Category Archives: Cryptocurrency Issues

Alternative Trading Systems (ATS)

ATS Registration Overview for Digital Asset Platforms

Digital asset platforms located in the U.S. that facilitate trading and exchange of digital assets (which are deemed to be securities) are generally subject to securities laws requiring such platforms to be registered as a national securities exchange (“NSE”) or fall within an exemption from NSE registration.  One exemption from registration as an NSE allows firms to conduct a platform business if such firm is registered as an alternative trading system (“ATS”).  This requirement was first highlighted by the SEC in the DAO Report released in July 2017.  We anticipate that many digital asset platforms currently facilitating trading will continue to face scrutiny as to whether they need to be registered as NSEs or an ATS and many have already begun the process to register as an ATS.

ATS Definition & Requirement to Register

The statutory definition of an ATS is:

any organization, association, person, group of persons, or system:

(1) That constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange within the meaning of § 240.3b-16 of this chapter; and

(2) That does not:

(i) Set rules governing the conduct of subscribers other than the conduct of such subscribers’ trading on such organization, association, person, group of persons, or system; or

(ii) Discipline subscribers other than by exclusion from trading.

As many digital asset platforms or exchanges technically fall within the ATS definition, these platforms will need to appropriately register with the SEC.  To register as an ATS, the platform will need to do the following:

  1. Register as (or buy) a broker-dealer
  2. File Form ATS
  3. Comply with Regulation ATS

1. Register as a Broker-Dealer

Registering as a broker-dealer (“BD”) is a pre-requite to becoming an ATS.  A firm may only file Form ATS with the SEC after receiving the Financial Industry Regulatory Authority’s (“FINRA”) approval of its broker-dealer application (or after purchase of a broker-dealer).  For platforms registering as a broker-dealer, at a high level the firm must:

  • Submit Form BD;
  • Comply with all applicable state requirements; and
  • Ensure all of its “associates persons” (BD representatives) have satisfied applicable qualification requirements.

The process to register as a new BD is well worn and relatively straight forward.  Firms applying to register as a BD will need to submit online through Form BD online and then submit a New Membership Application (“NMA”) to FINRA.  The NMA requires the firm to describe their business and compliance policies and controls in detail.  A firm will also be subject to an in-person new membership interview and will have to demonstrate how the ATS technology operates to FINRA staff.  As part of the BD process, the firm will need to become a member of at least one self-regulatory organization (“SRO”), which is likely to be FINRA, and become a member of the Securities Investor Protection Corporation (“SIPC”).

If a firm is already a broker-dealer (or has a broker dealer affiliate) but is not an ATS, the firm will need to submit a Continuing Membership Application (“Form CMA”) to FINRA.  For groups registering as a de novo BD, the firm should describe those parts of its business that will include the ATS function.  As with a de novo BD, an existing BD must demonstrate to FINRA staff how the ATS technology operates.

 2. File Form ATS

After a firm has registered as a BD and has discussed the ATS platform with FINRA (to FINRA’s satisfaction), the firm will need to notify the SEC that it is operating as an ATS.  Form ATS is the official SEC notification and must be submitted at least 20 days before the firm begins to operate its platform.

Form ATS is general in scope and requires information such as:

  • Certain identification information (i.e. full name, business name, address, CRD number, etc.)
  • Firm incorporation documents as attachments
  • Description of the types of users on the platform (i.e., broker-dealer, institution, or retail) and any differences in access to services between such users
  • List of the types of securities (digital assets/tokens which are deemed to be securities) that will be traded on the platform
  • Description of how the ATS will operate
  • Description of certain ATS operational procedures (i.e., entry of orders, transaction executions, reporting transactions, compliance, etc.)

It is important to note that Form ATS is a notice filing where the SEC provides no confirmation to the ATS regarding the filing status unless the form is deficient.  When a Form ATS has been filed with the SEC, it will be listed on the SEC website which will display the platform’s full name, the name(s) under which business is conducted, and the city and state of the ATS.  The reports on Form ATS are generally not published and are considered confidential.  Such reports will only be available to the SEC staff, state securities authorities, and any SRO for examination.

3. Ongoing Compliance

An ATS will be subject to numerous compliance obligations outside.  Some of the specific ATS obligations include:

  • File Form ATS-R (which summarizes the ATS’s transactions, on a quarterly basis) within 30 calendar days after the end of each quarter.
  • Amend Form ATS at least 20 calendar days before implementing a material change to the operation of the ATS.
  • Update Form ATS within 30 calendar days after the end of each quarter to correct any inaccurate or unreported information.
  • Permit the examination and inspection of its premises, systems, and records and cooperate with the examination, inspection, or investigation of subscribers by the SEC or SRO of which such subscriber is a member.

