October 20, 2023

Clients, Friends, and Associates:

As we end the third quarter and enter the fall season, we would like to highlight some of the recent industry updates and occurrences we found to be both interesting and impactful. The summaries below are intentionally brief. Please feel free to explore the links included and reach out to us if you have any related questions.

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CFM Items

Cole-Frieman & Mallon LLP, along with industry leaders MG Stover, Harneys, and KPMG, is a premier sponsor of the CoinAlts Annual Fund Symposium, which is being held in San Francisco on October 26, 2023. This annual event brings together the digital asset community to address investment, legal, and operational issues relevant to private fund managers. The CoinAlts Annual Fund Symposium is a must-attend gathering for industry professionals, providing unparalleled insights and networking opportunities. Join us for expert panels, top-notch speakers, and the chance to stay ahead of the curve in this rapidly evolving industry. More information is available at https://coinalts.xyz/.

Our firm was proud to sponsor the 14^th annual Sohn San Francisco Investment Conference that took place on September 26, 2023. The event brought together top investment managers and allocators to discuss specific investment ideas and the fund investment environment. The conference supported Bay Area organizations focused on improving educational opportunities and life outcomes for underserved youth. A portion of the proceeds also benefitted the Sohn Conference Foundation in its dedicated efforts to treat and cure pediatric cancer and other public health priorities. We were excited to be a part of this important event where attendees learned from some of the brightest minds in the investment world and supported a great cause. Cole-Frieman & Mallon LLP was also a proud sponsor of the Help For Children 2023 Denver Golf Tournament in Littleton, Colorado on September 22, 2023. The organization focuses on the prevention and treatment of child abuse and neglect.

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SEC Matters

SEC Begins Enforcement for Violations of the New Marketing Rule. In a September 11, 2023 press release, the Securities and Exchange Commission (“SEC”) announced that it charged nine registered investment advisers for showing hypothetical performance results on their websites without adopting the necessary policies and procedures required under the SEC’s new marketing rules and regulations (the “New Marketing Rules”). This targeted sweep is the first of its kind following the New Marketing Rules’ compliance deadline in November 2022.

As discussed in our July 2021 Update, the New Marketing Rules permit the use of hypothetical performance metrics if the investment adviser follows certain requirements aimed at protecting investors. These requirements include implementing policies and procedures that are “reasonably designed to ensure that the hypothetical performance is relevant to the likely financial situation and investment objectives of the intended audience of the advertisement.”

The press release noted that all nine firms published hypothetical performance results to the public rather than to their specific intended audience. In doing so, the accused could not ensure that all viewers had the necessary context to accurately understand the hypothetical performance results. The SEC’s Division of Enforcement Director, Gurbir Grewal, noted the “attention-grabbing power” of hypothetical performance on prospective investors who may conflate the advertised strategies with their own investment objectives. Additionally, two of the firms also failed to comply with record-keeping rules which required their firms to keep a copy of every advertisement disseminated.

These nine enforcement actions came quickly on the heels of the SEC’s first enforcement action alleging violations of the New Marketing Rules. In August 2023, the SEC charged a New York-based FinTech investment adviser of misleading investors with hypothetical performance results. The complaint alleged that the adviser’s marketing materials made claims of annualized returns of 2700%, but the underlying data was taken from only a three-week period.

The SEC’s active approach to enforce the New Marketing Rules sends a stern reminder to SEC-registered fund managers to remain diligent when preparing marketing materials. We encourage managers to review their marketing materials to ensure compliance if they have not done so already.

SEC Charges Fund Administrator for Missing Red Flags. On August 7, 2023, the SEC instituted cease and desist proceedings against a fund administrator (the “Administrator”) for failing to identify and appropriately respond to red flags involving a private fund client. The SEC asserted that the Administrator, at the behest of the fund’s sponsor, calculated the fund’s net asset value without including trading losses, resulting in materially overstated values in the investors’ account statements. The SEC has since accepted the Administrator’s settlement offer, which includes a civil penalty of $100,000, a disgorgement of $18,000, and a prejudgment interest of $4,271.

