment poster and distribute a fact sheet to new employees.

SEC Charges Firm for Deficient Cybersecurity. On September 26, the SEC settled charges against a broker-dealer/investment adviser based on the firm’s deficient cybersecurity procedures after parties posing as contractors accessed customers’ personal information. The charges are a reminder of the importance of maintaining strong cybersecurity policies and procedures. Firms should be aware that cybersecurity is an on-going obligation and has become a focus of the SEC.

IRS Ends Voluntary Disclosure Program. On September 28, the Internal Revenue Service ended the 2014 Offshore Voluntary Disclosure Program (“OVDP”). U.S. taxpayers are required to report and pay taxes on certain offshore assets and face potential stiff criminal and civil penalties for failing to do so, and the OVDP was designed to offer taxpayers certain protections from these penalties. Fund managers with unreported foreign assets that were not able to meet the September 28, 2018 deadline should discuss their options with tax counsel.

New Law Expands Disclosure and Approval Requirements for Investments by Foreign Entities. On August 13, the Foreign Investment Risk Review Modernization Act (“FIRRMA”) was signed into law. It expands the scope of investments by non-U.S. investors in critical domestic tech companies that must be disclosed to and approved by the federal government in an effort to strengthen national security. An example investment within the scope of FIRRMA is an investment by a non-U.S. entity in a tech company that gives the investing entity access to material non-public technical information. While there are limits and exemptions to the scope of FIRRMA and the typical fund will not need to worry about its new requirements, venture funds with foreign limited partners or foreign co-investors should be mindful of the expanded approval requirements.

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Compliance Calendar. As you plan your regulatory compliance timeline for the coming months, please keep the following dates in mind:

 

Deadline Filing
October 10, 2018 Form 13H amendment due for large traders if the information contained in the filing became inaccurate in Q3
October 15, 2018 Quarterly Form PF due for Large Liquidity Fund Advisers (for funds with December 31 fiscal year-ends) filing for Q3 2018 (if applicable)
October 15, 2018 Extended deadline to file Reports of Foreign Bank and Financial Accounts (FBAR)
October 30, 2018 Registered investment advisers must collect access persons’ personal securities transactions
November 14, 2018 Form PR filings for registered CTAs that must file for Q3 within 45 days of the end of Q3 2018
November 14, 2018 Form 13F is due for certain institutional investment managers
November 30, 2018 Form PF filings for Large Hedge Fund Advisers with December 31 fiscal year-ends filing for Q3 2018
November 30, 2018 Large registered CPOs must submit a pool quarterly report (CPO-PQR)
December 17, 2018 Deadline for paying annual IARD charges and state renewal fees
December 31, 2018 Small and mid-sized registered CPOs must submit a pool quarterly report (CPO-PQR)
December 31, 2018 Deadline for CIMA-registered Cayman funds formed prior to June 1, 2018 to confirm the identity of appointed anti-money laundering officers via REEFS; deadline for unregistered Cayman funds to appoint anti-money laundering officers
December 31, 2018 Cayman funds regulated by CIMA that intend to de-register (i.e. wind down or continue as an exempted fund) should do so before this date in order to avoid 2019 CIMA fees
Periodic Fund managers should perform “Bad Actor” certifications annually
Periodic Amendment due on or before anniversary date of prior Form D and blue sky filing(s), as applicable, or for material changes
Periodic CPO/CTA Annual Questionnaires must be submitted annually, and promptly upon material information changes

Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP.  Mr. Mallon can be reached directly at 415-868-5345.

Digital Asset Regulatory Items – Third Quarter 2018

The third quarter of 2018 saw increased interest from regulators in the digital asset space, as well as enforcement actions. For your convenience, we have provided an overview of key items from the quarter below.

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SEC MATTERS

Enforcement

SEC Charges Digital Asset Hedge Fund Manager

On September 11, the Securities and Exchange Commission (“SEC”) announced the settlement of charges against a digital asset hedge fund and its manager. The charges included misleading investors, offering and selling unregistered securities, and failing to register the hedge fund as an investment company. The manager marketed the fund as the “first regulated crypto asset fund in the United States” and claimed the fund had filed registration statements with the SEC. Based on investments in “digital assets that were investment securities”, the fund was required to register as an investment company with the SEC. However, the fund was not registered and did not meet any exemptions or exclusions from the investment company registration requirements. The settlement included cease-and-desist orders, censure, investor rescission offers, and a $200,000 penalty. This is the first action the SEC has taken against a digital asset fund based on violations of the investment company registration requirements.

