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Hedge Fund Bits and Pieces for May 26, 2017

Happy Friday.  Best wishes for a happy and safe Memorial Day Weekend!

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Initial Coin Offerings – Bitcoin and other cryptocurrencies took center stage this weeks as new high prices were reached in volatile trading and euphoria around the Consensus conference earlier this week. Initial coin offerings (or ICOs) were a major topic discussed there and should be a major topic going forward.

Artificial Intelligence Hedge Funds – perhaps lost over the last couple of weeks in the discussion of cryptocurrencies has been the general movement in finance toward utilizing artificial intelligence in the investment process. We recently wrote about artificial intelligence hedge fund strategies and detailed the issues that managers should consider when launching a fund in this space.

DOL Rule Effective June 9 – the delay of the DOL rule was short lived.  The DOL recently published a news release that provided that initial implementation of the rule would begin on June 9 (as opposed to April 10th, the originally scheduled implementation date) and that “advisers to retirement investors will be treated as fiduciaries and have an obligation to give advice that adheres to “impartial conduct standards” … [t]hese fiduciary standards require advisers to adhere to a best interest standard when making investment recommendations, charge no more than reasonable compensation for their services and refrain from making misleading statements.”

For hedge fund managers, life does not change to a large extent (managers will likely need to update their subscription documents, and may need to get additional representations from IRA and ERISA investors for any new investment made after June 9, 2017).  SMA managers will need to be careful and should review their relationship to retirement investors.  More information on this will be forthcoming on this blog and in our client updates.

CFTC Focus on FinTech – the CFTC launched a LabCFTC Initiative which “aimed at promoting responsible FinTech innovation to improve the quality, resiliency, and competitiveness of the markets the CFTC oversees.”  The overall goal of the program is to promote innovation for new FinTech products while providing the sponsors of such products more insight into the potential regulatory oversight of those products.  Central to that goal will be GuidePoint which will act as “dedicated point of contact for FinTech innovators to engage with the CFTC, learn about the CFTC’s regulatory framework, and obtain feedback and information on the implementation of innovative technology ideas for the market.”  This sort of proactive approach to innovation by regulators should be a welcome sight to new product sponsors.

Other Items

Cooperman Insider Trading Settlement – Leon Cooperman settled his insider trading case with the SEC and the SEC released an interesting statement on the settlement.  While the settlement allows his fund Omega to continue to operate, Cooperman and Omega were subject to a $1.7M fine for insider trading.  More importantly, the firm must retain an onsite independent consultant for the next 5 years to guard against insider trading.  There were a couple of additional requirements of the settlement which, with the various fines and independent consultant requirement, have to make the SEC feel like they got a big win here.  It will be interesting to see how or if this settlement is used as precedent in future cases.

SEC Issues Cybersecurity Alert – on the heels of the WannaCry ransomeware attack, the SEC issued a Cybersecurity Alert.   The alert is geared more towards smaller broker-dealers and investment advisory firms and provides background and links to other SEC resources on this issue.

New York Employers Cannot Ask About Salary History – on May 4, New York Mayor de Blasio signed a bill making it illegal (and subject to fines) for an employer to ask questions about a candidate’s prior compensation.  Hedge fund managers located in New York will want to discuss this issue with their internal HR persons, as well as their outside counsel.  The bill is called “Intro. 1253” and  goes into effect 180 days after the signing. A cached version of the de Blasio press release 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.

Initial Coin Offerings (ICOs)

ICO Overview and Securities Law Analysis

After a number of recent, high-profile and wildly successful Initial Coin Offerings or “ICOs”, the blockchain-based asset industry has been abuzz about new ICOs as well as the regulatory issues that surround the space.  This post provides a quick overview of the big securities laws issues surrounding these assets and discusses the regulatory structure currently applicable to the space.

Initial Background

An initial coin offering is the first distribution of a digital currency or digital token, normally offered exclusively through an online offering.  These coins or tokens, like many existing cryptocurrencies such as Bitcoin or Ether, may represent some sort of fractional ownership in something (working similar to a security) or may represent a form of payment (like a currency).  These tokens may be pre-launch (to raise money to develop the use case, similar to crowd-funding) or post-launch (use case already exists).

Are ICOs Securities?

The first and biggest question related to ICOs is whether they are securities offerings (essentially digitized IPOs).  For any inquiry into whether something is a security or not, the starting point is the Howey Test.  Howey is a basic four-part test that is used to determine whether a contract, a transaction, or a series of actions constitutes a security under the Securities Act of 1933. The very broad overview of the Howey prongs are:

  • It is an investment of money
  • There is an expectation of profits from the investment
  • The investment of money is in a common enterprise
  • Any profit comes from the efforts of a promoter or third party

For many ICOs the answers to all of the above are usually “yes”.  We do, however, believe that some ICOs are not securities under the test and, although we start with Howey, that is not where the analysis stops.  As mentioned before in our post dealing with Bitcoin Hedge Funds, we believe that Debevoise’s Securities Law Framework provides a thoughtful approach to think about and analyze this question.  We also believe that the SEC will clarify its position regarding ICOs in the next several months.

