July 11, 2024

Clients, Friends, and Associates:

As we welcome the summer season, we would like to highlight the recent industry updates that we found to be both interesting and impactful. While we strive to present an informative, albeit brief, overview of these topics to allow you to stay on top of the business and regulatory landscape in the coming months, we are also available should you have any related questions.

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CFM Items

CoinAlts Fund Symposium – October 16.  Cole-Frieman & Mallon LLP is again one of the Premier sponsors of the CoinAlts 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. 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/.

Hedgeweek Law Firm of the Year.  We are thrilled to share that Cole-Frieman & Mallon LLP was named “Law Firm of the Year – Overall” at Hedgeweek’s US Emerging Manager Awards in New York on June 6, 2024. This recognition highlights the firm’s commitment to excellence and innovation in providing legal services to the investment management industry. Thank you to our clients for your votes and ongoing trust.

CFM People. We are pleased to announce the promotions of Marisa Krueger to Legal Support Services Manager and Emma Kaplan to Paralegal. Congratulations to them both! Also, we are excited to introduce the newest members of our dedicated team at Cole-Frieman & Mallon LLP. Tae Kim has joined us as a Senior Associate and Maryam Najam has joined us as an Associate in our Hedge Funds practice, alongside our Summer Associates Alexandria Criner and Alisha Parikh. Please join us in warmly welcoming them as they begin this exciting chapter with us.

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SEC Matters

SEC Drops Investigation Against Ethereum. While the Securities and Exchange Commission’s (“SEC”) decision to close its investigation of Ethereum is a welcomed victory (or sigh of relief) for digital assets, the positive news was both expected and likely a hollow victory given that it does not change the short-term reality for many in the digital asset industry.

Without additional forward movement, such as with current SEC and other regulatory guidance on digital assets shifting to a more crypto-friendly tone or proposed crypto-friendly legislation being passed (especially relating to tokens and other potential digital assets that may or may not be securities), the SEC continues to police the digital asset industry with a heavy enforcement hand. Consequently, this creates a high barrier to entry, filled with complex legal, business, and other practical challenges for those doing business in the digital asset space. As such, for those parties investing or otherwise participating in the digital asset class, having an open dialogue with your attorneys and advisors can help navigate through the uncertainty.

SEC Enhances Reporting of Proxy Votes to Increase Transparency for Investors. Certain amendments to Form N-PX, passed by the SEC in November 2022, are set to go into effect on August 31, 2024, and will require investment advisers who must file a Form 13F with the SEC (“Institutional Investment Managers”) to file a Form N-PX with the SEC, disclosing all proxy votes cast in the preceding 12 months where the Institutional Investment Manager exercised voting power over a security. Institutional Investment Managers with a policy to not vote proxies, and who indeed did not vote proxies, are still required to file a truncated Form N-PX with the SEC. In preparation for this upcoming filing, Institutional Investment Managers should collect all proxy votes cast from July 1, 2023 to June 30, 2024, and provide them to their legal counsel. If you need assistance with this filing, please reach out to your CFM contact.

Fifth Circuit Strikes Down SEC Private Fund Advisers Rule. In August 2023, the SEC adopted the Private Fund Advisers Rule which imposed new requirements and prohibitions on private fund advisers, including the disclosure of preferential treatment of certain investors and quarterly reporting of private fund performance. Despite a swift challenge by a group of trade associations, many investment advisers were prepared with modified fund documents and side letters in anticipation of complying with the new Private Fund Advisers Rule.

Given its industry altering impact, the recent ruling from the U.S. Court of Appeals for the Fifth Circuit finding the Private Fund Advisers Rule to be invalid and unenforceable was a welcome reprieve; though, the SEC retains the ability to challenge or appeal the ruling. In striking down the Private Fund Advisers Rule, the Court found that the SEC exceeded its statutory authority because the term “investor,” as used within the Investment Advisers Act of 1940’s (the “Advisers Act”), was limited to “retail customers” and not private funds. While we await the SEC’s response to the Court’s ruling, private fund advisers can continue business as usual as if the Private Fund Adviser Rule was never passed.

