Monthly Archives: October 2018

Cole-Frieman & Mallon 2018 Third Quarter Update

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

Clients, Friends, Associates:

We hope that you had an enjoyable summer. The past quarter saw further interest in digital assets from regulators, as well as enforcement actions and indications of possible regulatory changes. In the traditional investment management space, this summer saw a continuation of the bull market. As we move into the fourth quarter, we would like to provide an overview of items we hope will help you stay up-to-date with regulatory developments.

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

  • CoinAlts Fund Symposium. In September, preceded by a well-attended Women in Crypto networking event sponsored by Coinbase, founding sponsor Cole-Frieman & Mallon hosted its third successful full day Symposium in San Francisco. Speakers including keynote Tim Draper, founder of Draper Associates, DFJ and the Draper Venture Network and Joe Eagan of Polychain Capital explored issues key to fund managers and investors in the digital asset space.
  • CFM San Francisco. We are delighted to announe our overflowing San Francisco team will shortly relocate to expanded premises at 255 California Street.

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SEC Matters

SEC Chairman Hints at Changes in Investor Standards. On August 29, Securities and Exchange Commission (“SEC”) Chairman Jay Clayton spoke at the Nashville 36|86 Entrepreneurship Festival. He discussed issues the SEC is focused on or intends to focus on, including initial coin offerings (“ICOs”), promoting capital formation for public companies or companies considering going public, and rethinking the SEC’s current private offering exemption framework. Of note, Chairman Clayton stated that the SEC should explore how the current private offering exemption landscape could be simplified and streamlined. In particular, the Chairman noted that the SEC should examine the possibility of focusing on factors beyond investor wealth (i.e. accredited investor status), such as investor sophistication or investment amount.

SEC Releases Best Execution Deficiencies Alert. On July 11, the Office of Compliance Inspections and Examinations of the SEC released an alert outlining common deficiencies observed in examinations of advisers’ “best execution” obligations. These requirements come from the Investment Advisers Act of 1940, as amended, and impose a duty on advisers to execute trades so that total costs and proceeds are most favorable to clients. While best execution obligations depend on the facts of each situation, the SEC observed the following common deficiencies:

  • Not Performing Reviews – advisers were unable to provide evidence that they periodically and systematically reviewed the broker-dealers used to execute transactions.
  • Not Considering Materially Relevant Factors in Broker-Dealer Services – advisers did not consider the full range and quality of broker-dealers’ services.
  • Not Seeking Other Broker-Dealers – advisers often used only one broker-dealer for all of their clients without evaluating the services, quality, and costs of others.
  • Not Disclosing Best Execution Practices – advisers did not fully disclose best execution practices to their clients.
  • Not Disclosing Soft Dollar Arrangements – soft dollar arrangements (i.e. commissions in exchange for brokerage and research services) were not fully and fairly disclosed in advisers’ Form ADVs.
  • Not Properly Allocating Mixed Use Products and Services – advisers did not properly allocate the costs of mixed use products or services (i.e. products or services obtained using soft dollars, where that product or service is also used for non-investment purposes, such as accounting or marketing). Additionally, advisers did not properly document the reasons for mixed use product or service allocations.
  • Inadequate Policies and Procedures – advisers lacked policies, had insufficient internal controls, or did not have policies tailored to their investment strategy.
  • Not Following Policies and Procedures – advisers failed to follow their own best execution policies and procedures.

In light of the deficiencies listed above, advisers should review their best execution policies and procedures, and contact legal counsel or a compliance professional with any questions.

Hedge Fund Adviser Charged with Short-and-Distort Scheme. On September 12, the SEC charged a hedge fund advisor with illegally profiting from a “short-and-distort” scheme. The adviser is alleged to have released false information about a public pharmaceutical business after shorting the company. The adviser allegedly used reports, interviews, and social media to spread false claims that, for example, the pharmaceutical company was “teetering on the brink of bankruptcy”. The SEC is seeking a permanent restraining order, disgorgement of ill-gotten gains, and civil penalties.