Use Case – Blockchain Capital

One of the more interesting ICOs recently has been the ICO for the Blockchain Capital Token (BCAP Token, on TokenHub), which was placed by Argon Group, a blockchain asset investment bank.  Here the value of the BCAP Token is linked to the value of a newly created venture capital fund (which initial assets were received through the BCAP Token ICO process).  The subscription process of the ICO was conducted through a Regulation D 506(a) offering (see Blockchain Capital Token Form D), so there are a number of regulations that the group has already gone through, although none specifically dealing with the ICO itself.  What is particularly amazing is that the offering of $10M was oversubscribed and closed in only 6 hours.  The power of the ICO is apparent – what investment fund manager would not want to raise money in a very quick and efficient manner?

Blockchain Capital paved the way for ICOs linked to private investment funds – we would expect to see tokens linked to hedge funds and private equity funds in the near future.  While the Blockchain Capital offering was limited to accredited investors, the offering still presents questions about regulations, including the potential for fraud.  We liken the ICO process to something akin to the crowdfunding process and believe there are similar risks, in addition to the normal risks associated with the linked asset (in this case, a VC fund).

Future Regulation?

There is no doubt that the regulators will begin to figure out a regulatory regime for ICOs and cryptocurrencies, and this is likely to happen before any sort of Congressional action to change the laws of any of the securities or commodities acts.  The CFTC has already been active in the space (see our previous notes in our Client Update here) and it is very likely that the SEC will be starting the process to issue regulations as well (see here where a group has petitioned the SEC to begin that process).  We believe that during that comment and rulemaking process, the regulators will need to address a number of items, including the process with respect to ICOs.  The SEC needs to move with a deft hand, however, because any onerous regulations will just push business offshore – there are already exchanges who discriminate against potential market participants based on domicile (either with respect to U.S. domicile, or in some cases, New York domicile for fear of issues around the New York BitLicense regulations).

The crowdfunding space became regulated fairly quickly and there are now specific crowdfunding broker-dealers and I believe the same will be the case with the ICO regime.  We believe that any cryptocurrency regulatory regime will include requirements with respect to ICOs and ICO investment banks.

Conclusion

The ICO market is white hot and getting hotter.  It will undoubtedly create both winners and losers (and the winners are likely to be massive winners) and in some cases will usher in new ideas and technologies that will help define the landscape of Web 3.0.  The most important thing for regulators (and lawmakers) is to make sure all investors in these offerings are protected and provided with all necessary information and opportunities as provided through the current securities and commodities laws.  We believe that such regulation will come sooner rather than later.

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.

Artificial Intelligence (AI) Hedge Funds

Overview of AI in Investment Management

Hedge funds utilizing artificial intelligence (AI) have increasingly gained attention as technology continues to be a driving force behind large and fundamental changes in the investment management and financial industries. For most groups in this space, AI hedge funds represent a new way to process information and ultimately to use that information to execute various investment strategies. This post discusses the various structural, regulatory, and operational issues that arise for managers who utilize an AI strategy in their hedge fund.

Foundational Items – AI Definition in this Context

Many will liken AI funds to quant strategies which operate on algorithms without human intervention (and probably most AI funds will have programs to automate all trading) but AI is not necessarily quant – AI really is the process behind the selection of investments.  Artificial intelligence fund strategies cannot be grouped into one category and there are not specific AI investments – instead, managers utilize AI with respect to their strategy.  So an AI hedge fund may be focused on certain sectors, may be long/short, short only, etc.  Many AI programs are going to be based on long/short strategies in the large cap space because there is going to be the widest possible universe of data points and liquidity, but this is not a requirement.  We would imagine that over time as AI programs have more experience and have learned more, the programs would migrate into other investment universes and trading strategies.

Structural Considerations

AI programs are likely to be focused on liquid markets with large investment universes so the structure is likely to be basic and straightforward.

·  Hedge Fund or Private Equity Strategy.  At this point in time we have only seen AI deployed in the public markets space so most strategies are going to be utilizing the more liquid hedge fund structure.  Some AI inventors may have expertise in other areas related to technology and those areas may be ripe for early stage investments which might make for good side pocket investments (including cryptocurrencies / altcoins).  Given what we see as investor appetite for the AI itself, and not necessarily the manager’s specific expertise in other technological areas, we believe that side pocket type structures in an AI hedge fund strategy are, and will continue to be, rare in the near term.

