Author Archives: Hedge Fund Lawyer

SEC Issues Cryptocurrency/Digital Asset/ICO Report

By: Bart Mallon (Co-Managing Partner of Cole-Frieman & Mallon LLP)

Certain Digital Assets are Securities Based on “Facts and Circumstances”

As has been widely anticipated by the cryptocurrency community, the SEC has finally made an initial declaration of the agency’s view that certain digital assets are securities subject to jurisdiction and regulation by the SEC.  In a series of four items (press release, investigative report, statement and investor bulletin), the SEC comes out with a strong warning to sponsors of Initial Coin Offerings (ICOs) to be careful of the U.S. securities laws.  While many will undoubtedly think the SEC missed a great opportunity to provide robust guidance (and leniency) to the industry, most market participants recognize that this series of discussions was the most likely outcome for many of these instruments (i.e. it is clear that they are securities).  Although it is not perhaps what the industry wanted, we at least have *something* to now go by and the industry can begin to figure out how it will structure itself from here.

Below we provide an overview of the various parts of the release as well as some of our observations.

SEC Four Items

The SEC released the following four items today which we describe in greater depth below:

  1. Press Release 2017-131
  2. Release No. 81207 (report)
  3. Divisions of Corporation Finance and Enforcement Statement (July 25, 2017)
  4. Investor Bulletin: Initial Coin Offerings

Press Release – the release discusses the investigative report it published on The DAO and discusses the investor bulletin created regarding ICOs.  The SEC cautions market participants to make sure they examine their activity with respect to ICOs and other structures built on blockchain and distributed ledger technology.  Most importantly the release states:

In light of the facts and circumstances, the agency has decided not to bring charges in this instance, or make findings of violations in the Report, but rather to caution the industry and market participants:  the federal securities laws apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology

SEC Report on the DAO – the report describes the rise and fall of The DAO, discusses how the related facts would be analyzed under the existing securities laws (Howey test), determines that DAO Tokens are securities, and makes the determination that certain “Platforms” are securities exchanges that should be (and should have been) registered with the SEC as securities exchanges.  The report ends by listing a number of SEC enforcement actions involving virtual currencies.  The SEC also provides the following warning to the industry:

Whether or not a particular transaction involves the offer and sale of a security—regardless of the terminology used—will depend on the facts and circumstances, including the economic realities of the transaction. Those who offer and sell securities in the United States must comply with the federal securities laws, including the requirement to register with the Commission or to qualify for an exemption from the registration requirements of the federal securities laws…These requirements apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology. In addition, any entity or person engaging in the activities of an exchange, such as bringing together the orders for securities of multiple buyers and sellers using established nondiscretionary methods under which such orders interact with each other and buyers and sellers entering such orders agree upon the terms of the trade, must register as a national securities exchange or operate pursuant to an exemption from such registration.

CorpFin/Enforcement Statement – the statement basically provides an overview of the U.S. securities regulatory framework and describes how the framework of laws and regulations are designed to protect investors.  It discusses the importance of “facts and circumstances” analysis, states that DAO Tokens are securities based on “facts and circumstances” and implores cryptocurrency market participants  to seek counsel from private attorneys or the SEC.  The statement also warns of bad actors and red flags.

Investor Bulletin – provides background on ICOs, discussed various concepts applicable to the digital asset industry (blockchain, virtual currency, virtual currency exchanges, smart contracts), and discusses the crowdfunding regulations.  The bulletin also alerts investors to the issues with getting money back in the event of a scam (tracing issues, international scope of digital assets, the fact there is no central regulator and there is no ability for the SEC to freeze digital assets) and describes the normal things to be careful of that are common in many scams.

Observations

The following are some quotes from the various items produced by the SEC which we found interesting, and our thoughts on those quotes.

Press Release

“Those participating in unregistered offerings also may be liable for violations of the securities laws.”

HFLB: we note that the SEC is intentionally being vague when it references “those participating” – this indicates they will be looking at all parties related to a particular transaction, from sponsors to exchanges to other persons within the ICO distribution chain.  

“Additionally, securities exchanges providing for trading in these securities must register unless they are exempt.”

