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Cole-Frieman & Mallon 2018 Second Quarter Update

Below is our quarterly newsletter.  If you would like to be added to our distribution list, please contact us.

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July 12, 2018

Clients, Friends, Associates:

We hope that you are enjoying the start of summer.  Although the second quarter is typically not as busy as the first quarter from a regulatory or compliance perspective, we continue to see rapid developments in the digital asset space.  As we move into the third quarter, we would like to provide a brief overview of some items we hope will help you stay abreast of these developments.

In addition to the discussion below, we would like to announce a couple of firm items:

CFM Atlanta.  Our Atlanta office has just moved into new space in the heart of Buckhead.  The new office address is 3348 Peachtree Road NE, Suite 1030, Atlanta, GA 30326.

CoinAlts Fund Symposium. In April founding sponsor Cole-Frieman & Mallon hosted its second full day Symposium attended by over 300 professionals, students, and investors in New York.  Featuring twenty eight speakers, including key-notes, John Burbank of Passport Capital and Mark Yusko of Morgan Creek Capital Management, CoinAlts East presented a broad spectrum of content essential to managers and investors in the digital asset space.  Our next CoinAlts Fund Symposium will take place in San Francisco on September 20, 2018. More details to follow.

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GDPR

GDPR Effective May 25.  The General Data Protection Regulation (“GDPR”) went into effect on May 25, 2018 as part of the European Union’s effort to protect personal data.  Any person or business that handles EU residents’ personal data must comply with the regulation.  GDPR also applies to businesses established outside of the EU if their activities involve processing personal data related to offering goods or services to persons within the EU.  US fund managers with EU resident investors will need to: (i) maintain records of any data processing activities; (ii) obtain EU clients’ affirmative consent to process data; and (iii) provide EU clients with access to the fund’s privacy policy.

Managers with EU resident investors, but no presence within in the EU may also be required to appoint an EU local representative unless they can demonstrate processing is “occasional”, does not include special categories of EU resident personal data, including criminal, on a large scale, and is unlikely to result in a risk to the rights and freedoms of natural persons.  We believe most of our clients generally fall into this exclusion and will not need to appoint an EU representative, but it may be challenging at present to find EU counsel that will advise on this requirement in the absence of more guidance from EU regulators.  For more information on GDPR, including compliance items for hedge fund managers, please see our earlier post.

Legal and Regulatory Developments

SEC Proposes Rules Regarding Form CRS, Form ADV, and Disclosures in Retail Communications.  On April 18, 2018, the Securities and Exchange Commission (“SEC”)  proposed new rules and amendments to certain rules and forms under the Investment Advisers Act of 1940, as amended (“Advisers Act”) and the Securities Exchange Act of 1934, as amended.  One proposal would require both registered investment advisers and broker-dealers to provide a summary (“Form CRS”) disclosing the nature and details of their relationship to retail investors.  Form CRS would be added as a section to Form ADV and would disclose: (i) the relationships and services the firms offer; (ii) the standard of conduct and fees and costs associated with the services; (iii) specified conflicts of interest; and (iv) reportable legal or disciplinary events on the firm’s part or its financial professionals.

The SEC also proposed two new rules to reduce investor confusion caused by communications with broker-dealers and investment advisers by placing additional requirements on retail investor communications.  One rule would restrict broker-dealers’ use of the terms “adviser” and “advisor” when communicating with retail investors.  The other rule would require broker-dealers and investment advisers to disclose their SEC registration status in retail investor communications.  It would also require associated natural persons and supervised persons to disclose their relationships with broker-dealers or investment advisers in retail investor communications.  Comments to the SEC are due on or before August 7, 2018.

SEC Proposes Interpretation of Standard of Conduct for Investment Advisers.  On April 18, 2018, the SEC proposed an interpretation of the conduct standard for investment advisers under the Advisers Act and requested comment on its proposal.  The SEC also seeks comment on the following proposed requirements for SEC registered investment advisers (“RIAs”): (i) federal licensing and continuing education; (ii) periodic account statements; and (iii) financial responsibility requirements similar to those required of broker-dealers.  Comments to the SEC are due on or before August 7, 2018.

SEC Charges 13 Private Fund Advisers for Repeated Form PF Filing Failures.  On June 1, 2018, the SEC  announced settlements with 13 SEC RIAs for repeatedly failing to provide risk monitoring information.  The SEC found that the advisers continually failed to file annual reports on Form PF.  Section 204(b) of the Advisers Act requires large fund managers to report information such as assets under management, fund strategy, and fund performance on Form PF.  The SEC uses these reports to inform their rulemaking process and to target examinations and enforcement investigations.  The SEC found that each of the advisers violated the Form PF reporting requirements under the Advisers Act.  Although the advisers did not admit or deny the SEC’s findings, they agreed to be censured, cease and desist, and to each pay a $75,000 civil penalty.

SEC Charges Hedge Fund Adviser with Deceiving Investors.  On May 9, 2018, the SEC charged a hedge fund adviser and certain principals, including the CEO and a former portfolio manager, for fraudulently overvaluing its funds by hundreds of millions of dollars.  Defendants are alleged to have placed trades in exchange for inflated broker-dealer quotes and applied “imputed” mid-point valuations in a manner that further inflated the value of securities.  The SEC is seeking permanent injunctions, the return of illicit profits with interest, and civil penalties.

SEC Charges Hedge Fund Firm for Asset Mismarking and Insider Trading.  The SEC announced on May 8, 2018 that a manager agreed to settle charges regarding insider trading and fraudulent overvaluation of certain assets held by its hedge funds.  The SEC found that two of the portfolio managers overstated the values of their hedge funds’ securities.  In a separate order, the SEC alleged that the CFO failed to supervise the two portfolio managers appropriately and respond to red flags regarding the mismarking.  The SEC also found that the portfolio managers violated insider trading laws by trading pharmaceutical securities on confidential information obtained through a former U.S. Food and Drug Administration official.

Second Circuit Amends Martoma Decision.  On June 25, 2018, the U.S. Court of Appeals for the Second Circuit amended its decision in United States v. Martoma to clarify tippee liability in insider trading cases.  As we discussed in a previous Quarterly Update, the Second Circuit once again upheld a former portfolio manager’s 2014 conviction for insider trading.  In its amended decision, the court confirmed that a “meaningfully close personal relationship” is not required for tippee liability in insider trading cases.

Digital Asset Matters

We see many thought-provoking items in the digital asset sector as the industry moves towards greater institutional infrastructure.  After numerous public statements by SEC officials, token issuers understand that there are several compliant ways to raise capital through token offerings.  One way is through Regulation A+, which has many advantages over other securities offering mechanisms.  We are also seeing many groups use airdrops as a way to try to circumvent the private placement regulatory regime.  One item to specifically note, is that privately placed tokens may have resale restrictions that could create issues for both the token issuers and token purchasers.  We are also aware of several groups beginning the process of registering as alternative trading systems or otherwise becoming broker-dealers and/or qualified custodians.

Outside of these items, we have summarized some notable regulatory developments in the second quarter.  For a complete review of these developments, please consult our Digital Asset Regulatory Items blog post.

CFTC Issues Advisory on Virtual Currency Derivatives.  On May 21, 2018, the Commodity Futures Trading Commission (“CFTC”) Division of Market Oversight and the Division of Clearing and Risk issued an advisory regarding virtual currency derivative products.  The CFTC outlined key expectations for exchanges and clearinghouses operating in the virtual currency derivatives space:

  • Enhanced Market Surveillance – an adequate market surveillance program would include sharing information on the underlying spot markets, allowing the CFTC to access a broad range of exchange trade data (i.e., trader identity, volumes, times, prices, and quotes), and real-time monitoring of all trading activity to identify red flags.
  • Close Coordination with the CFTC Surveillance Group – exchanges should engage in regular discussions with the CFTC on surveillance of virtual currency derivatives contracts and allow access to data on settlement processes referenced in such contracts.
  • Large Trader Reporting – exchanges should set large trader reporting thresholds for any contract at five BTC (or equivalent) to increase their ability to focus on relevant market information.
  • Outreach to Members and Market Participants – exchanges should obtain comments from stakeholders on listing issues beyond contract terms and conditions.  Comments should include explanations of opposing views and the exchanges’ perspectives.
  • Derivative Clearing Organization’s Risk Management – the CFTC requests information from derivative clearing organizations (“DCOs”) necessary to assess the suitability of proposed initial margin requirements.  The CFTC may require DCOs to amend inadequate initial margins.  They may also request information regarding the approval process of proposed contracts.