·  Fund Terms.  Fund terms will be linked to the strategy.  As we expect most AI programs to be long/short, large cap strategies, the fund terms are likely to be basic and are likely to have favorable liquidity terms because of the liquidity profile of the strategy and the (potential) investor unease with a strategy being implemented with an AI paradigm.  Contributions will normally be accepted monthly as is standard with more standard trading programs.  Fee terms may be favorable, especially based on the recent trend toward lower fees for hedge fund products – low management fees can always be offset by higher performance fees in a tiered performance fee structure.  Right now AI strategies may utilize leverage and we have seen a number of groups do this.

·  Onshore / Offshore Structures.  There is nothing about an AI fund structure which would materially change any decision with respect to an onshore or offshore structure.  In general, a fund complex will only maintain only a U.S. fund if there are only U.S. investors; if there are non-U.S. investors (or U.S. tax exempt investors, if the manager is utilizing leverage) then the structure will be a master-feeder structure or a mini-master structure.  We currently have only had experience with AI in the liquid securities space, but if programs move to other instruments that are illiquid or have tax characteristics different from publicly traded securities, then the onshore / offshore structure should be reviewed.

Business, Regulatory and Other Considerations for AI Hedge Funds

Whereas other strategies may have instrument-related issues to consider, AI programs have a host of technological, oversight, regulatory and perhaps most important, intellectual property, issues to consider.

·  Intellectual Property.  Identification of and protection of intellectual property will be a central concern to the AI manager (as it would be with the quant manager) and we have discussed a number of these issues below. [Note: this section written in conjunction with Bill Samuels, an expert in IP issues and of counsel to Cole-Frieman & Mallon.]

Ownership of AI Code – many times the AI code will originally be developed by an individual (or individuals) and then tested on data sets and tweaked.  Therefore ownership of the code will reside in the individual who created the code.  Once in final form the individual may assign the AI code to an IP holding company that will then license the AI code to the management company and/or fund.

License Agreement – in the event the IP holding company licenses the code to the management company and/or the fund, terms of any license agreement will depend on the needs of the manager and the fund structure as a whole, but the following are common issues which will be addressed: exclusivity/non-exclusivity, ownership (including of derivative works), fees, term, termination.  Each of these issues has a number of sub-issues and other items to consider and a manager should discuss this license agreement with their attorney very carefully.

Copyright and Patent Considerations – while the actual code underlying the AI program cannot be patented, it can be copyrighted.  The copyright protects the actual code, but the conceptual framework of the code cannot necessarily be protected.  If the code interacts with the AI program in such a way that the implantation is somehow improved, then the implementation of the software may be able to be patented.  For these reasons, managers are very sensitive about protecting who can see their code, but may be able to protect themselves (potentially) through a patent.

Employee or Contractor Considerations – managers will want to protect their AI code and will need to be careful with employees and independent contractors and therefore most managers will enter into written agreements with anyone involved in the development or improvement or implementation of the code.  These agreements will normally specify that any code produced (as well as any derivative and resulting code) belongs to the manager (or the IP holding company).

Data Set Terms – when developing AI, many managers will use large data sets to begin the learning process.  Managers should make sure that they understand the terms of the license and the rights of the data owner with respect to anything derived from use of the data sets.  The big point is to make sure that the manager has the rights to any resulting manipulation and development of the data and that the manager is aware of any other person’s right to the resulting information.

Safeguarding of Code – some firms will choose to safeguard their code in some way.  Although safeguarding is not strictly necessary, there are software escrow companies that can hold code specifically for licenses and demonstrating ownership. As mentioned above, managers may choose to secure copyright registration on source code, redacting any sections that are trade secrets.

·  Technology and the Prime Broker – there are a number of issues with respect to the implementation of the AI program with the prime broker.  The manager will work with the broker’s API to integrate their trading system with the prime – managers should be aware of any triggering events (drawdown, leverage, etc) that could affect normal trading of the AI, and the manager should create infrastructure for monitoring such events and perhaps such events should be integrated into the code.  The manager should also examine what kind of human overrides the program will have if the program is an automated trading program.  Many managers also are concerned with reverse engineering by a prime broker.

·  Reverse Engineering – this has traditionally been an issue for large quant managers so many decided to use multiple prime brokers to try to hide how their quant algorithms work.  AI managers, likewise, could be susceptible to reverse engineering and may want to think about multiple prime brokers.  The confidential information provisions of any prime brokerage agreement (PBA) then become very important.  At a minimum, AI fund managers should include language in the PBA specifically noting that the broker will not reverse engineer or create derivate works on the clients confidential information.