SEC Adopts Final Rules for Private Fund Advisers. On August 23, 2023, the SEC issued final rules focused on investment advisers who manage private funds (the “New Private Fund Adviser Rules”). We provide a brief summary of the key elements of the New Private Fund Adviser Rules below.

Rules for SEC-Registered Investment Advisers

The Quarterly Statement Rule requires SEC-registered investment advisers (“RIAs”) to provide new quarterly disclosures to fund investors about fees, expenses, and the fund’s performance metrics. This rule also introduces standardized reporting metrics to be used by private funds.

The Audit Rule requires RIAs to obtain annual audited financial statements for each of its fund clients. However, the SEC notes that any adviser who remains in compliance with the audit requirements of rule 206(4)-2 (i.e., the custody rule) of the Investment Advisers Act of 1940, as amended (the “Investment Advisers Act”), will also be in compliance with the Audit Rule.

The Adviser-Led Secondaries Rule requires RIAs to obtain a fairness opinion or valuation opinion and provide a summary of any material business relationships when asking investors to approve an adviser-led secondary transaction.

The Annual Review Rule will amend current rule 206(4)-7 (i.e., the compliance procedures and practices rule) of the Investment Advisers Act, which will now require all RIAs to document their annual compliance review in writing.

The Recordkeeping Rule will amend the current rule 204-2 (i.e., the recordkeeping rule) of the Investment Advisers Act to require RIAs to retain books and records related to the provisions of the New Private Fund Adviser Rules.

Rules for all Private Fund Investment Advisers

The Restricted Activities Rule restricts advisers from engaging in the following activities unless they are sufficiently disclosed or investor consent is obtained, as applicable: (i) allocating fees and costs from any governmental or regulatory investigation of the adviser to the fund; (ii) allocating regulatory or compliance fees, or fees or expenses associated with an examination, of the adviser to the fund; (iii) reducing carried interest clawbacks based on the adviser’s actual or estimated taxes incurred; and (iv) allocating fees from a portfolio investment among the adviser’s funds and other clients on a non-pro rata basis.

The Preferential Treatment Rule prohibits an adviser from giving preferential treatment to a prospective investor relating to (i) redemption rights and (ii) information rights of portfolio holdings which the adviser believes would have a material, negative effect on other investors. The rule allows for other forms of preferential treatment to certain investors, but the material terms of this preferential treatment must generally be disclosed, in writing, to all other investors and prospective investors. Advisers must also distribute an annual notice to all investors disclosing any preferential treatment provided to investors since the most recent notice was provided.

Next Steps

The compliance date for the New Private Fund Adviser Rules is determined by the size of the funds, and many deadlines remain years away. Ongoing litigation initiated by industry participants may further delay the effectiveness of these rules. On September 1, 2023, the Managed Funds Association, along with a number of other organizations, jointly filed a lawsuit against the SEC to prevent the adoption of the finalized rules, claiming the SEC has overstepped its authority and that these changes may increase costs, reduce opportunity, and harm both private funds and their investors.

The New Private Fund Adviser Rules have the potential to bring widespread change to the private funds industry, and managers must review their policies and procedures to ensure compliance. However, pending litigation against the SEC reflects the fierce resistance from some within the industry and reminds us that further changes may be introduced in the following months as compliance deadlines draw nearer.

SEC Proposes New Rules to Address Conflicts of Interest Presented by Predictive Data Analytics. On July 26, 2023, the SEC proposed new rules aiming to address conflicts of interest associated with the use of predictive data analytics (“PDA”) and other similar AI-powered tools. This announcement comes at a time when AI has supercharged the adoption of such tools by investment management professionals. The proposed rules reflect the SEC’s primary concern that PDA technologies may produce biased data or suggest biased outcomes, favoring investment advisers and broker-dealers over investors. The proposed rules aim to combat conflicts of interests created by these “covered technologies,” which the SEC defines broadly as “analytical, technological, or computational functions, algorithms, models, correlation matrices, or similar methods or processes that optimize for, predict, guide, forecast, or direct investment-related behaviors or outcomes of an investor.”

