Monthly Archives: October 2019

Cole-Frieman & Mallon 2019 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 you had an enjoyable summer. Typically, the third quarter is quieter than the second quarter from a compliance perspective, however we continue to see meaningful enforcement actions taken by regulatory authorities and rapid developments in the digital asset space. Entering the fourth quarter, we would like to highlight some items we hope will help you stay on top of the business and regulatory landscape in the coming months.  But first, a couple of items of firm news:

  • CoinAlts Fund Symposium. In September, In September, founding sponsor CFM broke new ground to host its fourth successful Symposium in Chicago. An impressive line-up of speakers addressed pressing issues for institutions in the digital asset ecosystem, including legal and operational concerns for fund managers, recent trends and innovations in blockchain, and raising capital from institutional allocators.
    • Cole-Frieman & Mallon’s Anniversary. On September 17th CFM celebrated with family, friends, colleagues and clients 10 years of successful growth to become the largest hedge fund practice in the West Coast. We very much appreciate the continued support from our clients and friends in the industry and look forward to the next decade of success.


Privacy Regulations

Cayman Islands Data Protection Law Effective September 30, 2019. The Cayman Islands Data Protection Law, 2017 (“DPL”) became effective on September 30, 2019 and applies to all investment advisers providing investment advice to Cayman Islands funds. Under the DPL, Cayman investment funds are considered “data controllers” whether or not they are registered with the Cayman Islands Monetary Authority and investment advisers to such funds are considered “data processors.” The DPL requires data controllers to update their Cayman fund’s subscription agreements to include language specific to the DPL and otherwise provide investors with an updated DPL-compliant privacy notice. There is no specific deadline to provide investors with such privacy notice. Fund administrators must also ensure that they are DPL-compliant and updates to the fund’s administration agreement may be required.

California Consumer Privacy Act to be Effective January 1, 2020. The California Consumer Privacy Act (the “Act”) was passed into California law on June 28, 2018 and will be effective on January 1, 2020. The Act will not apply to most fund managers and will generally only impact managers that serve California residents and have at least $25 million in annual gross revenue, have personal data on at least 50,000 Californians, or receive over half their revenues from the sale of personal data of California residents. The Act does not apply to current client data and, on October 11, 2019, Governor Newsom signed seven amendments into law that generally limit the Act’s reach even further. If the Act were to apply to a fund manager, to be in compliance, such fund manager should post a privacy policy on its website disclosing its collection of personal information, maintain an organized data collection process, and provide investors information regarding the use of their information and the right to opt-out of the sale and request the deletion of such information.

New York SHIELD Act Heightens the State’s Privacy Regulations. On July 25, 2019, the Stop Hacks and Improve Electronic Data Security Act (the “SHIELD Act”) was signed into New York law and amends the State’s data breach notification law. The SHIELD Act, which is set to take effect in March 2020, requires certain businesses or individuals implement safeguards to protect the security, confidentiality and integrity of information. The SHIELD Act broadens the definition of “private information” to include credit card or debit card numbers, usernames and passwords (or security questions and answers) used to access an individual’s online accounts, and biometric information, like fingerprints. The SHIELD Act also expands the definition of “breach”, from unauthorized acquisition of private information to include unauthorized access to private information, as well as the scope of the breach notification requirement to include any person or business that owns or licenses private information of a New York resident. This means the law is no longer limited to those conducting business in New York, but could affect managers who, for example, only store a New York investor’s private information. Because of the broad scope of the SHIELD Act, managers who own private information of a New York resident should review the updated security requirements the Act imposes on them, including the need to implement a data security program, as more specifically discussed in the SHIELD Act.

SEC Matters

SEC Publishes Risk Alert on Principal and Agency Cross Trading Compliance Issues. On September 4, 2019, the Securities and Exchange Commission (“SEC”) published a Risk Alert advising readers on common compliance issues identified in investment adviser examinations, related to principal and agency cross transactions under Section 206(3) of the Investment Advisers Act of 1940, as amended (the “Advisers Act”). These transactions occur when investment advisers execute client transactions as a broker or dealer, either acting as a broker or dealer for its advisory client or doing so for both its advisory client and its brokerage client on the other end of the same transaction. The examinations the SEC conducted showed advisers either did not know they had engaged in principal trades or did not disclose or obtain the required consent before completing the transactions. With respect to agency cross transactions, the examinations also showed advisers often engaged in agency cross transactions without properly disclosing this to clients or could not show proof they had complied with the applicable consent or disclosure requirements. The Risk Alert also expressed concern that many advisers engaging in these transactions either did not have proper compliance policies and procedures or failed to follow the policies and procedures that had been established. Advisers should look closely at potential transactions to determine whether they qualify as either principal trades or agency cross transactions and if so, what actions need to be taken to comply with the respective requirements.

