Monthly Archives: July 2018

Cole-Frieman & Mallon 2018 Second Quarter Update

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

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July 12, 2018

Clients, Friends, Associates:

We hope that you are enjoying the start of summer.  Although the second quarter is typically not as busy as the first quarter from a regulatory or compliance perspective, we continue to see rapid developments in the digital asset space.  As we move into the third quarter, we would like to provide a brief overview of some items we hope will help you stay abreast of these developments.

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

CFM Atlanta.  Our Atlanta office has just moved into new space in the heart of Buckhead.  The new office address is 3348 Peachtree Road NE, Suite 1030, Atlanta, GA 30326.

CoinAlts Fund Symposium. In April founding sponsor Cole-Frieman & Mallon hosted its second full day Symposium attended by over 300 professionals, students, and investors in New York.  Featuring twenty eight speakers, including key-notes, John Burbank of Passport Capital and Mark Yusko of Morgan Creek Capital Management, CoinAlts East presented a broad spectrum of content essential to managers and investors in the digital asset space.  Our next CoinAlts Fund Symposium will take place in San Francisco on September 20, 2018. More details to follow.

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GDPR

GDPR Effective May 25.  The General Data Protection Regulation (“GDPR”) went into effect on May 25, 2018 as part of the European Union’s effort to protect personal data.  Any person or business that handles EU residents’ personal data must comply with the regulation.  GDPR also applies to businesses established outside of the EU if their activities involve processing personal data related to offering goods or services to persons within the EU.  US 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 with EU resident investors, but no presence within in the EU may also be required to appoint an EU local representative unless they can demonstrate processing is “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, but it may be challenging at present to find EU counsel that will advise on this requirement in the absence of more guidance from EU regulators.  For more information on GDPR, including compliance items for hedge fund managers, please see our earlier post.

Legal and Regulatory Developments

SEC Proposes Rules Regarding Form CRS, Form ADV, and Disclosures in Retail Communications.  On April 18, 2018, the Securities and Exchange Commission (“SEC”)  proposed new rules and amendments to certain rules and forms under the Investment Advisers Act of 1940, as amended (“Advisers Act”) and the Securities Exchange Act of 1934, as amended.  One proposal would require both registered investment advisers and broker-dealers to provide a summary (“Form CRS”) disclosing the nature and details of their relationship to retail investors.  Form CRS would be added as a section to Form ADV and would disclose: (i) the relationships and services the firms offer; (ii) the standard of conduct and fees and costs associated with the services; (iii) specified conflicts of interest; and (iv) reportable legal or disciplinary events on the firm’s part or its financial professionals.

The SEC also proposed two new rules to reduce investor confusion caused by communications with broker-dealers and investment advisers by placing additional requirements on retail investor communications.  One rule would restrict broker-dealers’ use of the terms “adviser” and “advisor” when communicating with retail investors.  The other rule would require broker-dealers and investment advisers to disclose their SEC registration status in retail investor communications.  It would also require associated natural persons and supervised persons to disclose their relationships with broker-dealers or investment advisers in retail investor communications.  Comments to the SEC are due on or before August 7, 2018.

SEC Proposes Interpretation of Standard of Conduct for Investment Advisers.  On April 18, 2018, the SEC proposed an interpretation of the conduct standard for investment advisers under the Advisers Act and requested comment on its proposal.  The SEC also seeks comment on the following proposed requirements for SEC registered investment advisers (“RIAs”): (i) federal licensing and continuing education; (ii) periodic account statements; and (iii) financial responsibility requirements similar to those required of broker-dealers.  Comments to the SEC are due on or before August 7, 2018.

SEC Charges 13 Private Fund Advisers for Repeated Form PF Filing Failures.  On June 1, 2018, the SEC  announced settlements with 13 SEC RIAs for repeatedly failing to provide risk monitoring information.  The SEC found that the advisers continually failed to file annual reports on Form PF.  Section 204(b) of the Advisers Act requires large fund managers to report information such as assets under management, fund strategy, and fund performance on Form PF.  The SEC uses these reports to inform their rulemaking process and to target examinations and enforcement investigations.  The SEC found that each of the advisers violated the Form PF reporting requirements under the Advisers Act.  Although the advisers did not admit or deny the SEC’s findings, they agreed to be censured, cease and desist, and to each pay a $75,000 civil penalty.

SEC Charges Hedge Fund Adviser with Deceiving Investors.  On May 9, 2018, the SEC charged a hedge fund adviser and certain principals, including the CEO and a former portfolio manager, for fraudulently overvaluing its funds by hundreds of millions of dollars.  Defendants are alleged to have placed trades in exchange for inflated broker-dealer quotes and applied “imputed” mid-point valuations in a manner that further inflated the value of securities.  The SEC is seeking permanent injunctions, the return of illicit profits with interest, and civil penalties.

