We are moving into the next phase of operations after the FTX collapse – for those crypto funds that did not face issues with assets on FTX (and even for those who did and who are remaining in business), we are now examining how this disruption changes the way managers operate their business and/or how do investors look at crypto fund terms and operational structures.
As managers deal with questions from investors, or how they will proceed with their operations post-FTX bankruptcy, they may want to be thinking about the following items:
Side Pockets – some managers may have seen their investment in FTX turn from individual crypto assets into a single asset (a bankruptcy claim) that has much different liquidity parameters. The single asset bankruptcy claim may need to be sidepocketed and if so managers should review their fund documentation to see how that works and also discuss the mechanics with their fund administrator. Of course, when sidepocketing any asset, managers should be careful with accounting and valuation. There are a number of other issues applicable to side pockets that managers may want to think about, including maximum percentage allocable to side pockets and when assets can be so designated.
Lock-ups – in general liquid crypto funds have been able to institute longer initial and ongoing lock-up periods than traditional managers. How these periods interact with the withdrawal provisions will determine required liquidity for any withdrawal periods.
Suspension of withdrawals – most offering documents (both in the traditional and digital asset spaces) have pretty standard suspension of withdrawals discussions. Normally to suspend withdrawals there needs to be a major disruption in the industry. My normal talking point is that it would be a 9-11 type event. Here, for managers who had assets on FTX, this may be a suspension type event depending on the various circumstances of the particular fund (including total liquidity and normal withdrawal provisions, which may include a gate provision). Managers may want to take another look at this language given the recent market events.
Custody – this is always one of the most important disclosures for managers. Custody in the digital assets space, while much improved from 2017-2018, is still all over the place. Some managers will self-custody as much assets as possible while keeping certain assets with actual qualified custodians, and some managers will keep some or most assets on-exchange. Whatever the technical expertise the manager has, and the mix of cold/hot storages and off/on-exchange, should be reviewed to make sure that a manager’s current practice mirrors the disclosure in the offering documents.
Conflicts of interests (COI) – COI is always a vitally important section in any offering documents and managers should always try to over-disclose here. For most groups with streamlined structures (GP-Fund entities only), there are standard COIs. For groups with multiple management level entities and different agreements between them, or for groups with multiple fund structures and outside entities (like staking, mining, other service businesses) there will need to be more robust disclosure of the activities.
Discussion of investment program – the purpose of the investment program disclosure is to provide investors with some kind of an overview of how the assets will be invested. Some managers have multiple pages of disclosures and some will have a couple of paragraphs. Some will include a discussion of everything they could potentially do and percentages etc, and some will be purposefully vague (and then augment the discussion with more detail in a pitchbook or other marketing materials). Managers sould review the program and make sure it accurately describes their current state of affairs as well as how the program may change in the future.
Risk factors – perhaps the most important part of the documents for a crypto fund manager is the risk factor section. There are some limitations in what ultimately is disclosed because at any particular time because the industry is constantly evolving, and quickly. For managers in the traditional investment management space, most risks for any particular investment strategy has been developed over a long period of time. In the digital asset space, risk factors are constantly being added and also modified over time. For our manager clients, the risks related to exchanges and counterparties, both domestic and offshore, were robust and accurately depicted the issues that the FTX bankruptcy brought to the forefront. Many times we work hand in hand with managers to understand the risks of a particular part of the industry and we develop them together. Our specific risk factors have been informed by our interactions with regulators.
For each of the sections above, there are many different ways for managers to think about the issues presented. We believe that it is important to discuss and think about these items on the front end, and we also believe that investors will be giving greater weight to these items in the future (especially with respect to side pockets and liquidity) so crypto fund managers should give these items extra thought during the fund formation process. While the above items were written with the crypto space in mind, the concepts apply equally to those groups in the traditional investment management space.
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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon has been instrumental in structuring the launches of some of the first cryptocurrency focused hedge funds. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.
Contracting for the Sale of a FTX Bankruptcy Claim
There are a number of digital asset focused funds that have their assets on FTX frozen pending the bankruptcy process. These managers now have a claim against FTX and it is unclear when such claims will ultimately be settled and for how much. For a variety of reasons then many of these groups are looking to sell their claims and move on with their operations (either to continue their investment program or to close down).
In the event a crypto manager does decide to sell a claim, we believe the sale should be memorialized in a contact of some kind, as would be normal operating procedure. However there are not really any standardized contracts for these types of claims. What we are seeing though is that parties are modifying existing OTC trade document to fit the particulars of this situation. In these documents we are seeing the following as the main sections:
Discussion of the parties – this is pretty clear here, but the main selling party is the fund that holds the claim. That fund may be a standalone or may be the master fund in a master-feeder structure.
Discussion of the claim – the claim will normally be identified by the name of the selling party, but there may be additional information included as well including account numbers, account activity, outstanding amount, etc.
Price – obviously this is the most important part for the selling party. We are seeing/hearing anywhere from 3 cents to 8 cents on the dollar depending on a number of factors. Managers should speak to at least two counterparties to see what the prevailing price and other terms are for these claims.
Buyer due diligence – the contract may have a discussion about continued buyer due diligence on the claim. [Note: this seems a bit odd and kind of turns the “contract” into more of a kind of “binding term sheet”…]
Reps and warranties – manager sellers should be careful of any contract here that requires reps and warranties on the managers behalf. This is especially true if the manager will be shutting the fund down after the sale of the claim. It is unclear how the process will play out and the manager does not want to be creating a headache for themselves in later years based on a rep made in haste while trying to sell the asset. We would recommend negotiating this section pretty aggressively. Notwithstanding the above, normal reps regarding AML/KYC, ability to contract, etc are likely to not pose any issues to manager sellers.
Miscellaneous items – there are standard miscellaneous items in these contracts around jurisdiction, which is turning into an interesting issue in this bankruptcy case.
If the manager ultimately does decide to sell a bankruptcy claim, they should talk with their various service providers to make sure that all important items are addressed (legal, tax, accounting, audit).