NASAA Combats ICO Fraud.  On May 21, 2018, the North American Securities Administrators Association (“NASAA”) announced its involvement in “Operation Cryptosweep,” one of the largest coordinated enforcement efforts against fraudulent Initial Coin Offerings (“ICOs”), crypto-related products, and cryptocriminals.  Operation Cryptosweep is a combined effort between NASAA’s members, spanning more than 40 jurisdictions in the United States and Canada.  Since April 2018, the operation has produced almost 70 inquiries and investigations in addition to 35 pending or completed enforcement actions related to digital assets and ICOs, including multiple actions against private funds.  According to NASAA President Joseph Borg, these recent actions are only the beginning of further enforcement against ICO fraud.

Other Items

5th Circuit Issues Mandate on Fiduciary Rule.  On June 21, 2018, the U.S. Court of Appeals for the Fifth Circuit issued a mandate regarding the Department of Labor’s (“DOL’s”) Fiduciary Rule (“Fiduciary Rule”) after months of uncertainty.  The Fifth Circuit’s mandate effectuates its March 15 decision to vacate the Fiduciary Rule.  Although the DOL’s Fiduciary Rule appears defeated, the court’s decision may prompt the SEC and other regulators to revisit their plans for fiduciary reform.

Section 3(c)(1) of the Investment Company Act Amended.  President Trump authorized the Economic Growth, Regulatory Relief, and Consumer Protection Act (“Growth Act”) on May 24, 2018.  A portion of the Growth Act amends Section 3(c)(1) of the Investment Company Act of 1940, as amended, by increasing the number of investors allowed in a qualifying venture capital fund from 100 to 250 investors.  The Growth Act —  which will take effect in late 2019 —  defines a qualifying venture capital fund as one with less than $10 million “in aggregate capital contributions and uncalled committed capital.”

The CFTC and NASAA Sign Information Sharing Memorandum.  The CFTC and NASAA signed a Memorandum of Understanding (“MOU”) regarding the sharing of non-public information on May 21, 2018.  The MOU aims to forge a closer working relationship between the CFTC and individual state securities agencies— represented by the NASAA— to better enforce the U.S. Commodity Exchange Act of 1936, as amended (“CEA”) by promoting voluntary, inter-agency sharing of non-public information.  NASAA President Joseph Borg believes the MOU could assist NASAA members in enforcing both securities and commodities law violations, particularly against schemes related to digital assets and other modern commodities.

NFA Develops Swaps Proficiency Program and Exam.  The National Futures Association (“NFA”) announced on June 5, 2018 that its board approved the creation of an online proficiency requirements program and exam for all associated persons participating in swaps activities.  The swaps proficiency program is part of the NFA’s mandate under the CEA, which requires the NFA to set training standards and proficiency testing for individuals and activities governed thereunder.  The online program and exam are expected to launch in early 2020.

Cayman Islands Revises and Clarifies AML Regulations.  As mentioned in previous updates, the Cayman Islands released the 2018 revisions to its Anti-Money Laundering (“AML”) regulations earlier this year.  The following are some notable changes:

  • Non-Cayman Islands Monetary Authority (“CIMA”) registered funds (i.e., 4(4) funds) will be subject to AML regulations;
  • All investment funds (registered and unregistered) must designate natural persons to act as Anti-Money Laundering Compliance Officers (“AMLCOs”), Money Laundering Reporting Officers (“MLROs”), and Deputy Money Laundering Reporting Officers (“DMLROs”) by September 30, 2018 or, for funds registering after June 1, 2018, upon submission of the registration application; and
  • All investment funds (registered and unregistered) will be subject to enhanced AML processes and procedures.

CIMA also released a notice on April 6, 2018 to clarify its guidance notes on the AML regulations.

The guidance clarified that a fund could designate the same individual to serve as its AMLCO and MLRO.  Also, if an MLRO, DMLRO, and AMLCO have been appointed, a person carrying out the relevant financial business of a fund may delegate to another the performance of functions outlined in the AML regulations.  Significantly, managers should also note that these officers may be exposed to criminal sanctions for breach of their obligations.  Failure to comply with CIMA’s AML regulations could result in an unlimited fine and imprisonment for two years.  We recommend that fund managers discuss AML compliance and implementation issues with offshore counsel and the fund’s administrator.

Cayman Islands Appeals Court Holds That a Liquidator May Not Adjust a Shareholder’s NAV.  The Cayman Islands Court of Appeal held that an official liquidator of a fund could not change a contractually agreed upon net asset value (“NAV”), even if it were based upon fraudulent numbers.  The judge agreed with the lower court that allowing adjustment of the NAV would “interfere with the shareholders’ proprietary rights,” an action that legislators did not intend to permit.  This outcome may benefit shareholders by providing certainty regarding a fund’s NAV and the benefits derived from “their rights under a valid and subsisting contract.”

Cayman Issues AEOI Portal Update.  On May 29, 2018, the Cayman Islands issued an update regarding the Automatic Exchange of Financial Account Information Portal (“AEOI”).  The statutory deadline for filing Common Reporting Standard (“CRS”) and US Foreign Account Tax Compliance Act, as amended, (“FATCA”) reporting was May 31, 2018.  However, the Cayman Islands Department for International Tax Cooperation will allow Cayman Financial Institutions until July 31, 2018 to fulfill their 2017 CRS and US FATCA reporting obligations without facing adverse consequences, compliance measures, or penalties.

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

Deadline – Filing

  • June 29, 2018 – Delivery of audited financial statements to investors (private fund managers to fund of funds, including SEC, state, and CFTC registrants)
  • June 30, 2018 – Deadline for Cayman Island registered funds with a fiscal year end of December 31 to file the Fund Annual Return and audited financial statements with CIMA
  • June 30, 2018 – Deadline for making available AIFMD annual report for funds in or advertising in the EU (Alternative Investment Funds with a financial year ending on December 31st)
  • June 30, 2018 – Review transactions and assess whether Form 13H needs to be amended
  • July 15, 2018 – Quarterly Form PF due for large liquidity fund advisers
  • July 30, 2018 – Quarterly account statements due (CPOs claiming the 4.7 exemption)
  • July 30, 2018 – Collect quarterly reports from access persons for their personal
    securities transactions
  • July 31, 2018 – Cayman Islands CRS and US FATCA reporting deadline without adverse consequences (for those who missed the initial May 31, 2018 deadline)
  • August 14, 2018 – Form 13F filing (advisers managing $100 million in 13F Securities)
  • August 14, 2018 – CTA-PR filing with NFA
  • August 29, 2018 – Quarterly Form PF due for large hedge fund advisers
  • August 29, 2018 – CPO-PQR filing with NFA
  • September 30, 2018 – Review transactions and assess whether Form 13H needs to amended
  • September 30, 2018 – Deadline to designate an MLRO, DMLRO, and AMLCO for Cayman Islands AML compliance
  • October 15, 2018 – Quarterly Form PF due for large liquidity fund advisers
  • October 15, 2018 – Annual Foreign Bank and Financial Accounts Report deadline (for those who missed the April 17 deadline)
  • Periodic – Fund managers should perform “Bad Actor” certifications annually
  • Periodic – Amendment due on or before anniversary date of prior Form D filing(s), or for material changes
  • Periodic – CPO/CTA Annual Questionnaires must be submitted annually, and promptly upon material information changes
  • Periodic – Form D and blue sky filings should be current

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP.  Mr. Mallon can be reached directly at 415-868-5345.

Digital Asset Regulatory Items – Second Quarter 2018

The second quarter offers notable regulatory updates in the digital asset space. For your convenience, we provide an overview of these items down below.

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SEC MATTERS

Speeches & Testimony

Chairman Testifies on Cryptocurrencies Before the House Committee on Appropriations

On April 26, 2018, Securities and Exchange Commission (“SEC”) Chairman Jay Clayton testified before the Financial Services and General Government Subcommittee of the House Appropriations Committee that digital assets are divided into 2 categories: (1) a “pure medium of exchange”—considered to be “not a security”; (2) tokens—a tool “to finance projects.” Given the uncertainty around cryptocurrencies, this may suggest that even the SEC might not readily view all tokens as securities yet.

SEC Director Hinman Testifies Before the House That Many ICOs are Securities Offerings, Certain Utility Tokens Do Not Have Hallmarks of a Security

On April 26, 2018, SEC Director William Hinman stated his position that it is “hard to have an initial sale without a securities offering.” Consequently, Hinman believes that initial coin offerings (“ICOs”) will likely require registering as a securities offering or operating under an exemption. He clarified that it is possible for a token not to have the hallmarks of a security if the token was purchased solely for its functional use and not as an investment. For many issuers, it could mean that they can offer tokens for sale by relying on appropriate exemptions without having to comply with the SEC securities registration.

