Tag Archives: bitcoin

Initial Coin Offerings (ICOs)

ICO Overview and Securities Law Analysis

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

Initial Background

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

Are ICOs Securities?

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

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

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

Use Case – Blockchain Capital

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

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

Future Regulation?

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

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

Conclusion

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

Related articles:

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

Bitcoin Hedge Fund FAQs

Common Questions Related to Cryptocurrency Funds

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

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

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

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

Why does it matter?

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

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

What if the cryptocurrencies are not deemed to be securities?

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

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

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

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

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

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

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

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

What about an administrator?

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

What about bank accounts?

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

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

What about compliance and outside compliance consultants?

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

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

What about ICOs?

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

What are some common terms of bitcoin funds?

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

How is bitcoin taxed?

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

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

What about separately managed accounts or prop trading?

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

Other Items 

We anticipate writing about the following soon in some fashion:

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

Final Notes

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

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

 

New York BitLicense

Overview of the Cryptocurrency Licensing Regime in New York

As cryptocurrencies continue to make headlines, questions continue to arise about the regulatory landscape applicable to market participants. While there have been no new laws or regulations related to the cryptocurrency space from federal agencies (although in the Coinflip order, the CFTC stated that bitcoin is a virtual currency), some states are beginning to examine cryptocurrencies with New York as a forerunner in this space.  In 2015, New York created a BitLicense Regulatory Framework whereby certain cryptocurrency market participants were required to obtain a license to transact business within New York (and/or with New York residents).  This post focuses on New York’s regulatory action regarding cryptocurrencies with the issuance of the BitLicense, and the potential impact this may have on investment managers.

New York BitLicense

Pursuant to the Part 200. Virtual Currencies regulations, any persons involved in “virtual currency business activity” in New York must obtain a license known as the “BitLicense.”  The regulation defines a “virtual currency business activity” as:

  • receiving virtual currency for transmission or transmitting virtual currency, except where the transaction is undertaken for non-financial purposes and does not involve the transfer of more than a nominal amount of virtual currency;
  • storing, holding, or maintaining custody or control of virtual currency on behalf of others;
  • buying and selling virtual currency as a customer business;
  • performing exchange services as a customer business; and
  • controlling, administering, or issuing a virtual currency.

The above categories really seem to apply to those groups who are acting as cryptocurrency exchanges and/or are offering “wallet” type services.  For most fund managers who are simply managing a fund which is investing in virtual currencies, the above items would not implicate such managers and such managers would not need to obtain the BitLicense.  However, if a manager (or an investment fund) was engaged in activity other than simply buying/selling/holding cryptocurrencies, the manager should be aware of the above items.

BitLicense Application

In order to receive the license, an applicant must complete a 30-page Application for License to Engage In Virtual Currency Business Activity and pay a $5,000 application fee.  The application requires information on the history of the business, its owners and operators, operational items, financials, information on AML procedures, and information on its general compliance processes.  In total the application is fairly onerous and costly and will likely deter many potential companies for applying for the license.  Few BitLicenses have actually been granted to date, and those that have been granted were to major players in the industry such as Coinbase and Ripple.

Other Related Items

There are a number of interesting related items and a discussion about these can be found on the BitLicense FAQs page.  A couple of the more interesting items:

  • Chartered New York Bank – if a group is already chartered under the New York Banking Law, that entity does not need to apply for the BitLicense but must first receive prior approval from the New York Department of Financial Services to engage in the activity.
  • Money Transmitter License – groups who engage in certain activities may also need to apply for a money transmitter license in New York.  Groups who are applying to engage in both activities only need to submit one application.

The two items above are most likely not applicable to fund managers.

Looking Forward

The establishment of a BitLicense demonstrates that states are trying to figure out how to assert authority over a space that prides itself on decentralization. The New York BitLicense has been seen as controversial, along with similarly proposed licenses in other states. Although this appears to not have a direct impact on investment managers yet, investment managers that engage in certain kinds of virtual currency activity may fall within the scope of requiring a license.