With respect to the auditor, the most important item is to make sure that title over the claim has fully passed to the third-party so the auditor can determine that the transfer of the asset/claim to the buyer is complete and therefore off the books of the fund. Please note again there may be jurisdictional issues (needing Bahamian counsel) or issues with respect to the bankruptcy process (which may require bankruptcy counsel). We expect that these sales will pick up as managers try to get these claims off of their books by the end of the year.
We are also recommending to clients that they draft some kind of compliance memo to file that discusses all aspects of the decision to sell and the factors around the ultimate sale price.
Please feel free to reach out if you have questions on this process and we will try to keep this post updated as we deal with more of these sales over time.
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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon has been instrumental in structuring the launches of some of the first cryptocurrency focused hedge funds. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.
Remarks from Digital Asset Private Fund Conference
A couple of weeks ago on November 3rd our law firm sponsored and ran our digital asset fund conference called CoinAlts. While originally an open conference for all in the digital assets space, it has more recently turned into a client event centered around crypto fund managers. The goal has always been the same though – to come together to discuss topical digital asset items and to figure out ways for our manager clients to operate their business better. We were lucky that the conference happened just before the FTX debacle unfolded because the panels were engaged with the real day-to-day issues involved in running a crypto investment management business.
Below I’ve published my opening remarks and my quick closing remarks. For a list of the speakers and the panel topics, you can visit our CoinAlts website.
Before we get into everything, I wanted to ask this question – why are we here today? What are we hoping to accomplish?
Welcome everyone to CoinAlts 2022. This is the 5th full installment of the conference series which was started in 2017 dedicated solely to digital asset fund managers and put on by four founding sponsor firms – Cole-Frieman & Mallon, MG Stover, Cohen & Co, and Harneys. My name is Bart Mallon and I’ll be saying a few items this morning and will be with you throughout the day.
I often ask myself what am I trying to get out of a conference before I go – many times, it is just that I want to get away and see friends and have a few drinks. But in general, when I am going to conferences I try to look at what panels will help me with information help me be better in my business or how will it help me look at the world in a different way.
Over the last few crytpo conferences, I’ve felt there was not much new stuff or one good idea that I could carry through back to day to day life – the narratives that I’ve heard lately at these conferences are generally “well we’re in bear market and new good things are coming because that’s how the cycles work”…
So, I guess, if that’s where we are – that it’s a bear market and we have to wait until the next cycle until there is something interesting or important, then why are we here? Before I tell you my thoughts on that, let’s take a quick look at where we have been and what has been accomplished over these last five years since coinalts started.
Let’s start with just the sheer amount of different crypto strategies we’ve seen during this time:
Long bitcoin
Long bitcoin and other tokens
Token trading
Long/short tokens
High frequency trading
Exchange arbitrage
Blended or Multi-Strat offerings
Crypto VC
Mining focused funds and operations
Yield farming
Offshore focused exchange trading
Staking (and the rise of staking specific service entities)
Ecosystem dedicated strategies
Lending and DeFi strategies
NFTs
Web3, and,
DAO focused strategies
We all know that each of these are unique strategies, some literally having not existed even a couple of years ago. From these strategies the founding sponsors have collectively worked with our manager clients (many of you here today) to develop “the firsts” in an industry and I’ll list off a few of these:
The first to really force the definition of crypto tokens as securities – we started with the question of what are crypto assets? I am not sure we know for sure still – we know that bitcoin is not a security (at least for now), but what about ETH and Ripple? At some point we will gain clarity, but our law firm was adamant from the very beginning that many assets would “likely be deemed to be securities” and therefore are subject to many of the traditional investment management laws.
The first firm to specialize in the crypto audit – how do you even audit something that is not physical and may not have a traditional custodian? There are so many questions here that the team at Cohen had to deal with from the theoretical of “what does it mean to have the ability to control an asset?” to the mundane – “how do we see this asset on a blockchain?”
The first to deal with issues around Net Asset Value:
Traditional investment managent space markets don’t trade 24/7
Concept of first/last business day of a month or quarter versus the last calendar day
We collective saw themovement from midnight ET to UTC (which I now understand means Universal Time Coordinated – I had to look that up, perhaps Matt can confirm)
The first full crypto NAV process (as opposed to NAV Lite)
The first daily NAV crypto hedge fund
The first questions around Hard Forks – how do you deal with these from an accounting and tax standpoint? How do you deal with any legal issues. Operational items? What to be careful with? Same thing with Airdrops.
In-Kind Crypto Subscriptions and Redemptions – same thing here – this is a completely different process from the tradfi space and we helped facilitate all aspects of these transactions, from legal to tax to operations.
Custody – for a few years this was one of the bigger legal and compliance issues for our managers. How do you deal with the various issues around self-custody given the lack of qualified custodians? It’s been a pretty constant five years of dealing with this front and center issue and there are many knowledgeable people here.
SEC registration – similar to the custody issue, how would digital asset managers actually register with the SEC if they were trading digital assets.
SEC examination – perhaps even a bigger question than registration was examination. We didn’t know how the SEC would react to our clients – we helped our clients with both of these and found out that they did ok.
Many people here were some of the first people to speak with regulators of all kinds – SEC, state securities regulators, the IRS – about digital assets. Many people here have been and currently are involved with discussions with legislators for future tax and regulatory bills.
Finally, the firsts for really building the basis for the industry – obviously legal and audit and tax were huge in this space, but we literally had the folks at MG Stover building APIs into exchanges. Helped correct/fix/create APIs for various exchanges and custodians. Build pricing sources. Standardized OTC trade confirms. Standardized custody reporting. None of the day-to-day nuts and bolts for reporting would happen without these items…and
They even found $5mm hack of a client through their reconciliation process and the client ended up recouping all the crypto.