HFLB: here they are basically saying any exchange that DAO Tokens were available on were acting as securities exchanges and needed to be appropriately registered as such.

“The DAO has been described as a “crowdfunding contract” but it would not have met the requirements of the Regulation Crowdfunding exemption because, among other things, it was not a broker-dealer or a funding portal registered with the SEC and the Financial Industry Regulatory Authority.”

HFLB: we find it interesting that the SEC is specifically talking about the crowdfunding regulations.  We think that many ICOs / token sales would be good candidates for these platforms (and some tokens have started in that way) and the SEC seems to be highlighting an option for certain fund sponsors.  Crowdfunding platforms are regulated by the SEC and FINRA (and do not have as onerous requirements as normal securities registration statements) so they may become an acceptable compromise distribution platform for both ICO sponsors and the SEC.

Report on The DAO

“The United States Securities and Exchange Commission’s (“Commission”) Division of Enforcement (“Division”) has investigated whether The DAO, an unincorporated organization; Slock.it UG (“Slock.it”), a German corporation; Slock.it’s co-founders; and intermediaries may have violated the federal securities laws.”

HFLB: the “sponsors” of The DAO were investigated, which is to be expected.  We find it interesting they used the word “intermediaries” which is probably intentionally vague.

“The automation of certain functions through this technology, “smart contracts,” or computer code, does not remove conduct from the purview of the U.S. federal securities laws. This Report also serves to stress the obligation to comply with the registration provisions of the federal securities laws with respect to products and platforms involving emerging technologies and new investor interfaces.” (citations omitted)

HFLB: pretty much what securities lawyers have been saying all along.

“From April 30, 2016 through May 28, 2016, The DAO offered and sold approximately 1.15 billion DAO Tokens in exchange for a total of approximately 12 million Ether (“ETH”), a virtual currency used on the Ethereum Blockchain.” (citations omitted)

HFLB: we believe that the SEC is saying here that Ether is not a security, but is instead a virtual currency.  This is important because it shows that some ICOs or digital assets (like ETH) can be instruments other than securities.

“The Commission is aware that virtual organizations and associated individuals and entities increasingly are using distributed ledger technology to offer and sell instruments such as DAO Tokens to raise capital. These offers and sales have been referred to, among other things, as “Initial Coin Offerings” or “Token Sales.” Accordingly, the Commission deems it appropriate and in the public interest to issue this Report in order to stress that the U.S. federal securities law may apply to various activities, including distributed ledger technology, depending on the particular facts and circumstances, without regard to the form of the organization or technology used to effectuate a particular offer or sale.”

HFLB: unfortunately looking to the “facts and circumstances” is all we have here – the SEC is not going to come out with a list of tokens they think our securities so we have to use the “sniff test” to determine whether any particular token is a security.  The best advice we have here is to look at the Coinbase Securities Law Framework to come up a best guess.

“The Platforms that traded DAO Tokens appear to have satisfied the criteria of Rule 3b-16(a) and do not appear to have been excluded from Rule 3b-16(b). As described above, the Platforms provided users with an electronic system that matched orders from multiple parties to buy and sell DAO Tokens for execution based on non-discretionary methods.”

HFLB: the SEC is putting those website where DAO Tokens were bought/sold on notice that they were operating as a securities exchange.  This will likely give unregistered crypto exchanges pause with respect to many digital asset instruments.

CorpFin / Enforcement Statement

“Market participants in this area must also consider other aspects of the securities laws, such as whether a platform facilitating transactions in its securities is operating as an exchange, whether the entity offering and selling the security could be an investment company, and whether anyone providing advice about an investment in the security could be an investment adviser.”

HFLB: the SEC makes reference to the mutual fund regulations (also applicable to private funds via 3(c)(1) and 3(c)(7) exemptions) as well as the investment advisor regulations, which are applicable to cryptocurrency fund managers.

“Although some of the detailed aspects of the federal securities laws and regulations embody more traditional forms of offerings or corporate organizations, these laws have a principles-based framework that can readily adapt to new types of technologies for creating and distributing securities.”

