Author Archives: CFM Admin

Cole-Frieman & Mallon 2022 End Of Year Update

December 2022

Clients, Friends, Associates:

As we near the end of 2022, we have highlighted some recent industry updates that we believe may impact our clients. We have also developed a checklist to help managers effectively oversee the business and regulatory landscape for the coming year. While we strive to present an informative, albeit brief, overview of these topics, we are also available should you have any related questions.

This update includes the following:

Q4 Matters
Annual Compliance & Other Items
Annual Fund Matters
Annual Management Company Matters
Notable Regulatory & Other Items from 2022
Compliance Calendar

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Q4 Matters

New York Federal Reserve Digital Dollar Pilot Project. In collaboration with the Federal Reserve Bank of New York and several private sector financial institutions, the New York Innovation Center (“NYIC”) recently announced a pilot program to test the operability of digital asset transactions between financial institutions using the U.S. dollar as token. Although the project is being conducted in a purely experimental fashion using simulated data, the pilot can be seen as one of the first steps taken by a governmental agency towards creating a central bank digital currency.

SEC v. LBRY. In November, the U.S. District Court for the District of New Hampshire granted the SEC’s motion for summary judgment against LBRY, Inc., holding that LBRY offered a crypto asset in violation of the registration provisions of federal securities laws. The case addresses a fundamental issue in the crypto universe — whether blockchain tokens are considered securities by the SEC. The Court concluded that LBRY’s messaging would lead potential investors to understand that the company was pitching speculative value propositions for its digital token that created an expectation of profits under the Howey test. We generally advise that managers and others in the digital asset space should assume that the SEC considers all blockchain tokens to be securities, subject to SEC regulation and applicable registration requirements.

FTX. Our firm, like many others, continues to develop our understanding of the recent events related to FTX, what users of the exchange can and should expect going forward, and how it will affect the digital asset space generally. We have included links to our initial blog post and podcast below touching on the FTX situation. Stay tuned for additional information through multiple channels in the days and weeks ahead.

Blog Post: https://hedgefundlawblog.com/crypto-fund-offering-documents-post-ftx-collapse.html
Tokens of Wisdom Podcast: https://www.buzzsprout.com/2082177/share

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Annual Compliance & Other Items

Annual Privacy Policy Notice. On an annual basis, SEC-registered investment advisers (“SEC RIAs”) are required to provide natural person clients with a copy of the ﬁrm’s privacy policy if: (i) the SEC RIA has disclosed nonpublic personal information other than in connection with servicing consumer accounts or administering ﬁnancial products; or (ii) the ﬁrm’s privacy policy has changed. The SEC has provided a model form and accompanying instructions for firm privacy policies.

Annual Compliance Review. The Chief Compliance Officer (“CCO”) of a registered investment advisor (“RIA”) must conduct a review of the adviser’s compliance policies and procedures annually. This annual compliance review should be in writing and presented to senior management. CCOs should consider additions, revisions, and updates to the compliance program as may be necessary. We recommend ﬁrms discuss the annual review with their outside counsel or compliance ﬁrm to obtain guidance about the review process and a template for the assessment. Conversations regarding the annual review may raise sensitive matters, and advisers should ensure that these discussions are protected by attorney-client privilege. Advisers that are not registered may still wish to review their procedures and/or implement a compliance program as a best practice.

Form ADV Annual Amendment. RIAs or managers ﬁling as exempt reporting advisers (“ERAs”) with the SEC or a state securities authority must ﬁle an annual amendment to their Form ADV within 90 days of the end of their ﬁscal year. For most managers, the Form ADV amendment will be due on March 31, 2023. RIAs must provide a copy of the updated Form ADV Part 2A brochure and Part 2B brochure supplement (or a summary of changes with an oﬀer to provide the complete brochure) to each “client” and, if applicable, Part 3 (Form CRS: Client Relationship Summary) to each “retail investor” with which the RIA has entered into an investment advisory contract. Note that for SEC RIAs to private investment vehicles, a “client” for purposes of this rule refers to the vehicle(s) managed by the adviser and not the underlying investors. State-registered advisers need to examine their states’ regulations to determine who constitutes a “client.” For purposes of the Form ADV Part 3, a “retail investor” means a natural person, or the legal representative of such natural person, who seeks to receive or receives services primarily for personal, family, or household purposes.

Switching to/from SEC Regulation.

SEC Registration. Managers who no longer qualify for SEC registration as of the time of ﬁling the annual Form ADV amendment must withdraw from SEC registration within 180 days after the end of their ﬁscal year (June 30, 2023, for most managers), by ﬁling a Form ADV-W. Such managers should consult with legal counsel to determine whether they are required to register in the states in which they conduct business. Managers who are required to register with the SEC as of the date of their annual amendment must register with the SEC within 90 days of ﬁling the annual amendment (June 30, 2023, for most managers, assuming the annual amendment is filed on March 31, 2023).

Exempt Reporting Advisers. Managers who no longer meet the deﬁnition of an ERA will need to submit a ﬁnal report as an ERA and apply for registration with the SEC or the relevant state securities authority, as applicable, generally within 90 days after the ﬁling of the annual amendment (June 30, 2023, for most managers, assuming the annual amendment is filed on March 31, 2023).

Custody Rule Annual Audit.

SEC RIAs. SEC RIAs must comply with specific custody procedures, including: (i) maintaining client funds and securities with a qualiﬁed custodian; (ii) having a reasonable basis to believe that the qualiﬁed custodian sends an account statement to each advisory client at least quarterly; and (iii) undergoing an annual surprise examination conducted by an independent public accountant.

SEC RIAs to pooled investment vehicles may avoid both the quarterly statement and surprise examination requirements by having audited ﬁnancial statements prepared for each pooled investment vehicle in accordance with generally accepted accounting principles (“GAAP”) by an independent public accountant registered with the Public Company Accounting Oversight Board (“PCAOB”). Audited financial statements must be sent to investors in the fund within 120 days after the fund’s ﬁscal year-end (or for fund-of-fund clients, within 180 days after fiscal year-end). SEC RIAs should review their internal procedures to ensure compliance with the custody rules.

California RIAs. California-registered investment advisers (“CA RIAs”) that manage pooled investment vehicles and are deemed to have custody of client assets are also subject to independent party surprise examinations. However, CA RIAs can avoid these additional requirements by engaging a PCAOB-registered auditor to prepare and distribute audited ﬁnancial statements to all beneficial owners of the pooled investment vehicle, and the Commissioner of the California Department of Financial Protection and Innovation (“DFPI”). Those CA RIAs that do not engage an auditor must, among other things: (i) provide notice of such custody on the Form ADV; (ii) maintain client assets with a qualiﬁed custodian; (iii) engage an independent party to act in the best interest of investors to review fees, expenses, and withdrawals; and (iv) retain an independent certiﬁed public accountant to conduct surprise examinations of assets.

Other State RIAs. Advisers registered in other states should consult their legal counsel about those states’ specific custody requirements.

California Minimum Net Worth Requirement and Financial Reports.

CA RIAs with Discretion. Every CA RIA (other than those also registered as broker-dealers) that has discretionary authority over client funds or securities, regardless of if they have custody, must maintain a net worth of at least $10,000 (CA RIAs with custody are subject to heightened minimum net worth requirements, discussed further below).

CA RIAs with Custody. Generally, every CA RIA (other than those also registered as broker-dealers) that has custody of client funds or securities must maintain a minimum net worth of $35,000. However, a CA RIA that: (i) is deemed to have custody solely because it acts as the general partner of a limited partnership, or a comparable position for another type of pooled investment vehicle; and (ii) otherwise complies with the California custody rule described above is exempt from the $35,000 minimum (and instead is required to maintain the $10,000 minimum).

Financial Reports. Every CA RIA subject to the above minimum net worth requirements must file certain reports with the DFPI. In addition to annual reports, CA RIAs may be required to file interim reports or reports of financial condition if they fall below certain net worth thresholds.

Annual Re-Certiﬁcation of CFTC Exemptions. Commodity pool operators (“CPOs”) and commodity trading advisers (“CTAs”) currently relying on certain exemptions from registration with the Commodity Futures Trading Commission (“CFTC”) are required to re-certify their eligibility within 60 days of the calendar year-end. A common example includes the 4.13(a)(3) exemption also known as the “de minimis” exemption. CPOs and CTAs currently relying on relevant exemptions should consult with legal counsel to evaluate whether they remain eligible to rely on such exemptions.

CPO and CTA Annual Updates. Registered CPOs and CTAs must prepare and ﬁle Annual Questionnaires and Annual Registration Updates with the National Futures Association (“NFA”), as well as submit payment for annual maintenance fees and NFA membership dues. Registered CPOs must also prepare and ﬁle their fourth-quarter report for each commodity pool on Form CPO-PQR, while CTAs must ﬁle their fourth-quarter report on Form CTA-PR. Unless eligible to claim relief under Regulation 4.7, registered CPOs and CTAs must update their disclosure documents periodically, as they may not use any document dated more than 12 months prior to the date of its intended use. Disclosure documents that are materially inaccurate or incomplete must be promptly corrected, and redistributed to pool participants.

Trade Errors. Managers should ensure that all trade errors are properly addressed pursuant to the manager’s trade errors policies by the end of the year. Documentation of trade errors should be ﬁnalized, and if the manager is required to reimburse any of its funds or other clients, it should do so by year-end.

Soft Dollars. Managers that participate in soft dollar programs should make sure that they have addressed any commission balances from the previous year.

Schedule 13G/D and Section 16 Filings. Managers who exercise investment discretion over accounts (including funds and separately managed accounts) that are beneﬁcial owners of 5% or more of a registered voting equity security must report these positions on Schedule 13D or 13G. Passive investors are generally eligible to ﬁle the short-form Schedule 13G, which is updated annually within 45 days of the end of the year. Schedule 13D is required when a manager is ineligible to ﬁle Schedule 13G and is due 10 days after acquiring more than 5% beneﬁcial ownership of a registered voting equity security. For managers who are also making Section 16 ﬁlings, this is an opportune time to review your ﬁlings to conﬁrm compliance and anticipate needs for the ﬁrst quarter.

Section 16 ﬁlings are required for “corporate insiders” (including beneﬁcial owners of 10% or more of a registered voting equity security). An initial Form 3 is due within 10 days after becoming an “insider”; Form 4 reports ownership changes and is due by the end of the second business day after an ownership change; and Form 5 reports any transactions that should have been reported earlier on a Form 4 or were eligible for deferred reporting and is due within 45 days after the end of each fiscal year.

Form 13F. A manager must ﬁle a Form 13F if it exercises investment discretion with respect to $100 million or more in certain “Section 13F securities” within 45 days after the end of the year in which the manager reaches the $100 million ﬁling threshold. The SEC lists the securities subject to 13F reporting on its website.

Form 13H. Managers who meet one of the SEC’s large trader thresholds (generally, managers whose transactions in exchange-listed securities equal or exceed two million shares or $20 million during any calendar day, or 20 million shares or $200 million during any calendar month) are required to ﬁle an initial Form 13H with the SEC within 10 days of crossing a threshold. Large traders also need to amend Form 13H annually within 45 days of the end of the year. In addition, changes to the information on Form 13H will require interim amendments following the calendar quarter in which the change occurred.

Form PF. Managers to private funds that are either registered with the SEC or required to be registered with the SEC and who have at least $150 million in regulatory assets under management (“RAUM”) must ﬁle a Form PF. Private advisers with less than $1.5 billion in RAUM must ﬁle Form PF annually within 120 days of their ﬁscal year-end. Private advisers with $1.5 billion or more in RAUM must ﬁle Form PF within 60 days of the end of each fiscal quarter.

Form MA. Investment advisers that provide advice on municipal financial products are considered “municipal advisors” by the SEC and must file a Form MA annually, within 90 days of their fiscal year-end.

SEC Form D. Form D ﬁlings for most funds need to be amended annually, on or before the anniversary of the most recently ﬁled Form D. Copies of Form D are publicly available on the SEC’s EDGAR website.

Blue Sky Filings. On an annual basis, a manager should review its blue sky ﬁlings for each state to make sure it has met any initial and renewal filing requirements. Several states impose late fees or reject late ﬁlings altogether. Accordingly, it is critical to stay on top of ﬁling deadlines for both new investors and renewals. We also recommend that managers review blue sky ﬁling submission requirements. Many states now permit blue sky ﬁlings to be ﬁled electronically through the Electronic Filing Depository (“EFD”) system, and certain states will now only accept ﬁlings through EFD.

IARD Annual Fees. Preliminary annual renewal fees for state-registered and SEC-registered investment advisers are due on December 13, 2022. Failure to submit electronic payments by the deadline may result in registrations terminating due to a “failure to renew.” If you have not already done so, you should submit full payment into your Renewal Account by E-Bill, check, or wire as soon as possible.

Pay-to-Play and Lobbyist Rules. SEC rules disqualify investment advisers, their key personnel, and placement agents acting on their behalf from seeking to be engaged by a governmental client if they have made certain political contributions. State and local governments have similar rules, including California, which requires internal sales professionals who meet the deﬁnition of “placement agents” (people who act for compensation as ﬁnders, solicitors, marketers, consultants, brokers, or other intermediaries in connection with oﬀering or selling investment advisory services to a state public retirement system in California) to register with the state as lobbyists and comply with California lobbyist reporting and regulatory requirements. Note that managers oﬀering or selling investment advisory services to local government entities must register as lobbyists in the applicable cities and counties. State laws on lobbyist registration diﬀer significantly, so managers should carefully review reporting requirements in the states in which they operate to make sure they comply with the relevant rules.

