April 19, 2024

Clients, Friends, and Associates:

As we end the first quarter and enter the spring season, we would like to highlight some of the recent industry updates and occurrences we found to be both interesting and impactful. 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

We would like to highlight the promotions of Aaron Humes, Brandon Leppke, Kendra Snyder, and Erica Stefanik to Senior Associates. Congratulations to them! Also, we are thrilled to announce the latest additions to our distinguished team at Cole-Frieman & Mallon LLP. Iva Rukelj joins us as a Senior Associate in our Intellectual Property practice. Additionally, we’re pleased to welcome Afruz Sayah as an Associate and Stephanie Cepeda as a Paralegal for the Corporate and Transactional practice group. Please join us in extending a warm welcome to them as they embark on this exciting journey with us.

Cole-Frieman & Mallon LLP, along with industry leaders MG Stover, Harneys, and KPMG, is a premier sponsor of the CoinAlts Annual Fund Symposium. This annual event, being held at the Four Seasons Hotel in San Francisco on October 16, 2024, is the anchor event of SF Fund Week 2024. It brings together the digital asset community to address investment, legal, and operational issues relevant to private fund managers. It 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/.

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SEC Matters

SEC Approves Spot Bitcoin ETFs. The Securities and Exchange Commission (“SEC”) approved 11 spot Bitcoin exchange-traded funds (“ETFs”) on January 10, 2024, marking a historic moment in the crypto industry. The approved applications included those from BlackRock, Ark Investments/21 Shares, Fidelity, Invesco, Valkyrie, and WisdomTree.

Despite the approval, SEC chairman Gensler reiterated the agency’s stance on crypto by asserting that “… while [they] approved the listing and trading of certain spot Bitcoin ETP shares … [they] did not approve or endorse Bitcoin.” Chairman Gensler went on to advise investors to remain cautious about the risks associated with Bitcoin and any other products tied to crypto.

The statement came one day after the agency’s X (formerly Twitter) account was hacked, allowing the hacker to prematurely announce the agency approval. The agency subsequently deleted the post and launched an investigation into the security compromise.

Court Rules in Favor of SEC in Case Against Terraform. On December 28, 2023, Judge Radkoff issued an opinion and order on the motions and cross motions for summary judgment in the SEC enforcement action against crypto entrepreneur Do Kwon and his company, Terraform Labs. The court granted the SEC’s summary judgment motion in part, holding that the defendants had offered and sold unregistered securities since it found that TerraUSD, LUNA and MIR tokens were investment contracts under United States v. Howey. Additionally, the court granted summary judgment in part for the defendants regarding mAssets since it found that those tokens did not meet the statutory definition of security-based swaps. Of note, the Terraform ruling is in conflict with the same district court’s ruling in SEC v. Ripple Labs Inc. For more information on SEC v. Ripple Labs Inc., check out our October 2023 Update. The clear takeaway from these conflicting rulings is that the application of Howey to digital assets remains unclear, even to judges in the same court, acting as further evidence that a regulatory framework specific to cryptocurrency and digital assets is needed.

Judge Radkoff moved the trial from January 29, 2024, to March 25, 2024, to accommodate Do Kwon’s extradition proceedings in Montenegro. Terraform also filed a voluntary petition for Chapter 11 bankruptcy protections on January 21. On February 5, Do Kwon was extradited to South Korea, where he faces a potential life sentence.

Court Rules in Favor of SEC on Coinbase’s Motion to Dismiss. On January 17, 2024, during oral argument on Coinbase’s motion to dismiss, the SEC referenced the recent SEC v. Terraform Labs ruling (see above) and argued that the holding in Howey was sufficient to regulate Coinbase’s activities. Coinbase disagreed and argued that the tokens in dispute were not securities, but instead commodities. While the SEC has accepted Bitcoin as a commodity, the thirteen tokens identified in the SEC’s complaint have not been officially classified. For more information about the lawsuit in general, please refer to an earlier blog post. 

On March 27, 2024, the Court ruled on the motion, rejecting nearly all of Coinbase’s arguments and allowing the case to proceed beyond the pleading stage. In so ruling, the Court held that the SEC alleged facts sufficient to permit a finding that certain assets made available for trading on Coinbase’s platform constitute “investment contracts” under the Howey test. The Court rejected several of Coinbase’s arguments about the application of Howey, noting that Howey does not recognize a distinction between tokens purchased directly from an issuer and those purchased on the secondary market. The Court further rejected Coinbase’s contention that the Court’s broad construction of Howey would effectively extend SEC jurisdiction to all investment activity, noting the need for a “common enterprise,” which the Court found was sufficiently alleged in the SEC’s complaint as to the tokens at issue.

