Author Archives: nedaj

General Data Protection Regulation (GDPR)

Overview of GDPR for US Private Fund Managers

The General Data Protection Regulation (“GDPR”) is a new set of requirements intended to strengthen the protection of citizens’ personal data as well as data movement within the European Union (“EU”).  GDPR was adopted on May 24, 2016 by the European Parliament and the Council of the European Union and went into effect on May 25, 2018.  The regulation replaces Directive 95/46/EC, known as the Data Protection Directive and may apply to certain organizations (including private fund managers) in the US who work with persons in the EU.  This post is designed to give fund managers an overview of the regime and some initial items that should be considered.

What is GDPR?

GDPR sets restrictions on those who process, transfer, or monitor personal data and the procedures by which this is done.  The term “personal data” means any information relating to an identified or identifiable natural person.  The term generally means any information that directly or indirectly can lead to the identification number, location data, online identifier, or similar items related to the identity of a natural person (can include physical, physiological, genetic, mental, economic, cultural, social data, etc).   Organizations that are subject to GDPR but are not compliant can be fined the greater of €20 million or 4% of global annual turnover. GDPR requires that any personal data breach must be reported within 72 hours and justification must be given for any delays.

One of the key aspects of GDPR is that it requires organizations to appoint a Data Protection Officer (DPO) in the following three situations: (1) if the organization is processing public data as a public authority; (2) the organization’s processing operations require regular and systematic monitoring of data subjects on a large scale; and (3) the organization has large scale processing of personal data relating to criminal convictions or special categories that reveal identity of a natural person (including physical, physiological, genetic, etc.).  Although private fund managers may not fall into any of the above categories, it is encouraged under Article 29 Data Protection Working Party (“WP29”) for organizations to appoint a DPO as part of good practice procedures and to demonstrate compliance with GDPR.

Who is regulated?

The requirements of GDPR applies to controllers (the person(s) or entity that determines the purposes and means of processing personal data) or processors (the person(s) or entity that processes personal data on the controller’s behalf) of personal data.  It also applies to the processing activities related to offering goods or services to the data subjects from the EU or monitoring behaviors that take place within the EU.

*** Practically, for private fund managers, GDPR is applicable if you have European investors in a fund or actively solicit or market to European investors.  

What are the initial steps a private fund manager should take?

Depending on the scope of activity, we believe that managers should think about implementing a full GDPR compliance program.  In the meantime, managers subject to the directive should take immediate actions:

  • Send a disclosure statement to EU investors regarding GDPR and the fund’s obligations under GDPR.
  • Attach the disclosure statement regarding GDPR to the fund subscription documents moving forward to ensure that all new investors receive it.
  • Update the fund’s offering documents with a GDPR disclosure.
  • Amend agreements with service providers who processes EU investors’ personal data on the fund’s behalf.
  • Determine whether the fund needs to establish an EU Representative.

How do you create a GDPR compliance program?

Managers with data subject to GDPR will need to take inventory of their data which is covered by the regulation and should create certain procedures and controls with respect to the data.  We believe that initial steps should include the following:

  • Create a list of all types of personal information your fund holds, the source of that information, with whom you share it, what you do with it and how long you will keep it.
  • Create a list of places where your fund keeps personal information and the ways data flows between them.
  • Create a publicly accessible privacy policy, which includes a lawful basis to explain why the fund needs to process personal information, that outlines all processes related to personal data.
  • Appoint a Data Protection Officer (DPO) if necessary.
  • Create awareness among decision makers about GDPR guidelines.
  • Review and/or update the fund’s security technology that is used to process personal data (i.e. firewalls, security verification tools, etc.).
  • Update e-mail security to reduce the risk of phishing and other attacks on protected information.
  • Create a compliance program that includes staff training on data protection items.
  • Create a list of third parties that process personal data for you and update your privacy policy to disclose your use of these third parties.
  • Put a contract in place with any data processors with whom you share data containing explicit instructions for the storage or processing of data by the processor.