SEC Charges Adviser for Risky Investments and Secret Commissions. On July 18, the SEC charged an adviser and its CEO with misleading investors by putting their capital in risky investments and secretly pocketing large commissions from such investments. The adviser and CEO are accused of misleading investors about the risks of the investments, overbilling, concealing financial conflicts, and violating the anti-fraud and registration provisions of federal securities laws. The SEC is seeking a permanent injunction, disgorgement of ill-gotten gains and losses avoided plus prejudgment interest, and civil monetary penalties. 

CFTC/NFA Matters 

CFTC Chairman Outlines Increased CFTC Enforcement. On October 2, the Commodities Futures Trading Commission (“CFTC”) Chairman Christopher Giancarlo summarized the CFTC’s increased enforcement efforts from the prior fiscal year in a speech to the Economic Club of Minnesota. These efforts include:

  • Enforcement Actions – in the prior fiscal year, the CFTC filed approximately 25% more enforcement actions than each of the prior three fiscal years.
  • Large-Scale Matters – the CFTC has increased enforcement actions against large-scale matters (i.e. matters that threaten basic market integrity). In the CFTC’s last fiscal year, it brought more than three times the average number of large-scale actions as the previous administration.
  • Manipulative Conduct – the CFTC has brought more than five times the previous average number of actions against manipulative conduct in the past fiscal year. Such conduct includes fraud, spoofing (i.e. bidding with the intent to cancel before execution), and the use of technology to manipulate order books.
  • Accountability – the CFTC has prioritized individual accountability, and approximately 70% of the past fiscal year’s cases involved charges against individuals who committed illegal acts.
  • Partnership with Criminal Enforcement – the CFTC has filed “far more actions in parallel” with criminal law enforcement partners than in any previous year.
  • Whistleblower Awards – with respect to whistleblowers, the CFTC has strengthened protections, granted a record number of awards, and received a record number of tips and complaints.

With these increased enforcement efforts in mind, managers of funds subject to CFTC jurisdiction should ensure they are up-to-date with CFTC filings and regulations.

CTA Associated Person and Introducing Broker Charged with Fraud. On August 10, the CFTC settled charges against an associated person of a commodity trading adviser (“CTA”) and introducing broker. The charges were based on a fraudulent trading scheme where the trader entered unauthorized commodities trades in customers’ accounts, transferred profitable trades to his own account, and left losses in the clients’ accounts. The settlement included a cease and desist order, a permanent ban from engaging in trading with any CFTC-registered entity, and a $100,000 civil monetary penalty.

Digital Asset Matters

Regulators continued to show interest and initiate enforcement actions in the digital asset space. Below is a summary of certain key digital asset items from the third quarter. For a complete review of these and other crypto developments, please consult our Third Quarter Digital Asset Regulatory Items blog post.

SEC Charges Digital Asset Hedge Fund Manager. On September 11, the SEC announced the settlement of charges against a digital asset hedge fund and its manager. The charges include misleading investors, offering and selling unregistered securities, and failing to register the hedge fund as an investment company. After being contacted by the SEC, the fund offered rescission and disclosed its previous misstatements to investors. The settlement included cease-and-desist orders, censure, and a $200,000 penalty. This is the first action the SEC has taken against a digital asset fund based on violations of the investment company registration requirements.

SEC Charges ICO Platform for Operating as Unregistered Broker-Dealer. On September 11, the SEC settled charges against an ICO platform. The business was charged with failing to register as a broker-dealer, as well as offering and selling unregistered securities. This is the SEC’s first charge against an unregistered broker-dealer in the digital asset space following the SEC’s 2017 DAO Report, which cautioned anyone offering or selling digital assets to comply with federal securities laws.

New York Attorney General Releases Report on Digital Asset Exchanges. On September 18, the Office of the Attorney General of New York (the “OAG”) released a report summarizing a crypto exchange fact-finding initiative. Based on the digital asset exchanges examined, the OAG outlined three primary areas of concern: potential conflicts of interest, lack of anti-abuse controls, and limited customer fund protection.