SEC Charges Hedge Fund Firm for Asset Mismarking and Insider Trading.  The SEC announced on May 8, 2018 that a manager agreed to settle charges regarding insider trading and fraudulent overvaluation of certain assets held by its hedge funds.  The SEC found that two of the portfolio managers overstated the values of their hedge funds’ securities.  In a separate order, the SEC alleged that the CFO failed to supervise the two portfolio managers appropriately and respond to red flags regarding the mismarking.  The SEC also found that the portfolio managers violated insider trading laws by trading pharmaceutical securities on confidential information obtained through a former U.S. Food and Drug Administration official.

Second Circuit Amends Martoma Decision.  On June 25, 2018, the U.S. Court of Appeals for the Second Circuit amended its decision in United States v. Martoma to clarify tippee liability in insider trading cases.  As we discussed in a previous Quarterly Update, the Second Circuit once again upheld a former portfolio manager’s 2014 conviction for insider trading.  In its amended decision, the court confirmed that a “meaningfully close personal relationship” is not required for tippee liability in insider trading cases.

Digital Asset Matters

We see many thought-provoking items in the digital asset sector as the industry moves towards greater institutional infrastructure.  After numerous public statements by SEC officials, token issuers understand that there are several compliant ways to raise capital through token offerings.  One way is through Regulation A+, which has many advantages over other securities offering mechanisms.  We are also seeing many groups use airdrops as a way to try to circumvent the private placement regulatory regime.  One item to specifically note, is that privately placed tokens may have resale restrictions that could create issues for both the token issuers and token purchasers.  We are also aware of several groups beginning the process of registering as alternative trading systems or otherwise becoming broker-dealers and/or qualified custodians.

Outside of these items, we have summarized some notable regulatory developments in the second quarter.  For a complete review of these developments, please consult our Digital Asset Regulatory Items blog post.

CFTC Issues Advisory on Virtual Currency Derivatives.  On May 21, 2018, the Commodity Futures Trading Commission (“CFTC”) Division of Market Oversight and the Division of Clearing and Risk issued an advisory regarding virtual currency derivative products.  The CFTC outlined key expectations for exchanges and clearinghouses operating in the virtual currency derivatives space:

  • Enhanced Market Surveillance – an adequate market surveillance program would include sharing information on the underlying spot markets, allowing the CFTC to access a broad range of exchange trade data (i.e., trader identity, volumes, times, prices, and quotes), and real-time monitoring of all trading activity to identify red flags.
  • Close Coordination with the CFTC Surveillance Group – exchanges should engage in regular discussions with the CFTC on surveillance of virtual currency derivatives contracts and allow access to data on settlement processes referenced in such contracts.
  • Large Trader Reporting – exchanges should set large trader reporting thresholds for any contract at five BTC (or equivalent) to increase their ability to focus on relevant market information.
  • Outreach to Members and Market Participants – exchanges should obtain comments from stakeholders on listing issues beyond contract terms and conditions.  Comments should include explanations of opposing views and the exchanges’ perspectives.
  • Derivative Clearing Organization’s Risk Management – the CFTC requests information from derivative clearing organizations (“DCOs”) necessary to assess the suitability of proposed initial margin requirements.  The CFTC may require DCOs to amend inadequate initial margins.  They may also request information regarding the approval process of proposed contracts.

NASAA Combats ICO Fraud.  On May 21, 2018, the North American Securities Administrators Association (“NASAA”) announced its involvement in “Operation Cryptosweep,” one of the largest coordinated enforcement efforts against fraudulent Initial Coin Offerings (“ICOs”), crypto-related products, and cryptocriminals.  Operation Cryptosweep is a combined effort between NASAA’s members, spanning more than 40 jurisdictions in the United States and Canada.  Since April 2018, the operation has produced almost 70 inquiries and investigations in addition to 35 pending or completed enforcement actions related to digital assets and ICOs, including multiple actions against private funds.  According to NASAA President Joseph Borg, these recent actions are only the beginning of further enforcement against ICO fraud.

Other Items

5th Circuit Issues Mandate on Fiduciary Rule.  On June 21, 2018, the U.S. Court of Appeals for the Fifth Circuit issued a mandate regarding the Department of Labor’s (“DOL’s”) Fiduciary Rule (“Fiduciary Rule”) after months of uncertainty.  The Fifth Circuit’s mandate effectuates its March 15 decision to vacate the Fiduciary Rule.  Although the DOL’s Fiduciary Rule appears defeated, the court’s decision may prompt the SEC and other regulators to revisit their plans for fiduciary reform.

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 of 1940, as amended, by increasing the number of investors allowed in a qualifying venture capital fund from 100 to 250 investors.  The Growth Act —  which will take effect in late 2019 —  defines a qualifying venture capital fund as one with less than $10 million “in aggregate capital contributions and uncalled committed capital.”