Conclusion

Managers should begin this process of exploring the impact of GDPR on their operations immediately if they have not already done so.  Managers should also consult with offshore counsel, compliance consultants, and/or GDPR specialists for guidance on how to best comply with GDPR to meet the fund’s particular needs.  GDPR has radically changed how personal data is processed in the EU and abroad.  The sooner a manager enacts GDPR compliant policies, the sooner the manager can cater to EU citizens and the less likely it will be subject to penalties.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP.  Cole-Frieman & Mallon LLP has is a leader in the hedge fund space and routinely works with managers on legal, regulatory and compliance issues. If there are any questions on this post, please contact Mr. Mallon directly at 415-868-5345.

CoinAlts Fund Symposium East – New York, April 19th

Cryptocurrency Fund Conference Sponsored by Cole-Frieman & Mallon

As we have recently announced in our firm’s first quarter legal update, we are one of the founding sponsors of the second CoinAlts Fund Symposium which will be held in Midtown Manhattan on April 19th.  The agenda for the day is as follows:

  • Opening Remarks by Cory Johnson of Ripple
  • Legal & Regulatory Panel featuring Bart Mallon (moderator) and Karl Cole-Frieman (panelist)
  • Industry Keynote by Mark Yusko of Morgan Creek Capital Management
  • Featured Keynote by John Burbank of Passport Capital
  • Best Practices in Tax, Accounting and Operations
  • Trading & Execution in Digital Assets
  • Allocators to Digital Asset Funds
  • Cryptocurrency Trends and Innovations featuring Laura Shin (moderator) and Marco Santori (panelist)

The event is preceeded by a networking event for women in the blockchain/digital asset space on Wednesday evening sponsored by CoinAlts and Circle.  Attendance at the main event is expected at around 400 people and will include digital asset managers, investors, students and service providers.

For more information on the event please see the CoinAlts East press release.

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For more information on this topics related to the digital asset space, 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 LLP has been instrumental in structuring the launches of some of the first cryptocurrency focused hedge funds. If there are any questions on this post, please contact Mr. Mallon directly at 415-868-5345.

CoinAlts East Announced – April 19, 2018 (Press Release)

Below is the press release on our CoinAlts East event.  We hope to see you there.

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CoinAlts Fund Symposium Announces East Coast Event

NEW YORK (PRWEB) MARCH 30, 2018

The CoinAlts Fund Symposium is announcing its second event, called CoinAlts East, in New York on April 19, 2018. The event will be headlined by the keynote speaker John Burbank of Passport Capital in a fireside chat format. Mark Yusko of Morgan Creek Capital Management will be the featured industry speaker. Additional speakers include Cory Johnson of Ripple and Donald R. Wilson of DRW. The all-day conference will address issues that digital asset managers face on the legal and regulatory front, as well as issues related operation items, trading and fund raising from institutional investors.

“We are so fortunate to have such high-quality speakers and panelists. Our goal has always been to foster a community of the best minds in the crypto space and I think you see that in both our speaker list and the attendees of the conference,” said conference co-chair Bart Mallon of the law firm Cole-Frieman & Mallon LLP. CoinAlts East comes on the heels of the first full day conference for digital asset managers held in September in San Francisco and attended by over 400 industry professionals. CoinAlts East is expected to sell 500 tickets to the all-day event.

“The first CoinAlts event had such an overwhelmingly positive response that we knew we needed to bring the event to New York. The asset class is maturing and traditional investment managers are beginning to be very much involved in the space,” said Corey McLaughlin of Cohen & Company, one of the conference’s founding sponsors. Lauren Colonna of Ovis Creative, a marketing and consulting firm and sponsor of CoinAlts East, echoed Corey’s comments saying that “in addition to the standard alternative asset management work we continually see, we are experiencing a significant increase in the demand for institutional quality marketing materials and messaging for managers in the cryptocurrency and digital asset space.”

Current early bird pricing for investment managers is $500 per person and $750 per person for service providers. Early bird pricing ends on March 30, 2018, after which the price will be $750 and $1,000 respectively. The conference is also the sponsor of a Women in Crypto networking event which will be held on April 18, 2018.