All of these things are the firsts that were developed hand in hand between our clients and our firms through many hours of phone calls, collaborations, research, a lot of “I thinks” and “we’ll see” and “hopefullys”…some “I don’t knows”…these are the things you go through when you are building the infrastructure of an industry…
I’ve already mentioned the four founding sponsors, but this conference also could not be put on without our Partner level sponsors Cowen Digital, Figment, Standard Custody and Trust Company; and out Supporter level sponsor Aspect Advisors, IQEQ, Silvergate, Withum, Copper, and Nova. We also had our Women in Crypto networking event yesterday which was sponsored by Aspect, Strix Leviatian (a crypto fund manager), and StoneX that had about 75 attendees. CalAlts, HF Alert, Help for Children were also our partner sponsors and we appreciate all their help.
For the first time our conference auctioned off an NFT 1.07ETH to a private collector in the Bay Area…the proceeds from this transaction will be donated to Help for Children, along with a match from our law firm. Anyone else who wants to match, please see Sharon Hamilton over there. I will spend more time thanking Sharon later today, but she is the main person who put this conference on, along with Karen Thornton, so please thank her if you see her today.
We have six panels that will cover topics ranging from legal to custody to raising assets. We also have two special keynotes from Mark Yusko and Punk6529, a lunch, breaks and networking reception at the end. There is no shortage of current topical items that will probably be discussed during these times today:
Is crypto simply a risk-on asset that will move in lockstep with tech?
When is the crypto spring?
How do we not yet have a bitcoin ETF?
How will the recent OFAC rulings affect business going forward?
What did Terra Luna tell us about systemic risks of the industry?
Will the SEC and CFTC begin to regulate through rulemaking or continue with regulation by enforcement?
What does the successful ETH merge mean, if anything?
How will midterm elections affect the crypto space, if at all?
Will FTX continue buying everything in sight?
Apple, Twitter, Google, Starbucks, Reddit…each one of them have real and interesting crypto use cases…which of these are going to emerge as real things that will be integrated into our daily lives?
And… funds have raised hundreds of millions of dollars, there are billion dollar funds, and even multi-billion dollar crytpo and crypto VCs fund that have been raised over the last 12 months…what will they be doing with that capital?
So I go back to the original question – why are we here?
I submit we might not know the reason right now but I am hoping we all find ideas, or hints of ideas, during the panels today that will help us in our day to day business and in life going forward. I also hope that something here will spark another first we can add to our list…
With that as perhaps one reason for us to be here, we’ll move into our first item of the day, our Keynote discussion with Mark Yusko, Managing Partner of Morgan Creek Digital, talking here with Matt Stover of founding sponsor MG Stover.
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CLOSING REMARKS
Thanks to all of the speakers, panelists and moderators today – there were a number of distinct takeaways for me – from not calling NFTs NFTs (instead digital property rights), do not make misrepresentations in your offshore account paperwork, that exchanges and custody will continue to bifurcate, the importance of crypto fund service providers to work together, that defi platforms generally worked, that there is an opportunity with respect to asset prices right now because of the crypto winter, and operational due diligence for crypto funds is in a much different place than it was even a couple of years ago.
Thank you again to all of our sponsors who helped make this event possible and specific thank yous go out to Sharon Hamilton of Cole-Frieman & Mallon and Karen Thornton – I know these two spent an inordinate amount of time working to make sure this symposium would be a success and we obviously could not have done this without them.
At the beginning of the conference I had asked everyone why we were here today…I didn’t realize we would get such a forceful call to action from Punk 6529 but I think that he’s right – we have to look to ourselves to see what we have individually done to help this industry and we have to fight for it. It is not guaranteed.
And with that I’d like to invite you all to our cocktail reception.
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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon has been instrumental in structuring the launches of some of the first cryptocurrency focused hedge funds. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.
Aspect Advisors and Cole-Frieman & Mallon are excited to usher in our second annual compliance update, albeit in a virtual format this year. [For a summary of our event last year, please go here.]
These past twelve months have been especially eventful from both a regulatory and business perspective, with both the traditional investment management space and the digital asset world experiencing a number of noteworthy progressions. The event will address the following topics:
2021 compliance calendar (including Form ADV annual update)
Major issues from the SEC and courts in 2020
The year of Bitcoin and DeFi
Fintech regulations and best practices
Other hot topics
The event is on January 21, 2021 at 10am PT. You can register here.
Although virtual, we will have an opportunity for real time audience questions to help guide the discussion. We look forward to seeing you all then!
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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon has been instrumental in structuring the launches of some of the first digital currency-focused hedge funds. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.
As of July 15, 2017, the Colorado Division of Securities (“CDS”) adopted Rule 51-4.11(IA) of the Code of Colorado Regulations which exempts certain investment advisers whose sole clients are qualifying private funds from having to register with the state (the “Colorado Private Fund Adviser Exemption”). Investment advisers that meet the requirements of the Colorado Private Fund Adviser Exemption can file as an exempt reporting adviser (“ERA”) with the CDS. Previously, such investment advisers located in Colorado were required to register with the state. The Colorado Private Fund Adviser Exemption generally mirrors the SEC’s private fund adviser exemption and similar exemptions of other states; however, there are some important differences as discussed below.
Colorado Private Fund Adviser Requirements Generally.
In order to take advantage of the Colorado Private Fund Adviser Exemption, an investment adviser must:
provide investment advice solely to one or more “qualifying private funds” as defined by the SEC (generally, any private fund not registered under the Investment Company Act of 1940, as amended, (e.g., a 3(c)(1) or 3(c)(7) fund));
not be subject to any “bad actor” disqualification events under Regulation D (this does not apply specifically to SEC ERAs);
file a report (generally, Part 1A of the Form ADV) and any amendments thereto required of an SEC ERA; and
pay the fees prescribed by the Colorado securities commissioner.
