Author Archives: Hedge Fund Lawyer

The Coronavirus Aid, Relief, and Economic Security Act (CARES Act)

On March 27, Congress passed the $2 Trillion CARES Act, the largest financial relief bill in history, aimed at providing financial assistance to businesses and individuals to alleviate the economic fallout caused by the COVID-19 public health crisis. A core focus of the CARES Act is $350 billion in financial aid for small businesses through federal loans under a new Small Business Administration (“SBA”) loan program called the Paycheck Protection Program (the “PPP”). The highlights of the program for qualifying businesses include the following:

Eligibility. Eligible businesses include any business that already meets the applicable regulations to constitute “small business concerns” under the Small Business Act, businesses with up to 500 employees, non-profit organizations, businesses in the accommodation (lodging) and food services businesses with no more than 500 employees at each location, and eligible sole proprietorships and independent contractors.

Terms. An eligible business can borrow 2.5 times their monthly payroll costs, up to $10 million. “Payroll costs” includes salaries, wages, paid sick leave, health insurance premiums, retirement benefits, tips, state and local taxes on employee compensation, but does not include compensation to any individual employee or independent contractor in excess of $100,000.

Permitted Uses of Proceeds.Businesses may use PPP proceeds for the following business expenses: payroll costs (as defined above), rent, utilities, and interest payments on any mortgage or debt obligations incurred before February 15, 2020, excluding payments or prepayments of principal.

Loan Forgiveness. Borrowers may apply for loan forgiveness in an amount equal to funds used to pay eight weeks of payroll costs, mortgage interest, rent and utilities starting from the date of such Borrower’s PPP loan. The amount of loan forgiveness available is limited to the principal amount loaned under the PPP loan. Furthermore, in an effort to incentivize businesses to keep employees and maintain salaries or wages, the amount of loan forgiveness available is subject to reduction if the Borrower’s average number of full-time employees during the eight week period is lower than the average number of full-time employees in the 12-month period prior, or if there is a 25% reduction of the total salaries or wages of such employees during the eight week period. The 25% reduction guideline does not apply to employees whose annual salary or wages for any pay period in 2019 was greater than $100,000. An exemption from the reductions in loan forgiveness applies if the Borrower had reduced employees or salaries or wages as a result of the COVID-19 pandemic, but eliminates such reduction by rehiring the laid off employees or increasing salaries or wages to prior levels by June 30, 2020.

The highlights of the CARES Act is intended to be a summary of the over 800 page relief bill. The CARES Act is subject to change over time during the legislative process. For questions or concerns related to impacts of coronavirus on the operations or compliance of funds and advisers, please contact us.

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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.

Monitoring NAV Triggers Amidst Volatility

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Managers Should Be Aware of Additional Termination Events

By David Rothschild

At this time of extreme market volatility, it is critical for managers with ISDA Master Agreements (“ISDAs”) in place to understand the NAV Trigger Additional Termination Events described in their ISDAs, and what actions to take if they trip one.

As quick background, the Schedule to almost every ISDA Master Agreement to which a hedge fund is party will include an Additional Termination Event (“ATE”) pegged to a specific percentage decline in the fund’s net asset value over various periods (usually monthly, quarterly and annually). Some ISDAs will also include a “NAV Floor” concept triggering an ATE any time the fund’s NAV falls below a specific value (expressed either as a dollar value, or a percentage of a prior NAV, or both). If an ATE is triggered and the dealer elects to act on it, the dealer generally has the right close out all of a fund’s open positions, a result every manager wants to avoid.

NAV Trigger ATEs are among the most heavily-negotiated provisions in a hedge fund’s ISDA, and the specific figures for the monthly, quarterly and annual triggers, as well as NAV Floor provisions, will differ from fund to fund. What some managers may not realize is that the language describing these calculations and when they must be performed may also differ. Ideally, your NAV Trigger ATEs will be “point-to-point” and measured only as of the last day of the month – i.e., your NAV on the last trading day of a month is compared to your NAV on the last trading day of the prior month, quarter or year as applicable, to determine whether you have tripped an ATE. Many ISDAs, however, will have “any day” triggers – i.e., a NAV decline on any day as compared to the prior month, quarter or year could trigger an ATE. At this point, managers should review their NAV Trigger language and consult with legal counsel if they have questions regarding when or how these calculations must be performed.

If your fund has experienced a NAV decline that triggers an ATE under your ISDA, you are obligated to formally notify the dealer of that fact. That notice to the dealer should include an explicit request for them to waive the ATE; depending on your specific facts and circumstances and your relationship with a given dealer, they may grant you a waiver. A waiver means the dealer loses the right to close out your positions as a result of that ATE.

If you negotiated your ISDA, it may also include a “fish or cut bait” provision, which essentially gives the dealer a deadline to declare an ATE after you notify them that the relevant ATE was triggered. If you have a “fish or cut bait” provision in your ISDA that applies to a NAV Trigger ATE, pay close attention to the notice procedures described therein (many dealers require multiple forms of notification to specific addresses or emails in order for the “fish or cut bait” provision to be properly invoked), and follow them exactly to put the dealer on notice and start the clock running on the time period. If you properly follow those procedures and deadline passes, the dealer loses the right to close out your positions as a result of that ATE, whether or not they grant an explicit waiver.

Of course, if you have any questions while reviewing your ISDAs or how to interpret these critical provisions, you should reach out to your legal counsel immediately.

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David Rothschild is a partner of Cole-Frieman & Mallon LLP and routinely focuses on ISDA matters. Cole-Frieman & Mallon is a boutique law firm focused on the investment management industry. For more information on this topic, please contact Mr. Rothschild directly at 415-762-2854.