The CFTC and NASAA Sign Information Sharing Memorandum.  The CFTC and NASAA signed a Memorandum of Understanding (“MOU”) regarding the sharing of non-public information on May 21, 2018.  The MOU aims to forge a closer working relationship between the CFTC and individual state securities agencies— represented by the NASAA— to better enforce the U.S. Commodity Exchange Act of 1936, as amended (“CEA”) by promoting voluntary, inter-agency sharing of non-public information.  NASAA President Joseph Borg believes the MOU could assist NASAA members in enforcing both securities and commodities law violations, particularly against schemes related to digital assets and other modern commodities.

NFA Develops Swaps Proficiency Program and Exam.  The National Futures Association (“NFA”) announced on June 5, 2018 that its board approved the creation of an online proficiency requirements program and exam for all associated persons participating in swaps activities.  The swaps proficiency program is part of the NFA’s mandate under the CEA, which requires the NFA to set training standards and proficiency testing for individuals and activities governed thereunder.  The online program and exam are expected to launch in early 2020.

Cayman Islands Revises and Clarifies AML Regulations.  As mentioned in previous updates, the Cayman Islands released the 2018 revisions to its Anti-Money Laundering (“AML”) regulations earlier this year.  The following are some notable changes:

  • Non-Cayman Islands Monetary Authority (“CIMA”) registered funds (i.e., 4(4) funds) will be subject to AML regulations;
  • All investment funds (registered and unregistered) must designate natural persons to act as Anti-Money Laundering Compliance Officers (“AMLCOs”), Money Laundering Reporting Officers (“MLROs”), and Deputy Money Laundering Reporting Officers (“DMLROs”) by September 30, 2018 or, for funds registering after June 1, 2018, upon submission of the registration application; and
  • All investment funds (registered and unregistered) will be subject to enhanced AML processes and procedures.

CIMA also released a notice on April 6, 2018 to clarify its guidance notes on the AML regulations.

The guidance clarified that a fund could designate the same individual to serve as its AMLCO and MLRO.  Also, if an MLRO, DMLRO, and AMLCO have been appointed, a person carrying out the relevant financial business of a fund may delegate to another the performance of functions outlined in the AML regulations.  Significantly, managers should also note that these officers may be exposed to criminal sanctions for breach of their obligations.  Failure to comply with CIMA’s AML regulations could result in an unlimited fine and imprisonment for two years.  We recommend that fund managers discuss AML compliance and implementation issues with offshore counsel and the fund’s administrator.

Cayman Islands Appeals Court Holds That a Liquidator May Not Adjust a Shareholder’s NAV.  The Cayman Islands Court of Appeal held that an official liquidator of a fund could not change a contractually agreed upon net asset value (“NAV”), even if it were based upon fraudulent numbers.  The judge agreed with the lower court that allowing adjustment of the NAV would “interfere with the shareholders’ proprietary rights,” an action that legislators did not intend to permit.  This outcome may benefit shareholders by providing certainty regarding a fund’s NAV and the benefits derived from “their rights under a valid and subsisting contract.”

Cayman Issues AEOI Portal Update.  On May 29, 2018, the Cayman Islands issued an update regarding the Automatic Exchange of Financial Account Information Portal (“AEOI”).  The statutory deadline for filing Common Reporting Standard (“CRS”) and US Foreign Account Tax Compliance Act, as amended, (“FATCA”) reporting was May 31, 2018.  However, the Cayman Islands Department for International Tax Cooperation will allow Cayman Financial Institutions until July 31, 2018 to fulfill their 2017 CRS and US FATCA reporting obligations without facing adverse consequences, compliance measures, or penalties.

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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

  • June 29, 2018 – Delivery of audited financial statements to investors (private fund managers to fund of funds, including SEC, state, and CFTC registrants)
  • June 30, 2018 – 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 CIMA
  • June 30, 2018 – 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 31st)
  • June 30, 2018 – Review transactions and assess whether Form 13H needs to be amended
  • July 15, 2018 – Quarterly Form PF due for large liquidity fund advisers
  • July 30, 2018 – Quarterly account statements due (CPOs claiming the 4.7 exemption)
  • July 30, 2018 – Collect quarterly reports from access persons for their personal
    securities transactions
  • July 31, 2018 – Cayman Islands CRS and US FATCA reporting deadline without adverse consequences (for those who missed the initial May 31, 2018 deadline)
  • August 14, 2018 – Form 13F filing (advisers managing $100 million in 13F Securities)
  • August 14, 2018 – CTA-PR filing with NFA
  • August 29, 2018 – Quarterly Form PF due for large hedge fund advisers
  • August 29, 2018 – CPO-PQR filing with NFA
  • September 30, 2018 – Review transactions and assess whether Form 13H needs to amended
  • September 30, 2018 – Deadline to designate an MLRO, DMLRO, and AMLCO for Cayman Islands AML compliance
  • October 15, 2018 – Quarterly Form PF due for large liquidity fund advisers
  • October 15, 2018 – Annual Foreign Bank and Financial Accounts Report deadline (for those who missed the April 17 deadline)
  • Periodic – Fund managers should perform “Bad Actor” certifications annually
  • Periodic – Amendment due on or before anniversary date of prior Form D filing(s), or for material changes
  • Periodic – CPO/CTA Annual Questionnaires must be submitted annually, and promptly upon material information changes
  • Periodic – Form D and blue sky filings should be current