Additional Requirements for Certain 3(c)(1) Fund Advisers
Investment advisers to 3(c)(1) funds that are not “venture capital funds” (as defined by the SEC) (such 3(c)(1) fund, a “Non-VC 3(c)(1) Fund”) must also satisfy the following conditions with respect to each Non-VC 3(c)(1) Fund:
such Non-VC 3(c)(1) Fund’s securities may only be beneficially owned by persons who, after deducting the value of the primary residence from such person’s net worth, meet the qualified client definition (which deviates from the accredited investor threshold adopted by some states);
disclose the services, duties and other material information affecting the rights and responsibilities of each beneficial owner, if any; and
obtain and deliver annual audited financial statements to the Non-VC 3(c)(1) Fund’s investors.
Relief from “Gatekeeper” Requirement
Generally, Colorado investment advisers to pooled investment funds must engage an independent representative (a CPA or attorney) as a “gatekeeper” to review all fees, expenses and capital withdrawals from the pooled investment fund. However, an investment adviser availing of the Colorado Private Fund Adviser Exemption is not subject to this requirement and, thus, is not burdened with the obligation or expense to engage such third-party gatekeeper.
Transitioning to Registration and SEC Eligibility
Investment advisers no longer eligible for the Colorado Private Fund Adviser Exemption must register with the state within 90 days of such ineligibility. Moreover, once an adviser’s assets under management equals or exceeds $110 million as of an annual updating amendment to Form ADV, such adviser must file as an SEC ERA or register with the SEC, as applicable.
Conclusion
The Colorado Private Fund Adviser Exemption is a welcomed and useful exemption for Colorado private fund advisers. If you would like assistance in filing for the exemption or have any questions, please contact Scott Kitchens (415-762-2847) or Tony Wise (415-762-2863) at Cole-Frieman & Mallon LLP’s Denver office.
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Cole-Frieman & Mallon is a boutique law firm focused on providing institutional quality legal services to the investment management industry. Please contact us if you would like more information on this topic.
We hope you have had an enjoyable summer. While the third quarter is typically quieter than the second quarter from a compliance perspective, we continue to see meaningful enforcement actions pursued by regulatory authorities. As we move into the fourth quarter, we want to provide an overview of items we hope will help you stay up to date with regulatory requirements.
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SEC Matters
SEC Expands the “Accredited Investor” and “Qualified Institutional Buyer” Definitions. On August 26, 2020, the Securities and Exchange Commission (“SEC”) adopted amendments to the “accredited investor” definition under Rule 501(a) of Regulation D under the Securities Act of 1933, as amended (the “Securities Act”), which include additional categories of natural persons or entities who may qualify as accredited investors. Notably, certain of the new categories will enable natural persons to qualify as accredited investors on the basis that they have the requisite ability to assess an investment opportunity based on measures of professional knowledge, experience or certifications, irrespective of whether these persons meet any income or net worth thresholds. The SEC also amended the “qualified institutional buyer” definition under Rule 144A of the Securities Act to include institutional investors contained in the accredited investor definition so long as they meet the $100 million in securities owned and invested threshold. The amendments were published in the Federal Register on October 9, 2020 and will become effective within 60 days after such publication (i.e., December 8, 2020). Managers should review their fund documents to determine which documents will need to be updated to include the amendments to the accredited investor definition. Our recent blog post addresses FAQs we have received on the updated definition.
Private Funds Risk Alert. The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) published a Risk Alert identifying commonly observed key deficiencies in OCIE’s examinations of advisers to private funds. Notably, OCIE found investors in private funds may have paid more in fees and expenses as a result of these deficiencies, which included inaccurate allocations of fees and expenses, failures to value client assets in accordance with valuation policies and failures to track, apply and/or calculate fees received from portfolio companies (whether or not such fees were used to offset management fees received by the adviser). OCIE also highlighted inadequate conflicts of interest disclosures, finding that many advisers did not provide investors with sufficient detail regarding conflicts related to allocation of investments among the adviser’s clients and conflicts related to investments in the same portfolio company made by multiple clients of an adviser and co-investments. Managers should review their allocation policies as well as disclosures regarding potential allocations of investments among clients to ensure that adequate and clear disclosures are included.
Reg BI FAQ Updated with Guidance for Broker-Dealers When Using “Adviser/Advisor”. In response to confusion raised by broker-dealers, the SEC has indicated in a handful of recent updates to its FAQs regarding Regulation Best Interest (Reg BI) that a broker-dealer generally may not use the term “adviser” or “advisor” to refer to itself unless it is registered as an investment adviser (an “RIA”), subject to certain limited exceptions. The SEC’s responses included examples of common situations when broker-dealers typically may refer to themselves as “advisers” or “advisors” when not so registered, including when such broker-dealer is acting in a role defined by statute such as a municipal advisor or commodity trading advisor. Reg BI’s disclosure obligation requires in-scope broker-dealers and investment advisers to disclose to retail customers all material facts relating to the nature and terms of the relationship between them as well as all material facts relating to conflicts of interest that are associated with the recommendation. As discussed in our previous update, compliance with Reg BI was required as of June 30, 2020. Given the nascence of the Reg BI requirements we expect the SEC to continue updating the Reg BI FAQs to address other common confusion or Reg BI deficiencies identified in examinations of investment advisers and broker-dealers.
SEC Charges CA Adviser for Misappropriating Client Funds. In a recent enforcement action, the SEC charged a California adviser with violating the antifraud provisions of the Securities Exchange Act of 1934, as amended, the Securities Act and the Investment Advisers Act of 1940, as amended (the “Advisers Act”). The SEC alleges that during the adviser’s association with other SEC-registered firms, the adviser acted alone and through his company to misappropriate client funds (including the sale of client securities and diverting the proceeds for his use) and make other material misrepresentations and omissions. The SEC’s complaint further alleges that the adviser actively took steps to conceal his misconduct from existing and future advisory clients, including forging a letter from his client indicating that the client had gifted him the misappropriated funds. The adviser further failed to disclose to prospective clients that his affiliation with one of the SEC-registered firms had been terminated for stealing client funds. While the alleged conduct is particularly egregious, this action serves as a reminder that investment advisers owe their advisory clients a fiduciary duty to place the clients’ interest ahead of their own and to disclose all material facts to the clients about their investment.