HFLB: this is exactly why we were surprised that the SEC has not previously issued guidance when it was clear there were other groups who have conducted ICO sales that clearly were securities offerings.  The SEC has had the opportunity (and, really, the obligation) to be enforcing the current securities laws in this space and the SEC has specifically chosen not to.  

“Finally, we recognize that new technologies also present new opportunities for bad actors to engage in fraudulent schemes, including old schemes under new names and using new terminology. We urge the investing public to be mindful of traditional “red flags” when making any investment decision, including: deals that sound too good to be true; promises of high returns with little or no risk; high-pressure sales tactics; and working with unregistered or unlicensed sellers.”

HFLB: we agree.  We fully expect to a number of frauds and other enforcement actions taken with respect to ICOs in the future.

Investor Bulletin

“Although ICOs are sometimes described as crowdfunding contracts, it is possible that they are not being offered and sold in compliance with the requirements of Regulation Crowdfunding or with the federal securities laws generally.”

HFLB: we believe that these various releases will ultimately push more ICOs to look toward crowdfunding platforms for their initial offerings.  We also believe that there is the possibility in the future for some sort of digital asset specific crowdfunding platform or a digital asset broker-dealer.

“Ask what your money will be used for and what rights the virtual coin or token provides to you.  The promoter should have a clear business plan that you can read and that you understand.  The rights the token or coin entitles you to should be clearly laid out, often in a white paper or development roadmap.  You should specifically ask about how and when you can get your money back in the event you wish to do so.  For example, do you have a right to give the token or coin back to the company or to receive a refund? Or can you resell the coin or token? Are there any limitations on your ability to resell the coin or token?”

HFLB: we believe this guidance is not really helpful for many ICO structures.  

“Fraudsters often use innovations and new technologies to perpetrate fraudulent investment schemes.  Fraudsters may entice investors by touting an ICO investment “opportunity” as a way to get into this cutting-edge space, promising or guaranteeing high investment returns.  Investors should always be suspicious of jargon-laden pitches, hard sells, and promises of outsized returns.  Also, it is relatively easy for anyone to use blockchain technology to create an ICO that looks impressive, even though it might actually be a scam.”

HFLB: we agree.  We believe it is highly likely there will be a number of scams that will be perpetuated through ICOs.

Conclusion

This is a first step of sorts toward more robust regulation of the digital assets.  Although we get some insight from the SEC, we don’t really see anything new and we don’t see how the SEC is going to protect the digital asset markets in the U.S.  Instead, this probably plays into fears that the U.S. is not a hospitable jurisdiction to novel ideas and structures and will ultimately push ICOs that would be based in the U.S. to offshore jurisdictions.  We hope the SEC uses these statements as a springboard to a dialogue with the industry to keep (and attract) innovators to the U.S.  More obviously forthcoming…

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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.

Bitcoin Hedge Fund FAQs

Common Questions Related to Cryptocurrency Funds

[Note: information posted on May 19, 2017.  Certain areas below will be updated periodically and we will update the timing of the information in each particular section.]

We recently wrote an overview of bitcoin/altcoin hedge funds.  That post led to a number of conversations with current and future cryptocurrency managers which yielded a number of questions regarding the business and regulatory issues applicable to these fund structures.  Some of the items we discussed are issues of first impression.  Some of the items probably don’t have “for sure” answers and instead we look to industry best practices for guidance.  While there will be a lot of “grey areas” and “probablys” and “I don’t knows” in this space as the regulators start to become more involved, I have tried my best to address these items below in my answers to these common questions.

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Are Bitcoins and other Cryptocurrencies “securities” under the Securities Act of 1933?

Many of the very large cryptocurrencies like Bitcoin and Ethereum are probably not “securities”, and can probably be classified as “digital currencies” for now.  Other cryptocurrencies or tokens would need to be examined on a facts and circumstances basis.  For such an inquiry, I believe the Coinbase Securities Law Framework (See Appendix A) is a great place to start.

Why does it matter?