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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 – Second Quarter 2018

The second quarter offers notable regulatory updates in the digital asset space. For your convenience, we provide an overview of these items down below.

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SEC MATTERS

Speeches & Testimony

Chairman Testifies on Cryptocurrencies Before the House Committee on Appropriations

On April 26, 2018, Securities and Exchange Commission (“SEC”) Chairman Jay Clayton testified before the Financial Services and General Government Subcommittee of the House Appropriations Committee that digital assets are divided into 2 categories: (1) a “pure medium of exchange”—considered to be “not a security”; (2) tokens—a tool “to finance projects.” Given the uncertainty around cryptocurrencies, this may suggest that even the SEC might not readily view all tokens as securities yet.

SEC Director Hinman Testifies Before the House That Many ICOs are Securities Offerings, Certain Utility Tokens Do Not Have Hallmarks of a Security

On April 26, 2018, SEC Director William Hinman stated his position that it is “hard to have an initial sale without a securities offering.” Consequently, Hinman believes that initial coin offerings (“ICOs”) will likely require registering as a securities offering or operating under an exemption. He clarified that it is possible for a token not to have the hallmarks of a security if the token was purchased solely for its functional use and not as an investment. For many issuers, it could mean that they can offer tokens for sale by relying on appropriate exemptions without having to comply with the SEC securities registration.

SEC Director Hinman Speaks at the Yahoo Finance All Markets Summit on Crypto

On June 14, 2018, SEC Director of the Division of Corporation Finance William Hinman spoke at the Yahoo Finance All Markets Summit on Crypto in San Francisco.  He addressed questions regarding ICOs and token sales and whether a digital asset can be something other than a security.  He mentioned that currently, neither Bitcoin nor Ether meet the Howey test. However, he cautioned that classification of whether an instrument is a security is not static and the classification can change as the instrument changes.

Releases

SEC Creates Senior Advisor for Digital Assets and Innovation Position

On June 4, 2018, the SEC announced that Valerie A. Szczepanik would be the agency’s first ever Senior Advisor for Digital Assets and Innovation. This newly created position will allow the SEC to explore how U.S. securities laws would apply to digital asset technologies such as ICOs and cryptocurrencies. Ms. Szczepanik has been with the SEC since 1997. During her tenure, she has been an Assistant Director for the Division of Enforcement’s Cyber Unit. Currently, Szczepanik serves as the Head of the SEC’s Distributed Ledger Technology Working Group, Co-Head of the Dark Web Working Group, and a member of the FinTech Working Group.

Enforcement

SEC Takes Civil Actions Against Fraudulent ICO

On April 2, 2018, the SEC filed a complaint in the United States District Court for the Southern District of New York against Centra Tech., Inc. (“Centra”) for raising at least $32 million in unregistered securities through a fraudulent ICO. Centra falsely claimed that it had partnered with VISA, Mastercard, and Bancorp to create a “crypto debit card.” The complaint seeks a permanent injunction to stop Centra’s activities and to return the ill-gotten gains to investors. The U.S. Attorney’s Office has also filed criminal charges against the two founders.

SEC Files Charges Against Titanium Blockchain

On May 22, 2018, the SEC filed charges in the United States District Court for the Central District of California against Titanium Blockchain for violating antifraud and registration provisions under federal securities laws. The company used false corporate relationships and testimonies to inflate the values of their digital assets. Under the guise of an ICO, they fraudulently raised up to $21 million in cash and digital assets.

Other

SEC Creates Mock Initial Coin Offering

The SEC has created howeycoins.com. The website is designed to educate the public about fraudulent ICOs and how to avoid being a victim.

CFTC MATTERS

Advisory

The CFTC Issues Advisory on Virtual Currency Derivatives

On May 21, 2018, the Commodity Futures Trading Commission (“CFTC”) issued key expectations for exchanges and clearinghouses regarding virtual currency derivative products. These include: i) enhanced market surveillance; ii) close coordination with the CFTC surveillance group; iii) large trader reporting; iv) outreach to members and market participants; and v) derivative clearing organization’s risk management. For more details on these key points, please refer to our second quarterly update.