About the CoinAlts Fund Symposium

The CoinAlts Fund Symposium was established by four firms with significant practices devoted to fund managers in the cryptocurrency and digital asset space. Cohen & Company specializes in the alternative investment industry and advises cryptocurrency funds on important tax, audit and operational matters. Harneys Westwood & Reigels LLP is a leading international offshore law firm that advisers fund managers on all aspects of the life of a Cayman or BVI fund including formation, restructuring and closure. MG Stover & Co. is a full service fund administration firm built by former auditors and fund operators to deliver world class solutions to the global alternative investment industry. Cole-Frieman & Mallon LLP is a premier boutique investment management law firm, providing top-tier, responsive and cost-effective legal solutions for cryptocurrency fund managers.

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

Simple Agreement for Future Tokens (SAFT)

SAFT Background for Cryptocurrency Funds

As we discussed in a recent post, the SEC Report on the DAO, issued in July of this year, discussed how the SEC views Initial Coin Offerings (ICOs). One key takeaway from this report was that some digital assets/ tokens fall within the definition of securities, depending on the facts and circumstances related to the nature of the particular digital asset/token. If an ICO is considered an offer and sale of a security, then that offering must comply with federal securities laws.  This means the token must either be registered as a security with the SEC or that the token qualifys for an exemption from registration requirements.

In an attempt to comply with SEC regulations and account for some of the uncertainties around regulation of these digital assets, some recent ICOs have launched using a Simple Agreement for Future Tokens (SAFT) along with an accompanying offering memorandum. The SAFT, modeled after Y Combinator’s Simple Agreement for Future Equity (SAFE), is an agreement offering future tokens to accredited investors. Instead of offering an immediately available token, these SAFTs offer the right to a token upon a triggering event. SAFTS are intended to be private offerings exempt from registration with the SEC. Notably, Protocol Labs, Inc. offered the right to purchase Filecoin tokens through a SAFT earlier this year. Since then, multiple other ICOs have launched using SAFTS, including Unikrn, StreamCoin Labs, and Kik Interactive.

Overview of SAFT documentation

As part of some ICO launches, investors are subscribing through a SAFT and accompanying offering memorandum.  The SAFT is an agreement signed by both the issuer and the purchaser of the future tokens. The general SAFT template includes various provisions which we outline below.

  • Country legends – disclaimers directed toward specific countries, including statements on registration and restrictions on transfer of the tokens.
  • Sale information – purchase amount and price, token amounts, and vesting period.
  • Background information – various events including network launch, dissolution events, and termination events are discussed. A network launch will generally trigger an issuance of tokens based on the purchase amount of each investor.
  • Purchaser and Issuer representations – various representations made by both the issuer and purchaser are included. Notably, the purchaser will represent that it has been advised that the SAFT is a security and has not been registered, and cannot be resold without the consent of the issuer. The agreement also includes the procedures for purchase of rights under the SAFT including the form of payment.
  • Miscellaneous/ transfer provisions – various miscellaneous provisions including transfer restrictions and rights under the SAFT.

SAFT Offering Memorandum

The offering memorandum is similar private placement memorandum (PPM) for a traditional hedge fund and provides the prospective investor with information on the structural and business aspects of the offering. Below is a non-exhaustive list of some of the major sections of the offering memorandum:

  • Legends and securities laws notices
  • Table of contents
  • Company overview
  • Description of the directors and management
  • Terms of the purchase rights and the SAFTS
  • Risk factors
  • Description of the use of proceeds
  • Description of the plan of distribution

Potential Issues

There are a number of potential issues, including legal and regulatory, that may arise through the use of SAFTS.

Is a SAFT a security?

The SEC has applied the Howey test to digital assets, concluding that a token may be a security based on specific facts and circumstances. To determine whether tokens are securities, the SEC has looked to whether there is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.