Bitcoin Mining Panel Overview

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Thank you to everyone who attended our bitcoin mining panel last week. We had a fantastic audience with many questions for our panel of bitcoin mining experts – Mathew D’Souza of Blockware Solutions, Thomas Ao of MCredit and Yida Gao of Struck Capital. The panel lasted just over one hour and was ably moderated by Michael Fitzsimmons of Williams Trading and was sponsored by Cole-Frieman & Mallon LLP and Aspect Advisors LLC.

Here is the presentation with slides referenced below:

CFM-Aspect-Bitcoin-Mining-Presentation-02-11-20 Download

Here are the take-aways:

Many opportunities for BTC mining – there are many different businesses in the mining space including: direct mining, buying/selling mining rigs, making loans backed by mining rigs, developing a mining farm, and cloud mining, among others.

Potential for high returns – successful mining enterprises can make 8-12% ROI per month when BTC is priced around $10,000. (The panel focused mainly on the economics of BTC mining and did not touch on the mining of other crypto assets.)

Large secondary market for mining rigs – because it is relatively difficult to import mining rigs to the US (time and cost/tariffs), some groups buy and sell rigs on the secondary market in the US in addition to directly mining BTC and this can be a profitable strategy in its own right. Bitmain is the main supplier of new rigs and the prices from both Bitmain and the secondary market can be as volatile as the BTC market.

Cost of producing BTC – the cost to produce one BTC can vary widely depending on cost of electricity and the type of rig used, as the proprietary research from Blockware Solutions demonstrates (see attached presentation). Blockware’s research also shows that most rigs coming online are the more efficient next generation machines.

The Halvening – in May the halvening is expected to bolster the generally bullish BTC trend we’ve seen in 2020. This will undoubtedly impact the economics of mining and the secondary market for rigs.

China and mining – a favorable tax regime and lower electricity costs made China a popular location for mining, despite risks associated with the government’s stated aim to eliminate virtual currency mining as an industry. These risks have significantly abated after the recent announcement by the National Development and Reform Commission of China (NDRC) that mining has been removed from the elimination list.

Environmental impact – innovation in rig/chip designs are making mining more environmentally friendly as less watts are required per terahash. The panel generally believes that after the halvening less efficient miners will go offline.

Issues – there has been many scams with respect to mining, especially mining farms and cloud mining. Also, there is high general investment risk in mining operations because many operators just don’t know what they are doing.

Other BTC financial products – miners may decide to hedge their BTC exposure through OTC products, but in general miners are not concerned with BTC financial products unless they affect the demand/price of BTC.

We hope you enjoyed this event and if you have any feedback, we would love to hear it in our quick survey. Please feel free to forward this email along to anyone you think might be interested. We look forward to seeing you at our next event.

Regards,

Bart Mallon & Michael Fitzsimmons

Aspect Advisors LLC

Aspect Advisors LLC is a modern regulatory consultant providing customized compliance solutions to entrepreneurs. The firm has a focus on fintech companies, broker-dealers, and investment managers (hedge fund, VC, PE, RIA, etc). We provide compliance and back-office solutions engineered to decrease worry and save time and resources. Among other items, the firm helps clients with regulatory registration, drafting compliance policies and procedures, conducting annual reviews, and other bespoke items.

Cole-Frieman & Mallon LLP

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 visit us at colefrieman.com.

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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 us or you can call Mr. Mallon directly at 415-868-5345.

Bitcoin Mining Panel Event in San Francisco

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CFM & Aspect Advisors Sponsor Mining Discussion

As the price of bitcoin (and other digital assets) rises, the economics of mining changes – we plan to have an event to explore the economics of mining and other aspects of the industry including any digital asset compliance matters. Below is the invitation. If you are interested in attending or would like to see the notes on the event, please contact us.

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Please see attached an invitation to attend a discussion on the current environment for bitcoin mining. This event is presented by Michael Fitzsimmons of Williams Trading and sponsored by Cole-Frieman & Mallon LLP and Aspect Advisors LLC.

This event will feature the following panelists:

Mathew D’Souza of Blockware Solutions
Thomas Ao of MCredit
Yida Gao of Struck Capital

Location is at Cole-Frieman & Mallon LLP offices – 255 California Street, Suite 1350.

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Aspect Advisors & CFM 2020 IA/BD Compliance Update

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A while ago we mentioned that we were hosting a compliance update for investment advisers and broker-dealers. The below is our summary of that event.

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We wanted to take this opportunity to thank everyone who attended and participated in our 2020 compliance update with Justin Schleifer (Aspect Advisors) and Bart Mallon (Cole-Frieman & Mallon). We understand that compliance sometimes feels like an obligation. Still, we think that our discussion last week touched on many important items for financial industry professions to keep top of mind in this new year and new decade.

We have attached a copy of the presentation to this email. Please feel free to forward along to anyone who might be interested. Some high points included:

High level trends influence how the modern investment manager interacts with compliance. Trends include the ongoing bull market, the movement of investment dollars from public investments (via IPO) to private markets, and the emergence of technology/ fintech. While these are distinct trends that need to be acknowledged, traditional compliance concepts still apply to managers although the concepts may be deployed or utilized in a different way than before.

Regulation Best Interest (“Reg BI”) will have an impact on the investment management industry in 2020. Broker-dealer and IA firms will scurry to meet the Reg BI implementation deadline. The effects will be felt more keenly by broker-dealers as they revise their practices to account for the updated fiduciary standards. Asset managers will need to address the regulation through a new Form CRS (sometimes referred to as ADV Part 3).