SEC Director Hinman Speaks at the Yahoo Finance All Markets Summit on Crypto

On June 14, 2018, SEC Director of the Division of Corporation Finance William Hinman spoke at the Yahoo Finance All Markets Summit on Crypto in San Francisco.  He addressed questions regarding ICOs and token sales and whether a digital asset can be something other than a security.  He mentioned that currently, neither Bitcoin nor Ether meet the Howey test. However, he cautioned that classification of whether an instrument is a security is not static and the classification can change as the instrument changes.

Releases

SEC Creates Senior Advisor for Digital Assets and Innovation Position

On June 4, 2018, the SEC announced that Valerie A. Szczepanik would be the agency’s first ever Senior Advisor for Digital Assets and Innovation. This newly created position will allow the SEC to explore how U.S. securities laws would apply to digital asset technologies such as ICOs and cryptocurrencies. Ms. Szczepanik has been with the SEC since 1997. During her tenure, she has been an Assistant Director for the Division of Enforcement’s Cyber Unit. Currently, Szczepanik serves as the Head of the SEC’s Distributed Ledger Technology Working Group, Co-Head of the Dark Web Working Group, and a member of the FinTech Working Group.

Enforcement

SEC Takes Civil Actions Against Fraudulent ICO

On April 2, 2018, the SEC filed a complaint in the United States District Court for the Southern District of New York against Centra Tech., Inc. (“Centra”) for raising at least $32 million in unregistered securities through a fraudulent ICO. Centra falsely claimed that it had partnered with VISA, Mastercard, and Bancorp to create a “crypto debit card.” The complaint seeks a permanent injunction to stop Centra’s activities and to return the ill-gotten gains to investors. The U.S. Attorney’s Office has also filed criminal charges against the two founders.

SEC Files Charges Against Titanium Blockchain

On May 22, 2018, the SEC filed charges in the United States District Court for the Central District of California against Titanium Blockchain for violating antifraud and registration provisions under federal securities laws. The company used false corporate relationships and testimonies to inflate the values of their digital assets. Under the guise of an ICO, they fraudulently raised up to $21 million in cash and digital assets.

Other

SEC Creates Mock Initial Coin Offering

The SEC has created howeycoins.com. The website is designed to educate the public about fraudulent ICOs and how to avoid being a victim.

CFTC MATTERS

Advisory

The CFTC Issues Advisory on Virtual Currency Derivatives

On May 21, 2018, the Commodity Futures Trading Commission (“CFTC”) issued key expectations for exchanges and clearinghouses regarding virtual currency derivative products. These include: i) enhanced market surveillance; ii) close coordination with the CFTC surveillance group; iii) large trader reporting; iv) outreach to members and market participants; and v) derivative clearing organization’s risk management. For more details on these key points, please refer to our second quarterly update.

Speeches

CFTC Gives Keynote at the FIA 40th Annual Law & Compliance Division Conference on the Regulation of Futures, Derivative, and OTC Products, Washington, D.C.

CFTC Commissioner Rostin Behnam.  On May 3, 2018, CFTC Commissioner Rostin Behnam spoke at the Futures Industry Association’s 40th Annual Law & Compliance Division Conference on the Regulation of Futures, Derivative, and OTC Products. In his speech, the Commissioner noted that institutions look at digital assets as something more than a currency. He also acknowledged the National Futures Association’s work on understanding and regulating virtual currencies and their derivatives.

Commissioner Quintenz Announces the Establishment of TAC Subcommittees

CFTC Commissioner Brian Quintenz. On June 4, 2018, CFTC Commissioner Brian Quintenz announced the creation of the Technology Advisory Committee’s (“TAC”) four new subcommittees. The subcommittees will be tasked with exploring automated and modern trading markets, cybersecurity, distributed ledger technology and market infrastructure, and virtual currencies.

Enforcement

CFTC Files Complaint Regarding Fraudulent ATM Coin

On April 16, 2018, the CFTC filed a complaint against three investment funds for their connection with a “binary options” scheme that defrauded at least 6 U.S. clients of about $618,810. The managers invited investors to transfer their fund balances to a virtual currency firm in return for the fraudulent virtual currency called “ATM Coin.” Neither the defendants nor the executed transactions were registered with the CFTC or a registered exchange. One of the fund managers also faces criminal charges for altering records and obstructing the FBI investigation.

NFA MATTERS

Notice to Members

NFA Encourages FCMs and IBs to Review OFAC FAQs for Compliance Obligations

On May 3, 2018, the National Futures Association (“NFA”) released a notice recommending that futures commission merchants (“FCMs”) and introducing brokers (“IBs”) review the U.S. Treasury Department’s Office of Foreign Assets Control (“OFAC”) FAQs about compliance and sanctions with regard to illicit digital currency activities. The FAQs detail OFAC’s goal to combat terrorism and criminal exploitation of digital transactions, as well as compliance obligations in dealing with blocked persons or property.

FINRA MATTERS

Enforcement

FINRA Suspends a Member for Failure to Disclose Outside Business Activity.

On April 18, 2018, FINRA issued a $20,000 fine and a two-year suspension to a broker for failure to disclose his private blockchain business activity with his firm. According to FINRA, all firms’ employees must report outside business activities and any material changes to their firms. This rule is intended to strengthen investor protections against outside activities.

STATE MATTERS

California Legislation

The following bills regarding the digital asset space are moving through the California legislature.

  • CA AB-2658: it would define blockchain technology in California and create a government working group to evaluate the use of blockchain technology by CA businesses and the state government. The bill passed the State Assembly on May 30, 2018 and is currently in the State Senate.
  • CA SB-838: it would allow certain privately-owned corporations to amend their articles of incorporation to include provisions for the use of blockchain technology in recording information related to stock transactions. The bill passed the State Senate on May 17, 2018 and is currently in the State Assembly.

Colorado Division of Securities Participates in Coordinated International Crypto Crackdown

On May 3, 2018, the Colorado Securities Commission announced that it signed orders requiring Linda Healthcare Corporation and Broad Investments, LLC to cease and desist from selling securities in the state. The companies violated Colorado securities laws by promoting ICOs to Colorado residents without disclosing the risks involved.

Florida Chief Financial Officer Announces New Cryptocurrency Oversight Position

Jimmy Patronis, Florida Chief Financial Officer, released a statement on June 26, 2018 that Florida would be creating an oversight position for its cryptocurrency industry.  In coordination with the Office of Financial Regulation and the Office of Insurance Regulation, this new oversight position aims to develop policy, legislation, and regulation regarding cryptocurrency.

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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

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.

Token Distribution and Unregistered/Restricted Securities

Digital Assets and Restricted Securities Background

Many recent Initial Coin Offerings (ICOs) and other token sales are being conducted through a Simple Agreement for Future Tokens (SAFT) or other private placement that exempts the token from registration as a security with the SEC. Tokens sold through these structures have become hot investments, and access to deals selling these tokens is generally difficult to obtain. Accordingly, many investors are creating private funds, unincorporated investment groups, syndicates or other types of investment-fund-like structures (“syndicates” or “investors” for the purposes of this post) to invest in these tokens or SAFTs. Many times these syndicates are established with the stated intent or objective to make distributions of the tokens immediately upon receipt. Effectively the sponsors of such structures have created a de-facto distribution system for VC like investments into blockchain projects. The question is how such a distribution structure fits with traditional securities regulations – specifically, can privately placed tokens (securities) be distributed shortly after receipt? The answer is probably no.

Background on Unregistered Securities

SAFTs, tokens from a SAFT, or other private placements are in most cases going to be unregistered securities (unless the token or instrument later becomes registered with the SEC which is highly unlikely).  In general federal securities laws prohibit the transfer of unregistered securities unless an exemption applies to the transfer.  Any person then who has possession of, and then transfers, an unregistered security without complying with an applicable exemption is breaking the securities laws and subject to civil penalty (fine, rescission, bar from industry, etc).  Additionally, many private placements and SAFTs contain contractual provisions that restrict transfer of tokens for a certain amount of time after issuance (with a wink and a nod from the token issuer that “everyone transfers them anyways”). Unless there is an exemption allowing for the transfer of the tokens (restricted securities), the transferor would be both breaking securities laws and breaching contractual representations made to the token sponsor.