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Annual Fund Matters

New Issue Status. On an annual basis, managers need to conﬁrm or reconﬁrm the eligibility of investors that participate in initial public oﬀerings, or new issues, pursuant to both Financial Industry Regulatory Authority, Inc. (“FINRA”) Rules 5130 and 5131. Most managers reconﬁrm investor eligibility via negative consent (i.e., investors are informed of their status on ﬁle with the manager and are asked to notify the manager of any changes), whereby a failure to respond by any investor operates as consent to its current status.

ERISA Status. Given the signiﬁcant problems that can occur from not properly tracking ERISA investors in private funds, we recommend that managers conﬁrm or reconﬁrm on an annual basis the ERISA status of their investors. This is particularly important for managers that track the underlying percentage of ERISA funds for each investor, with respect to each class of interests in a pooled investment vehicle.

Wash Sales. Managers should carefully manage wash sales for year-end. Failure to do so could result in book/tax differences for investors. Certain dealers can provide managers with swap strategies to manage wash sales, including Basket Total Return Swaps and Split Strike Forward Conversion. These strategies should be considered carefully to make sure they are consistent with the investment objectives of the fund.

Redemption Management. Managers with signiﬁcant redemptions at the end of the year should carefully manage unwinding positions to minimize transaction costs in the current year (that could impact performance) and prevent transaction costs from impacting remaining investors in the next year. When closing funds or managed accounts, managers should pay careful attention to the liquidation procedures in the fund constituent documents and the managed account agreement.

NAV Triggers and Waivers. Managers should promptly seek waivers of any applicable termination events specified in a fund’s International Swaps and Derivatives Association (“ISDA”) or other counterparty agreement that may be triggered by redemptions, performance, or a combination of both at the end of the year (NAV declines are common counterparty agreement termination events).

Fund Expenses. Managers should wrap up all fund expenses for 2022 if they have not already done so. In particular, managers should contact their outside legal counsel to obtain accurate and up to date information about legal expenses for inclusion in the NAV for year-end performance.

Electronic Schedule K-1s. The Internal Revenue Service (“IRS”) authorizes partnerships and limited liability companies taxed as partnerships to issue Schedule K-1s to investors solely by electronic means, provided the partnership has received the investors’ aﬃrmative consent. States may have diﬀerent rules regarding electronic K-1s, and partnerships should check with their counsel whether they may be required to send hard copy state K-1s. Partnerships must also provide each investor with speciﬁc disclosures that include a description of the hardware and software necessary to access the electronic K-1s, how long the consent is eﬀective, and the procedures for withdrawing the consent. If you would like to send K-1s to your investors electronically, you should discuss your options with your service providers.

“Bad Actor” Recertiﬁcation Requirement. A security oﬀering cannot rely on the Rule 506 safe harbor from SEC registration if the issuer or its “covered persons” are “bad actors.” Fund managers must determine whether they are subject to the bad actor disqualiﬁcation any time they are oﬀering or selling securities in reliance on Rule 506. The SEC has advised that an issuer may reasonably rely on a covered person’s agreement to provide notice of a potential or actual bad actor triggering event pursuant to contractual covenants, bylaw requirements, or undertakings in a questionnaire or certiﬁcation. However, if an oﬀering is continuous, delayed or long-lived, issuers must periodically update their factual inquiry through a bring-down of representations, questionnaires, and certiﬁcations, negative consent letters, reexamination of public databases or other means, depending on the circumstances. Fund managers should consult with counsel to determine how frequently such an update is required. As a matter of practice, most fund managers should perform these updates at least annually.

U.S. FATCA. Funds should monitor their compliance with the U.S. Foreign Account Tax Compliance Act (“FATCA”). Generally, U.S. FATCA reports are due to the IRS on March 31, 2023, or September 30, 2023, depending on where the fund is domiciled. However, reports may be required by an earlier date for jurisdictions that are parties to intergovernmental agreements (“IGAs”) with the U.S. Additionally, the U.S. may require that reports be submitted through the appropriate local tax authority in the applicable IGA jurisdiction, rather than the IRS. Given the varying U.S. FATCA requirements applicable to diﬀerent jurisdictions, managers should review and conﬁrm the speciﬁc U.S. FATCA reporting requirements that may apply. As a reminder, we strongly encourage managers to ﬁle the required reports and notiﬁcations, even if they already missed previous deadlines. Applicable jurisdictions may be increasing enforcement and monitoring of FATCA reporting and imposing penalties for each day late.

CRS. Funds should also monitor their compliance with the Organisation for Economic Cooperation and Development’s Common Reporting Standard (“CRS”). All “Financial Institutions” in the British Virgin Islands (“BVI”) and the Cayman Islands must register with the respective jurisdiction’s Tax Information Authority and submit various reports with the applicable regulator via the associated online portal. Managers to funds domiciled in other jurisdictions should also conﬁrm whether any CRS reporting will be required in such jurisdictions and the procedures required to enroll and file annual reports. We recommend managers contact their tax advisors to stay on top of the U.S. FATCA and CRS requirements and avoid potential penalties.

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Annual Management Company Matters

Management Company Expenses. Managers who distribute proﬁts annually should attempt to address management company expenses in the year they are incurred. If ownership or proﬁt percentages are adjusted at the end of the year, a failure to manage expenses could significantly impact the economics of the partnership or the management company.

Employee Reviews. An eﬀective annual review process is vital to reduce the risk of employment-related litigation and protect the management company in the event of such litigation. Moreover, it is an opportunity to provide context for bonuses, compensation adjustments, employee goals, and other employee-facing matters at the ﬁrm. It is never too late to put an annual review process in place.

Compensation Planning. In the fund industry, and the ﬁnancial services industry in general, the end of the year is the appropriate time to make adjustments to compensation programs. Because much of a manager’s revenue is tied to annual income from incentive fees, any changes to the management company structure, affiliated partnerships, or any shadow equity programs should be eﬀective on the ﬁrst of the year. Partnership agreements and operating agreements should be appropriately updated to reflect any such changes.

Insurance. If a manager carries director and officer or other liability insurance, the policy should be reviewed annually to ensure that the manager has provided notice to the carrier of all claims and all potential claims. Newly launched funds should also be added to the policy as necessary.

Other Tax Considerations. Fund managers should assess their overall tax position and consider several steps to optimize tax liability. Managers should also be aware of self-employment taxes, which can potentially be minimized by structuring the investment manager as a limited partnership. Several steps are available to optimize tax liability, including: (i) changing the incentive fee to an incentive allocation; (ii) use of stock-settled stock appreciation rights; (iii) if appropriate, terminating swaps and realizing net losses; (iv) making a Section 481(a) election under the Internal Revenue Code of 1986, as amended (“Code”); (v) making a Section 475 election under the Code; and (vi) making charitable contributions. Managers should consult legal and tax professionals to evaluate whether any of these options are appropriate.

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Notable Regulatory & Other Items from 2022

SEC Matters

SEC Risk Alert on Material Non-Public Information Compliance Issues. In April, the SEC released a risk alert summarizing the most common compliance deficiencies of both registered and unregistered investment advisers. Of note were (1) the lack of written policies to prevent the misuse of material non-public information (“MNPI”) and (2) the lack of compliance with the reporting requirements for “Access Persons” under the Code of Ethics Rule. All advisers should periodically revisit their written policies and procedures for the use of MNPI and registered investment advisers should review their Code of Ethics and establish reporting requirements for their Access Persons.

Enforcement Action for Misrepresenting Fees. The SEC instituted an enforcement action against a venture capital fund adviser and its CEO for misrepresenting their management fees as “industry standard 2 and 20” when they collected 10 years of management fees up front. This was misleading because it led investors to believe they would be charged an annual 2% management fee, rather than 20% of their total investment up front. The SEC also found that the adviser breached operating agreements by making inter-fund loans and cash transfers between funds. The adviser and its CEO agreed to a cease-and-desist order, returned funds, and paid penalties. In addition to confirming that the fund administrator reviews the offering documents and follows the mechanics for charging fees described therein, we recommend advisers closely review marketing materials with legal counsel or compliance consultants for any misleading or subjective statements.

Insider Trading in the Digital Asset Space. In 2022, the SEC charged a former Coinbase employee and two others with insider trading and a high-ranking employee of OpenSea was indicted for wire fraud and money laundering. The actions indicate the willingness of federal and state officials to enforce regulations applicable to traditional finance in the digital assets space and that law enforcement is ready to tackle unsavory business practices and to attempt to provide greater consumer protections. While insider trading remains an unsettled area of law in the digital asset space, concepts of fraud are well established, malleable, and largely immune from claims that certain digital assets are not “securities.”

Adviser Liable for Late Audit Distribution. The SEC charged an RIA with Custody Rule and compliance violations for failing to complete an audit within 120 days of the private fund’s fiscal year end. The SEC found that the adviser failed to have required audits performed and failed to deliver audited financial statements to investors in certain funds from 2014 onward, and in certain other funds from 2018 onward. The adviser consented to a cease-and-desist order, a censure, a monetary penalty, and to provide a notice of the Order to past and current investors in the fund. This enforcement action serves as a reminder to all advisers to remain vigilant and stay on top of their auditors to complete and distribute the annual fund audit in a timely fashion.

SEC Doubles Size of Crypto Enforcement Unit. The SEC announced the allocation of 20 additional positions to a Crypto Assets and Cyber Unit (formerly the Cyber Unit) to protect investors in crypto markets from cyber-related threats. The expanded Crypto Assets and Cyber Unit will focus on investigating securities law violations related to crypto asset offerings, crypto asset exchanges, crypto asset lending and staking, decentralized finance, NFTs, and stable coins. We think this is a step in the right direction; it is clear the SEC recognizes that the digital asset space is growing and that greater resources need to be brought to bear on the industry.

New Marketing Rule for SEC Registered Investment Advisers. By November 4, 2022, all SEC RIA are required to be in full compliance with the SEC’s new marketing rules. As discussed in our 2021 Half Year Update, the new rule replaces the existing cash solicitation and advertising rules, with the most notable change being the allowance of testimonials and endorsements in a RIA’s marketing materials. Given the new rule’s detailed amendments and its significance to our investment adviser clients, we will soon publish a “Frequently Asked Questions” article addressing the specific changes and what they mean for investment advisers going forward. Please keep an eye out for this post on the Hedge Fund Law Blog in the coming weeks.

SEC Charges Investment Advisers for Non-Compliance with Reporting Requirements. In September, the SEC conducted a compliance sweep and charged nine investment advisers for various violations, including failing to deliver audited financial statements to investors in a timely manner, failing to promptly file required amendments to the adviser’s Form ADV upon receipt of audited financial statements, failing to properly describe the status of financial statement audits in the Form ADV, and other violations of Rule 206(4)-2 (the “Custody Rule”) of the Investment Advisers Act of 1940, as amended (the “Advisers Act”). Without admitting fault, all the advisers settled with the SEC and agreed to censure and penalties totaling over $1 million. These enforcement actions highlight the importance of compliance with the Custody Rule and its associated reporting requirements, as well as serve as a reminder to regularly review the Form ADV for accuracy and file timely updates as needed. Further, as specifically identified by the SEC in many of these enforcement actions, if you select “Report Not Yet Received” in Item 23(h) of Section 7.B(1) of the Form ADV regarding a private fund’s audited financial statements, the Custody Rule and related instructions to the Form ADV mandate the filing of an other than annual amendment to the Form ADV once the audited financial statements are available.

SEC Charges Venture Capital Adviser for Overcharging Fees. In September, the SEC charged a California-based ERA for overcharging management fees. The excess fees were a result of errors made by the manager, specifically with regard to (i) the failure to adjust its management fee calculations for securities subject to dispositions; (ii) calculations of the management fee based on aggregated invested capital at the portfolio company level instead of at the individual portfolio company level; (iii) including accrued but unpaid interest in its calculation of management fees; and (iv) calculating the funds’ post-investment period management fees on an incorrect date. As a result, the manager was ordered to return the excess management fees to fund investors and pay a penalty. This enforcement action underscores that while ERAs are subject to less regulatory oversight compared to RIAs, they are not exempt from SEC scrutiny. We recommend that all investment advisers routinely review their offering documents to ensure compliance with their fund offering terms.

SEC Pay-to-Play Rule. Rule 206(4)-5 of the Advisers Act bars investment advisers (except state registered investment advisers) from receiving compensation for advisory services provided to a government entity for two years after the adviser or its covered associates have made political contributions to that government entity or official. In September, the SEC investigated and settled four enforcement actions against investment advisers for violations of these pay-to-play rules as a result of political contributions of less than $1,000 by personnel of the investment advisers. The lack of allegations of an intent to exert influence highlights the strict liability enforcement mentality of the SEC with respect to pay-to-play rules as well as the importance of educating employees about political donations and implementing a robust internal compliance and reporting system.

CFTC Matters

Perpetual Futures and CFTC Regulation. Digital assets managers continue to inquire into the possibility of trading cryptocurrency futures contracts. With the CFTC recognizing certain digital assets as commodities, proper registration with the CFTC is required (or an appropriate exemption from registration must be utilized) if managers plan to trade cryptocurrency futures on registered exchanges. Under the Commodity Exchange Act, many, if not all, derivatives based on digital assets must be traded on a Designated Contract Market (“DCM”). However, many managers prefer not to trade on DCMs due to the lack of volume and liquidity and instead seek to trade on offshore exchanges that offer higher volume and reduced margin requirements. We caution U.S. managers who are trading on such exchanges – there may be risks to engaging with such counterparties in foreign jurisdictions and such U.S. managers often are unable to make the representations required in the account opening paperwork or terms of service (e.g., that the trading activity will not occur in the U.S.). To our knowledge, the CFTC has yet to take any formal action against managers trading on such offshore exchanges; however, we believe it is only a matter of time. Managers should carefully diligence any offshore exchanges they may use and disclose any applicable risks to investors.