The proposed rules require the users of PDA technologies to evaluate whether the technology could reasonably create a conflict of interest. The SEC did not create strict guidelines for this evaluation process, instead noting that the complexity of the evaluation will likely correlate to the complexity of the tool. Certain covered technologies, such as “black-box” tools where data inputs are not disclosed to end users, may be impossible to fully evaluate. In these cases, the SEC forbids the use of such a tool if the user cannot identify all potential conflicts from a PDA technology. Investment advisers will also be required to have written policies and procedures in place describing a tool’s conflict evaluation process and the processes for neutralizing and eliminating any identified conflicts. The proposed rules also introduce six new types of records that must be kept relating to covered technologies.   

The proposed rules serve as a poignant reminder that while AI continues to bring exciting new breakthroughs to the investment advisory business, it remains important to understand any biases or other pitfalls that such tools can present.

SEC Proposes Amendments to the Internet Adviser Exemption. On July 26, 2023,  the SEC proposed new amendments to rule 203A-2(e) of the Investment Advisers Act, otherwise known as the “Internet Adviser Exemption.”

In keeping with the spirit of the original rule while modernizing it to reflect new technologies, the proposed amendments clarify that an internet investment adviser is required to have an “operational” interactive website (which includes smartphone applications) at all times while relying on the Internet Adviser Exemption. To be considered operational, the website or application must provide “digital investment advisory services” on an ongoing basis to more than one client, which the SEC defines as advice generated by software-based models, algorithms, or applications. Once the proposed amendments are implemented, an investment adviser relying on this exemption can only provide investment advice through the operational interactive website. Investment advisers relying on this exemption will further be required to amend their Form ADV. The proposed amendments aim to modernize the Internet Adviser Exemption in response to the technological advancements and evolution of the investment advisory industry since its original adoption in 2002.

SEC Adopts Cybersecurity Rule for Public Companies. On July 26, 2023, the SEC adopted a final rule that will require public companies to disclose information about cybersecurity risk management, strategy, governance, and incident reporting. This rule was approved by the SEC ahead of a similar cybersecurity risk management rule specific to investment advisers, which the SEC is slated to approve sometime in October of 2023.

This rule will require public companies to adopt a myriad of cybersecurity practices and controls that encompass a variety of new compliance and disclosure obligations, including: (i) the disclosure of information regarding material cybersecurity incidents within four days after determining such event was material; (ii) describing in a public filing the material aspects of the scope, nature, and timing of any such incidents; (iii) creating detailed company policies for detecting and mitigating cybersecurity threats; and (iv) describing in a public filing the role of the public companies’ board of directors in assessing and managing cyber threats.

This new rule will impose more affirmative and stringent obligations on public companies to report cybersecurity incidents and to provide greater transparency about their cybersecurity practices. However, when compared to the impending cybersecurity risk management rule being directed at investment advisers, this public company version is more streamlined and requires fewer proscribed controls for these enterprise-level public companies whose resources and capabilities ironically far outweigh those of its investment adviser counterparts.

The SEC’s new cybersecurity risk management rule for investment advisers is expected to significantly expand the cybersecurity compliance obligations required of investment advisers. We intend to provide a detailed update on these rules once they are approved.

SEC Adopts Final Rules on Investment Company Names. On September 20, 2023, the SEC adopted amendments to rule 35d-1 of the Investment Company Act of 1940, as amended (the “Investment Company Act”). Commonly referred to as the “Names Rule”, the purpose of rule 35d-1 is to protect investors by requiring advisers to use names for their investment funds that align with the funds’ investment focus and risks.

The amendments expand the scope of the “80% investment policy” and now require any fund with a name suggesting specific types of investment invest at least 80% of its assets into those types of investments. This also includes any insinuations of particular characteristics such as the key words “growth” or “value.” The SEC also clarified that derivative investments can be counted toward the 80% benchmark, but advisers must use the investment’s notional value. Funds will be required to review their portfolio on a quarterly basis to ensure compliance with the rule. If a fund is found to be noncompliant, the fund will be granted a 90-day grace period to return to the 80% investment threshold.