Potential Exemptions

Section 4(a)(1)

Given the above framework, investors or syndicates will want to find an exemption so they can transfer the tokens in accordance with securities laws (the risk posed by breaching a contractual representation to the token sponsor is beyond the scope of this post). Among statutory exemptions, Section 4(a)(1) the Securities Act of 1933 (the “Securities Act”) provides an exemption from registration of the securities if the sales/transaction is not conducted by an issuer, dealer, or underwriter. These terms all have precise definitions, but in this context we would be most concerned about the transferor being deemed an “underwriter” which is defined, in part, as “any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates or has a direct or indirect participation in any such undertaking.” This is a broad definition, and because of the stated or not-stated intent of creating a distribution structure for tokens, the syndicates described above may well be considered “underwriters” in this context and need to find another exemption on which to rely.

Investors my be in luck though as there are two other common exemptions that may be available – Rule 144 and Section 4(a)(1 ½).

Rule 144

Rule 144 of the Securities Act allows public resale of restricted securities if certain conditions are met.  The central condition is that the unregistered securities are held by the investor for a period of at least one year.  Further, the transferor/investor may not be an affiliate of the issuer.  There may be reduced holding period requirements if the issuer is subject to the Exchange Act Reporting requirements, but this is not a likely scenario in the digital asset space.  We believe for most syndicate groups, Rule 144 is the best way to comply with the transfer restriction. Of course, certain syndicates operating in this space might want or need to distribute the tokens before the expiration of Rule 144’s one-year holding period, and while imperfect as a solution, Section 4(a)(1 ½) (discussed below) may grant another option.

Section 4(a)(1 ½)

As mentioned above, Section 4(a)(1) of the Securities Act provides an exemption from registration for transactions by any person other than an issuer, underwriter, or dealer.  Section 4(a)(2) of the Securities Act provides a separate exemption for transactions by an issuer through a private offering. Over time, through case law and acknowledged by the Securities and Exchange Commission (the “SEC”), the “Section 4(a)(1 ½)” exemption was created.  This exemption generally is an exemption for private offerings, similar to Section 4(a)(2), but for entities that are not issuers.

To avoid being deemed an underwriter (and to ensure that a resale is sufficiently private), the investor/transferor must be able to show that it did not purchase the restricted securities with a view to distribution or resale.  In order to show this the investor/transferor should examine the following criteria :

  • Number of Purchasers – there should be a limited number of purchasers of the restricted security.  This generally can be satisfied if there are less than 25 purchasers.
  • Investment Intent – the investing entity’s intent in purchasing the tokens or SAFT should be to hold for an indefinite period of time and not with a view to resell or distribute.  The longer the investing entity holds the tokens or SAFT, the better the argument for the investor/transferor’s original intent.  Generally, in conjunction with other facts and circumstances, holding the security for at least six months will evidence the investor/transferor’s investment intent. The investor/transferor should also obtain a representation from purchasers that (1) the purchase is being made as an investment and not for resale and (2) any subsequent transfer will be made only in an SEC-registered transaction or in compliance with an exemption from registration.
  • Offeree Qualification – the investor/transferor of the token or SAFT should determine whether the buyer can hold the securities for an indefinite period of time and assume the risk of the investment by looking to the experience and sophistication of the buyer.
  • Information – the investor/transferor should provide access to all information about the investment and business of the issuer that would be necessary to the buyer. The investor/transferor should also provide access to any nonpublic information if it is an insider with such information.
  • Private Offering – No form of general advertising or general solicitation may be used in reselling the securities.

Because of the facts and circumstances determination for Section 4(a)(1 ½), the safest approach to addressing these restricted securities’ holding periods is for the investor/transferor to hold the securities for greater than one year in order to fall under the Rule 144 safe harbor.

Other Issues to Consider

There are a number of additional items that should be considered in the context of transferred digital assets that may have been issued as private securities:

  • Securities v. Non-Securities.  The restricted securities transfer rules apply to securities – they do not apply to non-security instruments.  Entities that invest in tokens and SAFTs may want to consider taking a position that the tokens are not securities and therefore not subject to securities laws.  Such a position would entail a facts and circumstances determination, and taking such a position is likely a risky strategy based on recent comments from SEC Chairman Clayton.  Also, taking the position that a SAFT is not a security would be problematic if the SAFT included language that it was a restricted security or otherwise contained a restrictive legend.
  • Distribution to syndicate owners.  If an entity wants to distribute the tokens or a SAFT instrument to its underlying owners, it should be aware that the above exemptions do not apply to a distribution to a syndicate’s underlying owners.  Additionally, the SEC would likely consider an in-kind distribution of tokens in exchange for redemption of interests in a syndicate as consideration sufficient to constitute a sale.
  • Regulation S.  Non-US investors may consider investing in a SAFT or purchasing tokens under Regulation S of the US securities laws.  While such investors would be non-US investors, Regulation S contains a one-year holding period similar to Rule 144 for sales to US persons so resale of such instruments would potentially be limited.
  • Timing.  No official guidance has been issued regarding holding periods and SAFT instruments.  We do not know whether the holding period begins when a SAFT is issued or once the actual tokens are issued (i.e. whether the SAFT and tokens are separate securities).  In cases where tokens are issued after a significant period of time following the SAFT execution, this determination may be significant.  Again, a determination one way or another will require a facts and circumstances analysis.

Conclusion

Investors should be aware that SAFTs and tokens in which they invest may be restricted securities that may not be resold absent an applicable exemption. With respect to digital assets, this issue is nascent and evolving, but investment managers should be cognizant to follow the securities laws in the absence of additional guidance from the SEC. Please reach out if you have questions on any of the above.

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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.

CoinAlts Fund Symposium East – New York, April 19th

Cryptocurrency Fund Conference Sponsored by Cole-Frieman & Mallon

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

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

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

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

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For more information on this topics related to the digital asset space, please see our collection of cryptocurrency fund legal and operational posts.

Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP.  Cole-Frieman & Mallon LLP has been instrumental in structuring the launches of some of the first cryptocurrency focused hedge funds. If there are any questions on this post, please contact Mr. Mallon directly at 415-868-5345.

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

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

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CoinAlts Fund Symposium Announces East Coast Event

NEW YORK (PRWEB) MARCH 30, 2018

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

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

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

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

About the CoinAlts Fund Symposium

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

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

Cole-Frieman & Mallon 2018 First Quarter Update

Below is our quarterly newsletter. If you would like to be added to our distribution list, please contact us.

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April 5, 2018

Clients, Friends, Associates:

The first quarter of 2018 has seen many developments impacting traditional hedge fund managers as well as those in the digital asset space. We enter the second quarter with many topics worthy of discussion, including a number of important regulatory issues currently on the horizon.  Below, is our short overview of some of these items.

Before we begin though we’d like to quickly provide a couple of significant updates on Cole-Frieman & Mallon LLP. Effective January 1, 2018 we are delighted to announce that David C. Rothschild has been promoted to partner and welcome Kevin Cott as head of our Atlanta office following the merger of Cott Law Group, P.C. with our firm.

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CoinAlts East

CFM is a founding sponsor of the one-day symposium for digital asset managers in New York on April 19, 2018. The CoinAlts East Fund Symposium will feature a number of panelists (including Bart Mallon and Karl Cole-Frieman) with expertise in the legal and operational aspects of running a digital asset strategy. Keynote speakers are John Burbank of Passport Capital and Mark Yusko of Morgan Creek Capital Management, with opening remarks from Corey Johnson of Ripple and closing remarks by Don Wilson of DRW. The inaugural symposium, held in September in San Francisco, sold out with more than 450 attendees.

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SEC Matters

SEC Published Examination Priorities for 2018. The SEC announced its Examination Priorities for 2018, with a continued focus on examining matters of importance to retail investors, particularly risks to elderly and retiring investors. Specifically, the SEC will focus on: (i) disclosure and calculation of fees and other compensation, robo-advisers and other automated electronic investment advice platforms, never-examined investment advisers and exchange-traded funds, services offered to investors with retirement accounts, and regulatory compliance of advisers and broker-dealers in the cryptocurrency and initial coin offering (ICO) space; (ii) compliance and risk in critical market infrastructure, including clearing agencies, national securities exchanges, transfer agents, and Regulation Systems Compliance and Integrity (SCI) entities; (iii) FINRA and MSRB; (iii) cybersecurity; and (iv) anti-money laundering programs.

SEC Chairman Testifies on The Roles of the SEC and CFTC Concerning Virtual Currencies. On February 6, 2018, SEC Chairman Jay Clayton offered testimony to the Senate Committee on Banking, Housing, and Urban Affairs about the role of the SEC and CFTC in the regulation of cryptocurrencies, ICOs and related activities. Chairman Clayton expressed his support for new technological innovations in the financial markets, while emphasizing that these innovations should not be made at the expense of protecting investors and markets. The Chairman reaffirmed that whenever securities are bought and sold, investors are entitled to the protections and benefits of state and federal securities laws.