SEC Charges Fund Adviser with Antifraud Violations. The SEC was granted emergency relief to stop an RIA (and its sole individual owner) from continuing to offer interests in a private fund it managed and destroying documents which may contain evidence of fraudulent conduct. In soliciting investors for the fund, the SEC alleges that the RIA not only misrepresented the fund’s past performance, the amount of assets managed and the owner’s experience as a portfolio manager, but also falsified brokerage records and investor account statements, and sent fake audit opinions to investors and third parties. As an example of the fraudulent conduct, the SEC’s complaint alleges that a document provided to the fund’s investors and potential investors showed 37 months of positive monthly performance when the fund actually had approximately 26 months of negative monthly performance during the applicable time period. The SEC charged the RIA and its owner with violating the antifraud provisions of federal securities laws and charged the individual owner with aiding and abetting the RIA’s violations of the Advisers Act. The SEC is seeking injunctions, disgorgement of allegedly ill-gotten gains with prejudgment interest and financial penalties.
SEC Brings Action Against Manager for Expense Disclosure and Allocation Failures. In a recent enforcement action demonstrating the SEC’s continued scrutiny of the adequacy of fund managers’ expense disclosures and expense allocation procedures, the SEC censured a Florida-based RIA for failing to properly disclose and allocate to the applicable funds the expenses of “third party tasks” performed by the RIA “in-house.” The SEC cited the firm for failing to properly allocate these expenses between the applicable funds and co-investment vehicles managed alongside the funds, resulting in the funds being charged more than their pro rata share of the costs and expenses of reimbursing the firm for the third party tasks. In violation of the Advisers Act, the SEC found that the firm failed to adopt any written policies and procedures reasonably designed to properly disclose, calculate and allocate such that third party task expenses. Managers should review their fund documents and consider whether they sufficiently disclose expenses borne by the applicable fund as well as whether the manager has adequate policies and procedures in place regarding allocating expenses between the applicable fund and other funds or clients of the manager.
SEC Charges NY Firm and CCO for Compliance Failures. The SEC recently censured a dually-registered investment adviser and broker-dealer firm and its chief compliance officer (“CCO”) for failing to adhere to written policies and procedures implemented to remedy deficiencies discovered in a previous examination of the firm’s compliance program. The SEC further found that the CCO not only failed to conduct the monthly compliance reviews required under the program, but also altered monthly review documents that were provided to the SEC in a subsequent examination to give the appearance that the reviews had been conducted during the period covered by the SEC’s examination. To settle the charges, the firm and CCO paid a penalty of $1,745,000 and agreed to cease and desist from committing future violations of the antifraud provisions of the Advisers Act. The CCO was also barred from associating with any broker-dealer or investment adviser, subject to a right to reapply for association in the future, and prohibited from serving or acting as an employee or similar of an advisory board, investment adviser or depositor of, or principal underwriter for, a registered investment company, or an affiliated person of such investment adviser, depositor or principal underwriter.
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Offshore Matters
Cayman Islands Amends the Private FundsLaw. On July 7, 2020, the Cayman Islands Monetary Authority (“CIMA”) further amended the Cayman Islands Private Funds Law 2020 (the “PF Law”) to expand the definition of a private fund (“Private Fund”), thereby extending the scope of the PF Law to additional closed-ended entities which must now register with CIMA. The revised definition provides that a Private Fund is any company, unit trust or partnership that offers or issues (or has issued) investment interests to investors with the aim of providing such investors profits or gains from investments; provided that, (i) the investors do not have day-to-day control of the entity’s investments and (ii) the investments are managed by or on behalf of the entity’s operator. The PF Law also specifies narrow categories of persons or any non-fund arrangements that are not included in the Private Fund definition and, thus, do not need to register with CIMA. Entities that now fall under the Private Fund definition were required to register with CIMA by August 7, 2020. Managers of Cayman Islands closed-ended vehicles that have not registered with CIMA should discuss this matter with counsel.
BVI Financial Services Commission Issues Guidance on Digital Assets. On July 13, 2020, the British Virgin Islands (“BVI”) Financial Services Commission (“FSC”) issued guidance clarifying the regulatory framework applicable to digital assets. The guidance, which is part of the FSC’s burgeoning regulation of digital assets and investment activities related to digital assets, clarifies the types of digital asset products that may be captured under the Securities and Investment Business Act, 2010 (“SIBA”), either (i) when the products are initially issued or (ii) when the products are in the hands of a holder or the subject of a regulated investment activity after issuance. The guidance provides an illustrative table of the types of digital asset products that may be regulated under SIBA, although additional analysis may be required for certain types of digital asset products, such as digital assets that create an entitlement to shares, interests or debentures. The FSC is allowing a 6-month compliance period from the date of publication during which any relevant entity may submit an application for the applicable license or certificate. If a digital asset product falls within the definition of an “investment” under SIBA, persons carrying on an investment business activity with respect to such digital asset products will need to be licensed with the FSC by January 13, 2021. Managers should review and consider whether they are or may be engaged in any regulated investment activities in or from within the BVI such that a license from the FSC is required.
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Digital Asset Matters
INX Launches First SEC-Approved Blockchain IPO. INX Ltd., a Gibraltar-based company (“INX”), launched the first SEC-registered token IPO after the SEC declared that the registration statement relating to the offering of INX’s security tokens was effective on August 20, 2020. INX will allow investors to purchase INX tokens with certain cryptocurrencies and stablecoins as well as the U.S. dollar as it raises funds to further develop a multiservice digital asset platform aimed at providing its customers with a single entry-point for the trading of cryptocurrencies, security tokens and their derivatives. INX notes that INX tokens have both security and utility benefits for their holders: (i) as a security, by entitling the holders to a mandatory profit share of INX’s profit and a liquidation preference and (ii) as a utility, by providing a discount on transaction fees charged via INX’s platform when used to pay the fees and when used for staking on INX’s platform.