Privacy is paramount. There is general momentum toward consumers craving privacy. Governments and regulators are taking baby steps but are expected to do more in the future – we see that things such as the California Consumer Privacy Act and GDPR have already begun to influence the operations of many investment management companies. While managers should always maintain fundamental compliance records, there will be changes in the way that investor and customer data is ultimately accessed and available. It is therefore important for managers to stay up to date with those advances and any accompanying compliance processes.

Technological innovation (in both traditional and digital asset markets) is stretching the regulators’ ability to keep up. Regulators have trouble attracting talent to head new divisions to deal with technological innovation. Accordingly, money managers and entrepreneurs utilizing new technologies will need to understand the necessity of being able to explain the use of technology to regulators.

Access to new capital? The industry is always looking for ways to get new investors involved. A new accredited investor standard has been proposed but is not likely to significantly expand the pool of potential accredited investors and thus capital available for investment. Similar initiatives to broaden the distribution of investment products or management to a broader base of end investors (such as Regulation CF, Regulation A+, and 506(c) general solicitation) have seen generally middling to poor results for various reasons.

Information Security/Cybersecurity will continue to be a big regulatory focus and focus on this area is a business best practice. Larger firms will outsource to high tech IT firms or bring IT talent in-house. Smaller firms have many basic tools at their disposal and should focus on vendor management and selection, employee training, access to information, and other pivotal ways to increase security (2FA, using non-public wifi, port blockers, screen protectors, etc).

Taking humans out of investment management. Many investment management companies are creating organizations to bring services to the masses; these companies scale to limit human involvement. Questions on how to deal with compliance on a larger scale naturally emerge. The integration of technology (including with outside compliance vendors) becomes a key focus and commensurately decreases the reliance on human capital.

Other smaller trends have emerged. The focus on private markets is expected to heat up, not decrease (WeWork notwithstanding). Firms will continue to expand with sophisticated financial services, tools, investment strategies, different products, and new market participants, especially as millennials begin investing and saving more. As technology improves lower-fee products proliferate; many firms charge very low management fees and rely more on performance fees.

We look forward to seeing you again at a panel event in the future and wish you the best during this first quarter.

Regards,

Bart Mallon & Justin Schleifer

Aspect Advisors LLC

Aspect Advisors LLC is modern regulatory consultant providing customized compliance solutions to entrepreneurs. The firm has a focus on fintech companies, broker-dealers, and investment managers (hedge fund, VC, PE, RIA, etc). We provide compliance and back-office solutions engineered to decrease worry and save time and resources. Among other items, the firm helps clients with regulatory registration, drafting compliance policies and procedures, conducting annual reviews, and other bespoke items.

Cole-Frieman & Mallon LLP

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Aspect Advisors & CFM Compliance Update – January 23, 2020

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IA / BD 2020 Compliance Overview & Networking Event

We would like to take this opportunity to introduce you to Aspect Advisors, a firm that focuses on regulatory compliance services for investment managers. Aspect started at the beginning of 2019 and brings compliance solutions to broker-dealers, fintech companies, and traditional investment managers (hedge, PE, VC, real estate). In conjunction with Justin Schleifer (President and Co-Founder of Aspect), we’d like to invite you to a compliance update presentation and networking event at the offices of Cole-Frieman & Mallon LLP on January 23rd. The event will address the following topics:

2020 compliance calendar (including Form ADV annual update)
Major issues from the SEC and courts in 2019
SEC focus on crypto / digital assets in 2020
Fintech regulations and best practices
Regulation Best Interest
Other hot topics

We are planning an engaging event with audience participation and discussion so come ready with questions! If you are interested in joining, please review the information below and contact us for more information.

Best regards,
Bart

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Blockstack Regulation A+ Token Offering

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Overview of the Regulation A+ Offering Circular for Crypto Tokens

By Bart Mallon
Co-Managing Partner, Cole-Frieman & Mallon LLP

It is generally accepted that the initial coin offering (ICO) from mid-2017 is dead and that firms raising money for their blockchain or token projects will need to do so in a way that is compliant with SEC laws and regulations. For many groups, this means raising money through general private placements or various SAFTs (simple agreement for future tokens) and SAFEs (simple agreement for future equity). However, raising money in this manner does not put the seller’s tokens in the hands of a mass audience which is an important element for groups who are trying to obtain network effects for their project. One alternative to traditional private offerings for token projects is the Regulation A+ public offering of tokens for up to $50M in proceeds. Although Regulation A+ has been a potential avenue for a number of blockchain groups, it has been an untested and it was unclear what the time or costs would be to complete such an offering. This all changed with the Blockstack public offering of tokens pursuant to Reg A+.

Through considerable time and cost, Blockstack submitted its Regulation A+ “Tier 2” offering to the SEC for “qualification” to publicly sell its tokens (Stacks Tokens) on April 11 2019. We have reviewed all 203 dense pages of Blockstack’s Offering Circular (which is estimated to cost $1.8M in legal and accounting fees to produce) and take this opportunity to discuss the unique characteristics of the the offering which any token project will need to address in the future. While we can see that this will be the first step in standardizing token offerings under Regulation A+, we also see that there are a number of legal, business and operational issues that any token sponsor will need to address in what will inevitably be a “not as easy as advertised” process with the SEC.

What is Blockstack & the Stacks Token?

