Category Archives: Cryptocurrency Law & Regulation

NFA to Require Disclosure of Digital Asset Activities

CPOs and CTAs to Augment Disclosure Documents

On July 20, 2018, the National Futures Association (“NFA”) submitted an Interpretive Notice titled Disclosure Requirements for NFA Members Engaging in Virtual Currency Activities to the Commodity Futures Trading Commission (“CFTC”).  Through Section 17(j) of the Commodity Exchange Ac (“CEA”), the NFA has invoked the “ten-day” provision to allow the Interpretive Notice to become effective 10 days after its submission to the CFTC.  The NFA has proposed this Interpretive Notice in an effort to better inform and notify consumers of the risks involved with trading and investing in cryptocurrencies.  This Interpretive Notice sets forth disclosure requirements for two groups: (1) futures commission merchants (“FCMs”) and introducing brokers (“IBs”) and (2) commodity pool operators (“CPOs”) and commodity trading advisors (“CTAs”).

Proposed Interpretive Notice

The proposed Interpretive Notice specifies the following requirements:

For FCMs and IBs:

  • provide customers with the NFA Investor Advisory – Futures on Virtual Currencies Including Bitcoin and the CFTC Customer Advisory: Understand the Risk of Virtual Currency Trading (collectively, the “Advisories”) and for introduced accounts, the FCM or IB may provide the Advisories;
  • provide customers who traded a virtual currency derivative prior to the issuance of the Interpretive Notice with the Advisories within 30 calendar days of the Interpretive Notice’s effective date;
  • provide customers of FCMs and IBs offering services in spot market virtual currencies with a standardized disclosure[1] that specifically states that the NFA does not have regulatory oversight authority over underlying or spot virtual currency products or transactions or virtual currency exchanges, custodians, or markets;
  • provide the Advisories to a customer at or before the time the customer engages in a virtual currency derivative transaction;
  • provide the standardized disclosure at or before the time a customer or counterparty engages in any underlying or spot virtual currency activity with or through the FCM or IB;
  • provide retail customers the Advisories and standardized disclosure language in writing or electronically in a prominent manner designed to ensure that the customer is aware of them; and
  • display the standardized disclosure language on any promotional materials related to spot market virtual currencies.

For CPOs and CTAs:

  • address the following areas that are applicable to their activities in their disclosure documents, offering documents, and promotional material related to virtual currencies: (1) unique features of virtual currencies; (2) price volatility; (3) valuation and liquidity; (4) cybersecurity; (5) the opaque spot market; (6) virtual currency exchanges, intermediaries, and custodians; (7) the regulatory landscape; (8) technology; and (9) transaction fees;
  • customize disclosure documents and offering documents to address all the unique risks related to their particular activities;
  • include a standardized disclosure[2] in disclosure documents, offering documents, and promotional materials related to virtual currencies addressing the limits of the NFA’s oversight and informing investors that there currently is no sound or acceptable practice that the NFA can use to verify the ownership and control of underlying or spot virtual currencies (this is a requirement of CPOs or CTAs that operate a pool, exempt pool, or trading program that trades spot market virtual currencies); and
  • provide a standardized disclosure[3] to customers and counterparties that specifically states that the NFA does not have regulatory oversight authority over underlying or spot virtual currency activities and display it in any promotional materials for any spot market virtual currency activities (other than as an investment in a pool or managed account program) engaged in by a CPO or CTA.

“Spot” Digital Assets vs. Digital Asset Derivatives

Throughout the proposed Interpretive Notice the NFA discusses both spot and derivative digital assets.  “Spot” digital assets are digital assets that are purchased for cash intended for immediate delivery and not at some future date.  The CFTC generally does not oversee spot digital assets, other than in instances of fraud or manipulation.  In contrast, digital asset derivatives are instruments that stem from and are priced in comparison to the underlying digital asset, with the underlying asset intended to be delivered at a future date.  Digital asset derivatives include instruments such as futures and options.  Unlike spot digital assets, the CFTC and NFA have jurisdiction over the digital asset derivatives.

What comes next?

Over the last few days our law firm has spoken with both the NFA and CFTC about this matter.  Although they could not provide more information regarding the drafting of the Interpretive Notice, they mentioned that once the Interpretive Notice becomes effective, individuals subject to the Interpretive Notice will be given time to become compliant.  They also mentioned that it likely that the NFA will issue another announcement that will publicize the effective date of the notice and when qualifying members need to be in compliance.

Conclusion

It is unclear if the CFTC will take up the NFA’s Interpretive Notice for approval or if the Interpretive Notice will become effective 10 days after its submission to the CFTC.  However, it should be noted that the majority of NFA proposals sent to the CFTC are approved.  Despite this, all FCMs, IBs, CPOs, and CTAs should review the various indicated communications and documents to prepare for the potential approval of the Interpretive Notice.  We will continue to report on this issue.