SEC Charges Investment Advisers for Marketing Rules Violations.  On April 14, 2024, the SEC announced charges against five registered investment advisers for violations of Section 275.206(4)-1 of the Advisers Act (the “Marketing Rule”) for misleading advertisements of hypothetical performance on their public-facing websites. In addition to the violations surrounding hypothetical performance, one adviser was also found to have (i) made false and misleading statements, (ii) advertised misleading model performance, (iii) been unable to substantiate performance shown in its advertisements, (iv) failed to enter into written agreements with people it compensated for endorsements, and (v) violated recordkeeping and compliance standards including filing a prospectus with the SEC which contained misleading statements about its performance. The advisers agreed to civil penalties, censure, and a cease and desist from further violations.

This enforcement action, coupled with a similar enforcement action in September 2023, demonstrates the SEC’s focus on compliance with the Marketing Rule as an important safeguard to protect investors from “misleading advertising claims.” As such, we recommend that our clients remain vigilant and review all marketing materials (including content on public-facing websites) with their legal counsel and ensure that all policies and procedures are actively followed.

SEC Charges Investment Advisers for Misleading Investors. The SEC continued its focus on violations of the Marketing Rule, including fraudulent and deceptive practices, by initiating an enforcement action against an investment adviser and its founder for a breach of fiduciary duty for failing to disclose conflicts of interest and making misleading statements to their clients. According to the SEC’s investigation, the investment adviser advised its clients to invest into films produced by a specific production company without disclosing that the production company paid the founder approximately $530,000 in exchange for investments by its clients. The investment adviser subsequently misrepresented to investors that the monies were paid as compensation for work as an executive producer on the films. The SEC disgorged fees, levied civil penalties, and issued a censure and a cease and desist from committing or causing any violation of these rules.

In a separate enforcement action, on May 29, 2024, the SEC announced charges against an investment adviser and its co-founder for false and misleading statements in communications with investors. The SEC’s investigation found that the misleading statements were a result of improper modifications to underlying portfolio data made by the co-founder. Additionally, these communications failed to include necessary disclosures. Lastly, despite previous orders from the SEC, the investment adviser failed to disclose a conflict of interest arising from a different co-founder operating a separate hedge fund in China. The investment adviser and the co-founder paid civil penalties and the investment adviser also agreed to a censure and a cease and desist from further violations.

Cumulatively, these enforcement actions demonstrate the SEC’s present focus on consumer protection through complete and accurate reporting at all stages of the investment lifecycle and underscore the importance of investment advisers closely reviewing all materials, including any potential conflicts of interests, with legal counsel to ensure adequate and proper disclosure.

SEC Charges Firms for Recordkeeping Violations. On February 9, 2024, the SEC announced charges against multiple broker-dealers and investment advisers for longstanding failures to maintain and preserve electronic communications under the recordkeeping requirements of the Advisers Act and the Securities Exchange Act of 1934. In its investigation, the SEC found (i) use of off-channel communications, including personal text messages, to discuss work-related matters such as recommendations and advice to be given or proposed to be given and (ii) failure to maintain and preserve such off-channel communications. The SEC also found firms failed to reasonably supervise their employees to detect and prevent such violations. The firms agreed to civil penalties, censure, a cease and desist from further violations, and to retain independent compliance consultants to conduct comprehensive reviews of policies and procedures.

Clients should develop policies and procedures to ensure that all employees conduct work-related communications and activities utilizing sanctioned mediums. These policies and procedures should be reviewed regularly with employees and updated as needed. Additionally, registered investment advisers should develop protocols for regularly collecting and storing data from employee devices, including all work-related communications.