If a hedge fund invests in or buys a cryptocurrency, and that cryptocurrency is deemed to be a security, then the fund’s management company (general partner) will be, by definition, an investment adviser under federal law and most likely the laws of the state where the management company operates (where the sponsor/owner of the management company is physically located).  If the management company is an investment adviser, then the management company will need to register with the SEC (upon reaching certain asset levels, generally $150M) or with a state securities commission.  Some states may have exemptions from registration, like the Exempt Reporting Adviser (ERA) regime.  (See here for information on the SEC ERA regime and here for California’s ERA regime.)  If a management company registers as an investment adviser or ERA, the manager will be required to have the fund undergo an annual audit, and there will also be a requirement that performance fees be charged only to qualified clients.  Additionally, regardless of manager’s registration status (SEC, state or is an ERA) the manager will be subject to the anti-fraud provisions of Section 206-4 of the Investment Advisers Act which generally governs the manner in which the adviser communicates with the public.

If a cryptocurrency is deemed to be a security, then the fund would also technically be subject to the Investment Company Act of 1940.  Most hedge funds utilize either the 3(c)(1) or 3(c)(7) exemption from registration under the ICA.  In general this will not wildly change the fund’s offering documents, but it will be an item that needs to be addressed.

What if the cryptocurrencies are not deemed to be securities?

If the fund only invests in assets that are not securities, then the investment advisory regulatory regime does not apply.  This means there would be no regulatory requirement for an audit (assuming no CFTC regulations apply) and the manager could charge performance fees to non-qualified clients.  The Investment Company Act would also not apply which means that the fund would be able to have more than 99 investors.  The fund would, however, still be limited to 35 non-accredited investors over the life of the fund to maintain the 506 exemption under the Securities Act.

What about state regulations and New York’s BitLicense registration requirement?

Outside of the investment advisory regulations that would be applicable to a manager if the cryptocurrency or token was deemed to be a security, the states don’t really have regulations applicable to bitcoin managers.

With respect to New York’s BitLicense requirement, we believe that currently these regulations are not applicable to the standard bitcoin hedge fund manager who is only buying and selling bitcoin (and other tokens/altcoins) for the fund’s account.  The BitLicense requirements may apply (depending on facts and circumstances) to managers who engage in other aspects of the cryptocurrency industry – such as issuing coins or otherwise acting as an exchange platform.  We expect other states to develop legal and regulatory frameworks similar to New York in the future, and in the event the SEC attempts to shoehorn bitcoin managers into the definition of investment adviser, we believe the states would shortly follow suit.

What about an auditor?  If I have to have an audit, what will that be like and how much will it cost?

In the event a manager engages an auditor, the auditor will be able to discuss the process and procedures that will be employed.  Because there is additional work involved in a bitcoin launch, it is likely that an audit will be more expensive than for a similarly sized fund investing only in publicly traded securities.

There are not many groups who can audit funds in this space.  Some groups can audit in this space, but can only audit major cryptocurrencies. As more groups get into the space and procedures become more defined, we expect that audit prices will eventually come down a bit.

Cryptocurrencies present a number of issues for audit firms including: (1) existence of the asset/currency, (2) control of the asset/currency, and (3) custody.  For many altcoins, the first two issues can be addressed with a review of the blockchain and the manager showing control of the asset by moving it on the blockchain in some manner.  The last issue is potentially more problematic in that the investment management industry is used to a certain definition of custody (holding something) that may not fit within the digital asset space, where control and the ability to utilize an asset is really more of the applicable context.

What about an administrator?

A hedge fund administrator provides certain accounting and other operational functions for the fund like subscription document processing.  Normally the fund administrator will be responsible for calculating NAVs on a monthly/quarterly basis and when investors enter and exit the fund.  They also compute management and performance fees.  Having an administrator is not a regulatory requirement for a cryptocurrency fund, but it is a best practice.  We will note that all of the cryptocurrency funds we have worked with have decided to engage an administration firm.

What about bank accounts?