Speeches

CFTC Gives Keynote at the FIA 40th Annual Law & Compliance Division Conference on the Regulation of Futures, Derivative, and OTC Products, Washington, D.C.

CFTC Commissioner Rostin Behnam.  On May 3, 2018, CFTC Commissioner Rostin Behnam spoke at the Futures Industry Association’s 40th Annual Law & Compliance Division Conference on the Regulation of Futures, Derivative, and OTC Products. In his speech, the Commissioner noted that institutions look at digital assets as something more than a currency. He also acknowledged the National Futures Association’s work on understanding and regulating virtual currencies and their derivatives.

Commissioner Quintenz Announces the Establishment of TAC Subcommittees

CFTC Commissioner Brian Quintenz. On June 4, 2018, CFTC Commissioner Brian Quintenz announced the creation of the Technology Advisory Committee’s (“TAC”) four new subcommittees. The subcommittees will be tasked with exploring automated and modern trading markets, cybersecurity, distributed ledger technology and market infrastructure, and virtual currencies.

Enforcement

CFTC Files Complaint Regarding Fraudulent ATM Coin

On April 16, 2018, the CFTC filed a complaint against three investment funds for their connection with a “binary options” scheme that defrauded at least 6 U.S. clients of about $618,810. The managers invited investors to transfer their fund balances to a virtual currency firm in return for the fraudulent virtual currency called “ATM Coin.” Neither the defendants nor the executed transactions were registered with the CFTC or a registered exchange. One of the fund managers also faces criminal charges for altering records and obstructing the FBI investigation.

NFA MATTERS

Notice to Members

NFA Encourages FCMs and IBs to Review OFAC FAQs for Compliance Obligations

On May 3, 2018, the National Futures Association (“NFA”) released a notice recommending that futures commission merchants (“FCMs”) and introducing brokers (“IBs”) review the U.S. Treasury Department’s Office of Foreign Assets Control (“OFAC”) FAQs about compliance and sanctions with regard to illicit digital currency activities. The FAQs detail OFAC’s goal to combat terrorism and criminal exploitation of digital transactions, as well as compliance obligations in dealing with blocked persons or property.

FINRA MATTERS

Enforcement

FINRA Suspends a Member for Failure to Disclose Outside Business Activity.

On April 18, 2018, FINRA issued a $20,000 fine and a two-year suspension to a broker for failure to disclose his private blockchain business activity with his firm. According to FINRA, all firms’ employees must report outside business activities and any material changes to their firms. This rule is intended to strengthen investor protections against outside activities.

STATE MATTERS

California Legislation

The following bills regarding the digital asset space are moving through the California legislature.

  • CA AB-2658: it would define blockchain technology in California and create a government working group to evaluate the use of blockchain technology by CA businesses and the state government. The bill passed the State Assembly on May 30, 2018 and is currently in the State Senate.
  • CA SB-838: it would allow certain privately-owned corporations to amend their articles of incorporation to include provisions for the use of blockchain technology in recording information related to stock transactions. The bill passed the State Senate on May 17, 2018 and is currently in the State Assembly.

Colorado Division of Securities Participates in Coordinated International Crypto Crackdown

On May 3, 2018, the Colorado Securities Commission announced that it signed orders requiring Linda Healthcare Corporation and Broad Investments, LLC to cease and desist from selling securities in the state. The companies violated Colorado securities laws by promoting ICOs to Colorado residents without disclosing the risks involved.

Florida Chief Financial Officer Announces New Cryptocurrency Oversight Position

Jimmy Patronis, Florida Chief Financial Officer, released a statement on June 26, 2018 that Florida would be creating an oversight position for its cryptocurrency industry.  In coordination with the Office of Financial Regulation and the Office of Insurance Regulation, this new oversight position aims to develop policy, legislation, and regulation regarding cryptocurrency.

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

Regulation A+ for Token Offerings

Overview of Regulation A+ for Token Sponsors

Token issuers have come under increasing scrutiny with respect to their offerings on the heels of various statements by SEC personnel (see here, here and here).  SEC representatives have testified recently before House and Senate committees that the initial coin offerings (“ICOs”) they have seen are securities offerings and that it is “hard to have an [ICO] without a securities offering.”  These statements along with recent SEC enforcement actions against ICOs have created the desire for token issuers to make their offerings SEC compliant.  Many token issuers have thus begun to offer and issue tokens through certain exemptions from the securities registration regime including Regulation D private offerings and the Simple Agreement for Future Tokens (“SAFT”).  One option many groups are looking into is using Regulation A+ (“Reg. A+”) to offer security tokens publicly.