Notably, however, the Court did grant the motion to dismiss the claim that Coinbase acted as an unregistered broker through its self-custodial wallet service, since the wallet does not provide brokerage services such as order routing or making investment recommendations.

SEC Adopts Market Participant Dealer Rule. On February 6, 2024, the SEC adopted new rules 3a5-4 and 3a44-2 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), which expand the definitions of “dealer” and “government securities dealer” to cover additional market participants engaged in liquidity-providing activities.

Currently, Section 3(a)(5) of the Exchange Act provides an exception to the dealer definition for persons buying or selling securities for their own account, but “not as part of a regular business.” Liquidity providing market participants have historically relied on this exception.

The newly adopted rules alter the standard for determining what is considered “as part of a regular business,” including where the activity has the effect of providing liquidity to other market participants by either of the following means:

• regularly expressing trading interest that is at or near the best available prices on both sides of the market for the same security and that is communicated and represented in a way that makes it accessible to other market participants; or

• earning revenue primarily from capturing bid-ask spreads, by buying at the bid and selling at the offer, or from capturing any incentives offered by trading venues to liquidity-supplying trading interest.

The new rules provide certain exceptions to the above, including one for persons having or controlling total assets of less than $50 million.  

Of note, neither private funds nor investment advisers (trading for their own account) are exempt from the dealer or government securities dealer registration requirements. If a private fund or investment manager employs arbitrage, market-making, or similar liquidity-providing strategies, those funds and managers should be mindful of the new standards set forth in the rules and may need to register as dealers.

The rule will become effective 60 days after the date of publication of the adopting rule in the Federal Register, and the date of compliance for the final rules will be one year after the date the rule becomes effective.

Amendments to Schedule 13D and 13G. The SEC adopted amendments to rules governing beneficial ownership information reporting on Schedules 13D and 13G under Section 13 of the Exchange Act. These amendments, which become effective on February 5, 2024 or September 30, 2024, depending on Schedule 13D or 13G, change the timing of filing deadlines. For more information about the amendments and accelerated deadlines for the filings, please refer to our previous blog post.  

SEC Proposes Updated Definition of Qualifying Venture Capital Funds. On February 14, 2024, the SEC proposed an updated definition increasing the threshold for “qualifying venture capital funds” from $10 million to $12 million, meant to represent adjustment for inflation since the qualifying venture capital fund exemption was introduced in the Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018. A qualifying venture capital fund is a venture capital fund which, by virtue of its being under the applicable dollar threshold in aggregate capital contributions and uncalled committed capital, is exempted from the 100 beneficial owner limitation of Section 3(c)(1) of the Investment Company Act of 1940, as amended, and may instead raise capital from up to 250 beneficial owners.

The enacting law requires the SEC to index the dollar figure for this threshold to inflation every five years. The SEC’s proposed rule would provide such an inflation adjustment, allowing qualifying venture capital fund managers to raise additional capital within the limit of the proposed threshold and would establish a process for future inflation adjustments every five years.

SEC Charges Two Investment Advisers with Making False Statements Concerning Use of Artificial Intelligence.  On March 18, 2024, the SEC announced settled charges against two registered investment advisers for making false and misleading statements about their use of artificial intelligence (“AI”). Without admitting or denying the SEC’s findings, the advisers agreed to settle the charges and pay $400,000 aggregate penalties. The SEC’s orders against the advisers found that they had exaggerated the capabilities and use of their AI and machine learning software. The SEC in its release remarked on the current industry buzz around AI and urged investment advisers to be vigilant that, where an adviser claims to use AI in its investment processes, it needs to ensure that its representations are not false or misleading. Highlighting AI as an area of increased enforcement focus, the SEC also released this quarter an investor alert concerning the prevalence of AI-related fraudulent representations.

CFTC Items

CFTC Advisory Committee Submits DeFi Report. The CFTC’s Digital Asset and Blockchain Technology Subcommittee released a report regarding decentralized finance (“DeFi”), including examining the factors that affect the risks and benefits of DeFi and suggests that federal regulators proactively interact with the DeFi sector to clarify the specific application of pertinent laws.