The Chairman also stressed that ICOs should be viewed in the context of securities laws and that many ICOs claiming to be “utility tokens” may be securities, notwithstanding labels or the provision of some utility. Further, the Chairman stated most ICOs to date that he has seen have been offers and sales of securities. As a sign of the SEC’s commitment to this policy, Clayton pointed to the establishment of a new cyber unit focused on misconduct involving ICOs and distributed ledger technology, and enforcement actions initiated against fraudulent ICOs.

SEC Staff Letter on Digital Asset Funds. On January 18, 2018, Dalia Blass, the Director of Investment Management at the SEC, published a staff letter addressing issues the SEC has identified for registered funds and products focused on cryptocurrency. While the letter does not address private funds, it outlines various questions addressing how cryptocurrency funds would satisfy the securities laws. The key concerns outlined in the letter include:

  • Uncertainty around valuation of cryptocurrencies;
  • Ensuring liquidity for fund investors;
  • Ability to satisfy custody requirements given the lack of qualified custodians;
  • Compliance by ETFs given market volatility; and
  • Potential manipulation of cryptocurrency markets.

In light of the questions and uncertainties identified, the letter expresses the belief that cryptocurrency funds should withdraw registration statements.

SEC Action against Initial Coin Offering. On January 30, 2018, the SEC obtained a court order for an immediate asset freeze to halt an allegedly fraudulent ICO targeting retail investors and claiming to be the world’s first “decentralized bank”. The complaint alleges among other violations, the ICO was an illegal offering of securities and the sponsors made multiple false and misleading statements, including that its customers could be covered under federal deposit protections due to its purchase of a bank. The SEC is seeking preliminary and permanent injunctions, disgorgement of ill-gotten gains plus interest and penalties, and bars against the two co-founders to prohibit them from serving as officers or directors of a public company or offering digital securities again in the future. This SEC complaint highlights the SEC’s increased vigilance in pursuing securities violations in the cryptocurrency and ICO space.

SEC Statement on Unregistered Digital Asset Exchanges. On March 7, 2018, the SEC released a public statement affirming its view that platforms that trade securities and operate as exchanges must register as a national securities exchange or operate under an exemption from registration. This announcement reflects the SEC’s growing interest in online virtual currency trading platforms. The public statement offers advice to investors about how to stay safe while investing on these platforms. Additionally, the statement lists considerations for market participants operating online trading platforms and encourages those market participants to consult with legal counsel and contact SEC staff for assistance in analyzing and applying the federal securities laws.

CFTC Matters

CFTC Issues Virtual Currency Pump-and-Dump Customer Protection Advisory. On February 15, 2018 the CFTC issued its first Customer Protection Advisory focused on virtual currency, specifically warning against “pump-and-dump” schemes. As described in the advisory, pump-and-dump schemes are coordinated online efforts to artificially drive up demand for a virtual currency then quickly sell. In the advisory, the CFTC asserted its general anti-fraud and manipulation enforcement authority over virtual currency cash markets as a commodity. The CFTC advises all customers to only purchase virtual currency or tokens after thorough research.

District Judge Agrees with CFTC Jurisdiction Over Virtual Currencies. On March 6, 2018, a district court judge in the eastern district of New York found that the CFTC has standing in a case related to virtual currency fraud. The judge agreed with the CFTC that virtual currencies can be regulated as a commodity, despite other regulatory agencies asserting jurisdiction over virtual currencies in some cases. The judge also agreed the CFTC’s jurisdiction can be justifiably expanded into spot trade commodity fraud, beyond the classic “futures” contracts for commodities traditionally focused on by the CFTC. The court granted the CFTC a preliminary injunction against the defendants as the case continues.

CFTC Launches Virtual Currency Resource Web Page. The CFTC launched its own resource dedicated to virtual currency, designed to provide information to the public regarding possible risks involved with investing or speculating in virtual currencies. It includes a primer on virtual currency, tips to avoid fraud, a podcast that includes CFTC staff discussing virtual currencies, and other reference sources relating to the CFTC and virtual currency.

FINRA Matters

FINRA Published Regulatory and Examination Priorities Letter for 2018. Similar to the SEC, the Financial Industry Regulatory Authority, Inc. (“FINRA”) recently published its 2018 Regulatory and Examination Priorities Letter, outlining the organization’s enforcement priorities for the current year. FINRA’s specific focus areas for 2018 will include: (i) fraud, particularly microcap fraud schemes that target senior investors; (ii) hiring and supervisory practices for high-risk firms and brokers; (iii) cybersecurity; (iv) anti-money laundering; (v) sales practices and product suitability for specific investors, including the supervisory, compliance, and operational infrastructure firms have put in place with respect to ICOs; and (vi) investor protections related to market manipulation. We recommend that you speak with your firm’s outside counsel and service providers to learn more about these specific priorities and review your firm’s compliance with the applicable regulations.

Other Digital Asset Matters

We have detailed some of the major digital asset regulatory releases for the first quarter of this year in a separate post.  In addition to this information, there are some other items of note below.

U.S. Deputy Secretary of Treasury Provides Testimony On Financial Threats. On January 17, 2018, the U.S. Deputy Secretary of Treasury, Sigal Mandelker, testified before the Senate Committee on Banking, Housing, and Urban Affairs regarding a litany of financial threats to national security as well as the U.S. and global financial systems. Among the threats mentioned were emerging technologies including virtual currency. Mandelker emphasized FinCEN’s global focus on ensuring virtual currency providers and exchangers improve compliance activities. Mandelker’s testimony further evidences governmental agencies’ increasing focus on virtual currencies.

Proposed Virtual Currency Regulations Introduced in Hawaii and Nebraska. Multiple bills proposing to regulate cryptocurrency have been introduced in Hawaii and Nebraska. In Hawaii, one  proposal defines virtual currency and exempts virtual currency money transmitters from the state requirement to possess reserves to cover all outstanding customer investments. A second  proposal in Hawaii requires certain persons engaging the exchange, transfer, or storage of virtual currency in the state to be licensed. The proposal also outlines various other requirements for such a licensee, including the requirement to provide extensive personal information. Additionally, proposals in Hawaii, Connecticut, and Nebraska have been introduced to adopt the Uniform Regulation of Virtual-Currency Businesses Act (URVCBA) developed by the Uniform Law Commission (ULC), which provides a three-tiered structure for registration and licensing.

In Wyoming, multiple bills were passed related to virtual currency. A law was passed that exempts virtual currency from the Wyoming Money Transmitter Act. The Wyoming legislature also passed a law that specifies criteria by which an issuer of virtual currency will not be deemed an issuer of a security in Wyoming. Another law was also passed in Wyoming that exempts virtual currency from Wyoming property tax.

President issues executive order on Venezuela’s Digital Currency. On March 19, 2018, the President of the United States issued an executive order prohibiting transactions by United States persons or within the United States related to any digital currency issued by the Venezuelan government on or after January 9, 2018. This order was made in response the Venezuelan’s government’s issuance of a digital currency in an attempt to avoid United States sanctions. The order also provides that no prior notice is necessary for this order given the ability to transfer assets instantaneously.

Other Items

Fifth Circuit Vacates DOL Fiduciary Rule. On March 15, 2018, the Fifth Circuit Court of Appeals  issued a judgment vacating the Department of Labor Fiduciary Rule in its entirety, which we  discussed in an earlier update. The Fiduciary Rule expanded the definition of a “fiduciary” to include anyone making a securities or investment property “recommendation” to an employee benefit plan or retirement account. The rule also included a Best Interest Contract (“BIC”) Exemption, which permits investment advisers to retail retirement investors to continue their current fee practices, including receiving variable compensation, without violating prohibited transactions rules, subject to certain safeguards. The Court vacated the rule, finding that the Department of Labor lacked the authority to enact the rule under ERISA. The Court stated, in part, that Congress did not intend to expand the definition of fiduciary in passing ERISA in 1974. Just days earlier, the Tenth Circuit upheld a portion of the Fiduciary Rule, opening up additional uncertainty about the rule and inviting the Supreme Court to provide clarification.

CIMA Releases Guidance Notes for changes to its AML regulations. The Cayman Islands Monetary Authority (CIMA) has released guidance notes on its 2017 revisions to its Anti-Money Laundering Regulations, which were discussed in our previous quarterly update. The new guidance, in part, provides details of the requirements when compliance under the revisions are outsourced or delegated. If you have any questions, we recommend that you reach out to your administrator or offshore counsel.