***

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.   Mr. Mallon can be reached directly at 415-868-5345

Links to the other NFA items on digital assets:

[1] The standardized disclosure required is the following: [NAME OF NFA MEMBER] IS A MEMBER OF NFA AND IS SUBJECT TO NFA’S REGULATORY OVERSIGHT AND EXAMINATIONS. HOWEVER, YOU SHOULD BE AWARE THAT NFA DOES NOT HAVE REGULATORY OVERSIGHT AUTHORITY OVER UNDERLYING OR SPOT VIRTUAL CURRENCY PRODUCTS OR TRANSACTIONS OR VIRTUAL CURRENCY EXCHANGES, CUSTODIANS OR MARKETS.

[2] The standardized disclosure required is the following: [NAME OF NFA MEMBER] IS A MEMBER OF NFA AND IS SUBJECT TO NFA’S REGULATORY OVERSIGHT AND EXAMINATIONS. [NAME OF NFA MEMBER] HAS ENGAGED OR MAY ENGAGE IN UNDERLYING OR SPOT VIRTUAL CURRENCY TRANSACTIONS IN A [COMMODITY POOL OR MANAGED ACCOUNT PROGRAM]. ALTHOUGH NFA HAS JURISDICTION OVER [NAME OF NFA MEMBER] AND ITS [COMMODITY POOL OR MANAGED ACCOUNT PROGRAM], YOU SHOULD BE AWARE THAT NFA DOES NOT HAVE REGULATORY OVERSIGHT AUTHORITY FOR UNDERLYING OR SPOT MARKET VIRTUAL CURRENCY PRODUCTS OR TRANSACTIONS OR VIRTUAL CURRENCY EXCHANGES, CUSTODIANS OR MARKETS. YOU SHOULD ALSO BE AWARE THAT GIVEN CERTAIN MATERIAL CHARACTERISTICS OF THESE PRODUCTS, INCLUDING LACK OF A CENTRALIZED PRICING SOURCE AND THE OPAQUE NATURE OF THE VIRTUAL CURRENCY MARKET, THERE CURRENTLY IS NO SOUND OR ACCEPTABLE PRACTICE FOR NFA TO ADEQUATELY VERIFY THE OWNERSHIP AND CONTROL OF A VIRTUAL CURRENCY OR THE VALUATION ATTRIBUTED TO A VIRTUAL CURRENCY BY [NAME OF NFA MEMBER].

[3] The standardized disclosure required is the following: [NAME OF NFA MEMBER] IS A MEMBER OF NFA AND IS SUBJECT TO NFA’S REGULATORY OVERSIGHT AND EXAMINATIONS. HOWEVER, YOU SHOULD BE AWARE THAT NFA DOES NOT HAVE REGULATORY OVERSIGHT AUTHORITY OVER UNDERLYING OR SPOT VIRTUAL CURRENCY PRODUCTS OR TRANSACTIONS OR VIRTUAL CURRENCY EXCHANGES, CUSTODIANS OR MARKETS.

Regulation A+ for Token Offerings

Overview of Regulation A+ for Token Sponsors

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

Background

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

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

Tier 1 and Tier 2 Comparison

Tier 1

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

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

Process

The process will look something like the following:

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

Timeline

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

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

Issues & Other Items to Consider

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

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

Conclusion

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

****

Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP.  Cole-Frieman & Mallon LLP has been instrumental in structuring the launches of some of the first digital currency-focused hedge funds and works routinely on matters affecting the digital asset industry.  Bart can be reached directly at 415-868-5345.

****

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

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

Airdrops and Securities Laws

Legal Issues Surrounding Digital Asset Airdrops

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

Potential Application of Securities Laws to Airdrops

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

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

Conclusion

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

***

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.

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.

****

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+.

****

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.

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.

****

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.

SEC Issues Cryptocurrency/Digital Asset/ICO Report

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

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

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

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

SEC Four Items

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

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

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

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

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

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

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

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

Observations

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

Press Release

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

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

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

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

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

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

Report on The DAO

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

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

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

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

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

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

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

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

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

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

CorpFin / Enforcement Statement

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

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

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

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

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

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

Investor Bulletin

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

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

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

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

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

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

Conclusion

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

****

For more information on this topic, please see our collection of cryptocurrency fund legal and operational posts.

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

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

****

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.

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.

****

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.

Bitcoin Hedge Fund FAQs

Common Questions Related to Cryptocurrency Funds

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

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

****

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

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

Why does it matter?

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

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

What if the cryptocurrencies are not deemed to be securities?

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

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

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

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

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

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

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

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

What about an administrator?

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

What about bank accounts?

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

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

What about compliance and outside compliance consultants?

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

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

What about ICOs?

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

What are some common terms of bitcoin funds?

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

How is bitcoin taxed?

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

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

What about separately managed accounts or prop trading?

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

Other Items 

We anticipate writing about the following soon in some fashion:

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

Final Notes

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

****

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.