CFTC & SEC Consider Asking Large Hedge Funds to Disclose Crypto Exposure. In September, the CFTC and the SEC submitted a joint proposal to amend Form PF—a confidential reporting form for certain investment advisers to private funds that are registered with the SEC and/or the CFTC. The proposal observes that investments in digital assets are continuing to grow, and ultimately suggests there is a parallel need to gather information on the exposure of crypto funds. The proposal suggests a new asset class be created for digital assets, which would be reported by firms or funds separately, revealing their exposure to the crypto industry. Both agencies solicited comments through October 11, 2022 and the comments submitted prior to the deadline are available to the public. This proposal is one of many actions underway by U.S. government agencies to better understand and regulate crypto as an asset class. To the extent this proposal is part of a larger regulatory scheme that provides clarity as to how and to what extent digital assets will be regulated, we think this has the potential to increase investments in the crypto industry.

Digital Asset Matters

Coinbase’s Bankruptcy Disclosure. The industry was caught off guard when Coinbase filed its latest 10-Q filing in which it stated “custodially held crypto assets may be considered to be the property of a bankruptcy estate.” In essence, in the event of Coinbase’s bankruptcy, its customers’ crypto assets may not be returned, and such clients could be treated as general unsecured creditors, meaning they would not have a claim to specific crypto assets held with Coinbase and could only recover the value of their crypto assets to the extent the bankruptcy estate has assets remaining after more senior claims are satisfied. While the Coinbase founder and CEO subsequently tweeted that Coinbase’s statement was a response to SEC disclosure requirements and that “customers have strong legal protections…in a black swan event like this,” the bankruptcy risks that Coinbase disclosed remain a possibility, however remote. In addition, other crypto exchanges, as well as third party wallet providers and custodians, may be subject to similar bankruptcy risks even though they may not have an obligation to disclose such risks publicly like Coinbase. In light of Coinbase’s disclosures, managers who do not exclusively rely on self-custody or cold wallets should review their custody practices, policies, and procedures, as well as agreements with their service providers, to ensure they have taken all available steps to safeguard investor assets. Managers should also consider making additional risk disclosures in their fund offering documents or other investor communications to educate their investors on these potential bankruptcy risks.

Liability Issues for Investing in a DAO. Due to the emerging nature of, and the scarce legislation surrounding, Decentralized Autonomous Organizations (“DAOs”), operating, participating in, or investing in DAOs carries a heightened risk of liability as DAOs formed for the purpose of making a profit could be deemed general partnerships and therefore expose their participants to unlimited joint and several personal liability for the debts and obligations of such DAO. One recommendation to minimize exposure is to wrap the DAO in a liability blocker. As legislation related to, and use cases of, DAOs evolve and iterate, the need or effectiveness of liability blockers may change. Until then, managers should disclose this heightened risk to their investors and should consider only participating or investing in DAOs that are wrapped in a liability blocking entity such as a limited liability company.

Senators Introduce Bipartisan Crypto Regulatory Framework Bill. In June, Sens. Kirsten Gillibrand (D-NY) and Cynthia Lummis (R-WY) introduced bipartisan legislation to regulate the cryptocurrency market. The Responsible Financial Innovation Act aims to create a clear standard for determining whether certain digital assets are commodities or securities. The bill would give the CFTC authority over digital asset spot markets, allowing the agency to regulate digital assets in the same way as more traditional commodities. The bill has been referred to the Senate Finance Committee for examination and is pending approval of the Senate and the House of Representative.

OFAC/Tornado Cash. In August, the U.S. Office of Foreign Assets Control (“OFAC”) added Tornado Cash, a smart contract mixer that anonymizes Ethereum-based crypto exchanges, to the Specially Designated National (“SDN”) list for the alleged use of its services in laundering over $7 billion of digital assets. By taking this position, OFAC has essentially declared that anonymous exchanges are likely SDNs, effectively denying these exchanges access to the U.S. financial system by making it illegal for any U.S. person to transact using those exchanges – even if the U.S. person does not initiate or authorize the transaction via the SDN. This is particularly concerning because users may lose real-world access to their cryptocurrency, likely without any recourse and even when they have not actively engaged with an SDN.

SEC Actions Against Sponsors of Unregistered Crypto Offerings. Since October, the SEC ramped up its investigation and enforcement of securities violations in the crypto asset space. Notably, the SEC brought an enforcement action against Kim Kardashian for promoting a crypto asset via social media without disclosing that she was being compensated by the entity offering the security. Several other groups were charged for allegedly raising millions of dollars for tokens and other crypto assets without adequate registration and from unsophisticated investors. The recent expansion of the SEC’s enforcement unit coupled with the wave of enforcement actions in the digital asset space indicates a shift in focus to digital assets.

Other Items

In-Kind Crypto Contributions / Redemptions. We are starting to see greater difficulty for managers of offshore funds to utilize in-kind crypto contributions and redemptions because of administrator and Anti Money Laundering (“AML”) officers’ unease. We expect this trend to generally continue until administrators and AML officers become more comfortable with verifying and authenticating in-kind crypto transactions, either with additional regulatory guidance or with innovative processes.

Investors with Connections to Russia. It may be simply anecdotal, but we are seeing more administrator inquiries regarding investors with ties to Russia who are flagged for potential sanctions issues. In these instances, we encourage clients to work with legal counsel and their administrator to analyze their specific facts and circumstances and determine an appropriate course of action.

NFTs. Although far removed from its headline status of 2021, the NFT ecosystem continues to evolve, and many groups are developing products for the sector that more closely mirror the traditional asset space. We anticipate continued growth in this area and the development of business, legal and regulatory norms.

New EU AML Regulator Will Oversee Crypto. In June, the European Union (the “EU”) proposed the establishment of a new Anti-Money Laundering Authority to strengthen the EU’s AML and Countering the Financing of Terrorism (“CTF”) framework. If enacted, this proposal would create a new regulatory body and standardize AML/CTF regulations across the EU and replace the current AML regime which varies across individual nations. The new AML/CTF Authority would have supervisory powers including over selected obliged entities of the financial sector such as crypto-asset service providers and would also be responsible for the monitoring, analysis, and exchange of information concerning money laundering and terrorist financing. With the increasing anonymity provided by cryptocurrency, including through mixers such as Tornado Cash discussed above, the EU’s standardization of a comprehensive AML/CTF regime provides legitimacy to this asset class.

BVI Business Companies Act of 2004. On January 1, 2023, several amendments to the British Virgin Islands (“BVI”) Business Company Act of 2004 relating to voluntary liquidators of solvent BVI business companies will go into effect. Specifically, the amendment requires a voluntary liquidator to be a resident of the BVI (unless a joint voluntary liquidator is a BVI resident) that has at least 2 years of liquidation experience, is competent to perform the liquidation, and is familiar with relevant legislation. Further, voluntary liquidators will now be required to maintain the entity’s accounting records and to provide them to the entity’s registered agent

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Compliance Calendar

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

December 12, 2022

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

December 16, 2022

Cayman Islands FATCA and CRS reporting deadlines.

December 22, 2022

Last day to submit form filings via IARD prior to year-end. CRD/IARD will be unavailable to submit any filings from 11 PM ET, December 22, 2022 through January 2, 2023, due to year-end renewal processing.

December 31, 2022

Review RAUM to determine 2022 Form PF filing requirement.
Registered CPOs must submit a pool quarterly report (CPO-PQR).
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 to avoid 2022 CIMA fees.

January 10, 2023

Form 13H Quarterly Filing for Changes. Filing is for calendar quarter that ended December 31, 2022 and should be submitted within 10 days of quarter end.

January 15, 2023

Quarterly Form PF due for Large Liquidity Fund Advisers (if applicable).

January 31, 2023

“Annex IV” AIFMD filing.

February 14, 2023

Form 13F Quarterly Filing for Changes. Filing is for Calendar Quarter that ended December 31, 2022 and should generally be submitted within 45 days of quarter end.
Form 13H Annual Filing for Calendar Year that ended December 31, 2022.
Form 13G Annual Filing for Calendar Year that ended December 31, 2022.

March 1, 2023

Quarterly Form PF due for larger hedge fund advisers (if applicable).
Deadline for annual affirmation of NFA/CFTC exemptions. Exemptions must be affirmed within 60 days of Calendar Year end or exemptions will be withdrawn by the NFA.

March 31, 2023

Form ADV Annual Update Amendment. Deadline to update and file Form ADV Parts 1, 2A, 2B (and Form CRS, if applicable).

March 31, 2023

Cayman Islands CRS Compliance Form deadline.

Periodic

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

Consult our complete Compliance Calendar for all 2023 critical dates as you plan your regulatory compliance timeline for the year.

Please contact us with any questions or assistance regarding compliance, registration, or planning issues on any of the above topics.

Sincerely,

Karl Cole-Frieman, Bart Mallon, David Rothschild, Scott Kitchens, Tony Wise, Alex Yastremski, & Garret Filler

Cole-Frieman & Mallon LLP is an investment management law firm known for providing innovative and collaborative legal solutions to clients with complex financial needs in both the traditional and digital asset spaces. Headquartered in San Francisco, CFM services a wide variety of groups, from start-up investment managers to multi-billion-dollar firms. The firm provides a full suite of legal services including: formation of hedge funds, private equity funds, and venture capital funds; adviser compliance and registration; counterparty documentation; equity financings and token offerings; 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.

Cole-Frieman & Mallon 2021 End of Year Update

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Clients, Friends, Associates:

As we near the end of 2021, we have developed a checklist to help managers effectively oversee the business and regulatory landscape for the coming year. We have also highlighted some recent industry updates that we believe may impact our clients. While we strive to present an informative, albeit brief, overview of these topics, we are also available should you have any related questions.

This update includes the following:

Annual Compliance & Other Items
Annual Fund Matters
Annual Management Company Matters
Regulatory & Other Items from 2021
2022 Compliance Calendar

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Annual Compliance & Other Items

Annual Privacy Policy Notice. On an annual basis, Securities and Exchange Commission (“SEC”) registered investment advisers (“SEC RIAs”) are required to provide natural person clients with a copy of the ﬁrm’s privacy policy if: (i) the SEC RIA has disclosed nonpublic personal information other than in connection with servicing consumer accounts or administering ﬁnancial products; or (ii) the ﬁrm’s privacy policy has changed. The SEC has provided a model form and accompanying instructions for firm privacy policies.

Annual Compliance Review. The Chief Compliance Officer (“CCO”) of a registered investment advisor (“RIA”) must conduct a review of the adviser’s compliance policies and procedures annually. This annual compliance review should be in writing and presented to senior management. CCOs should consider additions, revisions, and updates to the compliance program as may be necessary. We recommend ﬁrms discuss the annual review with their outside counsel or compliance ﬁrm to obtain guidance about the review process and a template for the assessment. Conversations regarding the annual review may raise sensitive matters, and advisers should ensure that these discussions are protected by attorney-client privilege. Advisers that are not registered may still wish to review their procedures and/or implement a compliance program as a best practice.

Form ADV Annual Amendment. RIAs or managers ﬁling as exempt reporting advisers (“ERAs”) with the SEC or a state securities authority must ﬁle an annual amendment to their Form ADV within 90 days of the end of their ﬁscal year. For most managers, the Form ADV amendment will be due on March 31, 2022. RIAs must provide a copy of the updated Form ADV Part 2A brochure and Part 2B brochure supplement (or a summary of changes with an oﬀer to provide the complete brochure) to each “client” and, if applicable, Part 3 (Form CRS: Client Relationship Summary) to each “retail investor” with which the RIA has entered into an investment advisory contract. Note that for SEC-registered advisers to private investment vehicles, a “client” for purposes of this rule refers to the vehicle(s) managed by the adviser and not the underlying investors. State-registered advisers need to examine their states’ regulations to determine who constitutes a “client.” For purposes of the Form ADV Part 3, a “retail investor” means a natural person, or the legal representative of such natural person, who seeks to receive or receives services primarily for personal, family, or household purposes.

Switching to/from SEC Regulation.

Exempt Reporting Advisers. Managers who no longer meet the deﬁnition of an ERA will need to submit a ﬁnal report as an ERA and apply for registration with the SEC or the relevant state securities authority, as applicable, generally within 90 days after the ﬁling of the annual amendment (June 30, 2022, for most managers, assuming the annual amendment is filed on March 31, 2022).

Custody Rule Annual Audit.

SEC RIAs to pooled investment vehicles may avoid both the quarterly statement and surprise examination requirements by having audited ﬁnancial statements prepared for each pooled investment vehicle in accordance with generally accepted accounting principles (“GAAP”) by an independent public accountant registered with the Public Company Accounting Oversight Board (“PCAOB”). Audited financial statements must be sent to investors in the fund within 120 days after the fund’s ﬁscal year-end (or for fund-of-fund clients, within 180 days after fiscal year-end). SEC RIAs should review their internal procedures to ensure compliance with the custody rules.

California RIAs. California-registered investment advisers (“CA RIAs”) that manage pooled investment vehicles and are deemed to have custody of client assets are also subject to independent party surprise examinations. However, CA RIAs can avoid these additional requirements by engaging a PCAOB-registered auditor to prepare and distribute audited ﬁnancial statements to all beneficial owners of the pooled investment vehicle, and the Commissioner of the California Department of Financial Protection and Innovation (“DFPI”). Those CA RIAs that do not engage an auditor must, among other things: (i) provide notice of such custody on the Form ADV; (ii) maintain client assets with a qualiﬁed custodian; (iii) engage an independent party to act in the best interest of investors to review fees, expenses, and withdrawals; and (iv) retain an independent certiﬁed public accountant to conduct surprise examinations of assets.

Other State RIAs. Advisers registered in other states should consult their legal counsel about those states’ specific custody requirements.

California Minimum Net Worth Requirement and Financial Reports.