·  Regulation of Management Company – management companies implementing AI programs are subject to the normal forms of regulation for management companies investing in securities and futures/commodities.  Generally, if the AI hedge fund trades securities and has less than $150M in AUM, the management company will be subject to state-level securities regulations – in general the management company will need to register as an investment adviser with the state or claim an exemption from registration.  If the AI hedge fund trades securities and has more than $150M in AUM, the management company will be subject registration with the SEC.  If the AI hedge fund trades futures/commodities, the standard CPO/CTA exemptions are in place.

·  Future Regulation of Use of AI?  Both the SEC and CFTC have made minor mention of artificial intelligence when discussing technology and the investment markets.  FINRA has begun to look into artificial intelligence (see here) and broadly puts this under its FinTech focus.  We believe that these regulatory bodies will continue to explore how AI technologies work in the various marketplaces and we believe that there will eventually be specifically regulations about the use of AI in trading.  Managers should note, that while there are not specifically AI regulations, manager using AI are still subject to the same regulations as managers utlitizing only human intelligence.

·  Compliance Considerations for AI Managers – managers utilizing AI should have robust compliance systems in place.  Managers will either have in-house personnel devoted to implementing their compliance program or should think about utilizing outside compliance consultants.  In addition to normal investment advisor regulatory considerations, manager will also want to have trading level compliance systems in place – for example, if the manager trades futures, the manager should have position limit systems in place.

·  Other Items.  Other items for an AI fund manager to consider include the specific risks to be disclosed with respect to the AI; as mentioned above, most risks are related to the strategy and with respect to the technology in general.  There may be specific risks associated with a certain AI program though.  With respect to other fund service providers to the AI fund, there should not be any issues.

Conclusion

As some of the world’s largest asset managers are beginning to utilize artificial intelligence with respect to their investing (see here and here), and some of the largest tech companies in the world are placing a focus on developing AI (see here about Google’s “AI-first” world), we are entering the very beginning phase of a new world where AI is an integral part of our lives and the financial markets.

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

Hedge Fund Bits and Pieces for May 12, 2017

Happy Friday.

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SEC New Chairman Jay Clayton Sworn In – last week Justice Anthony Kennedy swore in Jay Clayton as the new SEC Chairman.  Clayton has a long background working in the the securities industry at a large law firm and has acted as a law school professor with respect to various aspects of the securities industry.  Clayton begins the Chairmanship during rapidly changing times – technological innovation is changing both the products in the securities industry as well as how market participants interact with those products.  We are both excited and hopeful that he will be able to lead the SEC in this this environment to adequately protect investors while also encouraging innovation and growth within the industry.  More information on his background can be found in the SEC press release.

State Cybersecurity Workshop – we hear about cybersecurity threats on an almost daily basis now; last week introduced a phishing scam involving Google Docs.  As this issue continues to be a forefront issue, the regulators and states are trying to help industry participants become better prepared in this area.  As an example, Washington state just announced that it will hold a “Cyber Security Workshop for Small & Medium Businesses”  in Washington state in conjunction with the National Cyber Security Alliance (NCSA).  We anticipate we will see more initiatives like this for investment managers going forward and encourage all managers to continue their education in this area.

CFTC Reduces Burden for Swap CCOs – last week the CFTC published in the Federal Register amendments to regulations applicable to certain chief compliance officers of firms that engage in swaps.  We recognize that these CCOs have a very difficult job (especially as the products become more and more complex) and we applaud the CFTC for attempting to identify areas where regulatory burdens can be lifted.  We anticipate there will be a number of comments in this area, which are due by July 7, and we will provide updates as applicable.

Other Items

AI Trend Continues – we note that a number of the legal projects we are currently working on deal with Artificial Intelligence (AI) in some way.  A service provider to the investment management industry, Orbital Insight, showcase that AI is front and center on the minds of the industry when it announced a $50M Series C round.

State Carried Interest Tax Changes? – according to this update a number of states are contemplating changes to the manner in which carried interest is taxed.  It seems like it will be a bit of a waiting game until a Federal tax bill is proposed, but it is interesting to note that there seems to be some kind of momentum toward changing the manner of taxation.

CFTC Requests Public Input on Simplifying Rules – the CFTC announced that it is asking for input on how regulations should be modified to better address regulatory items and to reduce costs.  We think this is a step in the right direction and also mirrors the initiative by FINRA (which we reported on earlier).  We believe that investor protection is paramount, but we also believe that modifications to certain investment regulations can increase efficiency and reduce costs for market participants which would be a benefit for everyone.  For more information see the CFTC’s ProjectKiss site; comments are generally due by September 30.

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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 April 28, 2017

Happy last Friday of April.