NFA Requires CPOs and CTAs to Disclose Digital Asset Activity. On July 20, the National Futures Association (“NFA”) released a notice that imposed new disclosure requirements on futures commission merchants, commodity pool operators (“CPOs”), and CTAs that are NFA members engaged in certain digital asset activities. The new disclosures cover, for example, the volatility and cybersecurity risks of digital assets. Additional details are available in our recent blog post.

Offshore Matters

Cayman Islands Delays AML Officer Deadline. Under new Cayman Islands requirements, investment funds that conduct business in or from the Cayman Islands must appoint individuals to new anti-money laundering officer positions. The Cayman Islands Monetary Authority (“CIMA”) has delayed certain deadlines for funds that launched prior to June 1, 2018:

  • CIMA-Registered Cayman Funds – registered funds still must have appointed the new officers by September 30, 2018, but now do not need to confirm the identity of the officers via CIMA’s Regulatory Enhanced Electronic Forms Submission (“REEFS”) portal until December 31, 2018.
  • Unregistered Cayman Funds – unregistered funds do not need to appoint the new officers until December 31, 2018, and they do not need to confirm the identity of these officers via the REEFS portal.

Funds formed on or after June 1, 2018 must have appointed the officers (and confirmed such officers through REEFS for registered funds) at launch. The new roles must be filled by individuals, and some service providers may be willing to provide individuals to serve such roles. We recommend fund managers discuss anti-money laundering compliance with offshore counsel and the fund’s administrator.

Other Matters 

FINRA Warns of Regulator Impersonators. On July 13, FINRA issued a warning that persons claiming to be working for FINRA have been calling firms and attempting to obtain confidential information. In particular, FINRA warned that the use of overseas telephone numbers or email addresses indicates a likely scam, as well as emails from suspicious domains that do not end with “@finra.org” and that contain attachments or embedded links. If you have questions about the legitimacy of purported FINRA communications, contact your FINRA Coordinator.

New York Issues Sexual Harassment Compliance Mandate. Managers with operations in New York State and New York City should be aware of recent changes to employers’ obligations with respect to sexual harassment. Effective October 9, 2018, all employers in New York State are required to adopt a sexual harassment prevention policy equal to or greater than the standards of the state-issued model policy. Additionally, New York State employers must provide sexual harassment prevention training annually that is equal to or greater than the state-created model. This training must be completed by current employees by January 1, 2019, and by new hires within 30 days of being hired. Managers that may be subject to these new requirements can learn more on New York State’s Combating Sexual Harassment in the Workplace website. New York City has also implemented similar training requirements for employers with 15 or more employees, which will take effect on April 1, 2019. Additionally, effective September 6, 2018, New York City employers must post a sexual harassment poster and distribute a fact sheet to new employees.

SEC Charges Firm for Deficient Cybersecurity. On September 26, the SEC settled charges against a broker-dealer/investment adviser based on the firm’s deficient cybersecurity procedures after parties posing as contractors accessed customers’ personal information. The charges are a reminder of the importance of maintaining strong cybersecurity policies and procedures. Firms should be aware that cybersecurity is an on-going obligation and has become a focus of the SEC.

IRS Ends Voluntary Disclosure Program. On September 28, the Internal Revenue Service ended the 2014 Offshore Voluntary Disclosure Program (“OVDP”). U.S. taxpayers are required to report and pay taxes on certain offshore assets and face potential stiff criminal and civil penalties for failing to do so, and the OVDP was designed to offer taxpayers certain protections from these penalties. Fund managers with unreported foreign assets that were not able to meet the September 28, 2018 deadline should discuss their options with tax counsel.

New Law Expands Disclosure and Approval Requirements for Investments by Foreign Entities. On August 13, the Foreign Investment Risk Review Modernization Act (“FIRRMA”) was signed into law. It expands the scope of investments by non-U.S. investors in critical domestic tech companies that must be disclosed to and approved by the federal government in an effort to strengthen national security. An example investment within the scope of FIRRMA is an investment by a non-U.S. entity in a tech company that gives the investing entity access to material non-public technical information. While there are limits and exemptions to the scope of FIRRMA and the typical fund will not need to worry about its new requirements, venture funds with foreign limited partners or foreign co-investors should be mindful of the expanded approval requirements.