CA RIAs with Custody. Generally, every CA RIA (other than those also registered as broker-dealers) that has custody of client funds or securities must maintain a minimum net worth of $35,000. However, a CA RIA that: (i) is deemed to have custody solely because it acts as the general partner of a limited partnership, or a comparable position for another type of pooled investment vehicle; and (ii) otherwise complies with the California custody rule described above is exempt from the $35,000 minimum (and instead is required to maintain the $10,000 minimum).

Financial Reports. Every CA RIA subject to the above minimum net worth requirements must file certain reports with the DFPI. In addition to annual reports, CA RIAs may be required to file interim reports or reports of financial condition if they fall below certain net worth thresholds.

Annual Re-Certiﬁcation of CFTC Exemptions. Commodity pool operators (“CPOs”) and commodity trading advisers (“CTAs”) currently relying on certain exemptions from registration with the Commodity Futures Trading Commission (“CFTC”) are required to re-certify their eligibility within 60 days of the calendar year-end. A common example includes the 4.13(a)(3) exemption also known as the “de minimis” exemption. CPOs and CTAs currently relying on relevant exemptions should consult with legal counsel to evaluate whether they remain eligible to rely on such exemptions.

CPO and CTA Annual Updates. Registered CPOs and CTAs must prepare and ﬁle Annual Questionnaires and Annual Registration Updates with the National Futures Association (“NFA”), as well as submit payment for annual maintenance fees and NFA membership dues. Registered CPOs must also prepare and ﬁle their fourth-quarter report for each commodity pool on Form CPO-PQR, while CTAs must ﬁle their fourth-quarter report on Form CTA-PR. Unless eligible to claim relief under Regulation 4.7, registered CPOs and CTAs must update their disclosure documents periodically, as they may not use any document dated more than 12 months prior to the date of its intended use. Disclosure documents that are materially inaccurate or incomplete must be promptly corrected, and redistributed to pool participants.

Trade Errors. Managers should ensure that all trade errors are properly addressed pursuant to the manager’s trade errors policies by the end of the year. Documentation of trade errors should be ﬁnalized, and if the manager is required to reimburse any of its funds or other clients, it should do so by year-end.

Soft Dollars. Managers that participate in soft dollar programs should make sure that they have addressed any commission balances from the previous year.

Schedule 13G/D and Section 16 Filings. Managers who exercise investment discretion over accounts (including funds and separately managed accounts) that are beneﬁcial owners of 5% or more of a registered voting equity security must report these positions on Schedule 13D or 13G. Passive investors are generally eligible to ﬁle the short-form Schedule 13G, which is updated annually within 45 days of the end of the year. Schedule 13D is required when a manager is ineligible to ﬁle Schedule 13G and is due 10 days after acquiring more than 5% beneﬁcial ownership of a registered voting equity security. For managers who are also making Section 16 ﬁlings, this is an opportune time to review your ﬁlings to conﬁrm compliance and anticipate needs for the ﬁrst quarter.

Section 16 ﬁlings are required for “corporate insiders” (including beneﬁcial owners of 10% or more of a registered voting equity security). An initial Form 3 is due within 10 days after becoming an “insider”; Form 4 reports ownership changes and is due by the end of the second business day after an ownership change; and Form 5 reports any transactions that should have been reported earlier on a Form 4 or were eligible for deferred reporting and is due within 45 days after the end of each fiscal year.

Form 13F. A manager must ﬁle a Form 13F if it exercises investment discretion with respect to $100 million or more in certain “Section 13F securities” within 45 days after the end of the year in which the manager reaches the $100 million ﬁling threshold. The SEC lists the securities subject to 13F reporting on its website.

Form 13H. Managers who meet one of the SEC’s large trader thresholds (generally, managers whose transactions in exchange-listed securities equal or exceed two million shares or $20 million during any calendar day, or 20 million shares or $200 million during any calendar month) are required to ﬁle an initial Form 13H with the SEC within 10 days of crossing a threshold. Large traders also need to amend Form 13H annually within 45 days of the end of the year. In addition, changes to the information on Form 13H will require interim amendments following the calendar quarter in which the change occurred.

Form PF. Managers to private funds that are either registered with the SEC or required to be registered with the SEC and who have at least $150 million in regulatory assets under management (“RAUM”) must ﬁle a Form PF. Private advisers with less than $1.5 billion in RAUM must ﬁle Form PF annually within 120 days of their ﬁscal year-end. Private advisers with $1.5 billion or more in RAUM must ﬁle Form PF within 60 days of the end of each fiscal quarter.

Form MA. Investment advisers that provide advice on municipal financial products are considered “municipal advisors” by the SEC and must file a Form MA annually, within 90 days of their fiscal year-end.

SEC Form D. Form D ﬁlings for most funds need to be amended annually, on or before the anniversary of the most recently ﬁled Form D. Copies of Form D are publicly available on the SEC’s EDGAR website.

Blue Sky Filings. On an annual basis, a manager should review its blue sky ﬁlings for each state to make sure it has met any initial and renewal filing requirements. Several states impose late fees or reject late ﬁlings altogether. Accordingly, it is critical to stay on top of ﬁling deadlines for both new investors and renewals. We also recommend that managers review blue sky ﬁling submission requirements. Many states now permit blue sky ﬁlings to be ﬁled electronically through the Electronic Filing Depository (“EFD”) system, and certain states will now only accept ﬁlings through EFD.

IARD Annual Fees. Preliminary annual renewal fees for state-registered and SEC-registered investment advisers are due on December 13, 2021. Failure to submit electronic payments by the deadline may result in registrations terminating due to a “failure to renew.” If you have not already done so, you should submit full payment into your Renewal Account by E-Bill, check, or wire as soon as possible.

Pay-to-Play and Lobbyist Rules. SEC rules disqualify investment advisers, their key personnel, and placement agents acting on their behalf from seeking to be engaged by a governmental client if they have made certain political contributions. State and local governments have similar rules, including California, which requires internal sales professionals who meet the deﬁnition of “placement agents” (people who act for compensation as ﬁnders, solicitors, marketers, consultants, brokers, or other intermediaries in connection with oﬀering or selling investment advisory services to a state public retirement system in California) to register with the state as lobbyists and comply with California lobbyist reporting and regulatory requirements. Note that managers oﬀering or selling investment advisory services to local government entities must register as lobbyists in the applicable cities and counties. State laws on lobbyist registration diﬀer significantly, so managers should carefully review reporting requirements in the states in which they operate to make sure they comply with the relevant rules.

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Annual Fund Matters

ERISA Status. Given the signiﬁcant problems that can occur from not properly tracking ERISA investors in private funds, we recommend that managers conﬁrm or reconﬁrm on an annual basis the ERISA status of their investors. This is particularly important for managers that track the underlying percentage of ERISA funds for each investor, with respect to each class of interests in a pooled investment vehicle.

Wash Sales. Managers should carefully manage wash sales for year-end. Failure to do so could result in book/tax differences for investors. Certain dealers can provide managers with swap strategies to manage wash sales, including Basket Total Return Swaps and Split Strike Forward Conversion. These strategies should be considered carefully to make sure they are consistent with the investment objectives of the fund.

Redemption Management. Managers with signiﬁcant redemptions at the end of the year should carefully manage unwinding positions to minimize transaction costs in the current year (that could impact performance) and prevent transaction costs from impacting remaining investors in the next year. When closing funds or managed accounts, managers should pay careful attention to the liquidation procedures in the fund constituent documents and the managed account agreement.

NAV Triggers and Waivers. Managers should promptly seek waivers of any applicable termination events specified in a fund’s International Swaps and Derivatives Association (“ISDA”) or other counterparty agreement that may be triggered by redemptions, performance, or a combination of both at the end of the year (NAV declines are common counterparty agreement termination events).

Fund Expenses. Managers should wrap up all fund expenses for 2021 if they have not already done so. In particular, managers should contact their outside legal counsel to obtain accurate and up to date information about legal expenses for inclusion in the NAV for year-end performance.

Electronic Schedule K-1s. The Internal Revenue Service (“IRS”) authorizes partnerships and limited liability companies taxed as partnerships to issue Schedule K-1s to investors solely by electronic means, provided the partnership has received the investors’ aﬃrmative consent. States may have diﬀerent rules regarding electronic K-1s, and partnerships should check with their counsel whether they may be required to send hard copy state K-1s. Partnerships must also provide each investor with speciﬁc disclosures that include a description of the hardware and software necessary to access the electronic K-1s, how long the consent is eﬀective, and the procedures for withdrawing the consent. If you would like to send K-1s to your investors electronically, you should discuss your options with your service providers.

“Bad Actor” Recertiﬁcation Requirement. A security oﬀering cannot rely on the Rule 506 safe harbor from SEC registration if the issuer or its “covered persons” are “bad actors.” Fund managers must determine whether they are subject to the bad actor disqualiﬁcation any time they are oﬀering or selling securities in reliance on Rule 506. The SEC has advised that an issuer may reasonably rely on a covered person’s agreement to provide notice of a potential or actual bad actor triggering event pursuant to contractual covenants, bylaw requirements, or undertakings in a questionnaire or certiﬁcation. However, if an oﬀering is continuous, delayed or long-lived, issuers must periodically update their factual inquiry through a bring-down of representations, questionnaires, and certiﬁcations, negative consent letters, reexamination of public databases or other means, depending on the circumstances. Fund managers should consult with counsel to determine how frequently such an update is required. As a matter of practice, most fund managers should perform these updates at least annually.

U.S. FATCA. Funds should monitor their compliance with the U.S. Foreign Account Tax Compliance Act (“FATCA”). Generally, U.S. FATCA reports are due to the IRS on March 31, 2022, or September 30, 2022, depending on where the fund is domiciled. However, reports may be required by an earlier date for jurisdictions that are parties to intergovernmental agreements (“IGAs”) with the U.S. Additionally, the U.S. may require that reports be submitted through the appropriate local tax authority in the applicable IGA jurisdiction, rather than the IRS. Given the varying U.S. FATCA requirements applicable to diﬀerent jurisdictions, managers should review and conﬁrm the speciﬁc U.S. FATCA reporting requirements that may apply. As a reminder, we strongly encourage managers to ﬁle the required reports and notiﬁcations, even if they already missed previous deadlines. Applicable jurisdictions may be increasing enforcement and monitoring of FATCA reporting and imposing penalties for each day late.

CRS. Funds should also monitor their compliance with the Organisation for Economic Cooperation and Development’s Common Reporting Standard (“CRS”). All “Financial Institutions” in the British Virgin Islands (“BVI”) and the Cayman Islands must register with the respective jurisdiction’s Tax Information Authority and submit various reports with the applicable regulator via the associated online portal. Managers to funds domiciled in other jurisdictions should also conﬁrm whether any CRS reporting will be required in such jurisdictions and the procedures required to enroll and file annual reports. We recommend managers contact their tax advisors to stay on top of the U.S. FATCA and CRS requirements and avoid potential penalties.

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Annual Management Company Matters

Employee Reviews. An eﬀective annual review process is vital to reduce the risk of employment-related litigation and protect the management company in the event of such litigation. Moreover, it is an opportunity to provide context for bonuses, compensation adjustments, employee goals, and other employee-facing matters at the ﬁrm. It is never too late to put an annual review process in place.

Compensation Planning. In the fund industry, and the ﬁnancial services industry in general, the end of the year is the appropriate time to make adjustments to compensation programs. Because much of a manager’s revenue is tied to annual income from incentive fees, any changes to the management company structure, affiliated partnerships, or any shadow equity programs should be eﬀective on the ﬁrst of the year. Partnership agreements and operating agreements should be appropriately updated to reflect any such changes.

Insurance. If a manager carries director and officer or other liability insurance, the policy should be reviewed annually to ensure that the manager has provided notice to the carrier of all claims and all potential claims. Newly launched funds should also be added to the policy as necessary.

Other Tax Considerations. Fund managers should assess their overall tax position and consider several steps to optimize tax liability. Managers should also be aware of self-employment taxes, which can potentially be minimized by structuring the investment manager as a limited partnership. Several steps are available to optimize tax liability, including: (i) changing the incentive fee to an incentive allocation; (ii) use of stock-settled stock appreciation rights; (iii) if appropriate, terminating swaps and realizing net losses; (iv) making a Section 481(a) election under the Internal Revenue Code of 1986, as amended (“Code”); (v) making a Section 475 election under the Code; and (vi) making charitable contributions. Managers should consult legal and tax professionals to evaluate whether any of these options are appropriate.

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Regulatory & Other Items from 2021

SEC Updates.

SEC Issues Risk Alert on Investment Advisers’ Fee Calculations. The SEC’s Division of Examinations has recently completed a review of 130 SEC-RIAs and published its findings in this November 2021 Risk Alert. The review focused on three key areas: (i) the accuracy of fees charged by investment advisers; (ii) the accuracy and adequacy of investment adviser disclosures; and (iii) the effectiveness of investment advisers’ compliance programs and the accuracy of their books and records. The risk alert notes key mistakes such as the failure to maintain written billing policies and inaccurate financial statements caused by errors in accounting procedures. Though mistakes such as these are not new to the industry, this report provides a reminder to investment advisers to consistently review and improve their policies and disclosures pertaining to client fees.

SEC Proposes Revisions to Electronic Recordkeeping Requirements. The SEC has published proposed amendments to electronic recordkeeping rules applicable to broker-dealers, as well as security-based swap dealers (“SBSDs”) and major security-based swap participants (“MSBSPs”) that are not also registered as broker-dealers (collectively, “SBS Entities”). Currently, broker-dealers, are required to maintain electronic records in a “non-rewritable, non-erasable format” while SBS Entities are not subject this requirement. However, the new proposal provides for an audit trail alternative whereby records may be preserved “in a manner that permits the recreation of an original record if it is lost, over-written or erased.” Under the new rule, SBS Entities without a prudential regulator would also be required to utilize one of the two authorized recordkeeping methods. The proposed amendment, if enacted, would apply only to newly created records and not to records created prior to the amendment. Applicable entities should keep an eye out for the final rule to ensure their electronic recordkeeping policies and procedures are appropriately updated.