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Cole-Frieman & Mallon LLP 2017 1st Quarter Update – we were a little late for this first quarter but the update addresses a number of items including:

  • Trump and Dodd-Frank Reform
  • DOL Fiduciary Rule Delay
  • Bitcoin Regulatory Matters
  • California’s Public Investment Fund Disclosure Requirements
  • SEC No-Action Letter and Guidance Clarify Inadvertent Custody
  • SEC / FINRA 2017 Exam Priorities
  • Compliance Calendar

Trump Tax Plan & Financial Industry – while our quarterly update talked in part about potential future reform of the financial system, there is not really much to say yet about Trump’s one page tax plan.  We do know, obviously, that the details will be forthcoming, but this plan leaves a lot of open questions and (surprise) remains silent on the carried interest issue. One item to note is that the tax plan proposes to repeal the 3.8% Obamacare tax – this is important because many fund managers have established structures to minimize the impact of this tax to the manager.  As more information rolls out, we expect to hear from both accountants and tax planners about how any new tax plan would affect the private funds industry.

Blockchain / Cryptocurrency / Altcoin Items – there continues to be an onslaught of items dealing with blockchain technology in the financial services sector, and we included some discussion of these items in our quarterly update linked above.  On Wednesday of this week I attended EY’s Global Blockchain Summit in San Francisco (more on this coming soon). In addition, FINRA just announced a Blockchain Symposium which will be held in New York on July 13.  According to the announcement, the “half-day program is designed to bring together regulators and industry leaders to discuss the use of blockchain and related opportunities and challenges.”  It is important to note that blockchain appears to be an inevitable new structure/paradigm in business generally and investment management specifically – surprisingly, the regulators seem to be aware of this sea change and ready to work with the industry to implement appropriate regulatory structures to address investor protection concerns.

Other Items

Connecticut Hedge Fund Tax – there have been a few news articles about a potential tax on private fund managers in Connecticut.  I have not kept up on this issue in depth, but it should be interesting to see how this plays out and whether any other states will follow suit.

FINRA Insider Trading Information – FINRA has begun to take an active role in finding and dealing with insider trading.  Just recently they released an interesting video with Cam Funkhouser, Executive Vice President of FINRA’s Office of Fraud Detection and Market Intelligence (OFDMI), about insider trading and some “red flags” to look out for.

FINRA Bootcamps – FINRA announced three compliance boot camps for may – Dallas (May 11), Memphis (May 17) and Charolette (May 31).

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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.

Cole-Frieman & Mallon 2017 First Quarter Update

Below is our quarterly update which went out via email today to our firm’s clients and friends.  Links coming soon.

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April 27, 2017

Clients, Friends, Associates:

We hope that you are enjoying an auspicious start to 2017. The first quarter of the year is typically one of the busiest for fund managers from a regulatory standpoint. As a variety of filing deadlines have passed and audit work is completed (or will be soon), we enter the second quarter with a number of important regulatory issues on the horizon, as well as many other topics worthy of discussion. Below, we have prepared a short overview of some of these items.

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Regulations and Proposed Regulations:

Trump Executive Order Could Reform Dodd-Frank. President Trump issued an executive order on February 3, 2017, setting out seven “Core Principles” which will serve as general guidelines for financial regulatory reform. The Core Principles include making regulation more efficient, effective and appropriately tailored, as well as rationalizing the Federal financial regulatory framework. The order appears implicitly targeted at reforming the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) and decreasing many of the current financial regulations, but we note that any changes to the current regulatory landscape may not be as immediate as many initial reactions assumed. According to the order, the Treasury Secretary is to meet with the various agencies that oversee and implement Dodd-Frank (including the SEC), to discuss areas that may be amended. While a repeal of Dodd-Frank is unlikely, the coming months may bring a number of deregulatory changes. We will be following any resulting changes and will discuss significant impacts of such changes in future quarterly updates.

Department of Labor Delays Fiduciary Rule. On April 7, 2017, in response to a presidential memo from President Trump, the Department of Labor (“DOL”) issued a Final Rule delaying the applicability of the “Fiduciary Rule” until June 9, 2017, although full compliance with the Fiduciary Rule is still expected by January 1, 2018. We had previously discussed the Fiduciary Rule, which expanded the scope of who is considered a “fiduciary”, imposing fiduciary obligations on firms which were historically free from such obligations. While the DOL will use the delay to reexamine the Fiduciary Rule and consider modifications to it, if you have not already done so, we recommend that you review and speak with your counsel about whether you would be considered a fiduciary and what additional obligations and implementation processes will need to be incorporated into your business practices.