Additional BD, FINRA, and other guidelines, regulations, and obligations include:

  • Participating in the lost and stolen securities program.
  • Complying with the fingerprinting requirement.
  • Maintaining and reporting information regarding affiliates.
  • Following certain guidelines when using electronic media to deliver information.
  • Maintaining an anti-money laundering program.
  • Complying with the Department of Treasury’s Office of Foreign Assets Control (“OFAC”) programs.
  • Filing quarterly and annual financial statements to the SEC.

If an ATS is not in compliance with the above requirements it may be subject to steep penalties.  In addition, it is important to note that securities on a registered ATS platform may be subject to a wide range of holding periods which must be enforced for an ATS to remain in compliance.

Registration Timing

It is unclear exactly how long a particular ATS application will take to be approved – it will largely depend on the exact scope of activities the platform will be involved with.  In general a platform designed for trading of private placements (in a kind of closed system for accredited investors) would likely take anywhere from 6-12 months to become fully licensed after submitting the Form NMA.  Technically, FINRA is required to review and process a substantially complete NMA within 180 calendar days after receiving it.

Issues to Consider

There are a number of issues to consider with respect to an ATS application.

  1. Underlying Instruments – the securities on most current digital asset exchanges are unregistered securities which were originally offered outside of any sort of registration exemption. Essentially these are restricted securities and any person selling or reselling such securities are arguably violating US securities laws (for more background, please see our post on restricted securities and distribution structures).  In such a case, we are not sure how FINRA will view a platform which facilitates the trading of restricted instruments.  We have seen many token issuers over the last 6-12 months who have decided to offer their tokens/securities according to registration exemptions, including through SAFTs.  To the extent a digital asset platform only transacts with such tokens (or tokens which go through the S-1 IPO process, which we think will happen within the next 12 months), we believe it is likely that such a platform would be able to be registered with FINRA.
  2. Discussion with FINRA Regarding Trading System – we have not talked directly with FINRA about their review of ATS platforms.  Most ATS platforms were created to allow for “dark pool” trading in the traditional institutional securities space.  It is unclear if FINRA has the experience or technical understanding (currently) to deal with digital assets and applicable trading platforms.
  3. IRS Reporting Requirements – the IRS released a notice in 2014 regarding the tax treatment of virtual currency. Since then, the IRS has subjected exchanges to certain user reporting requirements.  It is unclear whether the IRS will extend these types of user reporting requirements to ATS platforms as well.
  4. FinCEN’s Money Services Businesses Requirements – the Department of the Treasury’s Financial Crimes Enforcement Network (“FinCEN”) released guidance in March of 2013 regarding individuals who handle virtual currencies. FinCEN determined that a person engaged as a business in the exchange of virtual currency for real currency, funds, or other virtual currency (an “exchanger”) is subject to money services business (“MSB”) registration.  Although it is unclear if an ATS qualifies as a MSB, FinCEN has taken action against virtual currency exchanges that did not register with the bureau.
  5. Anti-Money Laundering and Know Your Customer Requirements – MSBs are required by the Bank Secrecy Act to have Anti-Money Laundering (“AML”) and Know Your Customer (“KYC”) procedures. AML procedures are required to detect and report suspicious actives that may indicate money laundering and terrorist financing.  KYC procedures are identification verification actions taken to ensure that the user is truly who they claim to be in order to prevent fraud.
  6. State Regulations – many states have imposed their own laws regarding digital assets. In addition, each state has its own rules and regulations regarding ATS platforms that operate within the state.  Before beginning to operate an ATS, you will want to research what rules and regulations your state has imposed.

Conclusion

After the DAO report, there have been a number of recent comments from SEC officials regarding digital assets and trading platforms that show the need for the cryptocurrency industry to quickly begin the process of integrating into the traditional securities regulatory landscape.  We believe that the ATS structure will become the predominant structure for digital asset exchanges in the future.  We also believe that over the next 12-24 months, as regulators flesh out various issues, the process will become more streamlined and well worn.  A few cryptocurrency related platforms have already started the process to become an ATS, with more likely to follow.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP.  Cole-Frieman & Mallon LLP has been instrumental in structuring the launches of some of the first digital currency-focused hedge funds and works routinely on matters affecting the digital asset industry.  Please contact Mr. Mallon directly at 415-868-5345 if you have any questions on this post.

Notes on Regulation A+

Last week members from our firm attended the inaugural Reg A Conference in New York, where various industry participants gathered to discuss Regulation A under the Securities Act of 1933 (Reg A+). The conference covered a wide range of topics on the Reg A+ landscape, including the recent shift towards utilizing Reg A+ for initial coin / security token offerings (more on this below).

As background, Reg A+ is a securities exemption created by Title IV of the JOBS Act that allows issuers to conduct securities offerings of up to (i) $20 million for Tier 1 offerings or (ii) $50 million for Tier 2 offerings on an annual basis. Reg A+ is viewed by some as a “mini-IPO” that provides small issuers with a more affordable and expedited method of publicly selling securities to retail investors throughout the United States.