One to two years ago, there was no issue for a manager to get a bank account for a bitcoin hedge fund.  Since then, bitcoin has become a risk for banks and over the last six months we’ve seen banks fully eschewing this space.  Groups who previously banked bitcoin funds will not bank new funds (although they would continue to maintain existing accounts) and groups who were not in the space are completely staying away.  We have fortunately been introduced to a couple of banks who are now more comfortable with banking cryptocurrency clients.  While these banks can provide the very basic subscription account for funds, there also may be value-added services, especially with respect to transfers to and from exchanges, as well as API integration.

The process to get a bank account is going to be a little longer than for a traditional hedge fund because the bank will complete more due diligence than for a normal fund (i.e., look into the business background of the manager, the proposed investment program, who the investors are, etc).  While these groups are comfortable with the cryptocurrency space in general, they likely will not bank groups who pose even the slightest reputational risk or groups who have had regulatory issues in the past.

What about compliance and outside compliance consultants?

Right now compliance really only applies to the fund structure (as opposed to the manager as would be the case if the manager was an investment adviser).  Fund compliance really just involves the legal requirements related to the Regulation D 506 offering applicable to the issuance of fund interests (e.g. Form D filings, annual updates and amendments, blue sky filings, etc).

Compliance related to the management of a cryptocurrency portfolio is really nonexistent.  We would expect that the managers would adhere to normal anti-fraud provisions, and a best practice would be to have certain business continuity plans and other standard fund management policies and procedures, even if there is no outside regulatory requirement.  Some groups have asked us about setting up compliance programs in anticipation of future compliance needs and we think this is a good idea.  Either a law firm or a compliance consulting firm would be able to draft a compliance manual for the needs of a cryptocurrency fund manager.

What about ICOs?

As of right now, there are no extra regulatory requirements around participation in initial coin offerings (ICOs).  We believe that this will change in the future.

What are some common terms of bitcoin funds?

The biggest questions are around lock ups and liquidity.  In general most managers will tend to want to provide less liquidity than investors are looking for and some managers have thought about instituting gate provisions, especially if the investment program is focused on smaller altcoins that may have less liquidity.  We are also seeing a number of managers who would like to allow in-kind contributions and distributions, which will implicate certain tax regulations.

How is bitcoin taxed?

The IRS addressed this issue in 2014 when it released Notice 2014-21, IRS Virtual Currency Guidance.  Right now most cryptocurrencies (and other “virtual currencies”) are treated as property and subject to the normal tax principles regarding property.  This means that dispositions of virtural currencies will result in short-term or long-term capital gains or losses and not foreign currency gains or losses.  Standard ways to determine gain or losses at disposition will apply (for most cryptocurrencies), and we would look to the various exchanges to determine a price of a cryptocurrency at any particular point in time.  This would be important if a manager or other investor in a fund decided to invest in a fund through an in-kind cryptocurrency contribution.

According to Notice 2014-21, bitcoin is deemed to be a “convertible” virtual currency because it has an equivalent value in real currency.  Early this year bitcoin became legal tender in Japan.

What about separately managed accounts or prop trading?

As of right now we do not know of any way to create a traditional separately managed account structure for an investment in cryptocurrencies.  In a SMA structure in the traditional securities space the client will typically establish a brokerage account at a large broker (Schwab, Fidelity, etc) and the manager will be given power of attorney to trade the account.  The relationship is governed by some kind of advisory agreement laying out the fees and term of the relationship.  Typically the brokers will have a way for the manager to have trading only access to the client’s account.  We do not believe that any of the exchanges currently have this functionality.  We anticipate that sometime after the regulatory agencies implement a regulatory structure that the exchanges will create mechanisms to implement such relationships on their platforms.

Other Items 

We anticipate writing about the following soon in some fashion:

  • Creating structures to allow funds to invest on exchanges that do not allow U.S. persons
  • Creating structures to allow funds to invest on exchanges that do not allow New York persons
  • Third party marketing in the cryptocurrency space
  • Using the ICO process to launch a private fund
  • Issues around Regulation D, including the Bad Actor regulations

Final Notes

Please reach out if you have questions on any of the above.  We will continue to update as we run into more issues and common questions.

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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.