The final rules will prohibit unlisted registered closed-end funds and business development companies that are required to comply with the 80% policy from changing that policy without a shareholder vote, unless: (i) the fund initiates a tender or repurchase offer and provides at least 60 days’ prior notice of the change to the policy; (ii) the offer is not oversubscribed; and (iii) the fund purchases shares at net asset value. Additionally, funds subject to the 80% investment policy must include definitions of any fund terms in their prospectus and such terms must follow their plain English meaning.

These amendments underscore the SEC’s view that an investment fund’s name can have a strong impact on potential investors, making it important that names accurately reflect the fund itself.

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Digital Asset Items

Terraform Labs Ruling Rejects Ripple Holding. On July 31, 2023, the U.S. District Court for the Southern District of New York sided with the SEC in the case of SEC v. Terraform Labs Ptd. Ltd. after it denied the defendants’ motion to dismiss. In doing so, the court rejected outright the holding in the recent summary judgment granted by another judge in the same District Court in SEC v. Ripple Labs Inc. For more information on SEC v. Ripple Labs Inc., check out our July 2023 Update from the Hedge Fund Law Blog.

The court in Terraform Labs found that both direct institutional investment sales and secondary market transactions involving retail investors were investment contracts, arguing that Howey makes no distinction between institutional and retail investors and concluded that the nature and type of purchases have no bearing on “whether a reasonable individual would objectively view the defendants’ actions and statements as evincing a promise of profits based on their efforts.” The court opted to apply the Howey test in a different manner than in Ripple Labs. In Ripple Labs, the court drew a distinction between sales of the XRP token to retail investors and institutional investors, holding that the sales of XRP to retail investors was not an investment contract because the purchasers did not have a reasonable expectation of profits from the efforts of Ripple Labs, Inc.

The inconsistent application of the Howey test from within the Southern District of New York illustrates the regulatory uncertainty surrounding the digital asset industry. We will continue to monitor similar cases brought by the SEC and other regulators.

Bittrex Settles with the SEC. On August 10, 2023, the SEC announced that crypto trading platform Bittrex agreed to settle charges that the company was operating an unregistered exchange, brokerage, and clearing house. As reported in our July 2023 Update, the SEC filed a complaint against Bittrex, alleging that the platform encouraged digital asset issuers to delete any public statements that insinuated that their tokens violate national securities laws. Bittrex agreed to settle for a total payment of $24 million, which will be paid within two months of filing a liquidation plan.

Digital Asset Taxation Updates. On July 11, 2023, the U.S. Senate Finance Committee issued a letter to the digital asset community, requesting feedback on existing digital asset tax law. In an effort to identify gaps and address uncertainties in digital asset taxation, the Committee is seeking input from stakeholders, experts, and other interested parties. This presents an opportunity for the digital asset community to proactively engage with the regulation and taxation of digital assets.

On July 31, 2023 the IRS announced in Revenue Ruling 2023-14 that a cash-method taxpayer who received staking rewards must include the fair market value of those rewards in the taxpayer’s gross income for the taxable year in which the taxpayer “gains dominion and control over the validation rewards.” This ruling is consistent with previous IRS views on the tax treatment of mining income, as per Notice 2014-21.

SEC Charges Media Company for Unregistered Offering of NFTs. On August 28, 2023, the SEC announced charges against NFT issuer Impact Theory, LLC (“Impact Theory”), arguing that Impact Theory’s NFT launch constituted an unregistered securities offering. This is the first time the SEC has brought an enforcement action against an NFT issuer. According to the order, Impact Theory alluded to the investment potential of the NFTs by emphasizing to purchasers that their NFTs would provide “tremendous value.” The SEC, applying the Howey Test, argued that Impact Theory’s statements “invited potential investors to view the purchase…as an investment into the business” and that the NFTs constituted investment contracts. Impact Theory neither admitted to nor denied the charges, but did agree to pay $6.1 million in disgorgement, prejudgment interest, and civil penalties.

