October 21, 2024

Clients, Friends, and Associates:

As we say goodbye to summer and welcome fall, we would like to highlight recent industry updates that we found 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 (“CFM”) 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/.

CFM Celebrates 15 Years. CFM recently celebrated its 15th anniversary with firm attorneys, staff, clients, and friends gathered to mark this important milestone and reflect on the firm’s success and growth over the years.

CFM People. We are excited to introduce the newest members of our dedicated team at CFM. Gwennaelle Fotso joined us as a Legal Assistant, Benjamin Hung joined us as a Law Clerk, and Lezel Legados joined us as an Executive Assistant. Please join us in warmly welcoming them as they begin this exciting chapter with us.

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SEC Matters

SEC Charges Company for Unlawful Securities Activities. The Securities and Exchange Commission (the “SEC”) charged a blockchain software company with engaging in the unregistered offer and sale of securities and operating as an unregistered broker.

The SEC claims that since January 2023, the company has offered and sold tens of thousands of what the SEC alleges to be unregistered securities for certain liquid staking program providers. These providers create and issue liquid staking tokens (stETH and rETH) in exchange for staked assets, which can be bought and sold freely. The SEC’s complaint alleges that the company operates as an unregistered broker with respect to these transactions and, furthermore, that its participation in the distribution of these staking programs constitutes the unregistered offer and sale of securities.

The SEC complaint further alleges repeated violations of the registration provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934 (the “Exchange Act”). Such alleged violations include brokering transactions in crypto asset securities, providing pricing and other investment information regarding crypto asset securities, purporting to provide investors with the “best” quote, accepting and routing customer orders, facilitating order execution, handling customer assets, and receiving transaction-based compensation. The SEC seeks injunctive relief and penalties for these alleged violations.

The SEC argues that the company is depriving investors of the protections afforded by federal securities laws by engaging in the unregistered offer and sale of securities.

SEC Charges Investment Adviser with Violation of the Advisers Act for Failing to Safeguard Client Assets. The SEC recently settled a case against a digital asset registered investment adviser for: (i) violating the SEC’s Custody Rule, (ii) misleading investors about certain redemption practices of its private investment fund (the “Fund”), and (iii) failing to adopt and implement written compliance policies.

Regarding custody of client assets, the SEC concluded that the investment adviser had custody of the Fund’s assets, as defined in Rule 206(4)(2) of the Investment Advisers Act of 1940 (“Advisers Act”), and accordingly was required to ensure that client funds and securities were maintained by a qualified custodian. The investment adviser held certain crypto assets of the Fund on crypto asset trading platforms and exchanges, including FTX Trading Ltd. (“FTX”) which was not a qualified custodian. To our knowledge, this is the first public enforcement action in which the SEC has decided to bring an action against a crypto asset manager relating to the qualified custodian rule.

With respect to its redemption practices, the SEC found that the Fund’s offering documents provided for investor redemption from the Fund upon 30 days’ notice, unless the Fund’s general partner, who is an affiliate of the investment manager,  allowed for a shorter notice period. In practice, the Fund’s general partner allowed investors to redeem upon five business days’ notice if requested, and this practice was made known to investors in the Fund. However, the general partner occasionally approved redemption requests made with even less than five business days’ notice, including for affiliated investors. The SEC determined that straying from the redemption policy communicated to investors through its offering documents was misleading. We encourage investment advisers to review their redemption policies to ensure alignment with historical redemption practices and to avoid preferential treatment of affiliated investors. 

The investment adviser was found to have violated Sections 206(4), 206(4)-2, and 206(4)-7 of the Advisers Act, and agreed to pay a civil penalty of $225,000 to be distributed to harmed investors in the Fund. 

SEC Updates PAUSE List of Soliciting Entities, Subject to Investor Complaints. The SEC recently added 34 unregistered entities to their list known as the Public Alert: Unregistered Soliciting Entities (“PAUSE”) list, which tracks unregistered agencies soliciting investors that falsely claim to be registered, licensed, and/or located in the United States. The newly added entities, which include 24 soliciting entities, six impersonators of genuine firms, and four bogus regulators, are known to use misleading or fraudulent information to solicit primarily non-U.S. investors. Inclusion on the PAUSE list does not mean that the SEC has found violations of U.S. federal securities laws or made a judgement about the securities offered by relevant entities. If you receive a communication that seems suspicious, do not share any personal information without verification of the source.