Regulatory Obligations

While Reg A+ may be an attractive option for many startup and emerging companies, there are some notable eligibility restrictions. Only issuers that have a principal place of business in the United States or Canada may conduct a Reg A+ offering. Additionally, Reg A+ is not available to:

  1. Companies subject to the Securities Exchange Act of 1934;
  2. Investment Companies;
  3. Business Development Companies;
  4. Blank Check Companies;
  5. Certain Bad Actors;
  6. Issuers of fractional undivided interests in oil or gas rights or a similar interest in other mineral rights; and
  7. Issuers disqualified due to filing deficiencies.

Issuers that are eligible to issue securities under Reg A+ must undergo a review process with the SEC and potentially state securities regulators. Tier 1 issuers must qualify with state securities regulators as well as the SEC. Tier 2 issuers must qualify offerings solely with the SEC, as state review is preempted for Tier 2 (although state notice filings may be required). Tier 2 issuers must also provide audited financials as part of the qualification process.

Issuers that do qualify and issue securities pursuant to Reg A+ are also required to maintain post-qualification filings. Tier 1 issuers must file a Form 1-Z after the termination of an offering, whereas Tier 2 issuers must file annual audited financials, semi-annual unaudited reports, and current reports for ongoing offerings.

Why Regulation A+?

The primary selling point of Reg A+ is that it provides an expedited path for startup and emerging companies to issue securities to retail investors. Unlike private placements under Rule 506(b) or Rule 506(c) of Regulation D, securities offered pursuant to Reg A+ are purchasable by retail investors and freely tradeable upon issuance. Furthermore, while Rule 506(b) offerings institute a prohibition on general solicitation and registered offerings enforce a quiet period, issuers offering securities pursuant to Reg A+ may freely advertise before, during, and after the qualification period (subject to certain disclosure and disclaimer requirements).

Equity offerings pursuant to Reg A+ can also be listed on a registered exchange, with many issuers opting to do so. In short, Reg A+ effectively bridges the gap between Regulation D private placements and registered securities offerings by providing issuers access to the broader retail market and exchanges without the commitment and expense of conducting a registered offering.

Application for Initial Coin Offerings

There has been much discussion of late regarding the best mechanism for digital asset issuers to conduct initial coin offerings (ICOs) that are compliant with United States securities laws. While there has been some evidence that certain digital assets—namely Bitcoin and Ethereum—are likely not securities, there is strong evidence that the SEC considers most ICOs unregistered securities offerings.

In what is seen as the SEC’s initial assertion of jurisdiction in the digital asset and cryptocurrency economy, the SEC has repeatedly stated that ICO issuers must register offers or sales of securities unless a valid exemption applies. This has led many to believe that the SEC was signaling that token offerings could be offered pursuant to existing securities rules and exemptions. This belief was further solidified when SEC Commissioner Jay Clayton plainly stated: “It is possible to conduct an ICO without triggering the SEC’s registration requirements.  For example, just as with a Regulation D exempt offering to raise capital for the manufacturing of a physical product, an initial coin offering that is a security can be structured so that it qualifies for an applicable exemption from the registration requirements.”

With these statements and policies in mind, we believe that an increasing number of token issuers will look to conduct security token offerings (STOs) pursuant to Reg A+. Currently, multiple entities are working to register with the SEC and FINRA as broker-dealers and/or alternative trading systems capable of listing STOs and brokering related transactions. If STOs gain popularity as an alternative method to raise capital and/or securitize interests in assets, Reg A+ is the natural landing spot for tokenized securities—it is the most practical exemption that allows issuers to access retail investors and list the tokenized securities on exchanges without going through a full registration.

Conclusion

Although Reg A+ has only been in existence for three years (Reg A+ became effective in June 2015), it appears to be gaining traction as a preferred method for raising capital. While it can be challenging to determine the exact amount of capital that issuers have raised due to staggered and less frequent reporting timeframes, the SEC’s Office of Small Business Policy disclosed that Reg A+ offerings raised approximately $600 million from June 2015 through September 2017. Industry professionals estimate that number is now closer to $1 billion in the three years since the establishment of Reg A+.

In March of this year, the U.S. House of Representative passed the Regulation A+ Improvement Act of 2017, which would increase the cap on Tier 2 Regulation A+ offerings to $75 million. If the legislation passes the Senate and is signed into law, the increased cap could potentially provide tailwinds for further proliferation of Reg A+ as a funding mechanism for startup and emerging companies.

Please feel free to reach out to us if you have any questions about this post or if you believe your company could benefit from issuing equity, debt, or digital assets pursuant to Reg A+.

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Kevin Cott is a partner of Cole-Frieman & Mallon LLP.  Cole-Frieman & Mallon LLP has been instrumental in structuring the launches of some of the first digital currency-focused hedge funds. For more information on this topic, please contact Mr. Cott directly at 770-674-8481.

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.

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.

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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.