SEC Charged RIA for Nondisclosure of Conflicts Arising from Revenue Sharing. On August 1, 2019, the SEC  charged an SEC RIA for failure to disclose conflicts of interest relating to a revenue sharing agreement with the broker used by most of its clients. The revenue sharing agreement provided that, if the adviser invested its client assets in certain classes of mutual funds that paid the broker to be listed on its platform, the adviser would receive a portion of those payments. The adviser received over $100 million from the broker from July 2014 to December 2018 because of this arrangement. However, the adviser never disclosed to its clients that there were other mutual fund investments less expensive than the investments subject to the revenue sharing agreement. The SEC considered these to be material omissions and determined the adviser’s clients did not make these investments with full knowledge of the adviser’s incentives. Fund managers should ensure that all pertinent conflicts of interest, including those related to the receipt of compensation from third parties, are properly disclosed to their clients.

FINRA Matters

FINRA Proposes Changes to Restricted Person and Spinning Provisions.  On July 26, 2019, FINRA, along with the SEC, proposed certain amendments to FINRA Rules 5130 and 5131. One of the amendments would exempt certain additional persons and certain types of offerings from the scope of the rules. Among other changes (eight total), the proposals would (i) include the definitions of “family member” and “family client” as defined under the Advisers Act in the definition of “family investment vehicle” under Rule 5130, (ii) exempt foreign employee retirement benefit plans that meet certain conditions from Rules 5130 and 5131 and (iii) exclude unaffiliated charitable organizations from the definition of “covered non-public company” in Rule 5131. If these changes are approved and become effective, fund managers can expect further regulatory consistency and clarity to result.

Digital Asset Matters

Bakkt Announces that it’s “Cleared to Launch” Bitcoin Futures. Bakkt, a bitcoin futures exchange and digital assets platform founded by the Intercontinental Exchange (“ICE”), announced in mid-August that the CFTC gave its go-ahead for Bakkt’s futures contracts. The announcement discussed that Bakkt’s bitcoin futures would be exchange-traded on ICE Futures U.S. and cleared on ICE Clear US, both of which are regulated by the CFTC. Bakkt further announced that it acquired a New York state trust charter through the New York State Department of Financial Services, and that this approval to create Bakkt Trust Company, a qualified custodian, would allow the Bakkt Warehouse, which is part of Bakkt Trust Company, to provide bitcoin custodial services for physically delivered futures. On September 23, 2019, Bakkt launched its custody and physically-settled bitcoin futures contracts products. Many disagree whether the launch, which had a trade volume during the first seven days of $5.8 million, was successful or not, and certain researchers speculate the launch was partially why bitcoin’s price has recently decreased. Despite this, the news of the launch can potentially benefit fund managers as Bakkt aims to provide access to this market and address issues that have slowed institutional participation in this market in the past.

SEC Delays Decision on Three Bitcoin ETFs. On August 12, 2019, the SEC once again delayed a decision on three bitcoin ETF proposals.  As of yet, the SEC has not approved a bitcoin ETF. In previous decisions, the SEC expressed concerns with market manipulation, market surveillance and a possible divergence with futures trading. One of the entities proposing a bitcoin ETF published reports addressing these concerns and indicating that the actual bitcoin market is more regulated and surveilled than expected. This ETF proposal received support from a number of well-known individuals in the industry. In fact, Cole-Frieman & Mallon submitted a comment to the SEC with respect to this ETF proposal in June. Unfortunately, on October 9, 2019, this ETF proposal was rejected as the proposal reportedly did not meet the legal requirements necessary to prevent market manipulation or other fraudulent activities. As another of the entities proposing a bitcoin ETF recently withdrew its proposal from SEC review, there remains only one bitcoin ETF proposal sitting before the SEC. Fund managers interested in the digital asset space should stay apprised of future developments regarding this ETF proposal and others that may follow.

FINRA Approves Membership of Placement Agent for Privately Placed Digital Securities. On August 7, 2019, FINRA approved the membership application of a placement agent for privately placed, digital securities on a permissioned blockchain platform developed by its parent company. It took the placement agent 18 months to get approved, which is longer than what is typically seen, as it had to prove to FINRA that it met regulatory requirements. The approval allows the placement agent to issue securities, provide services as a broker for digital securities, and potentially enter the secondary trading business. This approval stands out as many applications have been waiting to hear back from FINRA for months, and sometimes more than a year. Specifically, this approval will expand investment opportunities for investors and provide fund managers with a streamlined tool to utilize in its investment processes.