SEC Charges Business with Cybersecurity-Related Controls Violations. The SEC charged a global integrated communications company with a violation of section 13(b)(2)(B) and Rule 13a-15a of the Exchange Act for failing to create and maintain a sufficient internal cybersecurity-related control system. These findings were primarily based on the facts that the company (i) did not have adequate policies and procedures in place to report relevant cybersecurity information to management responsible for such oversight, (ii) failed to timely assess and respond to unusual activity alerts, and (iii) did not adequately assure that all access to proprietary information required management authorization.

The company entered into a settlement with the SEC, agreeing to cease and desist from any further violations, pay a civil penalty, and update its cybersecurity technology and controls. This enforcement action serves as a reminder to the industry that the SEC is taking a vested interest in cybersecurity compliance issues.

SEC Charges Firm with Failing to Inform Affiliates of a Cyber Intrusion in a Timely Manner. In mid-April of this year, a multinational financial services firm received an alert of a potential cybersecurity vulnerability and an impacted system, which triggered an immediate reporting obligation to the SEC by the firm and its affected affiliated entities. Although it was later found that all appropriate measures were followed to secure the vulnerability, the firm did not inform its nine affiliates of the issue immediately and in enough time for the affiliates to make their formal reports with the SEC, thereby causing all affected entities to be in violation of cyber intrusion reporting rules. A settlement was entered into a settlement with the SEC whereby the firm agreed to cease and desist from any future violations and pay a $10 million civil money penalty.

SEC Chairman Gensler Reaffirms Importance of T+1 Settlements. In February, the SEC implemented a new rule to shorten the settlement timing—the actual exchange of securities and payments—from trade date plus two business days (“T+2”) to trade date plus one business day (“T+1”).This rule follows the SEC’s trend to shorten the time period to settle securities transactions every few years.The last update to the settlement cycle was in 2017, when the SEC changed the settlement timing from trade date plus three business days to T+2.

This rule aims to improve market efficiencies and investors’ ability to access their money in a timely manner. Chairman Gensler emphasizes that the increased settlement time, “will make our market plumbing more resilient, timely, and orderly.” Thenew settlement cycle, T+1, went into effect on May 28, 2024.Additionally, Chairman Gensler outlined three future policy areas: (i) enhancing customer clearing, (ii) shortening settlement cycle for currency trading, and (iii) determining if the settlement cycle should be shortened even further than T+1.

SEC Adopts Rule to Update Definition of Qualifying Venture Capital Funds. The SEC expanded the definition of “qualifying venture capital fund” under the Investment Company Act of 1940, raising the threshold to $12 million in aggregate capital contributions and uncalled committed capital (up from $10 million). As a reminder, a qualifying venture capital fund is subject to an expanded 250 beneficial owner limit. The rule also establishes a process for the SEC to make future inflation adjustments every five years in compliance with the Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018. The rule becomes effective 30 days after publication in the Federal Register, the date of which has not yet been announced. 

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CFTC Items

Chairman Behnam Promotes Ted Kaouk to New Office Focused on AI. The Commodity Futures Trading Commission (the “CFTC”) announced Ted Kaouk as its first Chief Artificial Intelligence Officer.Prior to being named First Chief Artificial Intelligence Officer, Dr. Kaouk served as the CFTC’s Chief Data Officer and Director of the Division of Data. “The CFTC has been deeply engaged in efforts to deploy an enterprise data and artificial intelligence strategy,” said CFTC Chairman Benham, continuing that, “Ted has the requisite technical and leadership experience needed to lead and implement the CFTC’s data and AI roadmap.” Dr. Kaouk will lead the development of the CFTC’s enterprise data and artificial intelligence strategy, integrating the CFTC’s ongoing efforts to advance its data-driven capabilities. This move is part of the CFTC’s efforts to enhance oversights, surveillance, and enforcement, and modernize the agency.