ConsenSys Acquires Quorum, JP Morgan’s Blockchain Platform. ConsenSys, a blockchain software company, recently announced its acquisition of Quorum, an enterprise-variant of the Ethereum blockchain developed by J.P. Morgan. Through the acquisition, ConsenSys seeks to increase the availability of Quorum’s features and capabilities, such as digital asset functionality and document management, by offering a range of products, services and support for Quorum, which will become interoperable with other blockchain products offered by ConsenSys. J.P. Morgan, which also made a strategic investment in ConsenSys in connection with the acquisition, will become a customer of ConsenSys and will utilize the advanced features and services ConsenSys will provide for Quorum. J.P. Morgan’s development of Quorum and its partnership with ConsenSys are additional examples of the growing institutional adoption of blockchain technology and acceptance of digital assets.
SEC Charges Virginia-based Issuer of Unregistered ICO. In a recent enforcement action, the SEC found that a company and its CEO conducted an unregistered initial coin offering (“ICO”) in connection with its development of a platform to link employers and freelancers. The company raised approximately $5 million in the ICO, selling 125 million tokens to approximately 1,500 investors. The SEC found that the tokens were “securities” under the Howey Test since an investor would have had a reasonable expectation of profit based upon the company’s efforts. Therefore, the tokens could have only been sold through a registered offering or under an exemption from registration requirements. The order also describes the company’s and the CEO’s misrepresentations related to the technical capabilities of the platform and the stability and security of the tokens. The company was ordered to disgorge the monies raised in the ICO and to pay pre-judgment interest of over $600,000. The CEO was individually required to pay a penalty of $150,000, and was barred from serving as an officer or director of a public company and from participating in future offerings of digital asset securities.
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CFTC Matters
CFTC Prohibits Regulation 4.13 CPO Exemptions to Certain Persons Subject to Statutory Disqualifications. The CFTC approved a final rule amendment to Regulation 4.13 of the Commodity Exchange Act of 1934, as amended (the “CEA”), which prohibits a person from claiming an exemption from registration as a commodity pool operator (“CPO”) pursuant to Regulation 4.13 if the person or any of its principals are subject to any of the statutory disqualifications listed in Section 8a(2) of the CEA (the “Covered Statutory Disqualifications”). Previously a person claiming an exemption under Regulation 4.13, which includes the often-used “de minimis exemption” pursuant to Regulation 4.13(a)(3), was not required to represent that it was not subject to a Covered Statutory Disqualification to qualify for such exemption. Notably, the changes are not applicable to family office CPOs claiming the exemption under Regulation 4.13(a)(6). The amendment became effective on August 4, 2020. After the effective date, persons who wish to claim an exemption under Regulation 4.13 will need to represent that neither they nor their principals are subject to the Covered Statutory Disqualifications. For a CPO relying on an exemption prior to the effective date, the CFTC has determined not to mandate compliance until March 1, 2021, which is also the deadline for CPOs to file an annual reaffirmation notice for continued reliance on an exemption. As such, firms that wish to claim or reaffirm an exemption under Regulation 4.13, with the exception family office CPOS, will need to determine whether any of their principals have a Covered Statutory Disqualification in their background.
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Other Matters
Form BE-180 Requirement for U.S. Managers and Funds. The Bureau of Economic Analysis at the U.S. Department of Commerce (the “BEA”) requires certain U.S. Financial Service Providers (including investment advisers, funds and their general partners) that engaged in a financial services transaction with a foreign person during their 2019 fiscal year to file a report on Form BEA-180 (the “Form”). This requirement will apply to any of our U.S.-based clients that are investment advisers or general partners to an offshore fund, and certain other clients as well. The Form is a 5-year benchmark survey and the deadline to file the Form electronically is October 30, 2020.
The Form requires additional transaction-specific information from Financial Service Providers that either sold financial services to foreign persons in excess of $3,000,000, or purchased financial services from foreign persons in excess of $3,000,000. Please note that sales and purchases are calculated separately, meaning if a Financial Service Provider exceeds the threshold with respect to sales but not purchases, the requirement to provide additional transaction-specific information on the Form would only apply with respect to sales transactions.
Please see our previous post for more information as to who is considered a “Financial Service Provider” and what types of transactions are covered, as well as common scenarios that may apply to some of our clients.
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CFM Events
In early September our own Bart Mallon hosted a discussion forum with panelists from tax, compliance and legal firms which explored issues currently affecting digital asset managers, including among others DeFi, custody and regulatory developments. You can find a useful recap of the event on our blog. Later in the month, Cole-Frieman & Mallon LLP also co-sponsored a very well received fireside chat with Matthew Goetz of BlockTower Capital, in the second of an ongoing series of CoinAlts Fund Symposium webinars.
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Compliance Calendar Please note the following important dates as you plan your regulatory compliance timeline for the coming months.
Deadline
Filing
September 30
Review holdings to determine Form PF filing requirements.
October 13
Amendment to Form 13H due if there were changes during Q3.
October 15
SEC deadline to file 3rd Quarter 2020 Form PF for quarterly filers (Large Liquidity Fund Advisers), through PFRD.
October 15*
Extended deadline to file Reports of Foreign Bank and Financial Accounts (FBAR).
October 30
Form BE-180 due for managers and funds filing electronically to report sales or purchases to foreign persons for covered financial transactions, through BEA eFile.
October 30
Registered CPOs must distribute (i) monthly account statements to pool participants (pools with net asset value of more than $500,000) and (ii) quarterly account statements to pool participants (pools with net asset value less than $500,000 or CPOs claiming the 4.7 exemption).
October 30
Registered investment advisers must collect access persons’ personal securities transactions.
November 14
National Futures Association (“NFA”) deadline to file Form PR for registered CTAs. through NFA EasyFile.
November 16
Investment adviser firms may view, print and pay preliminary notice filings for all appropriate states, through IARD.