 

New York BitLicense

Overview of the Cryptocurrency Licensing Regime in New York

As cryptocurrencies continue to make headlines, questions continue to arise about the regulatory landscape applicable to market participants. While there have been no new laws or regulations related to the cryptocurrency space from federal agencies (although in the Coinflip order, the CFTC stated that bitcoin is a virtual currency), some states are beginning to examine cryptocurrencies with New York as a forerunner in this space.  In 2015, New York created a BitLicense Regulatory Framework whereby certain cryptocurrency market participants were required to obtain a license to transact business within New York (and/or with New York residents).  This post focuses on New York’s regulatory action regarding cryptocurrencies with the issuance of the BitLicense, and the potential impact this may have on investment managers.

New York BitLicense

Pursuant to the Part 200. Virtual Currencies regulations, any persons involved in “virtual currency business activity” in New York must obtain a license known as the “BitLicense.”  The regulation defines a “virtual currency business activity” as:

  • receiving virtual currency for transmission or transmitting virtual currency, except where the transaction is undertaken for non-financial purposes and does not involve the transfer of more than a nominal amount of virtual currency;
  • storing, holding, or maintaining custody or control of virtual currency on behalf of others;
  • buying and selling virtual currency as a customer business;
  • performing exchange services as a customer business; and
  • controlling, administering, or issuing a virtual currency.

The above categories really seem to apply to those groups who are acting as cryptocurrency exchanges and/or are offering “wallet” type services.  For most fund managers who are simply managing a fund which is investing in virtual currencies, the above items would not implicate such managers and such managers would not need to obtain the BitLicense.  However, if a manager (or an investment fund) was engaged in activity other than simply buying/selling/holding cryptocurrencies, the manager should be aware of the above items.

BitLicense Application

In order to receive the license, an applicant must complete a 30-page Application for License to Engage In Virtual Currency Business Activity and pay a $5,000 application fee.  The application requires information on the history of the business, its owners and operators, operational items, financials, information on AML procedures, and information on its general compliance processes.  In total the application is fairly onerous and costly and will likely deter many potential companies for applying for the license.  Few BitLicenses have actually been granted to date, and those that have been granted were to major players in the industry such as Coinbase and Ripple.

Other Related Items

There are a number of interesting related items and a discussion about these can be found on the BitLicense FAQs page.  A couple of the more interesting items:

  • Chartered New York Bank – if a group is already chartered under the New York Banking Law, that entity does not need to apply for the BitLicense but must first receive prior approval from the New York Department of Financial Services to engage in the activity.
  • Money Transmitter License – groups who engage in certain activities may also need to apply for a money transmitter license in New York.  Groups who are applying to engage in both activities only need to submit one application.

The two items above are most likely not applicable to fund managers.

Looking Forward

The establishment of a BitLicense demonstrates that states are trying to figure out how to assert authority over a space that prides itself on decentralization. The New York BitLicense has been seen as controversial, along with similarly proposed licenses in other states. Although this appears to not have a direct impact on investment managers yet, investment managers that engage in certain kinds of virtual currency activity may fall within the scope of requiring a license.

Related articles:

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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.

Greyline Solutions Continues Expansion

Regulatory Compliance Consulting Company Adds Significant Broker-Dealer Practice

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

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Greyline Solutions Expands with Addition of Vista Compliance

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

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

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

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

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

About Greyline Solutions

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

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

Hedge Fund Bits and Pieces for March 31, 2017

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

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

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

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

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

Other Items:

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

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

Hedge Fund Bits and Pieces for March 24, 2017

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

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

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

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

Other Items:

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

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

Cannabis Hedge Funds

Overview of Private Fund Investment in the Marijuana Industry

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

Structural Considerations

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

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

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

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

Regulatory and Other Considerations for Marijuana Fund Managers

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

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

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

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

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

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

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

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

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

Conclusion

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

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

IA Annual Form ADV Update for 2017

Investment Adviser Registration Update Due March 31

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

Process and Major ADV Update Items

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

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

Private Fund RAUM

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

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

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

Other Items

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

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

San Francisco Hedge Fund Events – April 22 and April 23

There are two big events in San Francisco this week.

SF Hedge Fund Networking Group

Meeting April 22 at 4pm at Blanc et Rouge in San Francisco.  For more information, please see the LinkedIn page.