CFTC Doubles Financial Thresholds for Qualified Eligible Person Status. The CFTC adopted amendments to Rule 4.7, which, in part, affect the financial requirements for certain investors in commodity pools. Rule 4.7 exempts commodity pool operators (“CPOs”) and commodity trading advisers (“CTAs”) from certain disclosure, reporting, and record-keeping requirements so long as pool participants are restricted to Qualified Eligible Persons (“QEPs”). Notably, the CFTC doubled the financial threshold for certain investors to qualify as QEPs suitable to invest in a Rule 4.7 pool or fund to reflect inflation. Managers of vehicles who rely on Rule 4.7 should consider that updates will be needed to such vehicles’ offering documents to account for this change.

The Final Rule will be effective 60 days after publication in the Federal Register and the compliance date for the updated portfolio requirement will be six months after publication.

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Crypto and Digital Asset Items

Defendants to Pay $4.5 Billion Following Fraud Verdict. A unanimous jury delivered a verdict in the SEC’s fraud case against a digital asset software company and its Chief Executive Officer. During the nine-day trial, the SEC offered evidence that the company lied to investors about the use of its blockchain to settle transactions, misled investors about the stability of its crypto assets, and de-pegged the coin from the U.S. dollar, wiping out $40 billion in market value “nearly overnight.” SEC Enforcement Director Grewal noted this is the “largest securities fraud in U.S. history,” and Chairman Gensler reaffirmed, “the economic realities of a product—not the labels, the spin, or the hype—determine whether it is a security under the securities laws.”

SEC Charges Brothers Behind $60 Million Crypto Ponzi Scheme. Two brothers ran a $60 million Ponzi scheme marketed as a cryptocurrency investment opportunity. According to the SEC complaint against them, the brothers claimed their proprietary bot had monthly returns of 13.5% and were able to lure more than 80 investors into contributing to a “lending pool.” These investors were told that the automated bot would enter into smart contracts, which would then provide flash loans to arbitrage traders. The brothers repeatedly misrepresented their backgrounds, qualifications and expertise, previous business ventures, and more to gain unsuspecting investors’ trust.

In reality, according to the allegations, the brothers diverted $53.9 million out of $61.5 million raised from investors. Some of that money was used to finance their expensive lifestyles, which included the purchase of two luxury vehicles and a multimillion-dollar condominium in Miami. Some remaining funds were used to pay earlier investors – a classic sign of a Ponzi-style scheme. It has since come to light that one of the brothers covered up three prior convictions for securities fraud. The SEC obtained an emergency asset freeze and charged them with violating the antifraud provisions of federal securities laws. No response has been filed against these allegations.

SEC Names NFTs Sold on Platform as ‘Securities.’ A well-known NFT marketplace received a Wells Notice from the SEC alleging that certain non-fungible tokens (“NFTs”) sold on its platform are securities. In the past, these Wells Notices have led to settlements with the SEC. Two NFT projects were subject to SEC enforcement actions in 2023 as well, alleging the projects broke certain securities laws, and both actions led to settlements with the SEC. In response to the current Wells Notice, the company’s CEO expressed shock at this move by the SEC and warned that it could force creators to stop making digital art due to regulatory boundaries.

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Other Items

California Requires Investment Advisers to Complete New Continuing Education Classes. In May, the State of California issued a new regulatory action requiring investment advisers registered with the State of California to complete 12 credits of continuing education courses by year-end 2024 and each calendar year thereafter (the “Rule”). The Rule further specifies that courses must be taught by an authorized provider and be split evenly between two categories: (i) ethics and professional responsibility, with at least three credits specifically covering ethics, and (ii) products and practice. We encourage investment advisers registered with the State of California to review the Rule carefully to ensure compliance.

The Federal Reserve Issues Enforcement Action Against Customers Bank. The Federal Reserve Bank of Philadelphia (the “Federal Reserve”) issued an enforcement action against a bank for not properly reducing risk to its clients from its digital asset business. The Federal Reserve identified “significant deficiencies related to the bank’s risk management practices and compliance,” and ordered the bank to submit several plans within 60 days of its settlement with the Federal Reserve, outlining the bank’s improved risk assessment efforts and compliance with the Bank Secrecy Act of 1970 (the “Bank Secrecy Act”) and certain anti-money laundering requirements therein. These plans include: (i) revising its customer due diligence program, (ii) developing a third-party monitoring system for transactions, and (iii) updating its program to monitor and report violations of the law. This bank is a primary provider of banking services for digital asset customers, specifically for large crypto firms, and this action may signal a new area of targeted enforcement in the crypto industry.