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CFTC Items

CFTC Issues Order Against Crypto Prime Brokerage Firm. On May 13, 2024, the Commodity Futures Trading Commission (“CFTC”) issued an order against Falcon Labs, Ltd. (“Falcon Labs”) for facilitating United States based customers’ access to cryptocurrency derivatives trading platforms without registering as a futures commission merchant (“FCM”). Falcon Labs agreed to cease and desist from acting as an unregistered FCM, disgorge fees, and pay civil penalties. Additionally, Falcon Labs also updated its know-your-customer (“KYC”) policies and procedures to require customers to identify the location of ultimate beneficial owners as well as the person controlling the account. The retroactive application of the enhanced KYC policies resulted in the offboarding of approximately half of those Falcon Labs customers that were utilizing the underlying product. As regulatory bodies become more familiar with the cryptocurrency asset class, we anticipate more service providers will adopt similar enhanced KYC procedures to further limit restricted users’ access to certain digital asset products.

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Crypto and Digital Asset Items

Uniswap Labs Responds to the SEC’s Wells Notice. In April 2024, Uniswap Labs (“Uniswap”) published a blog post informing investors that it received a Wells notice from the SEC indicating that the SEC was planning to initiate legal action against Uniswap on the basis that the UNI token is security and that Uniswap is an unregistered securities broker and exchange.

On May 21, 2024, Uniswap filed a response to the Wells notice, asserting four main defenses: that Uniswap and its affiliated entities (i) do not meet the definition of an exchange, (ii) do not meet the definition of brokers because they do not solicit users or provide advice to users, (iii) do not engage in clearing activity because they do not take custody of users’ tokens, and (iv) did not engage in an unregistered offer or sale of securities because their distribution of UNI tokens did not involve the investment of money or property. In addition to the foregoing, Uniswap also contends that the SEC’s attempt to regulate Uniswap and the crypto industry violates the major questions doctrine and the due process right to fair notice. Given that Uniswap’s legal counsel also represented Ripple in its recent victory over the SEC, it comes as no surprise that Uniswap utilizes similar defenses and also references Ripple’s recent victory in its response to the Wells notice.

Congress Repeals SAB 121, Biden Vetoes. In what appears to be an effort to further constrict the digital asset industry, in March 2022, the SEC passed Staff Accounting Bill 121 (“SAB 121”) which required firms that custody cryptocurrency to record customer cryptocurrency holdings as liabilities on their balance sheets. With bipartisan support, Congress voted to repeal SAB 121 as it created an undue burden on financial institutions and may deter firms from providing cryptocurrency custodial services. Despite support from industry leaders, Wall Street, and lobbyists, in a blow to the industry, President Biden vetoed the Congressional repeal of SAB 121 stating that his “Administration will not support measures that jeopardize the well-being of consumers and investors.” While we agree with President Biden’s sentiment that “appropriate guardrails that protect consumers and investors are necessary to harness the potential benefits and opportunities of crypto-asset innovations,” we disagree with President Biden’s decision as it will inevitably lead to fewer options to custody digital assets, and the reduced competition will ultimately stifle innovation.

House of Representatives Passed Federal Guidance for Digital Assets. The House of Representatives recently passed the Financial Innovation and Technology for the 21st Century (“FIT21”) Act, seeking to build a regulatory framework for the governance of digital assets by distributing regulatory responsibilities between the SEC and the Commodities Futures and Trade Commission by dividing digital assets into three separate classes: (i) restricted digital assets that would be subject to SEC jurisdiction, (ii) digital commodities which would be subject to CFTC jurisdiction, and (iii) permitted payment stablecoin which, depending on facts and circumstances, would be subject to either body’s jurisdiction. Unfortunately for the industry, neither FIT21 nor a similar bill is currently being considered by the Senate which keeps this asset class in a regulatory limbo.

As the United States slowly but surely progresses towards developing a viable regulatory regime for the digital asset industry, CFM continues to monitor the various developments in the legal and regulatory landscape.