SEC Proposes Substantial Reporting and Disclosure of Securities Lending Information. The SEC has published and requested comment on proposed Rule 10c-1 under the Exchange Act. The proposed rule would require all lenders of securities to provide certain information and material terms related to securities lending transactions. The proposal covers loans of any “security” as defined in Section 3(a)(10) of the Exchange Act, applying to both equity and debt securities. The reporting requirements would also apply to “lending agents,” in situations where securities are lent through an intermediary, and any broker dealers acting as “reporting agents” . Certain of the information provided, including, but not limited to, the legal name and legal entity identifier of the issuer, the securities’ ticker symbol, and the date and time the loan was effected, would be made public. Questions remain regarding the scope of the information to be collected, as well as how lending of certain digital assets that are classified as “securities” may be impacted by this proposal. There are various activities that involve the lending of digital assets, such as yield farming, which could be subject to the proposed rule. The SEC has not yet commented on the effect of Rule 10c-1 on digital asset lending, but we will continue to monitor this matter for any updates or related guidance.

New Qualified Client Standard in Effect. As a reminder, the SEC revised dollar thresholds for Qualified Clients went into effect August 16, 2021. The “net worth” threshold increased from $2,100,000 to $2,200,000 and the dollar amount for the “assets-under-management” test was raised from $1,000,000 to $1,100,000. Please refer to our previous update for more information.

SEC Adopts Marketing Rule. As a reminder, the SEC adopted new marketing rules for investment advisers that will drastically overhaul and replace the prior cash solicitation and advertising rules applicable to investment advisers, their marketing materials, and their advertising practices to replace. The compliance period for these new marketing rules begins on November 4, 2022. Please refer to our previous update for more information.

Digital Asset Updates.

The President’s Working Group on Financial Markets Issues Risk Assessment on Stablecoins. An interagency report released on November 1, 2021 outlines the risks that stablecoins pose to the safety and efficiency of the financial market, as well as recommendations for congressional and agency action intended to address such risks. The primary concerns raised are: (i) the loss of value; (ii) payment system risks; and (iii) systemic risks, such as rapid scaling or failures by key participants. The recommendations include requiring stablecoin issuers to be insured as depository institutions, implementation of federal oversight regimes for digital wallet providers, limiting stablecoin issuers’ and digital wallet providers’ ability to affiliate with commercial entities, and limiting their use of users’ transaction data. The report further recommends that federal agencies, including the SEC, CFTC, and the Financial Crimes Enforcement Network (“FinCEN”), use their oversight power where appropriate and that the Financial Stability Oversight Council (“FSOC”) designate certain stablecoin arrangement activities as, or as likely to become, systemically important payment, clearing, and settlement (“PCS”) activities, enabling agencies to establish appropriate risk-management standards for institutions engaging in PCS activities.

The Treasury Issues Reports Addressing Threats Linked to Virtual Currency Transactions and Ransomware Payments. The U.S. Department of the Treasury’s (“Treasury”) Office of Foreign Assets Control (“OFAC”) issued guidance on October 15, 2021 regarding the application of sanctions laws to virtual currency activity and best practices for compliance with such sanctions regulations. OFAC also issued an updated advisory report discouraging private companies and individuals from making ransomware or extortion payments and highlighting risks to companies that facilitate such payments on behalf of the victim, such as the risk of directly or indirectly engaging in a prohibited transaction with individuals or entities on OFAC’s Specifically Designated Nationals and Blocked Persons List. OFAC recommends companies implement sanctions compliance programs to mitigate exposure to related violations, and notes that such programs are taken into consideration in the event of a violation.

South Korea to Introduce 20% Tax on Crypto Trading Profits. As a reminder, South Korea will implement a 20% capital gains tax on Bitcoin (BTC) and cryptocurrency profits starting January 1, 2022.

Offshore Updates.

BVI’s New Data Privacy Law in Effect. A new BVI statute, the Data Protection Act, 2021 (“DPA”) went into effect on July 9, 2021. The DPA applies to all BVI companies, limited partnerships, other entities, such as data controllers and non-BVI entities that use data processing equipment in the BVI or use the BVI for data transmission. The DPA is modeled after the European Union’s General Data Protection Regulation (“GDPR”) and requires an individual or entity’s consent prior to data processing. Additionally, the law requires that data controllers implement data protection safeguards before they transfer personal data out of the BVI. Altogether, the DPA aligns with the international movement towards stringent data privacy laws as governments seek more accountability from companies managing personal data. Managers with BVI funds should consult offshore counsel to ensure compliance with the DPA.

Other Matters.

Treasury Form SHC Due by Owners of Foreign Securities on December 31, 2021. Investment advisers, managers, administrators, and fund sponsors that are involved in master-feeder structures established both inside and outside of the U.S. should report such interests to the Treasury by filing a Form SHC no later than December 31, 2021. This includes a U.S. feeder fund, created by a U.S. investment manager / fund sponsor (“IM / FS”) entity, that holds, as a portfolio investment, interests in a foreign master fund. The portfolio investment by the U.S. feeder fund will need to be reported by the IM / FS as the representative of the U.S. feeder. Conversely, if the IM / FS is a foreign entity, the U.S. feeder fund will need to self-report the ownership interest in the foreign master fund as ownership of foreign equity on the Form SHC. The Treasury provides further directions regarding how to know if you must report ownership of such foreign securities.

European Union Announces Delay of Sustainable Finance Disclosure Regulation (“SFDR”) Rollout. As a reminder, the EU’s SFDR will now be implemented on July 1, 2022, instead of January 1, 2022. The SFDR is a series of disclosure requirements for asset managers intended to increase the transparency of a fund’s sustainability and environmental impact. Please refer to our previous update for more information.

California Lenders’ License Update. As a reminder, the DFPI announced that starting on October 1, 2021 applications under California Financing Law (“CFL”) must be submitted through the Nationwide Multistate System and Registry (“NMLS”). Existing licenses must be transitioned onto NMLS by December 31, 2021. Please refer to our previous update for more information.

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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
December 13	Deadline for paying annual IARD charges and state renewal fees, through IARD.
December 16	Cayman Islands FATCA and CRS reporting deadlines.
December 26	Last day to submit form filings via IARD prior to year-end.
December 31	Review RAUM to determine 2021 Form PF filing requirement.
December 31	Small and mid-sized registered CPOs must submit a pool quarterly report (CPO-PQR).
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 to avoid 2022 CIMA fees.
January 11	Amended Form 13H filing due if any information on the previously filed Form 13H became inaccurate during the prior quarter.
January 15	Quarterly Form PF due for large liquidity fund advisers (if applicable).
January 31	“Annex IV” AIFMD filing.
February 16	Quarterly Form 13F due.
February 16	Annual Form 13H updates due.
March 1	Quarterly Form PF due for larger hedge fund advisers (if applicable).
March 1	Deadline for annual affirmation of CFTC exemptions.
March 31	Deadline to update and file Form ADV Parts 1, 2A &2B.
March 31	Cayman Islands CRS Compliance Form deadline.
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 NFA Annual Questionnaire system.

Please contact us 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.

2022 IARD Renewal

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As of November 8, 2021, FINRA issued Preliminary Statements for the 2022 IARD Renewal Program. You should have received an email from FINRA reminding you of the annual renewal fee due in December. The IARD Renewal Program is essentially where FINRA assists with the collection and disbursement of system processing and jurisdiction-related renewal fees. Please note that the renewal fee varies by jurisdiction/registration, but the exact amount will be reflected in your Preliminary Statement in the E-bill tab.

Please note that full payment of registration renewal fees will be due on or before December 13, 2021. You are responsible for logging into your firm’s FINRA account and making this payment, and we are happy to walk you through the process if you have any questions. If the renewal fee is not paid in a timely manner, the firm’s Form ADV will be withdrawn for failure to comply with the fee requirement. If you have any questions or concerns, please feel free to contact us for assistance.

Cole-Frieman & Mallon 2021 Q3 Update

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Clients, Friends, Associates:

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

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SEC Matters

New Qualified Client Standard in Effect. The Securities and Exchange Commission’s (the “SEC”) revised dollar thresholds for Qualified Clients (as such term is defined in Rule 205-3 under the Investment Advisers Act of 1940) became effective on August 16, 2021. Specifically, the “net worth” threshold has been increased from $2,100,000 to $2,200,000 and the dollar amount for the “assets-under-management” test has been raised from $1,000,000 to $1,100,000. As a reminder, investment advisers in many jurisdictions, including SEC registered investment advisers (“RIAs”), are prohibited from charging performance fees and incentive allocations to investors who are not Qualified Clients. The new standard will not be applied retroactively to contractual relationships existing prior to the effective date of the Order, provided that if a new person or entity becomes a party to the contract, the new standard will apply with regard to that person or entity.

SEC Brings Action for Personal Information Exposures. The SEC settled three actions against eight firms after hackers exposed deficiencies in the firms’ cybersecurity policies and procedures. Each firm was charged with violating Rule 30(a) of Regulation S-P (the “Safeguards Rule”). The Safeguards Rule calls for SEC RIAs to adopt written policies and procedures to secure personal information and prevent unauthorized access. The SEC found that the firms either (i) failed to adopt the required policies and procedures or (ii) failed to follow their own internal cybersecurity policies and procedures. In addition, the SEC found two firms provided misleading notifications to clients regarding the length of time between when the breach was discovered and when notice was provided. Each firm in question has agreed to cease and desist from future violations, to be censured, and to pay fines. The SEC’s message was clear—written policies and procedures are insufficient to avoid liability if those policies are ignored or clients and customers are misled.

FINRA Member Fined for Failure to Retain Text Messages. In July 2021, a United Kingdom-based firm settled with the Financial Industry Regulatory Agency (“FINRA”) after FINRA alleged the firm failed to preserve “business-related text messages” sent between employees and customers. The settlement agreement states that employees used their personal cell phones to discuss business matters internally and with customers and failed to forward the messages to higher management and the compliance team for review and retention. This conduct violates Rule 17a-4 of the Securities Exchange Act of 1934, as amended (“Exchange Act”), which requires certain exchange members, brokers, and dealers to preserve all business records for three years. The violations were brought under FINRA’s purview through FINRA Rule 4511, which mandates that such exchange member, broker, or dealer’s record retention policy must adhere to the rules established in the Exchange Act. The blurring of business and personal communications through the use of texting and other instant messaging platforms, while convenient, adds a new layer of complexity regarding the preservation of business records. These actions emphasize the importance of investment advisers maintaining internal policies on the use of messaging platforms as a form of business communication and implementing appropriate retention methods.

SEC Brings Enforcement Action for Securities Fraud Against an Alternative Data Provider. Alternative data provider App Annie Inc. (“App Annie”) and its CEO have agreed to settle with the SEC following charges of securities fraud. App Annie is a seller of market data on mobile app performance such as number of downloads, usage rates and revenue figures (also referred to as “alternative data”). The Commission’s Order states App Annie’s “Terms of Service” provided certain limitations on how App Annie could compile and use its subscribers alternative data—specifically, App Annie represented that it would aggregate the data it received, thereby making the data “non-identifiable.” However, App Annie used non-aggregated data in contravention of its Terms of Service, and manually altered app performance estimates in order to increase the accuracy of the estimates it provided. In addition, App Annie assured potential and existing trading firm subscribers that it had safeguards in place to prevent the sharing and selling of material non-public information (“MNPI”), but failed to properly implement such internal controls. This conduct violates SEC rules for manipulative and deceptive practices (Rule 10b-5). The terms of App Annie’s settlement require the company to pay a $10 million fine and cease the creation of non-aggregated estimates. This and other recent SEC statements have shown the SEC’s increased focus on how alternative data is used in investment research and underscores the importance of advisers performing adequate due diligence on their data vendors to ensure the data they receive does not contain MNPI, rather than solely relying on representations made by such data vendors.

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Digital Asset Matters

Emergence of NFTs as an Area to Watch. Non-fungible tokens (“NFTs”) have seen a massive surge in interest over the course of the last year, with large companies, including the Fox Corporation, who invested $100 million into a creators’ fund for NFTs, and Google Cloud, who recently partnered with the operator of a NFT marketplace network, entering the market. However, with the growth in interest in the sector, the opportunities for malicious actors to profit has also increased, with certain marketplaces seeing an increase in wash sales and OpenSea, one of the largest NFT marketplaces, recently announcing that they have accepted the resignation of an employee who used inside information to profit on the purchase and sale of NFTs from his personal account. As the NFT ecosystem continues to grow, we are likely to see increased attention from regulators as they seek to protect investors.

Coinbase Files to become Futures Commission Merchant. On September 15, Coinbase Financial Markets Inc, a subsidiary of Coinbase Global, Inc. (“Coinbase”) filed an application with the National Futures Association (“NFA”) to register as a Future Commission Merchant. Coinbase announced their application via tweet, stating their next step is to “broaden our offerings and offer futures and derivatives trading on our platforms.” Other platforms offer futures and derivatives for cryptocurrencies, but if successful in their application, Coinbase would be one of the first cryptocurrency-specific exchanges to register as a Future Commission Merchant.

Amid Increased Regulatory Attention on Stablecoins, Coinbase Abandons Lend Product. Janet Yellen, the U.S. Secretary of the Treasury, spoke to regulators in late July, stating the U.S. government needs to establish rules for stablecoins, a rapidly growing class of cryptocurrencies that peg their value to an asset, often fiat currencies. As reported by Reuters early in September, the U.S. Treasury has begun discussions with financial industry executives to discuss potential regulation of stablecoins.