SEC Charges ICO Platform for Operating as Unregistered Broker-Dealer

On September 11, the SEC settled charges against an initial coin offering (“ICO”) platform. The business and its principals were charged with failing to register as broker-dealers and selling unregistered securities. This is the SEC’s first charge against an unregistered broker-dealer in the digital asset space following the SEC’s 2017 DAO Report, which cautioned anyone offering or selling digital assets to comply with federal securities laws such as broker-dealer registration requirements. The business agreed to pay $471,000 plus prejudgment interest, and the principals each agreed to a three-year bar from certain investment-related activities and $45,000 in penalties.

SEC Fines and Halts Fraudulent ICO

On August 14, the SEC settled charges related to an ICO. The token issuer was charged with fraud and the sale of unregistered securities after it claimed the proceeds from its ICO would be used to fund oil drilling in California. However, the issuer falsely represented that it had the necessary drilling lease and misled investors about the potential for profit and the prior bankruptcy and criminal history of the issuer’s principal. The settlement included permanent cease and desist orders, a permanent bar from certain investment-related activities, and a $30,000 fine. In light of recent charges like this, fund managers investing in ICOs should ensure they complete adequate due diligence on investment opportunities.

Other

SEC Denies and Delays Bitcoin ETFs

On August 22, the SEC released three separate orders denying nine Bitcoin exchange-traded fund (“ETF”) proposals. These orders followed the SEC’s July 26 denial of another Bitcoin ETF. The SEC’s reasoning in these denials was mainly based on a concern that the price of Bitcoin may be susceptible to manipulation. However, on September 20, the SEC announced that it has begun a formal review for a physically-backed Bitcoin ETF. The acceptance of such an ETF would increase digital asset investment options and has the potential to promote the overall growth of the industry.

SEC Suspends Trading of Swedish Bitcoin Instruments

On September 9, the SEC temporarily suspended trading of two foreign cryptocurrency investment instruments commonly known as the “Swedish Bitcoin ETFs”. The instruments hold Bitcoin on behalf of shareholders and, prior to the suspension, had been tradable in U.S. brokerage accounts. The SEC suspended the ETFs out of a concern for investor confusion, which was likely based on inconsistent representations. The issuers’ broker-dealer applications referred to the instruments as ETFs, other sources characterized them as exchange-traded notes, and the issuers’ offering memoranda described them as “non-equity linked certificates”. With this suspension in mind, fund managers considering investing in novel digital asset instruments should ensure they understand the nature of the instruments.

CFTC MATTERS

Investor Alerts

CFTC Stresses Due Diligence in ICO Investments

On July 16, the Commodities Futures Trading Commission (“CFTC”) published an alert cautioning investors to conduct extensive research before investing in any ICO, especially those that claim to be utility tokens (i.e. non-securities). The alert includes factors that investors should consider before investing in a token offering, such as the potential for forks, mining costs, liquidity, and risk of hacks.

Enforcement

Court Enters Final Order for CFTC Charges Against Crypto Company

On August 23, a New York federal court entered final judgment against a digital asset company based on charges brought by the CFTC. The company claimed that, in exchange for sending digital assets, customers could receive expert crypto trading advice or have the company trade on their behalf. However, no such expert advice or trading services were provided. The company was charged with fraud and the final judgment included a permanent injunction from certain investment-related activities, more than $290,000 in restitution, more than $871,000 in civil penalties, and post-judgment interest.

NFA MATTERS

NFA Requires CPOs and CTAs to Disclose Digital Asset Activity

On July 20, the National Futures Association (“NFA”) released a notice that imposed new disclosure requirements on futures commission merchants, commodity pool operators (“CPOs”), and commodity trading advisers (“CTAs”) engaged in digital asset activity. Specific to CPOs and CTAs, the NFA is now requiring discussion of certain aspects of digital asset investing, such as volatility, liquidity, and cybersecurity, as well as the inclusion of certain standardized disclosures. Additional details are available in our recent blog post.

FINRA MATTERS

FINRA Charges Broker with Fraud and Unlawful Distribution for Token Offering

On September 11, the Financial Industry Regulatory Authority (“FINRA”) charged a broker in connection with a token offering. The broker attempted to raise money through the offering for an allegedly worthless public company and, in the process, misled investors about the company’s operations and finances. The broker is charged with making material misrepresentations, offering and selling unregistered securities, and failing to notify the broker’s firm about the transactions. This is FINRA’s first disciplinary action involving digital assets.