November 16
SEC deadline to file Form 13F for 3rd Quarter of 2020.
Deadline for paying annual IARD charges and state renewal fees, through IARD.
December 31
Cayman funds regulated by CIMA that intend to de-register (i.e. wind down or continue as an exempted fund) should do so before this date in order to avoid 2021 CIMA fees.
Periodic
Fund Managers should perform “Bad Actor” certifications annually.
Periodic
Form D and Blue Sky filings should be current.
Periodic
CPO/CTA Annual Questionnaires must be submitted annually, and promptly upon material information changes, through the NFA Annual Questionnaire system.
*Extended deadline pursuant to COVID-19 pandemic-related relief
Please contactus with any questions or for assistance with any of the above topics.
Sincerely,
Karl Cole-Frieman, Bart Mallon, Lilly Palmer, David Rothschild, & Scott Kitchens
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Cole-Frieman & Mallon LLP is a premier boutique investment management law firm, providing top-tier, responsive, and cost-effective legal solutions for financial services matters. Headquartered in San Francisco, Cole-Frieman & Mallon LLP services both start-up investment managers, as well as multi-billion-dollar firms. The firm provides a full suite of legal services to the investment management community, including hedge fund, private equity fund, venture capital fund, mutual fund formation, adviser registration, counterparty documentation, SEC, CFTC, NFA and FINRA matters, seed deals, hedge fund due diligence, employment and compensation matters, and routine business matters. The firm also publishes the prominent Hedge Fund Law Blog, which focuses on legal issues that impact the hedge fund community. For more information, please add us on LinkedIn and visit us at colefrieman.com.
The Bureau of Economic Analysis at the U.S. Department of Commerce (the “BEA”) requires certain U.S. Financial Service Providers (including investment advisers, funds and their general partners) that engaged in a financial services transaction with a foreign person during their 2019 fiscal year to file a report on Form BEA-180 (the “Form”). This requirement will apply to any of our U.S.-based clients that are investment advisers or general partners to an offshore fund, and certain other clients as well. Some of our clients may have been notified to complete this Form directly by the BEA, however even clients who have not been contacted may be required to submit the Form.
The Form is a 5-year benchmark survey and the deadline to file the Form electronically is October 30, 2020. Please note the deadline of September 30, 2020 for paper filers has passed. The Form requires additional transaction-specific information from Financial Service Providers that either sold financial services to foreign persons in excess of $3,000,000, or purchased financial services from foreign persons in excess of $3,000,000. Please note that sales and purchases are calculated separately, meaning if a Financial Service Provider exceeds the threshold with respect to sales but not purchases, the requirement to provide additional transaction-specific information on the Form would only apply with respect to sales transactions.
“Financial Service Provider” is broadly defined by the BEA and includes domestic investment advisers, funds and their general partners. Examples of covered financial services transactions include brokerage services, financial management services and security lending services. A direct investment in a foreign person is not a covered financial services transaction, however brokerage fees to a foreign person tied to underwriting the transaction, for example, do qualify as a covered financial service transaction if the purchase occurred in 2019. More information about each category of covered financial services transactions may be found in Section VI of the Form’s instructions.
If the BEA has contacted a Financial Service Provider directly, it must complete the Form even if it has no transactions to report.
We have outlined below a few common scenarios that may apply to our clients:
Management Company
A domestic investment adviser or general partner that receives fees (including management and/or performance fees) from an offshore investment fund must complete the Form. Depending on the offshore fund structure, a management company may receive a fee either from the offshore fund itself, or directly from the underlying foreign investors in the offshore fund. In either example, the offshore fund and the underlying foreign investors, as applicable, are “foreign persons” and the investment adviser’s services are “financial services transactions” for purposes of the Form. Management companies should only report fees received from foreign investors in a U.S. fund if the fee is charged directly to a foreign investor, rather than charged to the U.S. fund itself.
Domestic Fund
If a domestic fund has engaged in any covered financial services transactions with foreign persons, the fund may also need to complete the Form.
We would like to note for our clients that entities in a parent-subsidiary relationship may be able to file as a consolidated domestic U.S. enterprise. The parent-subsidiary relationship turns on whether one entity owns more than 50% of the other’s voting securities, and the instructions specifically state that for a limited partnership, the general partner is presumed to control and have a 100% voting interest unless there is a clause to the contrary in the limited partnership agreement. As such, it is likely that many of our clients will be able to report as a consolidated enterprise, completing just one Form for the general partner and domestic fund, as applicable (and filing a separate Form on behalf of the investment adviser in bifurcated management company structures).
Failure to submit the Form or comply with any of its reporting requirements may result in a civil penalty between $2,500 and $25,000 and/or injunctive relief. Further criminal penalties may arise upon willful violation of the reporting requirements under this Form.
The Form must be submitted via the BEA’s e-filing system here, and the paper copy can be found here (for reference only). Please contact us if you have any questions as to your requirements.
Frequently Asked Questions About New Accredited Investor Definition
There has been much discussion about the recent amendments to the “accredited investor” definition adopted on August 26, 2020 (the “Amendments”) by the Securities and Exchange Commission (“SEC”). We have provided a more detailed overview of all the Amendments here, but wanted to address many of the common questions we are receiving from clients specifically regarding the Amendments to the accredited investor definition. Please send us any other questions and we will update the below as they come in…
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Will a person who is a contractor to the management company or fund qualify as an accredited investor now?
The Amendments provide that a “knowledgeable employee” (as defined in Rule 3c-5(a)(4) of the Investment Company Act of 1940) of a 3(c)(1) or 3(c)(7) fund will now be considered an accredited investor. We have been asked by a few clients whether this expanded definition includes contractors. Because the definition of a knowledgeable employee does not include contractors and has not been altered by the Amendments or otherwise, contractors do not currently qualify as accredited investors under this expanded definition.
What about the professional certification designation?
A natural person holding at least one professional certification or designation or credential in good standing from a qualifying educational institution will now be considered an accredited investor.