In April of 2023, the Department of Treasury released a report on illicit financial risks in the DeFi industry, recommending that policymakers and regulators strengthen supervision of anti-money laundering policies by DeFi services to ensure compliance with obligations presented by the Bank Secrecy Act, by engaging with the industry. This new report evidences the start of such engagement. The report notes that the benefits and risks of DeFi technology depend on the schematics and design of each specific system, and that there is a concern about the lack of accountability built into the design of these systems. The report recommends certain steps and actions to mitigate the risks borne by investors and consumers, such as: increasing the technical capacity to understand DeFi, surveying existing regulatory guidelines, identifying gaps in regulatory frameworks, identifying, and assessing risks, and identifying policy responses to address such risks. Overall, the committee recommends that policymakers and regulators use a more comprehensive approach to understand the DeFi industry.

Digital Asset Items

Digital Asset Reporting Requirements from the IRS and the Treasury. On January 16, 2024, the Treasury Department (“Treasury”) and the Internal Revenue Service (“IRS”) issued an announcement informing the public that businesses do not have to report transactions involving the receipt of digital assets the same way businesses report the receipt of cash, until the Treasury or the IRS issue further regulations.

Announcement 2024-4 serves as transitional guidance to taxpayers on the status of the rules on digital asset reporting pursuant to Section 6050I of the Internal Revenue Code. This section requires that taxpayers engaged in business must report the receipt of $10,000 or more in cash within 15 days of receiving the cash. Historically, “cash” included currency, foreign currency, or any monetary instrument amounting to no more than $10,000. Digital assets were included in this definition on November 15, 2021, through the Infrastructure Investment and Jobs Act.

The Treasury and the IRS intend to issue regulations to provide additional procedures to report the receipt of digital assets and will give the public an opportunity to submit any comments. However, there is no proposed date or timeline for regulatory guidance yet.

Binance Pleads Guilty to Violating Federal AML and Sanctions Laws. Binance recently consented to multiple orders with federal regulators for violating regulations in its international exchange operations. A U.S. district judge approved Binance’s guilty plea in February, leading to $1.8 billion in fines and $2.5 billion in forfeiture. The settlement includes up to five years of independent firm monitorship, focusing on ethics programs, policies, and systems. Binance acknowledged its actions in a blog post and pledged to adhere to compliance and security guidelines.

The CFTC’s consent order with Binance and CEO Changpeng Zhao, for breaching the Commodity and Exchange Act, includes a permanent injunction and civil penalties. The CFTC imposed a monetary penalty of $150 million against Zhao, and Binance must disgorge $1.25 billion in transaction fees and pay $1.35 billion to the CFTC.

FinCEN accused Binance of failing to report over 100,000 suspicious transactions and insufficient AML and KYC compliance. Specifically, Binance did not implement comprehensive know-your-customer (KYC) protocols or systematically monitor transactions, never filed a suspicious activity report (SAR) with FinCEN, and, for years, Binance allowed users to open accounts and trade without submitting any identifying information beyond an email address. As a result, Binance must appoint an independent monitor for the safe removal of U.S. users from the platform.

Binance’s onboarding processes and KYC requirements have since been updated to include an assessment of applying entities with connections to the U.S., which will be used to determine whether an entity user is a U.S. user and thus prohibited from accessing the Binance platform. The new assessment includes questions for different types of entities, including look-through for U.S. beneficial owners, and a U.S. ownership/control attestation, requiring the signatory to attest that no U.S. person will make decisions related to the function of the entity user, including day-to-day management activities and trading activities.

Zhao’s sentencing is scheduled for April 30, 2024, while the SEC’s action against Binance for allegedly violating securities laws continues. For more on SEC and CFTC actions against Binance, see our previous blog post.

Wyoming Recognizes New Form of DAO Structured as Nonprofit Organization. On March 7, 2024, Wyoming Governor Mark Gordon approved the Wyoming Decentralized Unincorporated Nonprofit Association Act. The law will permit Decentralized Autonomous Organizations (“DAOs”) of at least 100 members to form as decentralized unincorporated nonprofit associations (“DUNAs”), allowing them to generate revenue as a nonprofit entity. Under the new law, DUNAs will have legal identity, with the ability to contract with third parties, initiate legal actions, address tax issues, and acquire and transfer property (including digital assets), while remaining decentralized in nature, consistent with the structure of a DAO. DUNAs are permitted to engage in profit-making activities so long as the proceeds of such activities are put toward the not-for-profit “purpose” of the DUNA. The statutory provisions permit the payment of “reasonable compensation” for services provided to a DUNA, but the definition of “reasonable” is still unclear.