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Other Items

Florida Adopts Private Fund Adviser Exemption. Joining other states with similar exemptions, the State of Florida has adopted a private fund adviser exemption based on the North American Securities Administrators Association’s (“NASAA’s”) model rule exempting certain private fund advisors from investment adviser registration. Under Florida’s private fund adviser exemption, a Florida-based investment adviser who provides advice solely to qualifying private funds, such as 3(c)(1) and 3(c)(7) funds excluded from the definition of “investment company” under the Investment Company Act of 1940, is exempt from having to register as an investment adviser with Florida’s Office of Financial Regulation (the “Office”) provided the investment adviser (i) is not subject to “bad actor” disqualification under SEC Rule 506(d)(1) and (ii) files Part 1 of Form ADV as an exempt reporting adviser with the Office via FINRA’s electronic Investment Adviser Registration Depository. There are additional requirements for a private fund adviser who advises at least one 3(c)(1) fund that is not a venture capital fund. Such advisor must ensure that the interests in the 3(c)(1) fund are only offered to accredited investors, and the advisor must disclose all services, duties, and any other material information affecting the rights or responsibilities of the beneficial owners of the 3(c)(1) fund. These additional requirements for 3(c)(1) funds are similar to NASAA’s model rule except Florida’s exemption only requires the 3(c)(1) fund’s interests to be offered to accredited investors instead of NASAA’s higher financial requirement that the interests be offered to “qualified clients.” Also, unlike the NASAA model rule, Florida’s exemption does not require 3(c)(1) funds to be audited.

In the past, Florida-based investment advisers to private funds were often faced with the choice of either (i) registering as an investment adviser in Florida, (ii) relocating to another state to avoid registering as an investment adviser in Florida, or (iii) taking the position that they were not holding themselves out as an investment adviser in Florida. With its adoption, Florida’s private fund adviser exemption now provides a welcome fourth option for private fund advisers who are based in Florida.

SEC Adopts Amendments to Regulation S-P. On May 16, 2024, the SEC adopted certain amendments to Regulation S-P requiring registered investment advisers and certain other financial institutions to implement enhanced data security and incident notification controls. Key requirements include (i) developing incident response programs for data breaches, (ii) notifying affected parties within 30 days of a breach, (iii) overseeing service providers, and (iv) meeting new record retention obligations. The amendments also formally codify certain industry-accepted exceptions regarding annual privacy notice requirements.  In adopting these amendments, the SEC has now effectively set a minimum standard for incident notification requirements.

For advisers to private funds, the applicability of amended Regulation S-P is ambiguous primarily for two reasons: first, private funds themselves are exempt from Regulation S-P (falling under the FTC’s Safeguards Rule instead); and second, Regulation S-P focuses on the sensitive information of the “customer” (i.e., a natural person), whereas a private fund client to a private fund adviser is an entity and not a natural person. However, the amendments expand Regulation S-P’s definition of “customer information” to now include information of “the customers of other financial institutions where such information has been provided to the covered institution.” Because private fund advisers are in fact provided with the information of the natural person beneficial owners of its private fund client, there appears to be no reasonable basis provided in the express language of amended Regulation S-P to conclude that private fund advisers are somehow exempt.

Although the SEC has effectively set a minimum standard for data breach notification requirements, it is likely that going forward, investment advisers will have to comply with other additional incident response requirements, such as those contemplated by the SEC’s impending Cybersecurity Risk Management rule.  As to Regulation S-P’s effect on private fund advisers, even if such an adviser could successfully argue it is somehow exempt, similar requirements would still apply under the FTC’s Safeguards Rule and potentially under any applicable state and/or foreign laws, making any such exemption moot from at least a practical perspective. We recommend that all registered investment advisers, including those solely advising private funds, prepare for compliance with these new amendments.