Hedge Funds Care 13th Annual Benefit

The annual Open Your Heart to the Children event featuring the San Francisco 49ers Foundation is on April 22 at 4:30pm.  This year the event will be at the City View space at the Metreon and will feature a number of Bay Area wineries.  For more information on the event and to buy tickets, please go here.

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Cole-Frieman & Mallon LLP provides legal services to the hedge fund industry.  Bart Mallon can be reached directly at 415-868-5345.

 

CFTC Issues No-Action Letters for CPO Registration Relief

Hedge Fund General Partner CPO Registration Relief 

In a series of no-action letters issued in March, the CFTC has granted no-action relief from registration as a commodity pool operator (“CPO”) for a general partner of a fund (or a managing member, if the fund is an LLC) that delegates its entire management authority over the fund to another entity – typically an “investment manager” entity – that is under common control with the general partner. Under this relief, the investment manager is required to register as a CPO, but the general partner is relieved from the CPO registration requirement.

Background on CPO Registration

Based on the legal structure of a fund organized as a limited partnership or limited liability company, typically the general partner or managing member (respectively) has the operational authority over the fund that makes CPO registration process necessary. Under the Commodity Exchange Act of 1936 (the “Act”), an entity that engages in the following activities on behalf of a fund (a “pool” in CFTC parlance) is generally required to register as a CPO:

“any person engaged in a business that is of the nature of a commodity pool, investment trust, syndicate, or similar form of enterprise, and who, in connection therewith, solicits, accepts, or receives from others, funds, securities, or property, either directly or through capital contributions, the sale of stock or other forms of securities, or otherwise, for the purpose of trading in commodity interests.”  See text here.

In some fund structures, however, the general partner may wish to delegate its CPO responsibilities to an investment manager. This is often (but not exclusively) done in the context where a fund’s performance allocation is paid to the general partner, in order to obtain favorable tax treatment, but the investment manager runs the fund on a day-to-day basis, often receiving management fees as compensation. In this situation, it would be costly and burdensome to register both the general partner and the investment manager as separate CPOs of the fund, so it may be worthwhile to request CFTC no-action relief.

Requirements for No-Action Relief

The CFTC issued four no-action letters outlining the general guidelines for how to take advantage of the CPO registration relief described in this article: CFTC Letter No. 13-17, CFTC Letter No. 13-18, CFTC Letter No. 13-19, and CFTC Letter No. 13-20. Although the facts of each no-action letter differ somewhat, the following basic requirements apply. The general partner and investment manager should be able to make representations to the CFTC with respect to each of the following:

Common Ownership and Control. The general partner entity and the investment manager entity should have the same owners and be subject to the control of the same persons.

Delegation Agreement – All Management Authority. The general partner and investment manager should enter into a “Delegation Agreement” whereby all of the CPO-related authority of the general partner is delegated to the investment manager.

Soliciting Clients and Managing Assets. The general partner must not engage in the solicitation of investors to the fund, and must not manage the property of the fund.

Books and Records. All books and records related to the CPO activities should be maintained at the offices of the investment manager.

CPO Registration. The investment manager must be registered or be in the process of registering as a CPO, and must maintain its registration on an ongoing basis.

Employees and Agents. The general partner must not have any employees or others acting on its behalf, and must not engage in any other activities that would subject it to the Act or the CFTC’s regulations.

Joint & Several Liability. The general partner and investment manager entities must agree to be jointly and severally liable for any violation of the Act or the CFTC’s regulations.

Statutory Disqualification. The general partner cannot be subject to statutory disqualification from CPO registration under section 8a(2) or 8a(3) of the Act.

How to Apply for No-Action Relief

If you wish to apply for the no-action relief described above, you will need to draft a letter to the CFTC to request the relief. This letter should comply with the requirements of CFTC Regulation 140.99. Please reach out to us if you would like any assistance with drafting such a letter.

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Cole-Frieman & Mallon LLP acts as legal counsel to the investment management industry.  If you have questions on the above please contact us or call Bart Mallon directly at 415-868-5345.