Background

Regulation A was overhauled through the JOBS Act, resulting in what is now referred to as Regulation A+.  Reg. A+ allows for a registered security to go through a general solicitation process without going through the long and costly IPO process.  Securities issued under Reg. A+ can be freely traded, subject to some restrictions and holding periods.  Another unique feature is that it allows for “testing the waters,” soliciting investors to gauge interest in the offering before or after filing the offering statement.  To qualify to use Reg. A+, an issuer must have their principal place of business in the United States or Canada and not be an ineligible investor (please see our blog post Notes on Regulation A+ for more information).

Reg. A+ has two tiers; Tier 1 allows issuers to raise up to $20 million and Tier 2 allows issuers to raise up to $50 million over a 12-month rolling period.[1]  Below is a side-by-side comparison of the two tiers.

Tier 1 and Tier 2 Comparison

Tier 1

  • Can raise up to $20 million
  • No limit on amount investor can purchase
  • All types of investors (qualified purchasers, accredited investors, and unaccredited investors)
  • 2,000 investor limit pursuant to Section 12(g) of the ’34 Act
  • Do not need audited financial statements except in special circumstances
  • Must comply with state “blue sky” laws regarding securities registration
Tier 2

  • Can raise up to $50 million
  • Limits on how much an unaccredited investor can purchase (see below)
  • All types of investors (qualified purchasers, accredited investors, and unaccredited investors)
  • Conditional exemption from Section 12(g) of the ’34 Act restrictions[2]
  • Audited financial statements
  • State “blue sky” laws regarding securities registration are preempted
  • Must file annual, semi-annual, and current event reports after the offering with the SEC

Process

The process will look something like the following:

  • Step 1: Entity Formation
    • To start the process, the entity must first be created.  This includes putting together the articles of incorporation and operating agreement, registering the entity with the state(s) in which it will operate, drafting promissory note distribution agreements (a SAFT can be used here instead), and issuing securities.
  • Step 2: Draft Form 1-A
    • There are three parts to Form 1-A: Part I: Notification Filing, Part II: Offering Circular, and Part III: Exhibits.
    • Part I: Notification Filing
      • This is a brief summary of information about the issuer, offering, and jurisdictional information.  It can be filled out online and is formatted like the Form D filing.  It requires information such as balance sheet financials, determination of eligibility, a summary of the offering, and designation of the jurisdiction.
    • Part II: Offering Circular
      • The offering circular is a simplified and scaled down version for the Form S-1 and is similar to hedge fund offering documents. It is the primary disclosure document prepared in connection with the Reg. A+ offering.  This section requires information such as risk factors, the business plan, plan of distribution, Management’s Discussion & Analysis (“MD&A”) of Financial Condition and Results of Operations, management interests, and detailed analysis of the securities being offered.
    • Part III: Exhibits
      • The exhibit that are required as part of the Form 1-A include:
      • Issuer formation documents (e., operating agreement, articles of incorporation, etc.)
      • Promissory note agreement (or SAFT)
      • Agreement between issuer and broker-dealer
      • Opinion from legal counsel
      • Consent of auditor
      • Testing the waters materials
      • Escrow agreement (if necessary)
  • Step 3: Submission to the SEC
    • Once all the materials for the Form 1-A are assembled, the Form 1-A will be filed for qualification on the SEC’s Electronic Data Gathering, Analysis, and Retrieval (“EDGAR”) system.  Issuers can request that their offering statement be non-public as long as they are publicly filed no later than 21 calendar days before qualification.  Once Form 1-A has been submitted, the issuer will correspond with the SEC regarding the submission to ensure that it is complete.  The offering statement on Form 1-A only needs to be qualified by order of the SEC and issuers will receive a notice of qualification from the Division of Corporation Finance.  With the consent of the Director of the Division of Corporation Finance, issuers are allowed to withdraw an offering statement so long as none of the securities under it have been sold and the offering statemen is not subject to a temporary order suspending the Regulation A exemption.
  • Step 4: Notice Filing
    • For this step, the issuer will need to determine in which states to concentrate their selling efforts.  Once the states have been selected, the issuer will need to conduct the required notice filings in each state.  Although Tier 2 offerings preempt state securities registration and qualification provisions, state securities regulators can still require issuers to file any documents that were with the SEC with state with state securities regulators.
  • Step 5: Ongoing Compliance
    • Tier 2 issuers are required to file Form 1-K, Form 1-SA, and Form 1-U with the SEC.
      • Form 1-K is an annual report that is filed 120 days after the fiscal year end. It consists of two parts: part 1 contain basic fillable information; part 2 requires the following: business operations of the issuer; transactions with related persons; information about directors, executives, and significant employees; MD&A; and two years of audited financials.
      • Form 1-SA is a semiannual report which is filed 90 days after end of first 6 months of fiscal year. It does not require an audit and includes financial statements and MD&A.
      • Form 1-U needs to be filed within 4 business days of any of the following:
        • Fundamental changes in the nature of the business;
        • Bankruptcy or receivership;
        • Material modification of the rights of security holders;
        • Changes in the certifying accountant of the issuer;
        • Non-reliance on previous financial statements or a related audit report or completed interim review;
        • Changes in control of the issuer;
        • Departures of the principal executive officer, principal financial officer or principal accounting officer; or
        • Unregistered sales of 10 percent or more of outstanding equity securities.
  • Final Step: Exit Reporting
    • Tier 1 issuers are required to file an exit report on Form 1-Z through EDGAR no later than 30 calendar days after the termination or completion of an offering.
    • Tier 2 issuers may file an exit report on Form 1-Z if the offering has fewer than 300 security holders of record, offers and sales are not ongoing, and the issuer is up to date on all filings required by Regulation A.