Supreme Court Narrows Dodd-Frank Whistleblower Protection. On February 21, 2018, in a unanimous decision, the Supreme Court of the United States held in Digital Realty Trust, Inc. v. Somers, that the anti-retaliation provision of the 2010 Dodd-Frank Act covers only individuals who have reported a violation of the securities laws to the SEC. The Dodd-Frank Act does not protect individuals who only report violations internally. This ruling does not affect the anti-retaliation provisions of the Sarbanes-Oxley Act which protects whistleblowers who report certain types of misconduct internally in public companies.

IRS Clarifies Carried Interest Taxation Regulation. On December 22, 2017, Congress passed the Tax Reform Act which, among other items, alters the taxation of carried interest. Under section 1061 of the Act, carried interest must be held for at least three years in order to recognize long-term capital gains on the distribution of that interest. Section 1061 provides an exception for partnership interests held by a corporation.

On March 1, 2018, the Internal Revenue Service and Department of the Treasury issued Notice 2018-18 announcing their intent to issue regulations providing guidance for section 1061 of the Internal Revenue Code. Specifically, the guidance would exclude “S corporations” from the definition of a “corporation” as applied to carried interest taxation. This guidance will be applied retroactively and is effective for taxable years beginning after December 31, 2017. Managers should discuss further implications with their tax advisor and legal counsel.

Supreme Court Narrows Scope of Bankruptcy Code Securities Clawback Safe Harbor. In a unanimous opinion, the United States Supreme Court narrowed the scope of transactions qualifying for protection under section 546(e) of the Bankruptcy Code. This provision generally provides an exception that disallows a bankruptcy trustee from recovering a settlement payment made by a financial institution in connection with a securities contract. The court’s ruling means that such exception will not apply when the financial institution acts only as an intermediary.

SEC Encourages Self-Reporting of Share Class Selection Disclosures. The SEC announced its Share Class Selection Disclosure Initiative (SCSD Initiative) which encourages investment advisers to self-report securities violations with respect to failure to make disclosures concerning mutual fund share class selection. Investment advisers are required to disclose the conflict of interest that arises when an adviser receives 12b-1 fees for a share class when a less expensive share class is available for the same fund. Generally, qualifying settlements with the SEC will require the adviser to return profits on the transaction to the harmed clients, but not impose any further monetary penalties. For those advisers that do not take advantage of the initiative, the SEC is still focused on violations associated with mutual fund share class selection.

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

Deadline – Filing

  • March 31, 2018 – Deadline to update and file Form ADV Parts 1, 2A & 2B
  • April 10, 2018 – Amendment to Form 13H due if necessary
  • April 16, 2018 – 1st Quarter 2018 Form PF filing for quarterly filers (Large Liquidity Fund Advisers)
  • April 30, 2018 – Collect quarterly reports from access persons for their personal securities transactions
  • April 30, 2018 – Distribute code of ethics and compliance manuals to employees. Require acknowledgement form to be executed in connection with such delivery
  • April 30, 2018 – Annual Privacy Notice sent to all clients or fund investors (for Advisers with Fiscal Year ending December 31)
  • April 30, 2018 – Distribute audited financial statements to investors (most private fund managers, including SEC, state and CFTC registrants)
  • April 30, 2018 – Distribute Form ADV Part 2 to clients
  • April 30, 2018 – Quarterly NAV Report (registered commodity pool operators claiming the 4.7 exemption)
  • April 30, 2018 – 2017 Annual Form PF due date for annual filers (Large Private Equity Fund Advisers and Smaller Private Fund Advisers)
  • May 15, 2018 – Quarterly Commodity Trading Advisor Form PR filing
  • May 15, 2018 – File Form 13F for first quarter 2018
  • May 31, 2018 – First deadline for Cayman Islands Financial Institutions to submit their CRS returns to the Cayman Islands Tax Authority
  • May 31, 2018 – Third reporting deadline (full reporting) for Cayman Islands Financial Institutions with reporting obligations under the Cayman FATCA regulatory framework to report their U.S. Reportable Accounts to the Cayman Islands Tax Authority
  • June 30, 2018 – Distribute audited financial statements to investors (private fund managers to funds of funds, including SEC, state and CFTC registrants)

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP.  Mr. Mallon can be reached directly at 415-868-5345.

Digital Asset Regulatory Items 2018 First Quarter

There have been a number of regulatory updates in the first quarter of the year in the digital asset space. Below we provide an overview of these items.

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SEC Matters

Speeches

Chairman’s Testimony on Virtual Currencies: The Roles of the SEC and CFTC
SEC Chairman Jay Clayton
On February 6, 2018, Chairman Jay Clayton offered testimony to the Senate Committee on Banking, Housing, and Urban Affairs about a wide range of issues concerning virtual currencies. Clayton voiced his support of technological innovations, his concern for Main Street investors, and provided a warning that labeling an asset a “utility token” would not in itself prevent it from being deemed a security.

Releases

Statement on Potentially Unlawful Online Platforms for Trading Digital Assets
On March 7, 2018, the SEC released a public statement affirming its view that platforms trading digital assets that meet the definition of securities and operating as exchanges must register as a national securities exchange or operate under an exemption from registration. The public statement lists considerations for market participants operating online trading platforms, encourages those market participants to consult with legal counsel, and to contact SEC staff for assistance in analyzing and applying the federal securities laws.

Regulators Are Looking at Cryptocurrency
In a joint op-ed published in the Wall Street Journal on January 25, 2018, SEC Chairman Jay Clayton and CFTC Chairman J. Christopher Giancarlo affirmed their support of innovative financial technologies but warned investors of the risks of new markets. In order to protect investors, the agencies will continue working to bring “transparency and integrity” to the digital asset markets.

SEC Comments on NASAA’s Release Reminding Investors of Risks in Cryptocurrency Investment:
The SEC commended the January 4, 2018 release from the North American Securities Administrators Association stressing concerns relating to cryptocurrencies and ICOs. The SEC’s statement also reminds investors that there is a substantial risk that SEC efforts will not result in recovery of digital asset investments, despite the fact that the SEC and state securities regulators are pursing violations by ICO promoters.

Staff Letter: Engaging on Fund Innovation and Cryptocurrency-related Holdings
Staff Letter: Engaging on Fund Innovation and Cryptocurrency-related Holdings
Dalia Blass, Director, Division of Investment Management, US Securities and Exchange Commission
In a staff letter to the Investment Company Institute and Asset Management Group, Blass addressed potential issues the SEC has identified concerning registered funds and products focused on cryptocurrency. The letter outlines issues in valuation, liquidity, custody, arbitrage for ETFs, and potential manipulation.

Enforcement

Charges Filed Against Former Bitcoin-Denominated Exchange and Operator
On February 21, 2018, the SEC filed charges against BitFunder and its founder Jon E. Montroll alleging fraud and operating an unregistered securities exchange. According to the complaint, Montroll misappropriated users’ funds and failed to report the theft of more than 6,000 bitcoins as part of a cyberattack.

SEC Suspends Trading in Three Issuers After Questionable Announcements Concerning Digital Assets
On February 15, 2018, the SEC suspended trading in the securities of three companies (Cherubim Interests, Inc., PDX Partners, Inc., Victura Construction Group, Inc.) after the companies made questionable statements about their acquisition of certain cryptocurrency and blockchain technology related assets.

SEC Action against Initial Coin Offering
On January 30, 2018, the SEC obtained a court order for an immediate asset freeze to halt an allegedly fraudulent ICO targeting retail investors and claiming to be the world’s first “decentralized bank.” The complaint alleges that among other violations, the ICO was an illegal offering of securities and that the sponsors made multiple false and misleading statements including that its customers could be covered under federal deposit protections due to its purchase of a bank.

CFTC Matters

Speeches  

Testimony of Chairman J. Christopher Giancarlo before the Senate Banking Committee, Washington, D.C.
Christopher Giancarlo
On February 6, 2018, CFTC Chairman J. Christopher Giancarlo offered testimony to the Senate Banking committee concerning virtual currencies. Giancarlo affirmed the commission’s authority to regulate virtual currencies derivatives markets while noting its limited authority to oversee spot virtual currency platforms. Within these parameters, Giancarlo described how the commission has worked toward its goals through enforcement actions, educating investors and market participants, and policy considerations that allow for both innovation and protection.