The SEC threatened a lawsuit against Coinbase if it continued to launch its Lend product, which would have offered interest on deposits of the stablecoin USDC. In recent weeks, Coinbase shared through its blog that it had attempted to discuss the matter directly with the SEC, but those discussions have not been productive. Coinbase’s CEO, Brian Armstrong, suggested in a series of tweets that the SEC has been unwilling to engage with Coinbase to offer guidance or clarify its position. In addition, the New Jersey Bureau of Securities has issued a Cease and Desist Order against BlockFi, Inc. (“BlockFi”) for its BlockFi Interest Account, alleging that they are engaging in the sale of unregistered securities in the form of cryptocurrency interest-earning accounts, and the Texas Securities Board has filed a Show-Cause Order alleging the same. While BlockFi offers interest on stablecoins and more traditional cryptocurrencies such as Bitcoin and Ethereum, it is clear their stablecoin interest accounts are part of the focus of the regulators as they each mentioned the interest rate offered on the Gemini dollar (GUSD) specifically in their Orders. While the BlockFi Orders are pending resolution and it is not yet known whether Coinbase plans to launch Lend in the future or to scrap the project entirely, it is clear that products offering interest on stablecoins and stablecoins in general are going to face increased regulatory scrutiny in the coming months.

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CFTC Matters

Update to NFA Branch Office Inspection Requirement and Physical Examination Requirement. In March 2020, the NFA issued Notice to Members I-20-12 exempting temporary work from home locations from being deemed a branch office of the registrant, thus exempting such locations from the substantive provisions of NFA Interpretative Notice 9002. Effective September 23, 2021, the NFA permanently codified this guidance (and allowed I-20-12 to expire) by revising NFA Interpretive Notice 9002, excluding from the concept of “branch office” “any location where one or more associated persons (“APs”) from the same household live or rent/lease (e.g., a shared or co-work space)” so long as certain requirements are met:

the exempt location is not held out to the public as an office of the Member;
the relevant APs do not meet in-person with customers at the exempt location;
the relevant APs do not physically handle customer funds at the exempt location; and
any CFTC or NFA required records created at the non-branch office location are accessible for inspection at the Member firm’s main or applicable listed branch office as required under CFTC and NFA rules.

In Notice to Members I-21-25, the NFA also extended through the end of 2021 its temporary relief of the requirement that a Member conduct an annual physical inspection of each of its branch offices. Although Members are still required to conduct an annual inspection of each branch office, Members may conduct such inspection remotely. Further, the NFA will also allow Members to conduct a remote inspection in 2022 if that Member’s “risk assessment indicates it is appropriate to do so,” and such assessment should explicitly take into account if no physical inspection has occurred during the prior two years.

Collectively, these modifications to NFA’s rules should, in the short-term, continue to permit NFA Members to prioritize COVID safety, while, in the long-term, allow NFA Members greater flexibility in offering remote work opportunities to their APs.

NFA Orders NY Introducing Broker to Pay Fines. A New York City Introducing Broker (“IB”) has been ordered to pay a $150,000 fine after the Business Conduct Committee (“BCC”) of the NFA uncovered a series of alleged record-keeping violations. The BCC Complaint stated the IB failed to meet NFA and CFTC compliance standards for “full, complete, and systemic records” pertaining to the IB’s commodity interest dealings. Specifically, the IB had limited their voice recording retention period to 96 hours for Associated Persons (“APs”) dealing in future and securities transactions. The Complaint further alleged that the IB failed to supervise record keeping activities and AP communications because the recording violations went undetected for 18 months. This action underscores the importance for NFA Members to not only implement, but also regularly test the effectiveness and adequacy of required policies and procedures.

CFTC Market Risk Advisory Committee Submits SOFR First for Consideration. The Commodities and Futures Trading Commission (“CFTC”) Market Risk Advisory Committee (“MRAC”) adopted SOFR First, a new market practice intended to transition trading conventions from LIBOR to Secured Overnight Financing Rate (“SOFR”). SOFR First was designed in response to recent global financial and banking supervisory guidance calling for market participants to move away from LIBOR, including, notably, “that banks cease entering new contracts that reference USD LIBOR post December 31, 2021.” The first two phases, related to linear swaps and cross currency swaps, were introduced on July 26 and September 21, respectively. To date, MRAC has not announced the rollout for phases three and four, which address non-linear derivatives and exchange traded derivatives. Interested parties should review the MRAC’s SOFR First Recommendation (found within the above hyperlink) which includes guidance on the types of products covered and best practices. In addition, as the LIBOR benchmark is phased out, fund managers should review their inventory of contracts to appropriately identify and amend LIBOR references. We recommend that you discuss the effective date of any contractual transitions and the specific remediation approach with your counsel.

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Offshore Matters

CIMA Issues Reminder to AML Officers. The Cayman Islands Monetary Authority (the “Authority”) has reiterated its expectation that relevant financial businesses adhere to the country’s Anti-Money Laundering Regulations (2020 Revision) (“AMLR”). Specifically, the Authority noted that “all Licensees and Registrants…are expected and required to ensure that their Anti-Money Laundering Compliance Officers (“AMLCOs”), Money Laundering Reporting Officers (“MLROs”) and their Deputies (together, the “AML Officers”) are aware of their respective duties and responsibilities as set out in the” AMLR. Such responsibilities include (i) the ability to dedicate sufficient time to effectuate their respective functions, (ii) the requisite foundational knowledge of the underlying business transactions needed to identify opportunities for money-laundering, terrorist financing, and other prohibited activity, and (iii) the need for adequate internal policies and procedures—even in situations where the AML Officer role is outsourced to an external third party. AML Officers are required by Cayman law to be management-level natural persons who report directly to a company’s Board of Directors or equivalent thereof. Companies must provide AML Officers with the access necessary to assess suspicious conduct and the authority to make final decisions on filing suspicious activity reports. Managers with Cayman funds should ensure that (i) the appropriate AML Officer roles are filled, (ii) such appointees have the necessary knowledge, expertise, and time to effectively carry-out their responsibilities, and (iii) internal policies and procedures are in place.

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Other Matters

California Lenders’ License Update. The California Department of Financial Protection and Innovation (“DFPI,” formerly known as the Department of Business Oversight) announced that starting on October 1, 2021 applications under California Financing Law (“CFL”) must be submitted through the Nationwide Multistate System and Registry (“NMLS”). Existing licenses such as company or branch licenses must be transitioned onto NMLS by December 31, 2021. Managers with CFL licenses should begin transitioning onto the NMLS if they have not already done so.

European Union Announces Delay of Sustainable Finance Disclosure Regulation (“SFDR”) Rollout. The EU’s SFDR will now be implemented on July 1, 2022, instead of January 1, 2022. The SFDR is a series of disclosure requirements for asset managers intended to increase the transparency of a fund’s sustainability and environmental impact. The 13 new standards (informally referred to as SFDR Level 2) are still in the drafting stage, but the EU plans to issue formal guidance in January 2022. Given its likely far-reaching and significant impact on the financial investment industry, SFDR Level 2’s rollout will be an important regulatory topic to keep an eye on.

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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
October 12	Amendment to Form 13H due if there were changes during Q3.
October 15	SEC deadline to file quarterly Form PF for Large Liquidity Fund Advisers, through PFRD.
October 30	SEC registered advisers must collect Transaction Reports from access persons for their personal securities transactions.
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).
November 8	Investment adviser firms may view, print and pay preliminary notice filings for all appropriate states, through IARD.
November 15	NFA deadline to file Form PR for registered CTAs, through NFA EasyFile.
November 15	SEC deadline to file Form 13F for 3rd Quarter 2021.
November 29	SEC deadline to file quarterly Form PF for Large Hedge Fund Advisers, through PFRD.
November 29	CPO-PQR Form due for CPOs, through NFA EasyFile.
December 13	Deadline for paying annual IARD charges and state renewal fees, through IARD.
December 31	Cayman funds regulated by CIMA that intend to de-register should do so before this date to avoid 2022 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 NFA Annual Questionnaire system.

Please contact us 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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Digital Assets and Energy

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Our law firm, Cole-Frieman & Mallon, has been a leader in helping fund managers form private investment funds focused on the digital asset space. We’ve seen the space mature from 2014 when programs were focused on long tokens, to later investment strategies that included long/short, jurisdictional and exchange arbitrage, VC-focused or hybrid, to the more recent focus on staking, yield-farming, long NFTs, etc. What these changing strategies show are two things: (1) the crypto space will continue to incorporate traditional investment management strategies as it iterates to find the most compelling investment scenarios and (2) the future of finance will also include crypto-centric strategies that cannot be achieved through traditional markets. The crypto space is dynamic and advances without the constraints of traditional markets. However, the crypto space, like the rest of the world we live in, requires energy to move forward. The time is now for the crypto industry to focus on how the next generation of blockchains (and infrastructure to support those blockchains) will coexist with a society that is starved for energy-efficient industry. This focus on energy consumption is vital and will have numerous consequences for the space moving forward. And because the crypto industry is so dynamic, led by visionary actors, we expect to see great movements in how the industry thinks about and uses energy in the future.

Bart Mallon

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Overview of Energy Issues Related to Crypto Mining

By Emily Irigoyen & Bart Mallon

In this post, we will explore energy consumption and its relation to cryptocurrency as well as discuss the factors that will shape this relationship moving forward. This article also provides insight into the different influences of various stakeholders in the digital asset space and identifies other important aspects that will guide the development of the industry going forward.

Proof of Work (PoW) versus Proof of Stake (PoS)

Depending on which protocol for validating transactions a particular blockchain uses, the energy intensity of its mining will vary. This is because cryptocurrencies that run on Proof of Work (PoW), such a Bitcoin, require substantial amounts of computer power and energy to mine versus Proof of Stake (PoS) which is more energy efficient. While these aren’t the only protocols that exist in the crypto space, these are the most well-known, and highlight a stark difference in a cryptocurrency’s expected energy consumption.

What are Miners Doing?

There are various groups who oppose crypto adoption because of the perceived negative environmental impacts of crypto mining. While it is true the mining process can be energy-intensive, the practical value of crypto and the diverse ways that mining facilities have been incorporating green practices into their business models, have transformed environmental concerns into a nuanced set of issues that deserve exploration.

When discussing mining’s environmental impact, the notion of high energy consumption and negative environmental externalities are often erroneously conflated. While some cryptocurrency mining operations use substantial amounts of energy, such as Bitcoin, the nature of the energy source used will ultimately determine a miner’s environmental impact. As evidenced by our own interactions with crypto miners, many operations are currently or, in the process of, implementing more sustainable fuel sources. By using renewable energy sources to power their operations, these miners are minimizing their negative environmental impact in comparison to operations based solely on fossil fuels.

Furthermore, while mining facilities abandon China, the hashrate in the United States continues to increase steadily. This phenomenon reflects a recent trend in mining facilities’ international expansion, with a particular focus on US areas that boast cheap renewable energy and pro-crypto politicians, such as Texas. The former grants them a huge reputation boost, as facilities based in renewable energy sources cause significantly less environmental harm than those based in fossil fuels, and the latter allows facility owners to stay secure in the knowledge that state and county regulations will remain lax for the foreseeable future.

Some mining facilities have also taken extra steps to engage in grid balancing, a process by which the facility — in conjunction with their local utility company — can ensure the stability of the power grid. Grid balancing ensures electricity supply meets electricity demand. Large mining facilities can take part in this process by shutting down their operations for small periods of time when the grid is experiencing a surge of demand. This prevents blackouts and can bolster the push for renewable energy, as more balanced grids mean fewer that must rely on increased fossil fuel consumption to respond to demand peaks. Essentially, when large electricity consumers such as crypto miners change their usage as needed, renewable energy can handle more of the grid’s electricity needs.

Is High Energy Use for Mining Any Less Valid Than Other Energy-Intensive Operations?

Almost all business activity consumes energy. In the same way commercial landlords power their warehouses and offices, so too crypto companies use energy to power their mining centers. This perspective contends crypto mining’s energy use is no more inherently wasteful or less legitimate than that of any other business operation. The flaw in this argument is the scale to which crypto mining has grown and will continue to grow, along with its extremely high energy consumption in comparison to other businesses. According to the University of Cambridge Bitcoin Electricity Consumption Index, the global bitcoin network annually consumes approximately 80 terawatt-hours of electricity, which is roughly equal to the annual output of 23 coal-fired power plants. While the scale of this electricity consumption cannot be ignored, it must be understood in the context of crypto mining’s growing reliance and impact on availability of renewables. Cryptocurrency mining could be a driver encouraging adoption of renewable sources until they become the predominant source of electricity generation.

ESG, the SEC and (Potential Future) Institutional Mandates

It’s clear that the demand for ESG investments is increasing and is currently on the forefront of the SEC’s agenda. In response, more institutional investors are committing to ESG investments, which in turn, has or will encourage cryptocurrency miners to follow in this direction.

This desire to offer more sustainable cryptocurrency has manifested in large private sector initiatives that focus on decarbonizing the cryptocurrency industry, such as the Crypto Climate Accord. These forms of risk management have shaped the crypto mining space environmentally and allow us to better predict how crypto mining will evolve in the future. Naturally, as the demand for ESG cryptocurrency increases — as well as the desire to get in front of regulatory uncertainty grows — more mining facilities will green their operations.

Currently, the main barrier that miners face is ensuring that both regulators and the public at large take note of their ESG initiatives and sustainability protocols. Since environmental critiques of the crypto mining industry have been incorporated so heavily into the national narrative surrounding cryptocurrency, many mining and general crypto users have been working together to publicize information that highlights their evolving green initiatives and the many benefits that crypto mining can provide. This has taken the form of both sustainable initiatives and intense lobbying, which brings us to our next point.