This follows Wyoming’s landmark 2021 law enabling individuals and organizations to create legally recognized DAOs as limited liability companies in the state. The new bill comes into effect July 1, 2024.

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Other Items

Federal Court Finds Corporate Transparency Act Unconstitutional. On March 1, 2024, the U.S. District Court of Northern Alabama ruled that the Corporate Transparency Act (“CTA”) was unconstitutional as it “exceeded the Constitution’s limits on Congress’ power,” consequently enjoining enforcement of the CTA against the plaintiffs. Shortly after the final rule was released by Financial Crimes Enforcement Network (“FinCEN”), plaintiffs National Small Business United and Isaac Winkles (collectively, “NSBA”) filed suit against the Treasury, Treasury Secretary Janet Yellen, and Acting Director of FinCEN, Himmauli Das (collectively, “Defendants”). NSBA argued that Congress lacked the authority under the Constitution to enforce the reporting requirements of the CTA. They alleged that the federal government was infringing upon the states’ sovereign authority over entity formation and governance, and by compelling disclosure of personal information, the CTA violated the First, Fourth, Fifth, Ninth, and Tenth Amendments of the Constitution.

The court declined to comment on NSBA’s arguments that the CTA violated several amendments but affirmed that the Act was unconstitutional. Importantly, the holding was limited to NBSA in the case.

On March 11, on behalf of the Department of the Treasury, the Department of Justice filed a Notice of Appeal. In a press release, FinCEN confirmed their compliance with the court order and stated it would not enforce the CTA against the NSBA, but emphasized all other reporting companies are still required to comply with the CTA.

New Guidance from FinCEN on Corporate Transparency Act Compliance. Prior to the NSBA decision, in January, FinCEN released an updated list of FAQs to address queries and provide additional guidance on compliance with the CTA.

As mentioned in a previous post, the requirements of the CTA became effective on January 1, 2024, requiring reporting companies to file their initial beneficial ownership reports with FinCEN before January 1, 2025. Companies created in 2024 will be required to file with FinCEN within 90 days of their creation or registration, and companies created on or after January 1, 2025, will be required to file their initial report within 30 days of its creation or registration. To learn more about the CTA and its implications, please refer to this post on our blog.

California Court Restores CPPA Authority to Enforce Privacy Regulations. On February 9, 2024, the Third District Court of Appeal in California ruled in favor of the California Privacy Protection Agency (“CPPA”), restoring the agency’s authority to enforce the regulations in the California Privacy Rights Act (the “CPRA”). This ruling follows the prior ruling in favor of the California Chamber of Commerce, which sought to delay the enforcement of the CPRA until the CPPA finalized the Act’s regulations. The appellate court stated that the one-year gap could be interpreted as allowing for the agency to have time to prepare for the enforcement of the rules.

The regulations set forth by the CPRA were on hold until conclusion of the appeal. The Court’s decision now makes all final CRPA regulations enforceable. The CPPA, therefore, may immediately resume enforcing the privacy regulations, but it is currently unclear whether the agency will provide any time for businesses to comply with the new rules. This ruling will allow for the enforcement of new rules by the agency, which concerns cybersecurity audits, risk assessments, and automated decision-making technology.

Qualified Plan Asset Manager (“QPAM”) Exemption Updated. Investment Managers who advise ERISA plan asset funds under the QPAM exemption should be aware of recent amendments to the QPAM exemption, which was adopted on April 3, 2024 and is expected to become effective June 17, 2024. The amendment will (i) require the QPAM to notify the Department of Labor, via email at [email protected], that it is relying on the QPAM exemption no later than September 15, 2024, or within 90 days of reliance on the Exemption; (ii) incrementally increase the assets under management threshold, in three separate increments (2024, 2027, and 2030) from $85,000,000 to $135,868,000; and (iii) incrementally increase the shareholder equity threshold, in three separate increments (2024, 2027, and 2030) from $1,000,000 to $2,040,000. We expect to provide further guidance in our next update.

FinCEN Proposes New Regulations to Combat Money Laundering. On February 13, 2024, FinCEN proposed a new rule to prevent money laundering and the financing of terrorism and other crimes. The rule intends to supplement recent Treasury actions to combat illicit financial risks through anonymous companies and cash-based real estate transactions by increasing the transparency of the financial system. The Treasury also published a risk assessment for investment advisers, which outlined threats and vulnerabilities posed by investors and other actors.