Blockstack is a blockchain platform with a goal of “sponsoring and commercializing an open-source peer-to-peer network using blockchain technologies to ultimately build a new network for decentralized applications.” The platform has been designed to do a number of things that current blockchains and centralized working solutions (i.e. Google Docs) do, but with a focus on decentralization and a high level of privacy. Blockstack is introducing use cases which include a browser, universal user accounts and personal data lockers which are all designed to give users control over their personal data. Eventually the blockchain will allow for more decentralized apps and a smart contract platform with a new smart contract language and more clarity on costs for use of the language.

The Stacks Tokens on the Blockstack network, which are being sold in the offering, will ultimately be used as fuel for running the smart contracts on the blockchain (the tokens will be burned). The Stacks Tokens will also be used by consumers as payments for the decentralized applications that will live on the network. Tokens will also be used for polling purposes and other incentives. In general, the platform looks very similar to other smart contract platforms with some technical differences. The project sponsored is Blockstack PBC, a Delaware public benefit corporation, a company with a number of well-healed and well known investors. For more information on the Stacks Token and project as a whole, you can see their sales deck for the token offering.

$50M Regulation A+ Raise

The proceeds from the raise will be generated through two different programs – the cash program and the app-mining program. Together the programs will raise $50M in consideration over the 12 months following the “qualification” of the offering.

Cash Program

In the cash program, there are two different sales prices for the tokens based on whether the tokens are sold in exchange for vouchers (to persons who indicated interest to Blockstack in November and December of 2017) or if they are sold in the general offering. The price is $0.12 per token (up to 215M tokens) for investors who participated in the voucher program and $0.30 (up to 40M tokens, but can be modified to be up to 62M tokens) for investors who participate through the general offering. The total consideration amount from the cash program (vocher and general offerings) will not exceed $38M, but the total amounts are subject to the tokens ultimately distributed through the app mining program, which is variable.

App Mining Program

Blockstack is offering tokens as rewards to certain developers of applications on its blockchain. [Include more here.] These token rewards are being included as part of the Reg A+ offering because they may be deemed to be investment contracts and/or as part of the offering. Pursuant to this program, all gifted tokens will be deemed to be work $0.30 per token for the first three months after the qualification of the offering, and then based on current market prices for the tokens. The idea is that Blockstack is getting consideration in-kind with work provided on its blockchain and is paying for that work with tokens.

Other Aspects of the Offering and Business

There are a number of other interesting legal and business items which were discussed throughout the offering circular. Many of these items are unique to Blockstack’s business, but many will have general applicability to future Reg A+ digital asset offerings.

Finalizing tokens offered in program – as previously discussed, the total amount of tokens sold through the offering is not set in stone. Directly after the SEC deems the offering “qualified”, Blockstack will finalize the allocation of tokens between the cash and app mining programs. A sale of the tokens will open 28 days after the SEC deems the offering to be “qualified”.
Tier 2 investor qualification – the offering is a “Tier 2” offering which means both accredited and unaccredited investors will be allowed to invest. Because it is a Tier 2 offering, the unaccredited investors are limited to invest 10% of the greater of annual income or net worth.
Concurrent Reg S offering – Blockstack is raising additional capital from non-US persons in a concurrent offering. The tokens sold in the Regulation S offering will be subject to a 1 year lockup (investors cannot use during the lockup period) and are being sold at $0.25 per token.
Tokens subject to a time-lock – for many reasons Blockstack has chosen that the purchased tokens will be introduced to the platform over time, with full distribution of all sold tokens 2 years after the qualification of the offering. Blockstack will release 1/24th of the sold tokens at inception, then will release 1/24th of the sold tokens once a month thereafter (every 4,320 blocks on the bitcoin blockchain).
No restriction on transfers of tokens – this offering is not of restricted securities (see our earlier post about token distribution issues / restricted securities) and are free usable and tradable (on a registered exchange or ATS) upon release from the time-lock; however, Blockstack believes the Stacks Tokens will not initially trade on any crypto exchanges and this will make it hard to sell the tokens.
“Cap Table” – there was much information presented about the current token float (the genesis block created 1.32B tokens) and the amount of tokens sold in previous offerings (various private placements and SAFTs). After all the offerings and various distributions, there will be 116M tokens unallocated that Blockstack will control and can utilize however they wish. Many of the issued tokens have been or are being provided to related entities to compensate employees, similar to stock option grants.
Use of proceeds – as is the case with most all offerings, there is a discussion of how the sponsors will use the cash proceeds from the sale. Blockstack also discusses the use of the cash proceeds under different levels of total subscription (25%, 50%, 75% and 100%).
Milestones – through a previous funding round, Blockstack was provided with capital if they met certain milestones with respect to the development and adoption of the Blockstack network. While they easily met the first milestone (technical implementation of certain features of the blockchain), it is unclear if they will meet the second milestone (dealing with adoption of the network). They will be required to “return a significant amount of capital that Blockstack currently intends to use in the development of the Blockstack network.” The milestone is 1M verified users by the end of January 2020. Blockstack specifically says that at current growth rates it will not achieve the second milestone.
Hard Fork from Bitcoin – Blockstack currently runs as a virtual blockchain on the bitcoin network. It will ultimately transition over to its own blockchain when it has a large enough network to maintain security. This will involve a “hard fork” to the Blockstack network and its associated risks.
Risk Factors – as with any public or private placement, there are attendant risks which are disclosed to potential investors. These include normal investment risks (operations, catastrophic events, etc) and general risks related to digital/crypto (loss of token, irreversible, loss of keys, various hacks, forks, volatility, uncertain tax treatment, etc), however, there were a number of interesting Blockstack specific risks including: risk of not attracting both users and developers to the platform, the time-lock risk, regulatory risk (does not have New York BitLicense, is not a money transmitter or money services business, potential violation of Regulation M with respect to its activities in its own tokens, etc).