CFTC Regulation of Bitcoin and Virtual Currencies. There has been an increasing interest in investments in Bitcoin and other cryptocurrencies as the financial and technological landscape evolves, but determining the regulations applicable to such products is less clear. While the CFTC established that Bitcoin and other virtual currencies are “commodities” within the definition of the Commodity Exchange Act of 1936, as amended (“CEA”), under the CEA, only commodity interests (which include futures, options, derivatives and certain spot transactions) based on the commodity are within the scope of the CFTC’s jurisdiction. Recent enforcement actions brought by the CFTC have helped clarify whether a transaction is subject to CFTC regulation. In an Order issued against the Coinflip, Inc. platform (“Coinflip”), the CFTC imposed sanctions against Coinflip for operating a facility for trading Bitcoin derivatives without being registered as a futures exchange or swap execution facility. In a contrasting enforcement action brought against the Bitfinex platform (“Bitfinex”), which did not list or permit the trading of derivatives, the CFTC asserted its jurisdiction over Bitfinex on the basis that the platform dealt in “retail commodity transactions”— leveraged, margined or financed transactions involving a commodity that are offered to persons that are not “eligible contract participants” — without being registered as a futures commission merchant with the CFTC. Certain retail commodity transactions are exempt from CFTC jurisdiction if the seller “actually delivers” the commodity to the buyer within 28 days of the date the contract was entered into; the CFTC deemed that Bitfinex did not “actually deliver” the cryptocurrencies to buyers because among other reasons, Bitfinex held the private key controlling access to the wallet where the buyers’ cryptocurrencies were held.

Managers investing in Bitcoin or other virtual currencies should consider whether and to what extent the types of transactions may subject them to CFTC jurisdiction and potential registration as a CPO or CTA. In the current regulatory landscape, we believe managers who invest purely in virtual currencies and who do not employ virtual currency derivatives or leverage are outside the scope of the CFTC’s jurisdiction, and should not be required to register as a CPO or CTA. Although further regulation is expected, firms should speak with outside counsel to confirm their status in light of the current regulatory framework.

Other Regulation of Bitcoin and Virtual Currencies. While the CFTC has been the most active regulatory authority to address investments in cryptocurrencies, managers should be cognizant that states (including New York), the SEC, FINRA and FinCEN are also deliberating the question of appropriate regulatory oversight. We will continue to monitor regulatory developments and more information about certain regulatory aspects applicable to private funds can be found in our blog post on Bitcoin / Cryptocurrency Hedge Funds.

NFA Provides Guidance on Amended CPO Financial Report Requirements. In our previous 2016 End of Year Update we discussed the CFTC’s amendments providing relief from certain financial report requirements for commodity pool operators (“CPOs”), which became effective on December 27, 2016. The NFA released a Notice setting forth instructions regarding how CPOs can file the appropriate notices with the NFA to claim any of the relief provided for in the amendments. CPOs who are eligible for the amended regulations should contact counsel or compliance consultants, or review the Notice, to determine whether any further action may be warranted to claim the appropriate relief.

U.S. and Global Regulators Relax March 1st Deadline for Swap Variation Margin Compliance. The Federal Reserve and the International Organization of the Securities Commission have provided some flexibility for swap dealers facing a March 1, 2017, deadline to implement certain variation margin compliance requirements for uncleared swaps. The rules require swap dealers to collect and post variation margin with no credit threshold unless an exception applies. Further, covered counterparties would be required to enter into new or amended credit support documentation, limit the types of collateral that may be posted and prescribe minimum transfer amounts. Compliance with the requirements can be challenging for swap entities and their counterparties as they work to implement the necessary documentation and underlying operational processes. Except for transactions with financial end users that present “significant exposures,” the Federal Reserve’s guidance directs examiners of CFTC-registered swap dealers to focus on the dealer’s good faith efforts to comply as soon as possible but by no later than September 1, 2017.

BEA Makes Changes to Direct Investment Survey Reporting Requirements for Certain Private Funds. The Bureau of Economic Analysis’ (“BEA”) changes to its direct investment surveys went into effect on January 1, 2017. The reporting changes apply to investments by U.S. entities of a 10% or more voting interest in a private fund, and to investments by foreign entities of a 10% or more voting interest in a U.S. domiciled fund. Under these changes, any cross-border voting investments of 10% or more in, or by, private funds will be subject to BEA reporting only if such investments involve, directly or indirectly, a direct investment in an “operating company” that is not another private fund or a holding company. The changes will simplify reporting for private funds because certain direct investments in private funds will be re-characterized as portfolio investments depending on the nature of the private fund’s investments. Many hedge funds that were traditionally subject to BEA direct investment reporting because of cross-border voting interests will instead only be required to report on portfolio investments to the Treasury Department on Treasury International Capital (“TIC”) surveys. The BEA will notify any filers that may be potentially affected by these changes, but we recommend that advisers consult with counsel to determine what, if any, BEA and/or TIC reporting obligations they may have.