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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
October 10, 2018 Form 13H amendment due for large traders if the information contained in the filing became inaccurate in Q3
October 15, 2018 Quarterly Form PF due for Large Liquidity Fund Advisers (for funds with December 31 fiscal year-ends) filing for Q3 2018 (if applicable)
October 15, 2018 Extended deadline to file Reports of Foreign Bank and Financial Accounts (FBAR)
October 30, 2018 Registered investment advisers must collect access persons’ personal securities transactions
November 14, 2018 Form PR filings for registered CTAs that must file for Q3 within 45 days of the end of Q3 2018
November 14, 2018 Form 13F is due for certain institutional investment managers
November 30, 2018 Form PF filings for Large Hedge Fund Advisers with December 31 fiscal year-ends filing for Q3 2018
November 30, 2018 Large registered CPOs must submit a pool quarterly report (CPO-PQR)
December 17, 2018 Deadline for paying annual IARD charges and state renewal fees
December 31, 2018 Small and mid-sized registered CPOs must submit a pool quarterly report (CPO-PQR)
December 31, 2018 Deadline for CIMA-registered Cayman funds formed prior to June 1, 2018 to confirm the identity of appointed anti-money laundering officers via REEFS; deadline for unregistered Cayman funds to appoint anti-money laundering officers
December 31, 2018 Cayman funds regulated by CIMA that intend to de-register (i.e. wind down or continue as an exempted fund) should do so before this date in order to avoid 2019 CIMA fees
Periodic Fund managers should perform “Bad Actor” certifications annually
Periodic Amendment due on or before anniversary date of prior Form D and blue sky filing(s), as applicable, or for material changes
Periodic CPO/CTA Annual Questionnaires must be submitted annually, and promptly upon material information changes

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 – Third Quarter 2018

The third quarter of 2018 saw increased interest from regulators in the digital asset space, as well as enforcement actions. For your convenience, we have provided an overview of key items from the quarter below.

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SEC MATTERS

Enforcement

SEC Charges Digital Asset Hedge Fund Manager

On September 11, the Securities and Exchange Commission (“SEC”) announced the settlement of charges against a digital asset hedge fund and its manager. The charges included misleading investors, offering and selling unregistered securities, and failing to register the hedge fund as an investment company. The manager marketed the fund as the “first regulated crypto asset fund in the United States” and claimed the fund had filed registration statements with the SEC. Based on investments in “digital assets that were investment securities”, the fund was required to register as an investment company with the SEC. However, the fund was not registered and did not meet any exemptions or exclusions from the investment company registration requirements. The settlement included cease-and-desist orders, censure, investor rescission offers, and a $200,000 penalty. This is the first action the SEC has taken against a digital asset fund based on violations of the investment company registration requirements.

SEC Charges ICO Platform for Operating as Unregistered Broker-Dealer

On September 11, the SEC settled charges against an initial coin offering (“ICO”) platform. The business and its principals were charged with failing to register as broker-dealers and selling unregistered securities. This is the SEC’s first charge against an unregistered broker-dealer in the digital asset space following the SEC’s 2017 DAO Report, which cautioned anyone offering or selling digital assets to comply with federal securities laws such as broker-dealer registration requirements. The business agreed to pay $471,000 plus prejudgment interest, and the principals each agreed to a three-year bar from certain investment-related activities and $45,000 in penalties.

SEC Fines and Halts Fraudulent ICO

On August 14, the SEC settled charges related to an ICO. The token issuer was charged with fraud and the sale of unregistered securities after it claimed the proceeds from its ICO would be used to fund oil drilling in California. However, the issuer falsely represented that it had the necessary drilling lease and misled investors about the potential for profit and the prior bankruptcy and criminal history of the issuer’s principal. The settlement included permanent cease and desist orders, a permanent bar from certain investment-related activities, and a $30,000 fine. In light of recent charges like this, fund managers investing in ICOs should ensure they complete adequate due diligence on investment opportunities.