Investment Advisers now Responsible for Compliance with Bank Secrecy Act. The Financial Crimes Enforcement Network (“FinCEN”) at the United States Department of Treasury issued a final regulation including investment advisers in the definition of “financial institution” under the Bank Secrecy Act.This change means that investment advisers registered with the SEC, or filing as an exempt reporting adviser with the SEC, will have to comply with anti-money laundering and countering the financing of terrorism requirements. Investment advisers will have until January 1, 2026, to file Suspicious Activity Reports and comply with other requirements of the Bank Secrecy Act.

Pay-to-Play Rules for the 2024 Elections. Investment advisers need to be aware of Pay-to-Play rules under Rule 206(4)-5 of the Advisers Act, as well as any applicable state or local rules or regulations during the 2024 election season. If an investment adviser or its covered associates make political contributions to officials who can influence the governmental entities’ selection of advisers, these rules could prohibit such adviser from receiving compensation for advising governmental entities.

Corporate Transparency Act Compliance. The requirements of the Corporate Transparency Act became effective on January 1, 2024. Reporting companies formed before January 1, 2024, must file their initial beneficial ownership report (“BOI Report”) with FinCEN before January 1, 2025. Companies formed between January 1, 2024, and December 31, 2024, are required to file a BOI Report within 90 days of formation, and companies formed on or after January 1, 2025, will be required to file their initial report within 30 days of formation. To learn more about the Corporate Transparency Act and its implications, please refer to this post on our blog.

Accelerated Deadlines for Schedule 13G Filings Now in Effect. In 2023, the SEC adopted amendments to its beneficial ownership rules including accelerated deadlines for Schedule 13G filings – effective as of September 30, 2024. The filing deadlines for Schedule 13G depend on whether a person files as a qualified institutional investor (“QII”), a passive investor, or an exempt investor, as those terms are defined in the Exchange Act.

Below are the updated filing deadlines:

Initial Filing Deadlines

• QIIs: The earlier of (a) 45 days after the end of the calendar quarter in which beneficial ownership exceeds 5% and (b) five business days after month-end in which beneficial ownership exceeds 10%.
• Passive Investors: Within five business days of acquiring a beneficial ownership of more than 5%.
• Exempt Investors: Within 45 days after the end of the calendar quarter in which beneficial ownership exceeds 5%.

Amendment Filing Deadlines

• All Schedule 13G Filers: Within 45 days after calendar quarter-end in which there was any material change in the information previously reported on Schedule 13G.

1. The first quarterly amendment deadline under the updated filing schedule will be November 14, 2024.

• QIIs: Within five business days after month-end in which beneficial ownership exceeds 10% or there is a 5% increase or decrease in beneficial ownership.
• Passive Investors: Within two business days after exceeding 10% beneficial ownership or a 5% increase or decrease in beneficial ownership.

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Compliance Calendar

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

October 10, 2024

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

November 11, 2024

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

November 14, 2024 

• Form 13F Quarterly Filing. Filing is for the calendar quarter that ended September 30, 2024, and should be submitted within 45 days of quarter end.
• Form 13G Quarterly Filing. Filing is for the calendar quarter that ended September 30, 2024, and should be submitted within 45 days of quarter end if there have been any material changes since the previous filing.
• CTA Form PR. Filing is for the calendar quarter that ended September 30, 2024, and should be submitted within 45 days of quarter end.

November 29, 2024

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

December 9, 2024

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

December 31, 2024

• Initial beneficial ownership reports due to FinCEN for reporting companies created before January 1, 2024.

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.
• Initial beneficial ownership reports due to FinCEN:

1. For reporting companies created in 2024, within 90 days of their creation or registration.
2. For reporting companies on or after January 1, 2025, within 30 days of their creation or registration.
3. For updated reports, within 30 days after previously reported information changes.

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.