Treasury Department Proposes New Anti-Money Laundering Rules for Investment Advisers. The Treasury Department’s Financial Crimes Enforcement Network previously proposed extending the requirements of maintaining a formal anti-money-laundering (“AML”) program under the Bank Secrecy Act of 1970 to SEC-registered investment advisers (“RIAs”). The final rule is expected to be published soon, and would require SEC RIAs to establish a robust AML program with policies and procedures to identify questionable activity, periodic testing of the program and ongoing training of appropriate personnel.

Other Items:

California’s Public Investment Fund Disclosure Requirements Now Effective. In our third quarter update, we reported that California passed a bill requiring increased disclosure by private fund managers for funds with investments by California state and local public pension and retirement systems. The legislation went into effect on January 1, 2017. All public pension and retirement systems in California must require hedge funds, private equity funds, venture capital funds and any other alternative investment vehicles in which they invest to disclose certain information regarding the fund’s fees, expenses and performance. In addition to applying to new contracts entered into on or after January 1, 2017, and pre-existing contracts with new capital commitments made on or after January 1, 2017, the legislation requires that public pension and retirement systems make “reasonable” efforts to obtain the increased disclosure information for contracts entered into prior to January 1, 2017. Fund managers with California public plan investors should review the types of information that will need to be provided to such investors and prepare to provide the required information.

SEC No-Action Letter and Guidance Clarify Inadvertent Custody. On February 21, 2017, the SEC issued a no-action letter responding to a request for clarification from the Investment Advisers Association as to whether an investment adviser has custody of a client’s assets if the adviser acts pursuant to a standing letter of instruction or other similar arrangement established between the client and its custodian (“SLOA”), that grants the adviser limited authority to direct transfers of the client’s funds to one or more third parties. The SEC’s position is that an SLOA that authorizes the adviser to determine the amount and timing of payments, but not the payee’s identity, is sufficient authority to result in the adviser having custody of the assets. However, the SEC agreed that it would not recommend an enforcement action against an adviser that does not obtain a surprise examination, if the adviser acts pursuant to an SLOA under certain specific circumstances set forth in the SEC’s letter. The SEC also reaffirmed that advisers will not be deemed to have custody of client assets if the adviser is given limited authority to transfer client assets between the client’s accounts maintained at one or more custodians.

To further clarify its views on inadvertent custody, the SEC also issued a guidance update highlighting certain circumstances where an investment adviser may inadvertently have custody of client funds or securities. An adviser may have custody because of the wording or rights of custodial and advisory agreements, even if the adviser did not intend to have custody and was not aware it was granted the authority that resulted in its having custody. We urge advisers to separately managed accounts to review their client agreements and any SLOAs they have entered into to determine whether their specific arrangements may cause them to have custody, and to evaluate their policies and practices related to custody of client assets.

SEC Published Examination Priorities for 2017. The SEC announced its Examination Priorities for 2017, which focus on themes of examining matters of importance to retail investors, focusing on risks specific to elderly and retiring investors and assessing market-wide risks. Specifically, the SEC will focus on: (i) identifying initiatives designed to assess risk in the context of retail investors, including never-examined investment advisers and exchange-traded funds, and notably, robo-advisers and other automated, electronic investment advice platforms, including the investment advisers and broker-dealers that offer them; (ii) services provided to retirement accounts, such as variable insurance products and fixed-income cross-transactions, as well as investment advisers to pension plans and other large holders of U.S. investor retirement assets; and (iii) cybersecurity, and systems and technology procedures and controls.

FINRA Published Examination Priorities for 2017. Similar to the SEC, the Financial Industry Regulatory Authority, Inc. (“FINRA”) recently published its 2017 Regulatory and Examination Priorities Letter, outlining the organization’s enforcement priorities for the current year. FINRA’s specific focus areas for 2017 will include: (i) supervisory policies and compliance controls for high-risk and recidivist brokers; (ii) sales practices and product suitability for specific investors; (iii) firm liquidity management practices; and (iv) cybersecurity issues. We recommend that you speak with your firm’s outside counsel and service providers to learn more about these specific priorities and review your firm’s compliance with the applicable regulations.

Cayman Islands Extends CRS First Notification and Reporting Deadlines. The Cayman Islands Department for International Tax Cooperation (“DITC”) has issued an industry advisory stating that it is adopting a “soft opening” to the notification and return deadlines required for Financial Institutions’ (“FIs”) compliance with the Common Reporting Standard (“CRS”). All FIs in the Cayman Islands are required to register with the Cayman Islands Tax Information Authority (“TIA”) by April 30, 2017, and to submit returns to the TIA by May 31, 2017. With the DTIC’s adoption of a “soft opening,” FIs may submit CRS notifications on or before June 30, 2017, and file “accepted” CRS returns on or before July 31, 2017, without any compliance measures or penalties.