To determine whether an investor meets this criteria, the SEC will consider: (i) whether the certification, designation or credential results from an examination or series of examinations administered by a self-regulatory organization, other industry body or accredited educational institution; (ii) whether the examination(s) are reliably designed to demonstrate an individual’s comprehension and sophistication in the areas of securities and investing; (iii) whether an investor obtaining such certification, designation or credential can reasonably be expected to have sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of a prospective investment; and (iv) whether it is publicly made available by the self-regulatory organization or other industry body (or is otherwise independently verifiable) that an investor holds the certification, designation or credential.
The professional certifications, designations or credentials currently recognized by the SEC to satisfy this criterion will be posted on the SEC’s website. One important item to note is that an investor does not need to practice in the field(s) related to the certification, designation or credential to meet the good standing requirement, except to the extent that continued affiliation with a firm is required to maintain such certification, designation or credential.
What has prompted this modernization of the accredited investor definition?
Whether an investor meets the definition of an accredited investor has been one of the most important considerations when determining whether an investor is eligible to invest in private capital markets. The primary purpose of this qualification has been to determine whether an investor based solely on an investor’s income or net worth (because they presumably would be able to withstand a loss in the investment). The effects of the limited tests have prevented many investors from partaking in private capital markets, regardless of their actual financial sophistication. Thus, after years of discussions, the SEC has expanded the accredited investor definition to provide new measures of determining financial sophistication that more holistically determine financial sophistication. These Amendments should decrease the economic barrier-to-entry in our private capital markets and result in the participation of newly qualified accredited investors with more diverse backgrounds.
When do the Amendments become effective?
The Amendments will become effective 60 days after publication in the Federal Register. As of the date we are posting this FAQ, the Amendments have not yet been posted to the Federal Register.
What kind of legal documents need to be updated to reflect the Amendments?
The accredited investor definition is used in many different legal documents in many different contexts so the the exact document that will need to be revised or updated will depend on the facts of the situation.
In the private fund context, the Amendments will generally only trigger necessary updates to the private fund subscription documents. While the “old” language is still accurate, it does not encompass all potential accredited investor categories so the language could still be used once the Amendments are effective but will not encompass all categories of potential accredited investor.
Once the Amendments are posted to the Federal Register, we will reach out to our clients to discuss updating their subscription documents.
No. The private fund adviser exemption in California, which is available only to advisers who provide advice solely to “qualifying private funds”, only permits CA ERAs to charge performance fees to “qualified clients”, as defined in the Investment Advisers Act of 1940. The Amendments do not change this limitation.
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Cole-Frieman & Mallon is a boutique law firm focused on providing institutional quality legal services to the investment management industry. For more information on this topic, please contact us.
On September 2nd we held our crypto discussion forum where we discussed legal, tax and compliance issues related to the digital asset space. The below is a quick recap the event from panelist Justin Schleifer of Aspect Advisors. We’ll keep updating everyone through this blog on future events as well.
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Thank you for attending our “Cryptocurrency and Digital Asset Forum: Trends in Legal, Tax, and Compliance” webinar last week. I would also like to extend many thanks to my fellow panelists, Ryan David Williams of Ashbury Legal and Nick Cerasuolo of Blockchain Tax Partners, and to Bart Mallon of Cole-Frieman & Mallon for hosting.
We had a very interesting and lively interactive discussion about putting crypto investments to work through yield and lending, and DeFi implications including market-making, governance and custody issues.
Here are my favorite tidbits from the various speakers:
Each state has their own regulations as well, and everyone is on different parts of the learning curve. People have to address the nuances of each individual state. States may not agree with the idea of a custodian. DeFi is just way out there for them. They’re still on this idea of what is a custodian in the crypto space? Just getting over that hurdle has proven to be very difficult. – Bart
With the advent of crypto/blockchain, we almost went back in time because are used to dealing with USD. It’s obvious when something is taxable. Crypto took us back to the stone age where we’re back to barter model; property for property (BTC for ETH). You have transactions that don’t involve fiat at all. Tax event triggers are traps for the unwary. It’s not always obvious when a transaction is taxable. – Nick
Insider trading is absolutely an issue in this industry, and it’s getting more nuanced. Firms in the venture capital space get involved with companies on working on their protocols and Dapps. You can very well come in contact with all types of MNPI, so both sides must evaluate what is material or public. You have to restrict yourself in certain areas and not commit to certain trading activities. – Justin
There was a fantasy that once you achieve decentralization, laws are gone. This is an ethos that a decentralized exchange doesn’t need KYC/AML. We are now dispelled of that notion (i.e. the SEC went after the founder of a crypto exchange). The CFTC has also said they will go after software developers. This is the concept of causing a violation of securities law. The expectation of profits is based on the efforts of others. The manager is doing all the work, but what do we do when there is no sponsor and the work is done by community participants? We haven’t finalized this yet. ETH is officially decentralized, so it doesn’t make sense to apply traditional securities laws. – Ryan
If you (or your friends or colleagues) would like to review any of the webinar content, please email Amanda Brown for a link to the recording. If you have any questions about any of the above topics, please reach out to any of our panelists.
We hope you enjoyed this event and if you have any feedback, we would love to hear from you. We look forward to seeing you at our next event!
Best regards, Justin Schleifer
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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon LLP has been instrumental in structuring the launches of some of the first cryptocurrency focused hedge funds. If there are any questions on this post, please contact Mr. Mallon directly at 415-868-5345.
Tax, Compliance and Legal for the Digital Asset Space – Ask Your Questions
Tomorrow, September 2nd, at 10am PT we will be hosting an open question and answer discussion forum on issues affecting the digital asset space. We have a number of interesting topics to explore from the legal, tax and compliance side including:
Yield and lending trends and consequences
DeFi, DeFi, DeFi
Market Making
Custody
Regulatory update and what this means for different groups (managers, stakers, custodians, etc)
Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon is a boutique law firm focused on providing institutional quality legal services to the investment management industry. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.