Issues That Will Influence This Discussion Going Forward

While the future of the crypto industry will be influenced by everything we discussed above. We also predict the following will increasingly affect the development of the industry in the coming years:

Lobbying the Government for Less Regulation & More Renewable Energy. As shown by the recent stalling of the 2021 Infrastructure Bill because of the crypto tax provision, lobbying pressure in the cryptocurrency community in unified and persistent. In the future, we can expect a larger lobbying contingent, and we can expect Representatives and Senators fighting for interests that affect their states. This is especially true in states like Texas where politicians are particularly friendly to crypto miners and business, boasting both lax state regulations and large renewable energy capacity to attract miners fleeing from Chinese regulatory scrutiny. Despite potential movement on the federal level, some states are going to fight hard to ensure bitcoin mining continues to flourish in their states so that they can continue to reap the current (and future) tax revenue.

Lobbying for more and cheaper renewable energy in the US will also benefit the crypto market and has already started to manifest itself in the new Infrastructure Bill. The new bill proposes a $73 billion government investment to rebuild the electric grid, build thousands of miles of new power lines, and expand renewable energy. As the US naturally moves to a cleaner power grid, it’s expected crypto miners will gradually follow.

International Crackdowns Affecting Bitcoin Value and Mining Hubs. Previously a major hub for bitcoin mining, China’s latest crackdowns on bitcoin mining and cryptocurrency exchanges have created space for other countries to become bigger players in the bitcoin arena. This explains why countries like the US have had an increasing number of bitcoin miners move their operations in their jurisdiction. While China justifies their harsher regulation in the name of their 2060 carbon neutrality plans, their regulatory scrutiny has also pushed many bitcoin miners towards countries with less renewable energy capacity, such as neighboring Kazakhstan, a former Soviet republic that is primarily dependent on coal and gas. This demonstrates how China’s actions may be hampering Bitcoin’s transition to cleaner energy sources, thus creating a larger carbon emissions problem. While some former Chinese miners that are now based elsewhere internationally are implementing greener operations in their new locations, it’s unclear whether these miners are outnumbered by miners who were forced out of China into countries with even less access to renewables. Also, it seems that China’s actions weren’t solely based on their national environmental plan, but also aimed to weaken Bitcoin in general so that the digital Yuan, their national digital currency, can run without competition. This greenwashing tactic has worked — China’s actions have brought Bitcoin’s value down substantially while also allowing them to claim their regulations are in response to their environmental concerns. This instance further demonstrates the impact stringent regulations in key mining countries can have on the crypto markets.

Elon Musk’s Comments on Cryptocurrency. On July 21, at the B-Word conference hosted by the Crypto Council for Innovation, Musk claimed that Tesla will once again receive Bitcoin as tender once it is clear Bitcoin’s mining operations and exchange are powered by 50% or more of renewable energy and is steadily growing its renewable energy sources. This announcement correlated to a rise in the price of bitcoin and comes after Musk’s original statement in May on Twitter that said Tesla would suspend vehicle purchases using Bitcoin citing environmental concerns. This statement dropped the value of bitcoin within minutes and demonstrates the power Elon Musk and the Tesla brand have on the perceived worth of cryptocurrency. If a tweet by Elon Musk can cause immediate volatility to crypto prices, investors and crypto advocates alike should take note of his future remarks.

Cryptocurrencies Moving Towards More Energy-Efficient Protocols. As Ethereum transitions from the consensus mechanism of Proof of Work (PoW) to Proof of Stake (PoS), it is expected that more digital assets will move towards “greener” protocols. Ethereum has already noted the benefits of their new protocol, such as its increased energy-efficiency, which signals to us that other protocol developers in the crypto space will also be mindful of energy consumption when creating their consensus mechanisms.

Conclusion

Because energy is such a broad topic in the crypto space, and encompasses so many parts, it is difficult to neatly address all of the factors that shape energy’s role in the crypto movement. Obviously, the people leading crypto are part of a generation that is focused on the environmental impact of their behaviors. This form of self-imposed environmental regulation, combined with the external pressure from other stakeholders concerned about crypto’s energy use, will not only affect the value and sustainability of cryptocurrency in the long term, but also potentially inform broader discussions of renewable energy capacity generally.

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Emily Irigoyen is an EDICT intern at Cole-Frieman & Mallon LLP. She is currently a senior at Vanderbilt University majoring in environmental sociology and will be attending Harvard Law School after graduation.

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.

Cole-Frieman & Mallon 2020 End of Year Update

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December 16, 2020

Clients, Friends, Associates:

As we prepare for a new year, we also reflect on an eventful, sometimes chaotic, 2020, dominated by the emergence of the novel coronavirus (“COVID-19”). The COVID-19 pandemic, the global response to it, and other worldwide events created a great deal of market volatility. Despite that volatility, we saw robust investment funds activity in the second-half of the year, particularly in the digital asset space.

Especially in these turbulent times, year-end administrative upkeep and planning for the next year are crucial, particularly for general counsels, Chief Compliance Officers (“CCOs”), and key operations personnel. As we head into 2021, we have put together this checklist and update to help managers stay on top of the business and regulatory landscape for the coming year.

This update includes the following:

Sexual Harassment Training Required under California Law
Annual Compliance & Other Items
Annual Fund Matters
Annual Management Company Matters
Regulatory & Other Items from 2020
Items from 2021 Compliance Calendar

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CFM & Aspect January Compliance Update Event

We would like to invite you to our next compliance-focused event. Last year, Cole-Frieman & Mallon hosted a well attended presentation and networking event with regulatory compliance firm Aspect Advisors. The event was so popular we’re bringing it back for 2021 as a webinar and we hope to see you there!

Please save the date on your calendar: January 21, 2021 @10:00am PT
You can also Register Here

Topics will include:

Trends and happenings in the industry impacting fintech companies, broker dealers, investment advisors and fund managers
Major issues from the SEC and courts in 2020
The year of Bitcoin and DeFi
Fintech regulations and best practices
Other hot topics

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Sexual Harassment Training Required under California Law

California state law now requires all employers with five or more employees to provide interactive sexual harassment training to their employees. The law formerly only applied to employers with 50 or more employees but was expanded under Senate Bill No. 778, approved by the governor of California on August 30, 2019. Notably, covered employers must provide at least two hours of interactive training to all supervisory employees and at least one hour to all nonsupervisory employees in California. The first training must be held by January 1, 2021 and thereafter must be held every two years. The State of California is providing free training resources, which you can access here.

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Annual Compliance & Other Items

Annual Privacy Policy Notice. On an annual basis, registered investment advisers (“RIAs”) are required to provide natural person clients with a copy of the RIA’s privacy policy if (i) the RIA has disclosed nonpublic personal information other than in connection with servicing consumer accounts or administering ﬁnancial products or (ii) the RIA’s privacy policy has changed. The Securities and Exchange Commission (the “SEC”) has provided a model form and accompanying instructions for firm privacy policies.

Annual Compliance Review. On an annual basis, the CCO of an RIA must conduct a review of the adviser’s compliance policies and procedures. This annual compliance review should be in writing and presented to senior management. We recommend ﬁrms discuss the annual review with their outside counsel or compliance ﬁrm, who can provide guidance about the review process and a template for the assessment and documentation. Conversations regarding the annual review may raise sensitive matters, and advisers should ensure that these discussions are protected by attorney-client privilege. CCOs may also want to consider additions to the compliance program. Advisers that are not registered may still wish to review their procedures and/or implement a compliance program as a best practice.

Form ADV Annual Amendment. RIAs or managers ﬁling as exempt reporting advisers (“ERAs”) with the SEC or a state securities authority must ﬁle an annual amendment to their Form ADV within 90 days of the end of their ﬁscal year. For most managers, the Form ADV amendment will be due on March 31, 2021. RIAs must provide a copy of the updated Form ADV Part 2A brochure and Part 2B brochure supplement (or a summary of changes with an oﬀer to provide the complete brochure) to each “client” and, if applicable, Part 3 (Form CRS client relationship summary) to each “retail investor” with which the RIA has entered into an investment advisory contract. Note that for SEC RIA’s to private investment vehicles, a “client” for purposes of this rule refers to the vehicle(s) managed by the RIA and not the underlying investors. State-registered advisers need to examine their states’ regulations to determine who constitutes a “client”. For purposes of the Form ADV Part 3, a “retail investor” means a natural person, or the legal representative of such natural person, who seeks to receive or receives services primarily for personal, family, or household purposes.

Switching to/from SEC Regulation.

SEC Registration. Managers who no longer qualify for SEC registration as of the time of ﬁling the annual Form ADV amendment must withdraw from SEC registration within 180 days after the end of their ﬁscal year (June 30, 2021, for most managers), by ﬁling a Form ADV-W. Such managers should consult with legal counsel to determine whether they are required to register in the states in which they conduct business. Managers who are required to register with the SEC as of the date of their annual amendment must register with the SEC within 90 days of ﬁling the annual amendment (June 30, 2021, for most managers, assuming the annual amendment is filed on March 31, 2021).

Exempt Reporting Advisers (“ERAs”). Managers who no longer meet the deﬁnition of an ERA will need to submit a ﬁnal report as an ERA and apply for registration with the SEC or the relevant state securities authority, as applicable, generally within 90 days after the ﬁling of the annual amendment.

Custody Rule Annual Audit.

SEC RIAs. SEC-registered investment advisers (“SEC RIAs”) must comply with specific custody procedures, including (i) maintaining client funds and securities with a qualiﬁed custodian; (ii) having a reasonable basis to believe that the qualiﬁed custodian sends an account statement to each advisory client at least quarterly; and (iii) undergoing an annual surprise examination conducted by an independent public accountant.

SEC RIAs to pooled investment vehicles may avoid both the quarterly statement and surprise examination requirements by having audited ﬁnancial statements prepared for each pooled investment vehicle in accordance with generally accepted accounting principles by an independent public accountant registered with the Public Company Accounting Oversight Board (“PCAOB”). Statements must be sent to investors in the fund within 120 days after the fund’s ﬁscal year-end. SEC RIAs should review their custody procedures to ensure compliance with the rules.

California RIAs. California-registered investment advisers (“CA RIAs”) that manage pooled investment vehicles and are deemed to have custody of client assets are also subject to independent party and surprise examinations. However, CA RIAs can avoid these additional requirements by engaging a PCAOB-registered auditor to prepare and distribute audited ﬁnancial statements to all beneficial owners of the pooled investment vehicle, and the Commissioner of the California Department of Financial Protection and Innovation (“DFPI”). Those CA RIAs that do not engage an auditor must, among other things, (i) provide notice of such custody on the Form ADV; (ii) maintain client assets with a qualiﬁed custodian; (iii) engage an independent party to act in the best interest of investors to review fees, expenses, and withdrawals; and (iv) retain an independent certiﬁed public accountant to conduct surprise examinations of assets.

Other State RIAs. Advisers registered in other states (collectively with CA RIAs, “State RIAs”) should consult their legal counsel about those states’ specific custody requirements.

California Minimum Net Worth Requirement and Financial Reports.

CA RIAs with Discretion. Every CA RIA that has discretionary authority over client funds or securities, whether or not they have custody, must maintain at all times a net worth of at least $10,000 (CA RIAs with custody are subject to heightened minimum net worth requirements).

CA RIAs with Custody. Generally, every CA RIA that has custody of client funds or securities must maintain at all times a minimum net worth of $35,000. However, a CA RIA that (i) is deemed to have custody solely because it acts as the general partner of a limited partnership, or a comparable position for another type of pooled investment vehicle, and (ii) otherwise complies with the California custody rule described above (such advisers, “GP RIAs”) is exempt from the $35,000 minimum (and thus must maintain at all times a minimum net worth of $10,000).

Financial Reports. Every CA RIA subject to the above minimum net worth requirements must file certain reports with the DFPI.

In the event a CA RIA breaches its minimum net worth requirement, it must file a report of its financial condition with DFPI by the close of business on the business day immediately following the date of the breach.
If a CA RIA’s net worth is less than 120% of its minimum net worth requirement, it must file at least three “interim reports” with DFPI. The first such report is due within 15 days of the date on which the CA RIA’s net worth was less than 120% of its minimum net worth and then within 15 days of each monthly accounting period thereafter until three consecutive interim reports show a net worth that is greater than 120% of the required minimum net worth.
Annually, within 90 days of a CA RIA’s ﬁscal year-end, the CA RIA must file a financial report with DFPI containing a balance sheet and income statement (prepared in accordance with generally accepted accounting principles), supporting schedule, and veriﬁcation form. If the CA RIA has custody (and is not a GP RIA), the financial report must be audited by an independent public accountant.

Annual Re-Certiﬁcation of CFTC Exemptions. Commodity pool operators (“CPOs”) and commodity trading advisers (“CTAs”) currently relying on certain exemptions from registration with the Commodity Futures Trading Commission (“CFTC”) are required to re-certify their eligibility within 60 days of the calendar year-end. CPOs and CTAs currently relying on relevant exemptions will need to evaluate whether they remain eligible to rely on such exemptions.

CPO and CTA Annual Updates. Registered CPOs and CTAs must prepare and ﬁle Annual Questionnaires and Annual Registration Updates with the National Futures Association (“NFA”), as well as submit payment for annual maintenance fees and NFA membership dues. Registered CPOs must also prepare and ﬁle their fourth-quarter report for each commodity pool on Form CPO-PQR, while CTAs must ﬁle their fourth-quarter report on Form CTA-PR. For more information on Form CPO-PQR, please see our earlier post. While not applicable for this filing, we note that Form CPO-PQR is changing (as discussed in more detail below), which will apply to the filing relating to Q1 2021. Unless eligible to claim relief under Regulation 4.7, registered CPOs and CTAs must update their disclosure documents periodically, as they may not use any document dated more than 12 months prior to the date of its intended use. Disclosure documents that are materially inaccurate or incomplete must be promptly corrected, and redistributed to pool participants.

Soft Dollars. Managers that participate in soft dollar programs should make sure that they have addressed any commission balances from the previous year.