Other

SEC Denies and Delays Bitcoin ETFs

On August 22, the SEC released three separate orders denying nine Bitcoin exchange-traded fund (“ETF”) proposals. These orders followed the SEC’s July 26 denial of another Bitcoin ETF. The SEC’s reasoning in these denials was mainly based on a concern that the price of Bitcoin may be susceptible to manipulation. However, on September 20, the SEC announced that it has begun a formal review for a physically-backed Bitcoin ETF. The acceptance of such an ETF would increase digital asset investment options and has the potential to promote the overall growth of the industry.

SEC Suspends Trading of Swedish Bitcoin Instruments

On September 9, the SEC temporarily suspended trading of two foreign cryptocurrency investment instruments commonly known as the “Swedish Bitcoin ETFs”. The instruments hold Bitcoin on behalf of shareholders and, prior to the suspension, had been tradable in U.S. brokerage accounts. The SEC suspended the ETFs out of a concern for investor confusion, which was likely based on inconsistent representations. The issuers’ broker-dealer applications referred to the instruments as ETFs, other sources characterized them as exchange-traded notes, and the issuers’ offering memoranda described them as “non-equity linked certificates”. With this suspension in mind, fund managers considering investing in novel digital asset instruments should ensure they understand the nature of the instruments.

CFTC MATTERS

Investor Alerts

CFTC Stresses Due Diligence in ICO Investments

On July 16, the Commodities Futures Trading Commission (“CFTC”) published an alert cautioning investors to conduct extensive research before investing in any ICO, especially those that claim to be utility tokens (i.e. non-securities). The alert includes factors that investors should consider before investing in a token offering, such as the potential for forks, mining costs, liquidity, and risk of hacks.

Enforcement

Court Enters Final Order for CFTC Charges Against Crypto Company

On August 23, a New York federal court entered final judgment against a digital asset company based on charges brought by the CFTC. The company claimed that, in exchange for sending digital assets, customers could receive expert crypto trading advice or have the company trade on their behalf. However, no such expert advice or trading services were provided. The company was charged with fraud and the final judgment included a permanent injunction from certain investment-related activities, more than $290,000 in restitution, more than $871,000 in civil penalties, and post-judgment interest.

NFA MATTERS

NFA Requires CPOs and CTAs to Disclose Digital Asset Activity

On July 20, the National Futures Association (“NFA”) released a notice that imposed new disclosure requirements on futures commission merchants, commodity pool operators (“CPOs”), and commodity trading advisers (“CTAs”) engaged in digital asset activity. Specific to CPOs and CTAs, the NFA is now requiring discussion of certain aspects of digital asset investing, such as volatility, liquidity, and cybersecurity, as well as the inclusion of certain standardized disclosures. Additional details are available in our recent blog post.

FINRA MATTERS

FINRA Charges Broker with Fraud and Unlawful Distribution for Token Offering

On September 11, the Financial Industry Regulatory Authority (“FINRA”) charged a broker in connection with a token offering. The broker attempted to raise money through the offering for an allegedly worthless public company and, in the process, misled investors about the company’s operations and finances. The broker is charged with making material misrepresentations, offering and selling unregistered securities, and failing to notify the broker’s firm about the transactions. This is FINRA’s first disciplinary action involving digital assets.

FEDERAL LEGISLATION

Congressional Representative Introduces Crypto-Friendly Bills

On September 21, Minnesota Congressional Representative Tom Emmer announced three crypto-friendly bills. The first bill would codify an overall “light touch, consistent, and simple” approach to digital asset regulation. The second bill would provide a safe harbor for certain businesses that lack control over consumer funds by exempting them from certain regulations, such as money transmitter licensing requirements. Lastly, the third bill would limit fines for taxpayers that failed to fully report forked digital assets until the Internal Revenue Service (“IRS”) provides further guidance on how such forks should be reported.