Related articles:

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

Hedge Fund Bits and Pieces for March 31, 2017

Happy Friday and congrats to everyone on making it though the first quarter!  Our firm will be sending out a 2017 first quarter update sometime in the next couple of weeks – if you are not on the distribution list and would like to be, please contact us.  We will also post the update to this blog.

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Annual ADV Updatedue TODAY by 11pm ET (when IARD system shuts down).  The ADV annual updates are due today.  Most firms have submitted their updates by now but if you have not done so, please call your legal or compliance professional immediately.  Additionally, fund managers generally will have their audits completed by today and those should be sent to investors as per the firm’s compliance procedures.

Another Bitcoin Trust Rejected by SEC – on Tuesday the SEC rejected an application by NYSE Arca to list shares of SolidX Bitcoin Trust.  The trust was set to a publicly traded vehicle designed to track the price of bitcoins as measured by an index of unregulated bitcoin exchanges (Bitfinex, Bitstamp, GDAX, itBit, and OKCoin International).  In rejecting the application, the SEC stated that it believes that the bitcoin markets are unregulated.  This is the second rejected listing of a bitcoin product for retail investors (see earlier post discussing the rejection of the Winklevoss bitcoin ETF).

SEC Focus on FinTech – it is abundantly clear that technology is beginning to change the capital markets in profound ways.  As practitioners, we are working with our clients to figure out how new ways of investing fit within the current regulatory structures applicable to both products and managers.  As these changes take deeper root, there will be growing pains and the SEC realizes this – below are recent remarks made on Monday in Washington by acting SEC Chairman Michael Piwowar about the FinTech industry and how the SEC will be working in the space in the future.  The full speech, made at the beginning of the SEC’s 27th Annual International Institute for Securities Market Growth and Development, can be found here.

Financial technology (“FinTech”) is also revolutionizing our industry. FinTech can bring tremendous benefits – streamlined market operations and more affordable ways to raise capital and advise clients.  Fifty-nine percent of all adults in developing nations do not have a bank account – but this is changing fast. With cell phones now in the pockets of many individuals in even the poorest of nations, mobile technology has greatly cut down on barriers to accessing capital. In Kenya, for example, I saw firsthand the transformative power of FinTech. Sixty-eight percent of Kenyan adults use their mobile phones for monetary transactions. In 2013, over 25% of the Kenyan GNP was transferred via M-PESA, the leading mobile money transfer service in the country. Services like M-PESA are not only for the transfer of money, but also can be used to take out micro-loans that would have been previously unavailable to small businesses.  The question for us regulators is how can we encourage this innovation and all the potential benefits that it promises, while also managing the risks? At the SEC, we started a FinTech working group. Not surprisingly, FinTech firms report that their greatest struggle is navigating a complex regulatory environment. The SEC, and other securities regulators, should take the leading role in working with the FinTech community to adapt longstanding laws and regulations to newfangled technology. (footnotes omitted)

Other Items:

  • CFTC Announces Committee Meeting on Cybersecurity – the CFTC just announced that the Market Risk Advisory Committee (MRAC) will meet on April 25, 2017 to discuss a number of important issues related to the futures and commodities markets.  A central focus of this meeting will be focused on cybersecurity trends in the futures markets.  The discussion will also cover “how well the derivatives markets are currently functioning, including the impact and implications of the evolving structure of these markets on the movement of risk across market participants” – we anticipate that some part of the discussion will focus on certain new instruments like cryptocurrencies and the emerging derivate products linked to such instruments.  The MRAC’s meeting will be public and be held at the CFTC’s Washington, DC, headquarters.
  • Adidas Trademark Issue – while not directly related to the investment management industry, this blog post (produced by our Of Counsel trademark attorney Bill Samuels) highlights the technical nature of the enforcement of trademarks.  It also highlights the strength of a registered mark (the sale of only two hats, which contain a trademarked phrase, are enough to implicate interstate commerce and allow a trademarked phrase to be protected under the trademark laws).  It is important for managers with questions on their trademarks and other intellectual property to discuss these matters with counsel.

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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.