Keynote Address by Commissioner Brian Quintenz before the DC Blockchain Summit
Brian Quintenz
On March 7, 2018, CFTC Commissioner Brian Quintenz gave the keynote speech at the DC Blockchain Summit, discussing his personal views on digital assets and the role of the CFTC. He discussed the history of the CFTC’s role with respect to digital assets, reminding the audience that “in the derivatives markets, the CFTC has both oversight and enforcement authority, while in the spot markets, or the platforms where commodities themselves are actually bought and sold, the CFTC has only enforcement authority.” He then discussed the future of regulation of digital assets, including possible exploration of “a new, private independent organization [that] could perform an oversight function for U.S. cryptocurrency platforms.”

Releases

CFTC Warns Investors About Virtual Currency Pump-and-Dump Schemes
On February 15, 2018 the CFTC issued its first Customer Protection Advisory focused on virtual currency, specifically warning against “pump-and-dump” schemes. In the advisory, the CFTC asserted its general anti-fraud and manipulation enforcement authority over virtual currency cash markets as a commodity. The CFTC advises all customers to only purchase virtual currency or tokens after thorough research.

CFTC Launches Virtual Currency Resource Web Page
The CFTC launched a virtual currency resource page in its ongoing effort to educate the public about the risks of virtual currencies. The site features an introduction to virtual currencies, consumer advisories, links to relevant CFTC podcasts, and more.

Enforcement  

US District Court Issues Preliminary Injunction Order Against Coin Drop Markets
On March 6, 2018, the US District Court of the Eastern District of New York issued a preliminary injunction against Patrick K. McDonnell and CabbageTech, Corp. d/b/a Coin Drop Markets in connection with the CFTC’s continuing litigation concerning fraud and misappropriation of virtual currencies. Under the terms of the injunction, the defendants are prohibited from engaging in fraudulent activities in violation of the Commodity Exchange Act.

CFTC Charges My Big Coin, Inc. with Fraud and Freezes its Operations
On January 16, 2018, the CFTC filed an enforcement action against Mark Gillespie, and My Big Coin Pay, Inc. in connection with an alleged ongoing virtual currency scam. On the same day, the US District Court for the District of Massachusetts granted an order freezing the assets of the defendants.

CFTC Charges Colorado Cryptocurrency Company with Fraud, Halting Alleged Ponzi Scheme
On January 18, 2018, the CFTC filed a civil enforcement action against Dillon Michael Dean and his company, The Entrepreneurs Headquarters Limited. The complaint alleged ongoing fraud, misappropriation of client funds, and failure to register with the CFTC.

State Matters

Wyoming Governor Signs Five Crypto-related Bills into Law

The governor of Wyoming recently signed into law five bills making the state friendlier to digital asset businesses.

  • HB 19 exempts virtual currency from the Wyoming Money Transmitter Act.
  • HB 70 provides criteria for which an issuer of virtual currency will not be deemed an issuer of a security in Wyoming.
  • SF 111 exempts virtual currency from Wyoming property tax.
  • HB 101 allows for electronic corporate records to be stored through blockchain and provides certain requirements of such systems.
  • HB 126 authorizes the formation of Series LLCs

Uniform Regulation of Virtual-Currency Businesses Act legislation introduced in several state legislatures
Proposals in Hawaii, Connecticut, and Nebraska have been introduced to adopt the Uniform Regulation of Virtual-Currency Businesses Act (URVCBA) developed by the Uniform Law Commission (ULC), which provides a three-tiered structure for registration and licensing.

Proposed Virtual Currency Regulations Introduced in Hawaii
Multiple bills proposing to regulate cryptocurrency have been introduced in Hawaii. One proposal defines virtual currency and exempts virtual currency money transmitters from the state requirement to possess reserves to cover all outstanding customer investments. A second proposal in Hawaii requires certain persons engaging the exchange, transfer, or storage of virtual currency in the state to be licensed. The proposal also outlines various other requirements for such a licensee, including the requirement to provide extensive personal information.

Proposed Bill in New York would Alter Audit and Licensing Requirements for Crypto-Businesses
A bill has been introduced to the New York Legislature that would change audit and licensing requirements for cryptocurrency related businesses. The bill would prohibit licensing fees targeted at cryptocurrency businesses and establish new audit requirements focusing on security.

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

Cole-Frieman & Mallon 2017 Second Quarter Update

Below is our quarterly newsletter. If you would like to be added to our distribution list, please contact us.

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August 23, 2017

Clients, Friends, Associates:

We hope you are enjoying the summer. Although the second quarter is typically not as busy as the first quarter from a regulatory/compliance standpoint, we saw many regulatory developments this quarter, as well as a surge in digital asset investment activity. Below is an overview of noteworthy items, as well as what to expect as we move into the third quarter.

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SEC Matters:

Proposed SEC Amendment to Advisers Act for VC and Private Fund Advisors. On May 3, 2017, the SEC proposed a rule to amend the Investment Advisers Act of 1940, as amended (the “Investment Advisers Act”), that would amend the definition of a “venture capital fund” and the definition of “assets under management” with respect to the private fund adviser exemption. For purposes of the exemption for advisers to venture capital funds, small business investment companies (“SBIC”) would be included in the definition of a venture capital fund. This would expand exemption coverage for advisers solely relying on the SBIC adviser’s exemption. Eligible advisers would file as an “exempt reporting adviser,” reducing the extra costs and burdens of recordkeeping required of registered investment advisers. Additionally, with respect to the private fund adviser exemption, currently firms that advise solely private funds and that have less than $150 million of regulatory assets under management are exempt from registration with the SEC. The proposed rule would exclude SBIC assets from the calculation of private fund assets used to determine if the $150 million threshold has been crossed. The SEC closed requests for comment on the proposal on June 8, 2017.

SEC Seeks Input Regarding Department of Labor (“DOL”) Fiduciary Rule. SEC Chairman Jay Clayton issued a statement on June 1, 2017 welcoming public input to help the SEC formulate its assessment of the impact the DOL’s Fiduciary Rule (as discussed further below) may have on investors and entities regulated by the SEC. The statement was released in anticipation of a DOL request for information from the SEC to promote consistency and clarity with respect to implementation of the rule between the two agencies. Interested individuals can respond to SEC questions about the rule’s impact on investment advisers and broker-dealers via email or an online webform. Public submissions remain open and are currently available for review.

SEC Action Against Outsourced CCO.  On August 15, 2017, the SEC reached a settlement with an outsourced CCO and his consulting firm, which offered compliance consulting and outsourced CCO services to investment advisory firms. The outsourced CCO served as CCO for two registered investment advisers (collectively, “Registrants”). The SEC found the Registrants either filed their Form ADV annual amendments late or not at all, and the outsourced CCO relied on estimates provided by the Registrants’ CIO. It was established the AUM and number of advisory accounts reported on the Form ADV were greatly overstated, and the outsourced COO did not confirm the accuracy of the information. The SEC held the outsourced CCO violated the Investment Advisers Act by failing to amend the Form ADV annually and willfully submitting a false statement. The SEC suspended the outsourced CCO from association or affiliation with any investment advisers for one year and ordered him to pay a $30,000 civil penalty. The action indicates that outsourced compliance persons solely relying on internal estimates of AUM and number of advisory contracts, without further confirmation, are at risk of filing false reports and subject to enforcement with the SEC.

CFTC Matters:

CFTC Requests Input to Simplify and Modernize Commission Rules. In response to President Trump’s executive order to reform regulations to stimulate economic growth, the CFTC is requesting public input in an effort to simplify and modernize CFTC rules and make complex CFTC regulations more understandable for the public. Rather than rewrite or repeal existing rules, a primary goal of Project Keep it Simple Stupid (“Project KISS“) is to find simpler means of implementing existing rules. The CFTC will review rules with an ultimate goal of reducing regulatory burdens and costs for industry participants. The solicitation period for comments began on May 3, 2017 and will close on September 30, 2017. Comments can be submitted via the Project KISS portal on the CFTC’s website.

CFTC Approves Amendments to Strengthen Anti-Retaliation Whistleblower Protections. The CFTC unanimously approved new amendments to the “Whistleblower Incentives and Protection” section of the Commodity Exchange Act of 1936, as amended (the “CEA”) on May 22, 2017. The amendments provide for greater anti-retaliation measures against employers who attempt to retaliate against employees that report employer CEA violations. Further, the amendments help clarify the process of determining whistleblower awards. The amendments will become effective July 31, 2017.

CFTC Unanimously Approves Recordkeeping Amendment Requirements. On May 23, 2017, the CFTC unanimously approved amendments to Regulation 1.31 to clarify the rule and modernize the manner and form required for recordkeeping. Specifically, the amendment will allow the manner and form of recordkeeping to be technology-neutral (i.e. not requiring or endorsing any specific record retention system or technology, and not limiting retention to any format). The amendments do not expand or decrease any existing requirements pertaining to regulatory records covered by other CFTC regulations.