Legal Issues Presented

In addition to the description of many of the business issues related to the creation of the blockchain, there are a number of novel legal issues presented and addressed in the offering circular. Below we have identified the most interesting of these issues and have included how Blockstack has addressed them.

Are the tokens securities? Blockstack believes that the current tokens (non-sufficiently decentralized) are a type of security called an investment contract and are not equity or debt securities:

We do not believe that the Stacks Tokens should be characterized as either debt or equity under the securities laws. We believe that these tokens should currently be characterized as investment contracts. Holders will not receive a right to any repayment of principal or interest, as might be expected under a traditional debt instrument; nor will they receive an interest in the profits or losses of any Blockstack affiliate, any rights to distributions from any Blockstack affiliate, or any legal or contractual right to exercise control over the operations or continued development of any Blockstack affiliate, as might be expected for a traditional equity instrument.

When will the tokens be “sufficiently decentralized” so they are no longer securities? This is one of the most important questions of the offering and essentially addresses the question of when the SEC will lose jurisdiction over the tokens in the offering and when/how Blockstack can issue, sell or otherwise use the tokens as rewards for certain activity on its blockchain.

The board of directors of Blockstack PBC will be responsible for regularly considering and ultimately determining whether the Stacks Tokens no longer constitute securities issued by us under the federal and state securities laws of the United States. In making this determination, the board will refer to the relevant legal and regulatory standards for such determination in effect at the time of such determination, will consult with legal counsel and will, if possible and appropriate, seek consultation with relevant regulatory authorities including, we expect, the Commission. At the present time, based on the guidance cited above, we expect this determination to turn the SEC’s recent guidance on the application of the test under SEC v. W. J. Howey Co. (the “Howey test”) to digital assets set forth in its release “Framework for ‘Investment Contract’ Analysis of Digital Assets,” and specifically on whether the Blockstack network is sufficiently decentralized, which will, in turn, depend on whether purchasers of Stacks Tokens reasonably expect Blockstack to carry out essential managerial or entrepreneurial efforts, and whether Blockstack retains a degree of power over the governance of the network such that its material non-public information may be of special relevance to the future of the Blockstack network, as compared to other network participants. Under current guidance, Blockstack would expect to take the position that if the answers to these questions are that purchasers do not and Blockstack does not, the Stacks Tokens will no longer constitute a security under the federal and state securities laws of the United States. The board of directors of Blockstack PBC may also assess other criteria for making this determination, including any criteria based on additional guidance we receive from U.S. regulators. …

In the event that the board of directors of Blockstack PBC determines that the Stacks Tokens are no longer a security issued by Blockstack Token LLC, Blockstack will make a public announcement of its determination at least six months prior to taking any actions based on this determination, such as filing an exit report on Form 1-Z terminating its reporting obligations with respect to the Stacks Tokens under Regulation A.

Are any actors related to Blockstack or its blockchain required to be registered in any way? Here, Blockstack addresses the issue of whether certain actors are required to be transfer or clearing agents because of their relationship to the blockchain and creation or distribution of the tokens:

We have taken the position that Blockstack, the miners on the network, and the network’s blockchain are not required to register as transfer agents, both because the Stacks Tokens are not currently securities registered under Section 12 of the Exchange Act, and because none of the activities Blockstack, the miners, or the blockchain is involved in are described in the definition of a transfer agent. In addition, to the extent that certain activities that meet the definition of a transfer agent are performed automatically on the blockchain, the blockchain is not a “person” that would be required to register. …

We have taken the position that Blockstack, the miners and the blockchain are not clearing agencies under the Exchange Act because the types of activities they engage in are not those described in the definition of a clearing agency. To the extent that these activities occur on the blockchain, the blockchain is not a “person” that would be required to register.

Blockstack has included similar discussions related to questions on whether it or any related actor is an investment company, broker-dealer, money transmitter, money services business, or subject to New York BitLicense requirements. All of these discussions conclude that the way the current blockchain works, and pursuant to the current interpretation of the securities laws, Blockstack and related actors would not be required to register as any of the above. It is possible that the SEC or the various state securities regulators could disagree with conclusions presented in the offering circular.

Is the Blockstack Network or the browser an ATS? The issue of what actors may be deemed to be an ATS is an open one and will eventually be an important issue when the SEC provides FINRA and the digital asset industry with future guidance. (HFLB note: SEC and FINRA just recently released a joint statement on digital asset custody which we will be reviewing shortly.)

We have taken the position that neither the network nor the Browser should be viewed as an exchange or an ATS because neither will “bring together” anyone by sorting or organizing orders in the Stacks Tokens in a consolidated way or by receiving orders for processing and execution of transactions in the Stacks Tokens. Instead, each proposed transaction involving Stacks Tokens on the network will by individually negotiated and implemented. For example, transactions by users (such as developers or users of Decentralized Applications) will be posted on an individual basis. In addition, we will be the only “seller” of Stacks Tokens when we distribute them as rewards on the network. …

We also take the position that payments on the network and the Browser for services do not involve “orders” of securities, because they are not primarily purchases of securities. Instead, these payments are commercial sales of access to Decentralized Applications or of items bought through in-app purchases.

Conclusion

It is clear that Blockstack has carefully thought through the business and legal issues involved in launching a Regulation A+ capital raise in order to expand a blockchain and token network. While the offering circular provides thoughtful analysis, it also highlights the many unresolved issues that plague the digital asset space. The digital asset industry in the US is starved for clarity on many of these issues and, if this offering is ultimately qualified, it will be a large step forward in solidifying how token sponsors should proceed with capital raises. Blockstack spent a lot of money to produce the offering circular and we must hope that this filing, or a filing similar to this, can become the template for blockchain token projects of the future.