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Other Items

Corporate Transparency Act Provisions Coming into Effect. The Corporate Transparency Act of 2019, as amended (the “CTA”), becomes effective on January 1, 2024, and will require virtually all U.S. entities to file detailed beneficial ownership reports with the Financial Crimes Enforcement Network (FinCEN). Pursuant to the CTA, legal entities incorporated, organized, or registered to do business in a state must disclose certain information related to its owners, officers, and controlling persons. Companies that will be required to provide such information include domestic or foreign corporations, limited liability companies, or other entities created or registered to do business in a state by virtue of such entity making a filing with the secretary of state. The required disclosure for beneficial owners includes legal name, date of birth, address, and ID with a unique identifying number (i.e., a driver’s license or a passport). There are a handful of exemptions to the CTA, including for (i) SEC-registered investment advisers, (ii) venture capital fund advisers relying on the exemption pursuant to Section 203(l) of the Investment Advisers Act that file Form ADV with the SEC, and (iii) “pooled investment vehicles” managed by a bank, credit union, broker-dealer, registered investment company, SEC-registered investment adviser, or a venture capital fund adviser as described in (ii).

Under the CTA, entities formed before January 1, 2024 must comply within one year. Entities formed after January 1, 2024 will have 30 days to comply once they are officially formed. Additionally, FinCEN recently published a proposal to extend the 30-day deadline to 90 days for reporting entities created or registered between January 1, 2024 and December 31, 2024. Applicable entities that fail to comply or provide false or fraudulent information will be subject to civil and criminal penalties. The CTA contains a safe harbor, however, which enables an individual representing a reporting company to voluntarily correct any submitted false information within 90 days of submitting an inaccurate report.

To learn more about the Corporate Transparency Act and its implications, please refer to this article by CFM Partner Tony Wise.

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Compliance Calendar

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

November 6, 2023

• Preliminary Statements for Annual Renewal fees are available through E-Bill and can be accessed through FINRA Firm Gateway.

November 14, 2023

• Form 13F Quarterly Filing. Filing is for the calendar quarter that ended September 30, 2023, and should be submitted within 45 days of quarter end.
• CTA Form PR. Filing is for the calendar quarter that ended September 30, 2023, and should be submitted within 45 days of quarter end.

November 29, 2023

• Form PF for Large Hedge Fund Advisers. Filing is for the calendar quarter that ended September 30, 2023.
• CPO-PQR Form. Filing is for the calendar quarter that ended September 30, 2023, and should be submitted within 60 days of quarter end.

December 11, 2023

• Annual Renewal Payments Due for Preliminary Statement Issued in E-bill for Registration/Notice Filings. Payment can be made through FINRA Firm Gateway.

Periodic

• Form D and Blue Sky Filings should be current.
• CPO/CTA Annual Questionnaires must be submitted annually, and promptly upon material information changes, through the NFA Annual Questionnaire system.

Consult our complete Compliance Calendar for all 2023 critical dates as you plan your regulatory compliance timeline for the year. 

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

Sincerely,

Karl Cole-Frieman, Bart Mallon, John T. Araneo, Garret Filler, Scott Kitchens, Frank J. Martin, Lilly Palmer, David Rothschild, Bill Samuels, Tony Wise, and Alex Yastremski

Cole-Frieman & Mallon LLP is a leading investment management law firm known for providing top-tier, innovative, and collaborative legal solutions for complex financial services matters. Headquartered in San Francisco, Cole-Frieman & Mallon LLP services both start-up investment managers and multibillion-dollar funds. The firm provides a full suite of legal services to the investment management community, including fund formation (hedge, VC, PE, real estate), investment adviser and CPO registration, counterparty documentation (digital and traditional prime brokerage, ISDA, repo, and vendor agreements), SEC, CFTC, NFA and FINRA matters (inquiries, exams, and compliance issues), seed deals, cybersecurity regulatory matters, full-service intellectual property counsel, manager due diligence, employment and compensation matters, and routine business matters. The firm also publishes the prominent Hedge Fund Law Blog. For more information, please add us on LinkedIn, follow us on Twitter, and visit us at colefrieman.com.