Digital Asset Matters:

CoinAlts Fund Symposium.  Cole-Frieman & Mallon LLP is pleased to announce that it is hosting, along with fellow symposium sponsors Arthur Bell CPAs, MG Stover & Co., and Harneys Westwood & Riegels, the CoinAlts Fund Symposium on Thursday, September 14, 2017, in San Francisco. This one-day symposium is for managers, investors and service providers in the cryptocurrency space and discussion points will include cryptocurrency investment, as well as legal and operational issues pertaining to this new asset class. The key-note speaker will be Olaf Carlson-Wee, Founder and CEO of Polychain Capital, and the symposium will include a number of other speakers representing the perspectives of investment management, fund administration, audit and tax, custody of funds, offshore fund formation and compliance. Early bird registration for investors, manager and students ends August 31st.

California Proposes a BitLicense via the Virtual Currency Act. Following in New York’s footsteps with its implementation of a BitLicense to regulate virtual currency activity in New York, California has proposed A.B. 1123 (or the “Virtual Currency Act”), its own version of a BitLicense. If passed, any persons involved in a “virtual currency business” must register with the California Commissioner of Business Oversight (the “Commissioner”). Under the Virtual Currency Act, a “virtual currency business” is defined as maintaining full custody or control of virtual currency in California on behalf of others. The application and registration process includes an extensive review of the business by the Commissioner, maintenance of a minimum capital amount, annual auditing, and an application fee of $5,000 with a $2,500 renewal. Currently aimed at those offering exchanges or wallet services we do not believe digital asset fund managers will need to obtain this licence. More information can be found here.

SEC Grants Review of Initial Rejection of Winklevoss Bitcoin Exchange-Traded Fund. In March, the SEC rejected a proposed rule change to list and trade shares of the Winklevoss Bitcoin Trust as commodity-based trust shares on the Bats BZX Exchange. In the disapproval order, the SEC claimed that the bitcoin market was too unregulated at the time, and the BZX Exchange would therefore lack the capability of entering into necessary surveillance-sharing agreements that are required of current commodity-trust exchange traded products. Bats BZX Exchange filed a petition for review of the disapproval order. The SEC granted the petition in April and has yet to release any further comments. As digital asset trading has increased over the past few months, many are looking at the review of the petition as a potential indicator of future cryptocurrency regulation to come.

SEC Petitioned for Proposed Rules and Regulation of Digital Assets and Blockchain Technology.  A broker-dealer operating an alternative trading system (“ATS”) for unregistered securities, petitioned the SEC for rulemaking regarding guidance on digital assets. The Petitioner argued that some digital assets should be considered securities, and that current regimes in the United Kingdom and Singapore can be modeled domestically to successfully facilitate the issuance and trading of digital assets. The model currently used by those countries is known as a “regulatory sandbox,” in which companies are allowed to operate without significant regulatory interference, so long as they do so within a set of established rules. As of today, the SEC has not responded to the petition, but we expect the frequency of petitions and requests for no-action letters to increase as this space continues to grow.

Other Items:

Department of Labor (“DOL”) ‘Implements’ Fiduciary Rule. On June 9, 2017, the DOL partially implemented its amended fiduciary rule (the “Fiduciary Rule”), which expands the definition of a “fiduciary” subject to important exemptions.  On August 9, 2017 the DOL submitted proposed amendments to these exemptions thereby delaying enforcement; and extending the transition period and uncertainty over the ultimate fate of the fiduciary rule by another eighteen months to July 1, 2019. Managers with questions regarding the applicability of these exemptions should discuss with counsel.

Generally, anyone that makes a “recommendation” as to the value, disposition or management of securities or other investment property for a fee or other compensation, to an employee benefit plan or a tax-favored retirement savings account such as an individual retirement account (“IRA”) (collectively “covered account”) will be deemed to be providing investment advice and, thus, a “fiduciary,” unless an exception applies. Many fund managers and other investment advisers may unintentionally be deemed to be fiduciaries to their retirement investors under the amended rule. Fund managers with investments from covered accounts or that wish to accept contributions from covered accounts will need to consider whether their current business activities and communications with investors could constitute a recommendation, including a suggestion that such investors invest in the fund. Under certain circumstances, fund managers may be deemed fiduciaries.  Notably, the Fiduciary Rule provides an exception for activity that would otherwise violate prohibited transaction rules which is applicable to investments made by plan investors who are represented by a qualified independent fiduciary acting on the investor’s behalf in an arms’ length transaction (typically for larger plans). For clients or investors that do not have an independent fiduciary, managers must evaluate whether they are fiduciaries and what actions must be taken to comply with ERISA’s fiduciary standards or the prohibited transaction rules.  The Fiduciary Rule also contemplates a Best Interest Contract (“BIC”) Exemption, which permits investment advisers to retail retirement investors to continue their current fee practices, including receiving variable compensation, without violating prohibited transactions rules, subject to certain safeguards.

We recommend that investment advisers contact their counsel regarding making any necessary updates to the applicable documents.

MSRB Establishes Continuing Education Requirements for Municipal Advisors. Beginning January 1, 2018, the Municipal Securities Rulemaking Board (“MSRB”) will implement amendments requiring municipal advisors to have a continuing education program in place for “covered persons” and require such persons to participate in continuing education training. The amendment will require an annual analysis to evaluate training needs, develop a written training plan, and implement training in response to the needs evaluated. The amendments also provide for record-keeping of the plans and analysis to promote compliance. Municipal advisors will have until December 31, 2018 to comply with the new requirements. To further clarify the requirements, the MSRB will be hosting an education webinar for municipal advisors on Thursday October 12, 2017, from 3:00 p.m. to 4:00 p.m. EDT.

Full Implementation of MSRB Series 50 Examination. The grace period for municipal advisor representatives and municipal advisor principals that have not passed the Series 50 examination to qualify as a municipal advisor representative or principal will be ending on September 12, 2017. Thereafter, all municipal advisor professionals who either engage in municipal advisory activities or engage in the management or supervision of municipal advisory activities will be required to pass the Series 50. The MSRB has a content outline which specifies eligibility, the structure of the exam, and the regulations to be tested.

Form ADV Technical Amendment Including Wyoming for Mid-Size Advisers. On July 1, 2017, a technical amendment to Form ADV was implemented to reflect a new Wyoming law that now requires investment advisers with $25 million to $100 million in AUM and a principal place of business in Wyoming to register with the state as an investment adviser instead of the SEC. The technical amendment will also appear on Form ADV-W.

Further Updated CRS Guidance Notes. The Cayman Islands Department for International Tax Cooperation (“DITC”) and the Cayman Islands Tax Information Authority (“TIA”) issued further guidance notes on April 13, 2017 for compliance with Automatic Exchange of Information (“AEOI”) obligations. Among some of the more important notes are the following:

  • US FATCA notification and reporting deadlines will now parallel the Common Reporting Standard (“CRS”) deadlines. The notification deadline was June 30, 2017, and the reporting deadline will be July 31, 2017.
  • The deadline for correcting any FATCA report errors for 2014 and for 2015 will be July 31, 2017.
  • CRS reporting must be completed with the CRS XML v1.0 or a manual entry form on the AEOI portal.

We recommend contacting your tax advisors to discuss any potential issues regarding the above updates and deadlines.

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

Deadline – Filing

  • July 15, 2017 – Quarterly Form PF due for large liquidity fund advisers (if applicable).
  • July 30, 2017 – Collect quarterly reports from access persons for their personal securities transactions.
  • August 14, 2017 – Form 13F filing (advisers managing $100 million in 13F Securities).
  • August 29, 2017 – Quarterly Form PF due for large hedge fund advisers (if applicable).
  • September 30, 2017 – Review transactions and assess whether Form 13H needs to be amended.
  • October 2017 – Revised Form ADV 1A goes into effect for advisers filing an initial ADV or an annual updating amendment.
  • October 16, 2017 – Quarterly Form PF due for large liquidity fund advisers (if applicable).
  • November 14, 2017 – Form 13F filing (advisers managing $100 million in 13F Securities).
  • November 29, 2017 – Quarterly Form PF due for large hedge fund advisers (if applicable).
  • Ongoing – Amendment due on or before anniversary date of prior Form D filing(s), or for material changes.
  • Ongoing – Due on or before anniversary date, and promptly when material information changes


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

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

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP.  Mr. Mallon can be reached directly at 415-868-5345.

Hedge Fund Bits and Pieces for April 7, 2017

Happy Masters Friday!

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

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

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

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

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

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

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