The rule would classify SEC-registered investment advisers and SEC exempt reporting advisers as “financial institutions” under The Bank Secrecy Act of 1970 (“BSA”) and require such advisers to adopt Anti-Money Laundering and Countering the Financing of Terrorism (“AML” and “CFT”) guidelines pursuant to the BSA. Such investment advisers would be required to report suspicious financial activity to FinCEN and fulfil certain recordkeeping requirements.

The period for public commentary has opened and FinCEN will accept comments regarding the proposed rule until April 15, 2024.

Reminder Regarding SEC Pay-to-Play Rules.  As an election year reminder to the firm’s investment adviser clients, pursuant to Rule 206(4)-5 under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), if you make a political contribution to an elected official who is in a position to influence the selection of the adviser to provide advisory services to a government entity, then you will be barred for two years from providing advisory services for compensation to that government entity. The rule applies to advisers registered or required to be registered with the SEC, advisers exempt from registration under Advisers Act Section 203(b)(3) as “foreign private advisers,” and advisers that are exempt reporting advisers as defined in Rule 275.204–4(a) under the Advisers Act, as well as to certain executives and employees of the adviser.

Under Rule 206(4)-5 you also may not pay a third party, such as a solicitor or placement agent, to solicit a government client on your behalf, unless the solicitor or placement agent is a “regulated person” subject to prohibitions against engaging in pay-to-play practices. Further, you may not coordinate or ask another person or political action committee (PAC) to make contributions to an elected official, candidate or political party for purposes of influencing the selection of the adviser. Finally, you and certain of the adviser’s executive officers and employees may not engage in pay-to-play conduct indirectly, such as by directing or funding contributions through third parties such as spouses, lawyers or companies affiliated with the adviser, if that conduct would violate the rule if the adviser engaged in it directly.

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Compliance Calendar

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

April 7, 2024

• Form N-MFP Filing for Monthly Schedule of Portfolio Holdings of Money Market Funds, if applicable.

April 10, 2024

• Form 13H Quarterly Filing for Changes. Filing is for calendar quarter that ended March 31, 2024, and should be submitted within 10 days of quarter end. 
• Form 13G Monthly Filing for Applicable Reporting Persons. Filing is for month end of March 31, 2024, and should be submitted within 10 days of month end. 

April 15, 2024

• Form PF Quarterly Filing for Large Liquidity Fund Advisers. Filing is for calendar quarter that ended March 31, 2024.

April 29, 2024

• Form ADV Part 2A Delivery to Existing Clients. 
• Audited Financials Distribution to Private Fund Investors (excluding Funds of Funds).
• Form PF Annual Filing. Filing is for fiscal year end December 31, 2023, and should be submitted within 120 days of fiscal year end. 

May 7, 2024

• Form N-MFP Filing for Monthly Schedule of Portfolio Holdings of Money Market Funds, if applicable.

May 10, 2024

• Form 13G Monthly Filing for Applicable Reporting Persons. Filing is for month end of April 30, 2024, and should be submitted within 10 days of month end. 

May 15, 2024

• Form 13F Quarterly Filing for Changes. Filing is for calendar quarter that ended March 31, 2024, and should generally be submitted within 45 days of quarter end.
• CTA Form-PR Filing with the NFA, which can be filed through NFA’s EasyFile.

May 30, 2024

• CPO-PQR Form Filing with the NFA, which can be filed through NFA’s EasyFile.
• Form PF Quarterly Filing for Large Hedge Fund Traders and Large Liquidity Fund Advisers, if applicable.
• Form N-PORT Filing Monthly Schedule of Portfolio Holdings of Funds other than Money Markey Funds and SBICs, if applicable. 

 June 7, 2024

• Form N-MFP Filing for Monthly Schedule of Portfolio Holdings of Money Market Funds, if applicable. 

June 10, 2024

• Form 13G Monthly Filing for Applicable Reporting Persons. Filing is for month end of May 31, 2024, and should be submitted within 10 days of month end. 
• Audited Financials Distribution to Fund of Funds Investors. 

Periodic

• Fund Managers should perform “Bad Actor” certifications annually.
• Form D and Blue Sky Filings should be current.
• CPO/CTA Annual Questionnaires must be submitted annually, and promptly upon material information changes, through NFA Annual Questionnaire system.

Consult our complete Compliance Calendar for all 2024 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.