Ninth Circuit Rules Internal Reports Protected under Whistleblower Rules. On March 8, 2017, the Ninth Circuit followed a ruling by the Second Circuit in finding that an employee who makes a report internally, rather than to the SEC, is protected under Rule 21F-17 of the Securities Exchange Act of 1934, as amended (“Whistleblower Rule”) enacted under Dodd-Frank. In contrast, the Fifth Circuit previously ruled that the provisions of the Whistleblower Rule only apply when an employee makes disclosures directly to the SEC. The Ninth Circuit and Second Circuit rulings reflect a broad interpretation of the definition of a whistleblower, and signal a split among the circuit courts on who may be considered a whistleblower for purposes of protection under the Whistleblower Rule.

Regulatory Assets Under Management. We have observed that many managers have expressed confusion regarding the calculation of assets under management (“AUM”) for purposes of filing the Form ADV and determining when the manager may be subject to SEC registration. We thought it would be helpful to clarify that investment advisers must look to their “regulatory assets under management” (“RAUM”), a specific metric designed by the SEC, which is calculated differently from the more common and more traditionally understood calculation of AUM. In calculating RAUM, managers should include the value of all assets managed without deducting for any offsetting liabilities. Managers with questions about the calculation of specific assets or managers seeking further clarification of RAUM should speak with their firm’s outside counsel or compliance consultants.

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

Deadline – Filing

  • March 31, 2017 – Deadline to update and file Form ADV Parts 1, 2A & 2B
  • April 10, 2107 – Amendment to Form 13H due if necessary
  • April 15, 2107 – 1st Quarter 2017 Form PF filing for quarterly filers (Large Liquidity Fund Advisers)
  • April 28, 2107 – Collect quarterly reports from access persons for their personal securities transactions
  • April 28, 2107 – Distribute code of ethics and compliance manuals to employees. Require acknowledgement form to be executed in connection with such delivery
  • April 28, 2107 – Annual Privacy Notice sent to all clients or fund investors (for Advisers with Fiscal Year ending December 31)
  • April 28, 2107 – Distribute audited financial statements to investors (most private fund managers, including SEC, state and CFTC registrants)
  • April 28, 2107 – Distribute Form ADV Part 2 to clients
  • April 30, 2107 – Quarterly NAV Report (registered commodity pool operators claiming the 4.7 exemption)
  • May 1, 2107 – 2016 Annual Form PF due date for annual filers (Large Private Equity Fund Advisers and Smaller Private Fund Advisers)
  • May 15, 2017 – Quarterly Commodity Trading Advisor Form PR filing
  • May 15, 2017 – File Form 13F for first quarter 2017
  • May 31, 2017 – First deadline for Cayman Islands Financial Institutions to submit their CRS returns to the Cayman Islands Tax Authority
  • May 31, 2017 – Third reporting deadline (full reporting) for Cayman Islands Financial Institutions with reporting obligations under the Cayman FATCA regulatory framework to report their U.S. Reportable Accounts to the Cayman Islands Tax Authority
  • June 30, 2017 – Distribute audited financial statements to investors (private fund managers to funds of funds, including SEC, state and CFTC registrants)

Variable

  • Distribute copies of K-1 to fund investors
  • Ongoing All Limited Non-U.S. Financial Institutions and limited branches that seek to continue such status during the 2017 calendar year must edit and resubmit their registrations after December 31, 2015, on the FATCA registration website; SEC form D must be filed within 15 days of first sale of securities

Please contact us with any questions or for assistance with any compliance, registration or planning issues on any of the above topics.

Sincerely,
Karl Cole-Frieman, Bart Mallon & Lilly Palmer

Hedge Fund Bits and Pieces for April 14, 2017

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

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

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

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

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

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

Hedge Fund Bits and Pieces for April 7, 2017

Happy Masters Friday!

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

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

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

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

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

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

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

Hedge Fund Bits and Pieces for March 17, 2017

Happy Friday. This week’s updates below.

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

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

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

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

Bitcoin Hedge Funds (Cryptocurrency / AltCurrency Funds)

Overview of Blockchain Based Digital Currency Investment Fund Structures

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

Foundational Items – Definition

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

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

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

Structural Considerations for Fund Formation

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

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

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

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

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

Regulatory and Other Considerations for Bitcoin Investment Managers

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

Federal & State Regulatory System.

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

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

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

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

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

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

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

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

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

Conclusion

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

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.