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Bitcoin ETF – Bitwise Asset Management

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Cole-Frieman & Mallon Comment Letter to SEC

On June 12, 2019 our law firm submitted a comment letter to the SEC with respect to the Bitwise Bitcoin ETF application. In our comment we stated that we believe it is in the best interest of the bitcoin market that the Bitwise ETF be approved. We made this statement based on our firm’s experience with asset managers generally, and specifically with asset managers in the digital asset space. We also believe that the various Bitwise presentations and research prepared for the staff (here, here, and here) present strong arguments for the approval of the Bitwise ETF.

The Bitwise ETF application was originally submitted to the SEC by the listing Exchange (NYSE Arca) on January 28, 2019 and has subsequently under gone two statutory extensions (see here) as the SEC tries to figure out how they are going to regulate the digital asset industry. Ultimately the SEC will need to make a final decision (accept or reject) by mid-October. The various comment letters (found here) show overall support for the Bitwise ETF and generally implore the SEC to approve the application.

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For more information on this topic, please see our collection of cryptocurrency fund legal and operational posts.

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.

Crypto Headlines from Week of April 26 – Bitfinex/Tether & SeedInvest

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There were two big announcements in the crypto space this week and we anticipate that both will shape the dialogue in crypto circles over the course of the next few months.

NY AG Order re Bitfinex and Tether – the New York Attorney General announced an order requiring Bitfinex to provide certain information on its corporate activities to New York in connection with an investigation into Tether. The central issue is whether Bitfinex used Tether funds to “hide the apparent loss of $850 million dollars of [Bitfinex] co-mingled client and corporate funds.” The order was announced yesterday and sent the entire crypto market down 10%. Bitfinex has released a statement in response to the order saying that Bitfinex and Tether are “financially strong – full stop.” We anticipate this will be a major story over the next couple of weeks.

SeedInvest Receives ATS License – ever since the SEC released the DAO report in July 2017, firms have been trying to secure a broker-dealer with an Alternative Trading System. A broker-dealer with an ATS designation would allow a digital asset trading platform to legally provide an exchange/trading service in the US. SeedInvest (which was recently bought by Circle), through its affiliated broker-dealer SI Securities, just received the ATS designation (see here on page 11 – “The Firm operates an alternative trading system to facilitate the trading of securities previously purchased in private placement transactions through SI Securities.”). The ATS designation in this instance allows the firm to have a trading system/platform for previously issues equity securities (private placements) and not for tokens; however, it is generally viewed that this is the first step toward FINRA ultimately allowing for the ATS designation to apply to a token platform. We will see how this plays out with other platforms in the near future but this is certainly a sign that regulators are moving in the right direction.

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For more information on this topic, please see our collection of cryptocurrency fund legal and operational posts.

Cole-Frieman & Mallon 2018 Third Quarter Update

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Below is our quarterly newsletter. If you would like to be added to our distribution list, please contact us.

Clients, Friends, Associates:

We hope that you had an enjoyable summer. The past quarter saw further interest in digital assets from regulators, as well as enforcement actions and indications of possible regulatory changes. In the traditional investment management space, this summer saw a continuation of the bull market. As we move into the fourth quarter, we would like to provide an overview of items we hope will help you stay up-to-date with regulatory developments.

In addition to the discussion below, we would like to announce a couple of firm-related items:

CoinAlts Fund Symposium. In September, preceded by a well-attended Women in Crypto networking event sponsored by Coinbase, founding sponsor Cole-Frieman & Mallon hosted its third successful full day Symposium in San Francisco. Speakers including keynote Tim Draper, founder of Draper Associates, DFJ and the Draper Venture Network and Joe Eagan of Polychain Capital explored issues key to fund managers and investors in the digital asset space.

CFM San Francisco. We are delighted to announe our overflowing San Francisco team will shortly relocate to expanded premises at 255 California Street.

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SEC Matters

SEC Chairman Hints at Changes in Investor Standards. On August 29, Securities and Exchange Commission (“SEC”) Chairman Jay Clayton spoke at the Nashville 36|86 Entrepreneurship Festival. He discussed issues the SEC is focused on or intends to focus on, including initial coin offerings (“ICOs”), promoting capital formation for public companies or companies considering going public, and rethinking the SEC’s current private offering exemption framework. Of note, Chairman Clayton stated that the SEC should explore how the current private offering exemption landscape could be simplified and streamlined. In particular, the Chairman noted that the SEC should examine the possibility of focusing on factors beyond investor wealth (i.e. accredited investor status), such as investor sophistication or investment amount.

SEC Releases Best Execution Deficiencies Alert. On July 11, the Office of Compliance Inspections and Examinations of the SEC released an alert outlining common deficiencies observed in examinations of advisers’ “best execution” obligations. These requirements come from the Investment Advisers Act of 1940, as amended, and impose a duty on advisers to execute trades so that total costs and proceeds are most favorable to clients. While best execution obligations depend on the facts of each situation, the SEC observed the following common deficiencies:

Not Performing Reviews – advisers were unable to provide evidence that they periodically and systematically reviewed the broker-dealers used to execute transactions.
Not Considering Materially Relevant Factors in Broker-Dealer Services – advisers did not consider the full range and quality of broker-dealers’ services.
Not Seeking Other Broker-Dealers – advisers often used only one broker-dealer for all of their clients without evaluating the services, quality, and costs of others.
Not Disclosing Best Execution Practices – advisers did not fully disclose best execution practices to their clients.
Not Disclosing Soft Dollar Arrangements – soft dollar arrangements (i.e. commissions in exchange for brokerage and research services) were not fully and fairly disclosed in advisers’ Form ADVs.
Not Properly Allocating Mixed Use Products and Services – advisers did not properly allocate the costs of mixed use products or services (i.e. products or services obtained using soft dollars, where that product or service is also used for non-investment purposes, such as accounting or marketing). Additionally, advisers did not properly document the reasons for mixed use product or service allocations.
Inadequate Policies and Procedures – advisers lacked policies, had insufficient internal controls, or did not have policies tailored to their investment strategy.
Not Following Policies and Procedures – advisers failed to follow their own best execution policies and procedures.