Timeline

The timeline for a Reg. A+ offering will look something like the following:

  • Week 1: The initial discussion of terms and the offering will take place.  The issuer and their legal counsel will create a detailed legal and operational timeline.
  • Week 2: The issuer will form the necessary entities, start drafting Form 1-A, and begin gathering the needed financials statements and other documents.
  • Week 3-4: All documents and financials will be finalized and submitted to the SEC.
  • Week 5: The issuer will begin the notice filing process and conduct the necessary ongoing compliance.
  • Week 6 and on: The issuer will begin back and forth discussion process with the SEC regarding the offering.

Issues & Other Items to Consider

There are a few items to consider when choosing to register under the Regulation A exemption:

  1. Testing the Waters – If testing the waters occurs after filing the offering statement, any solicitation materials used must be preceded or accompanied by a preliminary offering circular or contain a notice informing potential investors where and how the most current preliminary offering circular can be obtained.  These solicitation materials must also be included as an exhibit when the offering statement is submitted for nonpublic review or filed.
  2. Tier 2 Unaccredited Investor Limit – In a Tier 2 offering, an unaccredited investor can purchase no more than: (a) 10% of the greater of annual income or net worth (for natural persons); or (b) 10% of the greater of annual revenue or net assets at fiscal year end (for non-natural persons).
  3. Auditing – Tier 2 issuers will need to have their financial statements audited and should begin this process as soon as possible.  However, if a Tier 1 issuer has had previously audited financial statements, in certain cases they may need to submit these.
  4. Solicitation through Electronic Communication – An issuer is allowed to “test the waters” through platforms that limit the number of characters or text that can be included and still satisfy the requirements of Rule 255 if: (a) the electronic communication is distributed through a platform that limits the number of characters or text that may be included in the communication; (b) including the required Rule 255 statements together with the other information would cause the communication to exceed the platform’s characters or text limit; and (c) the communication contains an active hyperlink to the required Rule 255 statements and prominently conveys important or required information through the hyperlink.  However, if an electronic communication can contain the Rule 255 statements in their entirety along with the other information without exceeding the platform’s characters or text limit, it is not appropriate to only include hyperlink to the required statements.
  5. Payment for Securities – For both tiers, an issuer can accept payment for the sales of its securities only after its offering material have been qualified by the SEC.  In addition, issuers under Tier 1 offerings generally must have their offering materials qualified by state securities regulators in each state in which it plans to sell securities.
  6. Secondary Sales – For the 12 months following its first offering, no more than 30% of the aggregate offering price may be sold by security holders.  After the 12 months, secondary sales by affiliates will be subject to the 30% limit over a 12-month period.  Secondary sales by non-affiliates at this point will only be curtailed by the maximum offering allowed under each tier.

Conclusion

Thus far, Reg. A+ provides the most flexibility for SEC compliant ICOs.  Although there are reporting obligations and other restrictions, Reg. A+ allows for what is essentially a “mini-IPO” without the cumbersome process.  As token issuers look to be compliant, we are likely to see an uptick in Reg. A+ offerings.

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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.  Bart can be reached directly at 415-868-5345.

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[1] This rolling 12-month period means that each month you will need to recalculate the aggregate sales, dropping off the sales from more than 12 months ago. For example, if an offering pursuant to Reg. A+ started in January of 2018, it means that by February of 2019 initial sale of securities from January 2018 are no longer in the aggregate total (thus only calculating February 2018 – February 2019 sales).

[2] As long as the issuer remains current with their periodic reporting, engages the services of a transfer agent registered with the SEC pursuant to Section 17A of the Exchange Act, and meets the size-based requirements similar to those of a “smaller reporting company” under the Securities Act and the Exchange Act.