SEC Freezes $8 Million in Assets Related to Fraudulent Scheme to Sell Digital Securities to Investors. On August 12, 2019, the SEC froze $8 million in assets raised by an individual and two companies he owns. Allegedly, the parties sold their own token on the internet and induced investors to invest in the token based on material misrepresentations and omissions. The complaint also alleged that the individual manipulated the token price and transferred a significant amount of investor assets to his own personal account. The SEC charged the parties with violating the registration and antifraud provisions of the Federal securities laws and further charged the individual for violating antifraud provisions by manipulating the price of tokens. While this digital asset age has certainly shown promise and innovation, fund managers should be on alert for fraudulent schemes such as this.

SEC Charges Group Operating Unregistered Digital Asset Exchange. On August 29, 2019, the SEC settled charges with a company and its founders who created and sold unregistered tokens to more than 13,000 investors. The founders allegedly falsely claimed each token provided an interest in the company’s cryptocurrency mining facility using below-market rate electricity. In reality, the mining facility did not exist. The company and its founders also allegedly illegally operated an unregistered national security exchange to trade the single token. As new and exciting opportunities in the digital asset space continue to emerge, investors should proceed with caution and should conduct ample due diligence prior to moving forward with such opportunities.

IRS Targets Cryptocurrency Investors with Educational Letter about Back Taxes. In July, the IRS began sending educational letters to taxpayers who have purchased or sold cryptocurrencies but either did not report the income entirely or did not report the income correctly. There are three variations of this letter that more than 10,000 taxpayers will receive, depending on how or if the transactions were reported: Letter 6173, 6174 and 6174-A. In mid-August, the IRS began sending a second round of letters to relevant taxpayers. This notice, which the IRS calls CP2000, is aimed at taxpayers that the IRS has actual records of, showing that there is a discrepancy between the trading profits or losses reported by the taxpayer and what third parties (like exchanges) report to the IRS. The notice includes an amount that each recipient taxpayer is expected to pay in 30 days, with interest. Taxpayers trading cryptocurrency can expect the IRS to ramp up these types of letters and notices and should properly report their transactions to the IRS when filing tax returns to avoid penalties.

SEC Approves First-Ever Reg A+ Token Offering. On July 12, 2019, Blockstack became the first company in history to receive SEC approval for a public securities offering where investors would receive tokens, in this case, called “Stacks”. Blockstack raised a total of $23 million from more than 4,500 investors. $15.5 million was raised through a Reg A+ sale in the United States and the other $7.6 million was raised through a Reg S offering in Asia. Blockstack is working with international exchanges to list Stacks tokens potentially as soon as October 2019. While the full effects of this approval are not yet determined, the SEC’s approval has potential to create a new regulatory roadmap for public token offerings.

FINRA and SEC Issue Joint Statement on Custody of Digital Assets by Broker-Dealers. On July 8, 2019, FINRA and the SEC issued a statement expressing the challenges facing broker-dealer’s custody of digital assets. The statement discussed that a broker-dealer seeking to custody such assets must, like all broker-dealers, comply with the SEC’s Customer Protection Rule. This rule protects customer securities and funds held by broker-dealers by requiring broker-dealers to keep customer assets separate from their firm’s assets, making it more likely that customers’ securities and assets can be returned to them in the case of a broker-dealer’s failure. Many unregistered entities and registered broker-dealers that want to engage in activities involving digital asset securities have been submitting applications to FINRA in the hope that FINRA will allow them to engage in such activities. How these entities could custody digital asset securities while complying with the Customer Protection Rule is still under discussion, but as a start, broker-dealers would need to put in place significant technological enhancements unique to digital asset securities.


Compliance Calendar.

Please note the following important dates as you plan your regulatory compliance timeline for the coming months:

Deadline Filing
October 10, 2019 Form 13H amendment due if there were changes during Q3
October 15, 2019 Quarterly Form PF due for Large Liquidity Fund Advisers
October 15, 2019 Extended deadline to file Reports of Foreign Bank and Financial Accounts (FBAR)
October 30, 2019 Registered investment advisers must collect access persons’ personal securities transactions
November 1, 2019 Registered investment advisers that seek to withdraw registration with the SEC may begin to submit Form ADV-W‘s, which must be dated 12/31/19
November 11, 2019 Firm may view, print and pay preliminary notice filings (RIA) with all appropriate states
November 14, 2019 Form 13F is due for certain institutional investment managers
November 14, 2019 Form PR filings for registered CTAs that msut file for Q3 within 45 days of the end of Q3 2019
November 29, 2019 Form PF filings for Large Hedge Fund Advisers with December 31 fiscal year-ends filing
November 29, 2019 Large registered CPOs must submit a pool quarterly report (CPO-PQR)
December 16, 2019 Deadline for paying annual IARD charges and state renewal fees
December 31, 2019 Small and mid-sized registered CPOs must submit a pool quarterly report (CPO-PQR)
December 31, 2019 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 2020 CIMA fees
January 1, 2020 California Consumer Privacy Act goes into effect
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.