In light of the deficiencies listed above, advisers should review their best execution policies and procedures, and contact legal counsel or a compliance professional with any questions.

Hedge Fund Adviser Charged with Short-and-Distort Scheme. On September 12, the SEC charged a hedge fund advisor with illegally profiting from a “short-and-distort” scheme. The adviser is alleged to have released false information about a public pharmaceutical business after shorting the company. The adviser allegedly used reports, interviews, and social media to spread false claims that, for example, the pharmaceutical company was “teetering on the brink of bankruptcy”. The SEC is seeking a permanent restraining order, disgorgement of ill-gotten gains, and civil penalties.

SEC Charges Adviser for Risky Investments and Secret Commissions. On July 18, the SEC charged an adviser and its CEO with misleading investors by putting their capital in risky investments and secretly pocketing large commissions from such investments. The adviser and CEO are accused of misleading investors about the risks of the investments, overbilling, concealing financial conflicts, and violating the anti-fraud and registration provisions of federal securities laws. The SEC is seeking a permanent injunction, disgorgement of ill-gotten gains and losses avoided plus prejudgment interest, and civil monetary penalties.

CFTC/NFA Matters

CFTC Chairman Outlines Increased CFTC Enforcement. On October 2, the Commodities Futures Trading Commission (“CFTC”) Chairman Christopher Giancarlo summarized the CFTC’s increased enforcement efforts from the prior fiscal year in a speech to the Economic Club of Minnesota. These efforts include:

Enforcement Actions – in the prior fiscal year, the CFTC filed approximately 25% more enforcement actions than each of the prior three fiscal years.
Large-Scale Matters – the CFTC has increased enforcement actions against large-scale matters (i.e. matters that threaten basic market integrity). In the CFTC’s last fiscal year, it brought more than three times the average number of large-scale actions as the previous administration.
Manipulative Conduct – the CFTC has brought more than five times the previous average number of actions against manipulative conduct in the past fiscal year. Such conduct includes fraud, spoofing (i.e. bidding with the intent to cancel before execution), and the use of technology to manipulate order books.
Accountability – the CFTC has prioritized individual accountability, and approximately 70% of the past fiscal year’s cases involved charges against individuals who committed illegal acts.
Partnership with Criminal Enforcement – the CFTC has filed “far more actions in parallel” with criminal law enforcement partners than in any previous year.
Whistleblower Awards – with respect to whistleblowers, the CFTC has strengthened protections, granted a record number of awards, and received a record number of tips and complaints.

With these increased enforcement efforts in mind, managers of funds subject to CFTC jurisdiction should ensure they are up-to-date with CFTC filings and regulations.

CTA Associated Person and Introducing Broker Charged with Fraud. On August 10, the CFTC settled charges against an associated person of a commodity trading adviser (“CTA”) and introducing broker. The charges were based on a fraudulent trading scheme where the trader entered unauthorized commodities trades in customers’ accounts, transferred profitable trades to his own account, and left losses in the clients’ accounts. The settlement included a cease and desist order, a permanent ban from engaging in trading with any CFTC-registered entity, and a $100,000 civil monetary penalty.

Digital Asset Matters

Regulators continued to show interest and initiate enforcement actions in the digital asset space. Below is a summary of certain key digital asset items from the third quarter. For a complete review of these and other crypto developments, please consult our Third Quarter Digital Asset Regulatory Items blog post.

SEC Charges Digital Asset Hedge Fund Manager. On September 11, the SEC announced the settlement of charges against a digital asset hedge fund and its manager. The charges include misleading investors, offering and selling unregistered securities, and failing to register the hedge fund as an investment company. After being contacted by the SEC, the fund offered rescission and disclosed its previous misstatements to investors. The settlement included cease-and-desist orders, censure, and a $200,000 penalty. This is the first action the SEC has taken against a digital asset fund based on violations of the investment company registration requirements.

SEC Charges ICO Platform for Operating as Unregistered Broker-Dealer. On September 11, the SEC settled charges against an ICO platform. The business was charged with failing to register as a broker-dealer, as well as offering and selling unregistered securities. This is the SEC’s first charge against an unregistered broker-dealer in the digital asset space following the SEC’s 2017 DAO Report, which cautioned anyone offering or selling digital assets to comply with federal securities laws.

New York Attorney General Releases Report on Digital Asset Exchanges. On September 18, the Office of the Attorney General of New York (the “OAG”) released a report summarizing a crypto exchange fact-finding initiative. Based on the digital asset exchanges examined, the OAG outlined three primary areas of concern: potential conflicts of interest, lack of anti-abuse controls, and limited customer fund protection.

NFA Requires CPOs and CTAs to Disclose Digital Asset Activity. On July 20, the National Futures Association (“NFA”) released a notice that imposed new disclosure requirements on futures commission merchants, commodity pool operators (“CPOs”), and CTAs that are NFA members engaged in certain digital asset activities. The new disclosures cover, for example, the volatility and cybersecurity risks of digital assets. Additional details are available in our recent blog post.