Airdrops and Securities Laws

Legal Issues Surrounding Digital Asset Airdrops

Given the regulatory scrutiny on initial coin offerings, many digital asset company sponsors (those launching an ICO token/product/security/utility/etc) have been looking for ways to get their assets in the hands of a large number of people to begin creating network effects so the digital asset become valuable.  One way to accomplish this is through an “airdrop” where the sponsor gives away the digital asset to certain persons under certain circumstances.  Airdrops come in many shapes and forms – in some, the sponsor deposits only the digital asset they have created and in others a sponsor or other third party might deposit a variety of digital assets created by different groups.  Some airdrops require users to do something (sign up for a list or tweet a link related to the sponsor) and some are done for “free”.  In any event, there are potentially securities laws issues related to the airdrops and any transactions in the digital asset after the airdrop.  The below analysis is intended as a broad overview, but each airdrop should be considered in light of its facts and circumstances.  Additionally, the regulation of airdrops, including how they may be taxed, is beginning to evolve and subject to change.

Potential Application of Securities Laws to Airdrops

The legal status of digital assets is uncertain and continually developing – whether a token is a security ultimately depends on the particulars of each token.  Given recent statements by the SEC, however, it is safest to assume that any airdropped tokens are securities.  The public offering or sales of securities must be registered with the SEC or qualify for an exemption, though many token companies are not complying with these requirements.  As a result, a number of these airdrops may be violating securities laws, even if the teams behind the assets claim they are not securities, or if they do not realize their activities fall within the scope of the securities laws.  In light of this, the following legal issues may apply to an airdrop:

  • Transfer Restrictions – Even if a token qualifies for an exemption from registration with the SEC, it may be subject to transfer restrictions. For example, many securities are exempt from SEC registration via the private placement exemption under Regulation D (also known as “Reg D”), which requires a certain holding period (e.g. 6-12 months) before a purchaser can transfer the securities.  While the Reg D exemption applies to purchases and sales of securities, the Reg D holding restrictions may apply because the SEC may view the exchange of personal information and/or public promotion as payment.  In light of this, the recipients of digital assets (unknowingly) may be restricted from transferring those assets and should be careful.
  • Free Stock Enforcement Actions – In the late 1990’s the SEC brought enforcement actions in cases of “free stock” offerings. In such instances, companies gave out “free” stock in exchange for something of value to the company.  For example, recipients provided personal information, solicited additional investors, and linked to issuers’ websites.  The SEC was concerned that investors were not receiving full and fair disclosures about the securities.  Airdrops resemble free stock since the airdrop teams give “free” tokens, often in exchange for information like email addresses or social media shares.  Additionally, these airdrop programs are often promoted in mediums such as Telegram chats where disclosures are entirely absent.  Because of these similarities with free stock, the SEC could bring enforcement actions against the sponsors of the airdrops in the future.
  • Broker-Dealer Regulations – Generally, a broker is anyone that engages in securities transactions on behalf of another person for compensation, and must be registered with the SEC. If a team airdrops digital assets on behalf of other token companies, it could be deemed a broker if it receives compensation for the airdrop.  This compensation could take the form of tokens or marketing services from issuers of the airdropped assets.
  • Underwriter Liability – An underwriter is someone that acts on behalf of a securities issuer, for example, by distributing securities of the issuer. Depending on the circumstances, underwriters can be liable for an issuer’s securities violations.  If an airdrop team deposits tokens that are issued by another company, it could also be liable for the securities violations of that company, which very well may be the case, as described above.
  • Pump & Dump – Pump and dump schemes occur when an organized group coordinates to artificially change the price of an asset. The SEC and CFTC have issued warnings about token pump and dump schemes, and the SEC has already pursued certain groups for these schemes.  In light of this, airdrop announcements and marketing materials will likely be subject to heightened scrutiny by the SEC and CFTC.
  • KYC/AML – Know Your Customer (“KYC”) and Anti-Money Laundering (“AML”) laws are aimed at combatting money laundering and bribery and require certain due diligence on clients. KYC and AML regulations typically apply to banks, broker-dealers, FINRA members, and other financial institutions, as well as large cash transactions.  Many token exchanges already implement KYC and AML procedures, for example, by requiring new users to upload a driver’s license in order to prove their identities.  It’s possible that an airdrop team may be subject to KYC and AML requirements such that it would need to verify the identity of each recipient.

Conclusion

As the digital asset industry becomes more aware of the securities laws and the nuances of the application of those laws to the digital asset space, sponsors of digital assets are working to make sure their business plan and token distribution structure fit within the laws.  While airdrops (“free tokens”) seem like one way to get around certain securities laws, there are still risks and sponsors should vet any potential distribution, even if free, with legal counsel.  We do expect to see a wider variety of token offering structures used in the future, including Regulation A+ which has fewer restrictions on securities transfers.

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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.  Please contact Mr. Mallon directly at 415-868-5345 if you have any questions on this post.