The drafters of SAFTs have generally taken the position that SAFTs are securities (e.g., investment contracts). The SEC has commented in the past on SAFEs with respect to crowdfunding, mentioning that SAFEs are a type of security, warning investors to be cautious. SAFTs that are limited to accredited investors will likely elicit less concern from the SEC as they are not aimed at retail investors. It remains to be seen, however, whether the SEC will also consider SAFTs securities in a similar context with SAFEs. While any determination on whether the SAFT is a security will likely be based on the specific use of the underlying tokens, it seems likely that many SAFTs would be deemed securities because the purchasers are investing money (or other digital assets) in the rights to the future underlying token with the expectation of profits from the efforts of the issuers of the SAFT.

Restrictions on transfer

Under a SAFT, there is typically a restriction on the purchaser’s ability to transfer or make use of the tokens until the tokens are vested. Vesting takes place once the network is launched and the tokens are mined. A purchaser generally can, however, transfer its rights in a SAFT to another person or entity with the consent of the company issuing the SAFT. Below is a non-exhaustive list of some of the major provisions that should be in the transfer agreement.

  • Transfer of the SAFT
  • Consideration
  • Consent of the company that issued the SAFT
  • Transferor representations and warranties that it owns the SAFT and is able to transfer
  • Transferee representations that it will be bound by the terms of the SAFT

Source of funds

Many of these SAFTs allow purchasers to use various forms of consideration for these contracts including US dollars, Bitcoin, and other digital assets. This may raise anti-money laundering concerns around the source of the funds used for these purchases.

How do regulators view SAFTs?

US regulators have not provided specific guidance on the use of SAFTS. As discussed previously, the SEC has stated that some tokens are securities. Additionally, earlier this year, the SEC charged a businessman with allegedly running two fraudulent ICOs and appears to be taking an increasing interest in these issues. The SEC has mentioned the crowdfunding regulations in the SEC Report on the DAO, and the SEC seemed to be highlighting an option for certain fund sponsors. Given also that the SEC has commented on SAFEs with respect to venture and crowdfunding, it is possible that regulators will draw certain parallels between SAFEs and SAFTs in its views on these instruments. Unfortunately, until regulators issue additional guidance, it is not yet clear whether the SAFT in some cases will be sufficient to satisfy the SEC or other regulators.

Looking Forward

The SAFT represents some investment managers’ response to the concerns of the SEC and may encourage more ICOs to be based in the US. We hope the SEC and other regulators comment on their view of SAFTs, although much of the discussion over whether a SAFT or token is a security will remain a facts and circumstances determination.

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For more information on this topics related to the digital asset space, 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 LLP 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.

Cryptocurrency Fund Legal & Operational Posts

The goal of the posts on this page are to address the legal and operational issues applicable to fund managers who invest in the cryptocurrency space.  We believe the emergence of this new asset class gives rise to a need for open discussion of the protocols, operations, industry norms, and best practices (now and in the future) related to investments in this space.  Our goal is to help with that process and we look forward to hearing your feedback on these posts.

Fund Overview

Regulatory Items

Other Resources

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

Hedge Fund Bits and Pieces for June 16, 2017

We are a day late but hope you had a happy Friday.  As has been the trend, we are seeing a large focus on cryptocurrency assets and this update reflects that focus.

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Speaking on Cryptocurrency Hedge Funds – I will be in New York next week to speak Thursday at the Blockchain, Accounting, Audit & Tax Conference.  The conference will have panels speaking throughout the day on various blockchain related issues.  I will be part of a panel entitled “Digital Asset Management and New Financial Products” where we will discuss current and future investment vehicles as well as how investors are (and should be) viewing these products.  More information on the event can be found here.

California BitLicense – continuing the trend toward increased regulation of digital assets, California has proposed (for a second time) a regulatory regime for certain exchanges dealing with bitcoin and other “virtual currency”.  This legislation comes on the heels of New York’s BitLicense requirement, along with other regulators beginning to look at blockchain based digital assets.  As described below, we believe the SEC will be addressing the industry soon with questions and comments regarding certain aspects of the FinTech industry.  For more on the California BitLicense requirement, please see here.