Offshore Matters

Cayman Islands Delays AML Officer Deadline. Under new Cayman Islands requirements, investment funds that conduct business in or from the Cayman Islands must appoint individuals to new anti-money laundering officer positions. The Cayman Islands Monetary Authority (“CIMA”) has delayed certain deadlines for funds that launched prior to June 1, 2018:

CIMA-Registered Cayman Funds – registered funds still must have appointed the new officers by September 30, 2018, but now do not need to confirm the identity of the officers via CIMA’s Regulatory Enhanced Electronic Forms Submission (“REEFS”) portal until December 31, 2018.
Unregistered Cayman Funds – unregistered funds do not need to appoint the new officers until December 31, 2018, and they do not need to confirm the identity of these officers via the REEFS portal.

Funds formed on or after June 1, 2018 must have appointed the officers (and confirmed such officers through REEFS for registered funds) at launch. The new roles must be filled by individuals, and some service providers may be willing to provide individuals to serve such roles. We recommend fund managers discuss anti-money laundering compliance with offshore counsel and the fund’s administrator.

Other Matters

FINRA Warns of Regulator Impersonators. On July 13, FINRA issued a warning that persons claiming to be working for FINRA have been calling firms and attempting to obtain confidential information. In particular, FINRA warned that the use of overseas telephone numbers or email addresses indicates a likely scam, as well as emails from suspicious domains that do not end with “@finra.org” and that contain attachments or embedded links. If you have questions about the legitimacy of purported FINRA communications, contact your FINRA Coordinator.

New York Issues Sexual Harassment Compliance Mandate. Managers with operations in New York State and New York City should be aware of recent changes to employers’ obligations with respect to sexual harassment. Effective October 9, 2018, all employers in New York State are required to adopt a sexual harassment prevention policy equal to or greater than the standards of the state-issued model policy. Additionally, New York State employers must provide sexual harassment prevention training annually that is equal to or greater than the state-created model. This training must be completed by current employees by January 1, 2019, and by new hires within 30 days of being hired. Managers that may be subject to these new requirements can learn more on New York State’s Combating Sexual Harassment in the Workplace website. New York City has also implemented similar training requirements for employers with 15 or more employees, which will take effect on April 1, 2019. Additionally, effective September 6, 2018, New York City employers must post a sexual harassment poster and distribute a fact sheet to new employees.

SEC Charges Firm for Deficient Cybersecurity. On September 26, the SEC settled charges against a broker-dealer/investment adviser based on the firm’s deficient cybersecurity procedures after parties posing as contractors accessed customers’ personal information. The charges are a reminder of the importance of maintaining strong cybersecurity policies and procedures. Firms should be aware that cybersecurity is an on-going obligation and has become a focus of the SEC.

IRS Ends Voluntary Disclosure Program. On September 28, the Internal Revenue Service ended the 2014 Offshore Voluntary Disclosure Program (“OVDP”). U.S. taxpayers are required to report and pay taxes on certain offshore assets and face potential stiff criminal and civil penalties for failing to do so, and the OVDP was designed to offer taxpayers certain protections from these penalties. Fund managers with unreported foreign assets that were not able to meet the September 28, 2018 deadline should discuss their options with tax counsel.

New Law Expands Disclosure and Approval Requirements for Investments by Foreign Entities. On August 13, the Foreign Investment Risk Review Modernization Act (“FIRRMA”) was signed into law. It expands the scope of investments by non-U.S. investors in critical domestic tech companies that must be disclosed to and approved by the federal government in an effort to strengthen national security. An example investment within the scope of FIRRMA is an investment by a non-U.S. entity in a tech company that gives the investing entity access to material non-public technical information. While there are limits and exemptions to the scope of FIRRMA and the typical fund will not need to worry about its new requirements, venture funds with foreign limited partners or foreign co-investors should be mindful of the expanded approval requirements.

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

Deadline	Filing
October 10, 2018	Form 13H amendment due for large traders if the information contained in the filing became inaccurate in Q3
October 15, 2018	Quarterly Form PF due for Large Liquidity Fund Advisers (for funds with December 31 fiscal year-ends) filing for Q3 2018 (if applicable)
October 15, 2018	Extended deadline to file Reports of Foreign Bank and Financial Accounts (FBAR)
October 30, 2018	Registered investment advisers must collect access persons’ personal securities transactions
November 14, 2018	Form PR filings for registered CTAs that must file for Q3 within 45 days of the end of Q3 2018
November 14, 2018	Form 13F is due for certain institutional investment managers
November 30, 2018	Form PF filings for Large Hedge Fund Advisers with December 31 fiscal year-ends filing for Q3 2018
November 30, 2018	Large registered CPOs must submit a pool quarterly report (CPO-PQR)
December 17, 2018	Deadline for paying annual IARD charges and state renewal fees
December 31, 2018	Small and mid-sized registered CPOs must submit a pool quarterly report (CPO-PQR)
December 31, 2018	Deadline for CIMA-registered Cayman funds formed prior to June 1, 2018 to confirm the identity of appointed anti-money laundering officers via REEFS; deadline for unregistered Cayman funds to appoint anti-money laundering officers
December 31, 2018	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 2019 CIMA fees
Periodic	Fund managers should perform “Bad Actor” certifications annually
Periodic	Amendment due on or before anniversary date of prior Form D and blue sky filing(s), as applicable, or for material changes
Periodic	CPO/CTA Annual Questionnaires must be submitted annually, and promptly upon material information changes

Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Mr. Mallon can be reached directly at 415-868-5345.