STATE MATTERS

New York

New York Attorney General Releases Report on Digital Asset Exchanges

On September 18, the Office of the Attorney General of New York (the “OAG”) released a report summarizing a crypto exchange fact-finding initiative. The report outlines three primary areas of concern:

  • Conflicts of Interest – Crypto exchanges are exposed to potential conflicts of interest in several ways. For example, exchanges often have additional lines of business (e.g. broker-dealer) that would either be prohibited or carefully monitored in traditional securities contexts. Additionally, employees may have access to non-public information, and may hold and trade digital assets on their employer’s or competitors’ exchanges. Some exchanges also lack standards for determining which tokens are listed, and the possibility that an exchange may take fees for such a listing create a potential conflict of interest.
  • Lack of Anti-Abuse Efforts – Digital asset exchanges have not consistently implemented safeguards to protect the integrity of their platforms. Such safeguards include monitoring real-time and past trades, and restricting the use of bots. Additionally, some exchanges engage in proprietary trading (i.e. trading from the exchange’s own account in order to, for example, promote market liquidity) which may expose users to price manipulation or other abuse.
  • Limited Customer Funds Protections – Exchanges lack a consistent and transparent approach to auditing the digital assets they hold. Additionally, several exchanges do not have independent audits completed. These shortcomings make it difficult to determine whether crypto exchanges adequately maintain and protect customers’ assets. The OAG also raised concerns over whether exchanges have adequate protection against hacks and maintain sufficient insurance policies.

Digital asset fund managers should keep these concerns in mind and ensure they properly vet exchanges they may utilize.

Court Rules ICO Tokens May Be Subject to Securities Laws

On September 11, the U.S. District Court for the Eastern District of New York ruled that a criminal case brought against the individual behind two ICOs can proceed to trial. The defendant faces conspiracy and securities fraud charges for allegedly making false claims that the tokens sold in the ICOs were backed by real estate and diamonds. The defendant moved to dismiss the case on the grounds that securities laws are too vague to apply to ICOs, and that the issued tokens were not securities. The issue of whether the tokens in question are securities may now ultimately be decided by a jury.

Texas

Texas Issues Emergency Cease and Desists Against Crypto Investment Scheme

On September 18, the Securities Commissioner of Texas (the “Commissioner”) released three orders related to digital asset investment schemes. First, the Commissioner issued a cease and desist order against a mining company that used promotional materials falsely implying third-party endorsements and associations. Second, the Commissioner issued a cease and desist order against a company that solicited investments to develop a biometric token wallet. The business misled investors with a video of former President Barack Obama that falsely implied he was discussing the company. The business also made unsubstantiated claims, for example, that it was backed by “a leading financial institution”. Lastly, the Commissioner issued a cease and desist order against a company that solicited investments for its crypto and forex trading programs. The company told investors they could earn 10x returns, that those returns were guaranteed, and that there was no investment risk. All orders allege that the companies violated securities laws by offering and selling unregistered securities, engaging in fraud, and making materially misleading statements. These orders further highlight the need for fund managers to conduct due diligence on digital asset investment opportunities.

OTHER MATTERS

Statements

Congressional Representatives Urge IRS to Provide Guidance on Cryptocurrency

On September 19, five members of the House of Representatives published a letter urging the IRS to issue updated guidance on digital asset taxation. The last major guidance from the IRS, Notice 2014-21, was issued in March 2014. Since then, the IRS has increased digital asset scrutiny by, for example, requesting transaction records from crypto exchanges and choosing not to provide leniency through a voluntary crypto disclosure program. Such guidance would hopefully resolve some of the tax uncertainties digital asset fund managers currently face.

NASAA Announces Coordinated Digital Asset Investigations

On August 28, the North American Securities Administrators Association (“NASAA”) announced that regulators in the U.S. and Canada are engaged in more than 200 digital asset-related investigations as part of a coordinated NASAA initiative known as “Operation Cryptosweep”. While investigations have focused on suspected securities fraud, regulators have uncovered other violations, such as the offer and sale of unregistered securities. The initiative has resulted in at least 46 enforcement actions related to ICOs or digital asset investment products.

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