Qualified Plan Asset Manager (“QPAM”) Updates. As discussed in our previous quarterly update, investment advisers using the QPAM exemption must notify the Department of Labor via email at [email protected] no later than September 15, 2024, of their reliance on the QPAM exemption. Additionally, investment advisers should be aware that the assets under management threshold required to qualify for the QPAM exemption are increasing from $85,000,000 to $101,956,000 as of December 31, 2024. Similarly, the equity threshold required to qualify for the QPAM exemption is increasing from $1,000,000 to $1,346,000. These thresholds are set to further increase in 2027 and 2030. Please reach out to the team at CFM if you have any questions or need support with this transition.

Expansion of Internet Advisers Exemption for Investment Advisers. To modernize the law and further ensure protections for investors in the digital age, the SEC adopted amendments to the Advisers Act (otherwise known as the “Internet Adviser Exemption”) allowing for fully remote internet-based investment advisers to register with the SEC. To qualify for the Internet Adviser Exemption, an investment adviser must maintain an operational and interactive website where the adviser exclusively and continually provides digital investment advisory services to more than one client. Internet Advisers must comply with the new rule by March 31, 2025. Additionally, all corresponding changes must be reflected on their form ADV, and an adviser that is no longer eligible under the new rules must register in one or more states and file a Form ADV-W by June 29, 2025, signifying their withdrawal.

Supreme Court Limits Powers of Federal Agencies. In the recent Supreme Court case SEC v. Jarkesy, the Court significantly limited the SEC’s authority to impose civil penalties in agency proceedings via its administrative law judge (ALJ) system.  The decision, involving allegations of securities fraud against a hedge fund manager, underscores some brewing constitutional concerns regarding the SEC’s in-house adjudication process and reinforces the importance of separation of powers and the right to a jury trial.

The Supreme Court essentially held that the ALJ system violates the Constitution’s Seventh Amendment right to a jury trial and further found that Congress had unconstitutionally delegated legislative power to the SEC by allowing it to choose between civil proceedings in federal court and administrative proceedings. As this decision effectively restricts the SEC’s ability to pursue civil penalties solely through administrative proceedings, the SEC will need to bring more cases to federal court, where defendants are entitled to a jury trial.

This ruling will necessarily reshape the SEC’s enforcement strategy, potentially leading to fewer cases being pursued due to the higher burden of federal court proceedings. It also signals increased judicial scrutiny of agency adjudication processes and may inspire challenges to other federal agencies’ administrative proceedings.

NVCA Model Documents. In May 2024, the National Venture Capital Association (“NVCA”) updated their model legal documents in light of a recent ruling by the Delaware Chancery Court. Clients who currently utilize the NVCA model documents should review the revised documents and consult with their legal counsel to determine if any changes or updates are needed.

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Compliance Calendar

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

July 1, 2024

• Changes to proxy voting and form N-PX go into effect.

July 10, 2024

• Form 13H Quarterly Filling. Filling is for the calendar quarter that ended June 30, 2024 and should be submitted within 10 days of the quarter’s end.

July 15, 2024 

• Quarterly Form PF due for Large Liquidity Fund Advisers. Filing is for the calendar quarter that ended June 30, 2024.

July 30, 2024

• ERISA Schedule C of DOL Form 5500 Disclosure.

August 14, 2024

• Form 13F Quarterly Filing. Filing is for calendar quarter that ended June 30, 2024, should be submitted within 45 days of quarter end.
• CTA Form PR. Filing is for calendar quarter that ended June 30, 2024, and should be submitted within 45 days of quarter end.

August 29, 2024

• Form PF for Large Hedge Fund Advisers. Filing is for calendar quarter that ended June 30, 2024, and should be submitted within 60 days of quarter end. 
• CPO-PQR Form. Filing is for calendar quarter that ended June 30, 2024, and should be submitted within 60 days of quarter end.

August 30, 2024

• Initial Form N-PX Filing. This filing covers the 12-month period that ended June 30, 2023.

Periodic

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

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.