Industry asks SEC to Publish Concept Release on Regulation of Digital Assets – a FINRA registered broker-dealer recently petitioned the SEC to provide guidance with respect to the regulation of digital assets (to be called Regulation DA).  The broker-dealer asked that the SEC also consider adopting a regulatory sandbox for certain FinTech companies, similar to what is being employed in the UK and Singapore (the latter of which has seen a large influx of oversight/regulation of ICOs).  The broker-dealer also mentioned that the regulation of digital assets should be consistent with crowdfunding regulations given that digital assets (ICOs specifically) share many characteristics in common with the crowdfunding industry.  You can access the full petition here.

Financial CHOICE Act of 2017 – on June 8, the House of Representatives passed the Financial CHOICE Act which is aimed at rolling back many of the changes implemented by the Dodd-Frank Act.  There are a number of interesting things that this bill introduces, including: structural changes to the SEC, repeal of the Department of Labor’s (DOL’s) fiduciary rule, restructure the CFPB, and repeal the Volker Rule.  All of the above would affect the investment management industry in profound ways but it is unlikely we will see any movement on this bill in the Senate any time soon.  When and if we do, we will provide more analysis on the content of any legislation that is likely to pass and be implemented.  An executive summary of the bill can be found here. The full text 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.

California BitLicense

Overview of the Cryptocurrency Licensing Regime in California

As we discussed in a recent post, New York has already implemented a statute that requires those engaged in certain virtual currency business activities to obtain a license from the state. In a similar fashion, California has proposed A.B. 1123 (the “Bill” or “Virtual Currency Act”)  that would allow the state to begin regulating the industry. This post focuses on California’s proposed version of a “BitLicense”, which like New York, would prohibit a person from engaging in a virtual currency business activity unless they receive a license from California’s Commissioner of Business Oversight (“Commissioner”).

California Virtual Currency Act – A.B. 1123

Pursuant to the Virtual Currency Act, any persons involved in a “virtual currency business” in California must register with the Commissioner.   The Act defines a “virtual currency business” as “maintaining full custody or control of virtual currency in this state on behalf of others.”  The definition of “virtual currency” is very broad (“any type of digital unit that is used as a medium of exchange or a form of digitally stored value”) although there are some carveouts for gaming platforms and for consumer reward programs.

The above definition seems to capture those groups who are offering exchange and wallet services for persons who are buying, selling and holding bitcoin and other digital currencies. Right now we don’t believe that a cryptocurrency hedge fund entity or its manager/general partner would need to obtain the license – a fund would simply be holding virtual currency on behalf of itself and therefore the general partner entity would not need to be registered.  

California Application Process

In the event an entity needs to register, there is an application process where the Commissioner will engage in an extensive review of the applicant’s background and services offered. California would also require an initial $5,000 application fee, a renewal fee of $2,500, and the maintenance of a minimum amount of capital as determined by the Commissioner. The licensee would be required to have an annual audit and would need to provide balance sheets, income statements, and other financial verification forms on a periodic basis.  A provisional license may be granted for a $500 fee to those engaged in a virtual currency business with less than $1,000,000 in outstanding obligations, and if the business model represents a low or no risk to consumers (as determined by the Commissioner). The provisional licensee may also be required to register as a money services business.

Looking Forward

As the definition of a virtual currency business is very broad, this Bill (like a predecessor bill which was abandoned) is heavily opposed by digital non-profit organizations, as well as many others in the space. It is yet to be seen whether this Bill will be passed or amended once again. However, the Bill’s reintroduction does demonstrate that lawmakers are still eager to regulate the industry. If passed, the Virtual Currency Act would become effective July 1, 2018. We will continue to follow the developments surrounding California’s Virtual Currency Act, and any potential impact this may have on investment managers in the state.

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

Hedge Fund 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 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 announcing that initial implementation of the rule would begin on June 9 (as opposed to April 10, 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 obtain 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 with 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, which released an interesting statement on the settlement.  While the settlement allows Cooperman’s fund, Omega, to continue operating, 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.