FEDERAL LEGISLATION

Congressional Representative Introduces Crypto-Friendly Bills

On September 21, Minnesota Congressional Representative Tom Emmer announced three crypto-friendly bills. The first bill would codify an overall “light touch, consistent, and simple” approach to digital asset regulation. The second bill would provide a safe harbor for certain businesses that lack control over consumer funds by exempting them from certain regulations, such as money transmitter licensing requirements. Lastly, the third bill would limit fines for taxpayers that failed to fully report forked digital assets until the Internal Revenue Service (“IRS”) provides further guidance on how such forks should be reported.

STATE MATTERS

New York

New York Attorney General Releases Report on Digital Asset Exchanges

On September 18, the Office of the Attorney General of New York (the “OAG”) released a report summarizing a crypto exchange fact-finding initiative. The report outlines three primary areas of concern:

  • Conflicts of Interest – Crypto exchanges are exposed to potential conflicts of interest in several ways. For example, exchanges often have additional lines of business (e.g. broker-dealer) that would either be prohibited or carefully monitored in traditional securities contexts. Additionally, employees may have access to non-public information, and may hold and trade digital assets on their employer’s or competitors’ exchanges. Some exchanges also lack standards for determining which tokens are listed, and the possibility that an exchange may take fees for such a listing create a potential conflict of interest.
  • Lack of Anti-Abuse Efforts – Digital asset exchanges have not consistently implemented safeguards to protect the integrity of their platforms. Such safeguards include monitoring real-time and past trades, and restricting the use of bots. Additionally, some exchanges engage in proprietary trading (i.e. trading from the exchange’s own account in order to, for example, promote market liquidity) which may expose users to price manipulation or other abuse.
  • Limited Customer Funds Protections – Exchanges lack a consistent and transparent approach to auditing the digital assets they hold. Additionally, several exchanges do not have independent audits completed. These shortcomings make it difficult to determine whether crypto exchanges adequately maintain and protect customers’ assets. The OAG also raised concerns over whether exchanges have adequate protection against hacks and maintain sufficient insurance policies.

Digital asset fund managers should keep these concerns in mind and ensure they properly vet exchanges they may utilize.

Court Rules ICO Tokens May Be Subject to Securities Laws

On September 11, the U.S. District Court for the Eastern District of New York ruled that a criminal case brought against the individual behind two ICOs can proceed to trial. The defendant faces conspiracy and securities fraud charges for allegedly making false claims that the tokens sold in the ICOs were backed by real estate and diamonds. The defendant moved to dismiss the case on the grounds that securities laws are too vague to apply to ICOs, and that the issued tokens were not securities. The issue of whether the tokens in question are securities may now ultimately be decided by a jury.

Texas

Texas Issues Emergency Cease and Desists Against Crypto Investment Scheme

On September 18, the Securities Commissioner of Texas (the “Commissioner”) released three orders related to digital asset investment schemes. First, the Commissioner issued a cease and desist order against a mining company that used promotional materials falsely implying third-party endorsements and associations. Second, the Commissioner issued a cease and desist order against a company that solicited investments to develop a biometric token wallet. The business misled investors with a video of former President Barack Obama that falsely implied he was discussing the company. The business also made unsubstantiated claims, for example, that it was backed by “a leading financial institution”. Lastly, the Commissioner issued a cease and desist order against a company that solicited investments for its crypto and forex trading programs. The company told investors they could earn 10x returns, that those returns were guaranteed, and that there was no investment risk. All orders allege that the companies violated securities laws by offering and selling unregistered securities, engaging in fraud, and making materially misleading statements. These orders further highlight the need for fund managers to conduct due diligence on digital asset investment opportunities.

OTHER MATTERS

Statements

Congressional Representatives Urge IRS to Provide Guidance on Cryptocurrency

On September 19, five members of the House of Representatives published a letter urging the IRS to issue updated guidance on digital asset taxation. The last major guidance from the IRS, Notice 2014-21, was issued in March 2014. Since then, the IRS has increased digital asset scrutiny by, for example, requesting transaction records from crypto exchanges and choosing not to provide leniency through a voluntary crypto disclosure program. Such guidance would hopefully resolve some of the tax uncertainties digital asset fund managers currently face.

NASAA Announces Coordinated Digital Asset Investigations

On August 28, the North American Securities Administrators Association (“NASAA”) announced that regulators in the U.S. and Canada are engaged in more than 200 digital asset-related investigations as part of a coordinated NASAA initiative known as “Operation Cryptosweep”. While investigations have focused on suspected securities fraud, regulators have uncovered other violations, such as the offer and sale of unregistered securities. The initiative has resulted in at least 46 enforcement actions related to ICOs or digital asset investment products.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon LLP has been instrumental in structuring the launches of some of the first digital currency-focused hedge funds and works routinely on matters affecting the digital asset industry. Mr. Mallon can be reached directly at 415-868-5345