Schedule 13G/D and Section 16 Filings. Managers who exercise investment discretion over accounts (including funds and separately managed accounts (“SMAs”)) that are beneﬁcial owners of 5% or more of a registered voting equity security must report these positions on Schedule 13D or 13G. Passive investors are generally eligible to ﬁle the short-form Schedule 13G, which is updated annually within 45 days of the end of the year. Schedule 13D is required when a manager is ineligible to ﬁle Schedule 13G and is due 10 days after acquiring more than 5% beneﬁcial ownership of a registered voting equity security. For managers who are also making Section 16 ﬁlings, this is an opportune time to review your ﬁlings to conﬁrm compliance and anticipate needs for the ﬁrst quarter.

Form PF. Managers to private funds that are either registered with the SEC or required to be registered with the SEC and who have at least $150 million in regulatory assets under management (“RAUM”) must ﬁle Form PF. Smaller private advisers (fund managers with less than $1.5 billion in RAUM) must ﬁle Form PF annually within 120 days of their ﬁscal year-end. Larger private advisers (fund managers with $1.5 billion or more in RAUM) must ﬁle Form PF within 60 days of the end of each fiscal quarter.

Form MA. Investment advisors that provide advice on municipal financial products are considered “municipal advisors” by the SEC and must file a Form MA annually, within 90 days of their fiscal year-end.

IARD Annual Fees. Preliminary annual renewal fees for state-registered and SEC-registered investment advisers were due on December 14, 2020. Failure to submit electronic payments by the deadline may result in registrations terminating due to a “failure to renew.” If you have not already done so, you should submit full payment into your Renewal Account by E-Bill, check or wire as soon as possible.

Pay-to-Play and Lobbyist Rules. SEC rules disqualify investment advisers, their key personnel, and placement agents acting on their behalf from seeking to be engaged by a governmental client if they have made certain political contributions. State and local governments have similar rules, including California, which requires internal sales professionals who meet the deﬁnition of “placement agents” (people who act for compensation as ﬁnders, solicitors, marketers, consultants, brokers, or other intermediaries in connection with oﬀering or selling investment advisory services to a state public retirement system in California) to register with the state as lobbyists and comply with California lobbyist reporting and regulatory requirements. Note that managers oﬀering or selling investment advisory services to local government entities must register as lobbyists in the applicable cities and counties. State laws on lobbyist registration diﬀer widely, so managers should carefully review reporting requirements in the states in which they operate to make sure they comply with the relevant rules.

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Annual Fund Matters

Redemption Management. Managers with signiﬁcant redemptions at the end of the year should carefully manage unwinding positions so as to minimize transaction costs in the current year (that could impact performance) and prevent transaction costs from impacting remaining investors in the next year. When closing funds or managed accounts, managers should pay careful attention to the liquidation procedures in the fund constituent documents and the managed account agreement.

NAV Triggers and Waivers. Managers should promptly seek waivers of any applicable termination events specified in a fund’s ISDA or other counterparty agreement that may be triggered by redemptions, performance, or a combination of both at the end of the year (NAV declines are common counterparty agreement termination events).

Fund Expenses. Managers should wrap up all fund expenses for 2020 if they have not already done so. In particular, managers should contact their outside legal counsel to obtain accurate and up to date information about legal expenses for inclusion in the NAV for year-end performance.

Electronic Schedule K-1s. The Internal Revenue Service (“IRS”) authorizes partnerships and limited liability companies taxed as partnerships to issue Schedule K-1s to investors solely by electronic means, provided the partnership has received the investor’s aﬃrmative consent. States may have diﬀerent rules regarding electronic K-1s, and partnerships should check with their counsel whether they may still be required to send state K-1s on paper. Partnerships must also provide each investor with speciﬁc disclosures that include a description of the hardware and software necessary to access the electronic K-1s, how long the consent is eﬀective, and the procedures for withdrawing the consent. If you would like to send K-1s to your investors electronically, you should discuss your options with your service providers.

“Bad Actor” Recertiﬁcation Requirement. A security oﬀering cannot rely on the Rule 506 safe harbor from SEC registration if the issuer or its “covered persons” are “bad actors”. Fund managers must determine whether they are subject to the bad actor disqualiﬁcation any time they are oﬀering or selling securities in reliance on Rule 506. The SEC has advised that an issuer may reasonably rely on a covered person’s agreement to provide notice of a potential or actual bad actor triggering event pursuant to contractual covenants, bylaw requirements or undertakings in a questionnaire or certiﬁcation. If an oﬀering is continuous, delayed or long-lived, however, issuers must update their factual inquiry periodically through bring-down of representations, questionnaires, and certiﬁcations, negative consent letters, periodic re-checking of public databases and other steps, depending on the circumstances. Fund managers should consult with counsel to determine how frequently such an update is required. As a matter of practice, most fund managers should perform such an update at least annually.

U.S. FATCA. Funds should monitor their compliance with the U.S. Foreign Account Tax Compliance Act (“FATCA”). Generally, U.S. FATCA reports are due to the IRS on March 31, 2021 or September 30, 2021, depending on where the fund is domiciled. However, reports may be required by an earlier date for jurisdictions that are parties to intergovernmental agreements (“IGAs”) with the U.S. Because of COVID-19, the Cayman Islands has extended its FATCA reporting deadline for the 2019 period until December 16, 2020. Additionally, the U.S. may require that reports be submitted through the appropriate local tax authority in the applicable IGA jurisdiction, rather than the IRS. Given the varying U.S. FATCA requirements applicable to diﬀerent jurisdictions, managers should review and conﬁrm the speciﬁc U.S. FATCA reporting requirements that may apply. As a reminder, we strongly encourage managers to ﬁle the required reports and notiﬁcations, even if they already missed previous deadlines. Applicable jurisdictions may be increasing enforcement and monitoring of FATCA reporting and imposing penalties for each day late.

CRS. Funds should also monitor their compliance with the Organisation for Economic Cooperation and Development’s Common Reporting Standard (“CRS”). All “Financial Institutions” in the British Virgin Islands (BVI) and the Cayman Islands must register with the respective jurisdiction’s Tax Information Authority and submit various reports with the applicable regulator via that regulator’s online portal. While the BVI 2020 filing deadlines for 2019 CRS reporting have passed, because of COVID-19, the Cayman Islands have extended its CRS filing declaration and reporting deadline for the 2019 reporting period until December 16, 2020 and the “compliance report” deadline for the 2019 reporting period until March 31, 2021. Managers to funds domiciled in other jurisdictions should also conﬁrm whether any CRS reporting will be required in such jurisdictions and the procedures to follow to enroll and file annual reports. We recommend managers contact their tax advisors to stay on top of the U.S. FATCA and CRS requirements and avoid potential penalties.

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Annual Management Company Matters

Employee Reviews. An eﬀective annual review process is vital to reduce the risk of employment-related litigation and protect the management company in the event of such litigation. Moreover, it is an opportunity to provide context for bonuses, compensation adjustments, employee goals and other employee-facing matters at the ﬁrm. It is not too late to put an annual review process in place.

Compensation Planning. In the fund industry, and the ﬁnancial services industry in general, the end of the year is the appropriate time to make adjustments to compensation programs. Since much of a manager’s revenue is tied to annual income from incentive fees, any changes to the management company structure, affiliated partnerships, or any shadow equity programs should be eﬀective on the ﬁrst of the year. Make sure that partnership agreements and operating agreements are appropriately updated to reflect such changes.

Insurance. If a manager carries D&O or other liability insurance, the policy should be reviewed annually to ensure that the manager has provided notice to the carrier of all claims and all potential claims. Newly launched funds should also be added to the policy as appropriate.

Other Tax Considerations. Fund managers should assess their overall tax position and consider several steps to optimize tax liability. Managers should also be aware of self-employment taxes, which can potentially be minimized by structuring the investment manager as a limited partnership. Managers can take several steps to optimize their tax liability, including (i) changing the incentive fee to an incentive allocation; (ii) use of stock-settled stock appreciation rights; (iii) if appropriate, terminating swaps and realizing net losses; (iv) making a Section 481(a) election under the Internal Revenue Code of 1986, as amended (the “Code”); (v) making a Section 475 election under the Code; and (vi) making charitable contributions. Managers should consult legal and tax professionals to evaluate these options.

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Regulatory & Other Items from 2020

SEC Updates.

The SEC Expands its Definition of “Accredited Investor” and “Qualified Institutional Buyer”. On August 26, 2020, the SEC Commissioners voted to adopted amendments to expand the definition of “accredited investor” and “qualified institutional buyer”. A more detailed breakdown can be found in our blog post here.

With respect to investors who are natural persons, historically, the “accredited investor” qualification status was based mainly on an individual’s income or net worth. These categories remain and have been broadened slightly to include the income or net worth from an investor’s “spousal equivalent,” which generally is a cohabitant occupying a relationship generally equivalent to that of a person’s spouse. Additionally, the SEC expanded the definition of “accredited investor” to account for certain knowledge qualifications, including (i) persons with certain professional financial designations such as those holding the Series 7, Series 65 or Series 85 licenses and (ii) “knowledgeable employees” (as defined in Rule 3c-5 of the Investment Company Act of 1940, as amended (the “Investment Company Act”)).

The SEC also expanded the definition of “accredited investor” with respect to entity investors. The new definition encompasses (i) SEC RIAs and State RIAs, (ii) rural business investment companies, (iii) limited liability companies with total assets in excess of $5,000,000 (not also formed for the specific purpose of acquiring the securities offered), (iv) entities owning in excess of $5,000,000 of “investments” (as defined in Rule 2a51-1(b) of the Investment Company Act), and (v) family offices with at least $5,000,000 in assets under management.

The SEC has updated the definition of “qualified institutional buyer” in Rule 144A to include entities and any individual investors that have at least $100,000,000 in securities owned and invested in issuers unaffiliated with the qualified institutional buyer. The scope is intended to include Native American tribes, governmental bodies, and bank-maintained collective investment trusts.

These amendments became effective on December 8, 2020. Private fund advisers should consider updating their subscription documents to incorporate these new categories.

SEC Revises Rules to Harmonize Exempt Offerings. On November 2, 2020 the SEC adopted amendments to certain rules under the Securities Act of 1933, as amended (the “Securities Act”), seeking to harmonize various “private offering” exemptions to the registration requirement of the Securities Act. In summary, these amendments are intended to establish a singular and broadly applicable rule giving issuers the ability to move from one exemption to another. Offering limits for Regulation A (“Reg A”), Regulation Crowdfunding (“Reg CF”), and Rule 504 offerings are also to be increased. The adopted amendments are anticipated to become effective in early 2021.

Highlights of the amendments include:

Integration – when companies engage in multiple offerings near in time, it may be necessary to analyze whether the offerings are integrated into a single offering. The amendments provide four non-exclusive safe harbors from integration, thereby making it easier for companies to engage in multiple offerings without the fear of integration.
Offering limitations – as discussed above, the amendments would also raise offering limits to various exemptions. For example, under Tier 2 of Reg A, the amendments would increase both the maximum offering amount from $50MM to $75MM and secondary sales from $15MM to $22.5MM. The Reg CF offering limit would increase from $1.07MM to $5MM. Accredited investors would also have their investment limits removed for a Reg CF offering. Non-accredited investors utilizing Reg CF would also be able to use the greater of their annual income or net worth when calculating investment limitations. For Rule 504 under Regulation D – the amendments would raise the maximum offering amount from $5MM to $10MM. Accredited investors would also have their investment limits removed for a Reg CF offering. Non-accredited investors utilizing Reg CF would also be able to use the greater of their annual income or net worth when calculating investment limitations. For Rule 504 under Regulation D – the amendments would raise the maximum offering amount to $10MM up from $5MM previously.
Exemption Improvements – the SEC amendments also would improve certain exemptions. In Rule 506(b) offerings, the mandatory information and disclosures provided to non-accredited investors will align with those provided to investors in a Reg A offering. Reg A offerings are to have certain requirements simplified and there would be greater consistency between a Reg A offering and a registered offering. The amendments would also harmonize the bad actor disqualification provisions under a Regulation D, Reg A and Reg CF offering.
Rule 506(c) Offerings – Issuers, including private funds, sometimes rely on Rule 506(c), which allows the issuer to engage in “general solicitation” with respect to a private offering so long as the issuer, among other things, takes “reasonable steps” to verify that each investor is, in fact, an “accredited investor.” To that end, the SEC has published a non-exclusive list of methods an issuer may undertake to verify that a person is an “accredited investor.” The adopted amendment adds to that list by allowing an issuer selling securities to a person that was (or is) an investor in that issuer to rely on its prior verification of that person’s “accredited investor” status, so long as (i) the verification occurred within five years of the date on which the person will again invest, (ii) the issuer receives a written representation by that person that it continues to qualify as an “accredited investor”, and (iii) the issuer is not aware of contrary information. The SEC believes this simplification will make it easier for issuers to utilize a Rule 506(c) offering, such that unnecessary efforts will not be expended to verify a known investor’s “accredited investor” status.

RIA Compliance Risk Alert. On November 19, 2020, the SEC Office of Compliance Inspections and Examinations (“OCIE”) issued a risk alert related to certain compliance-related deficiencies it had found during the course of its examination of SEC RIAs. Notably, OCIE identified the following deficiencies:

A lack of compliance personnel and authority. OCIE found advisers who had inadequate staffing to maintain compliance or who did not give their compliance officers sufficient authority to discipline breaches of the adviser’s compliance policies and procedures.
Relatedly, OCIE observed advisers that failed to implement or perform actions required by the adviser’s policies and procedures, including failing to maintain up-to-date information and failing to perform required annual reviews or, if performed, failing to address identified deficiencies.
OCIE also found advisers that lacked written policies and procedures entirely or who implemented “off the shelf” policies and procedures that were not tailored to their business.

This risk alert serves as a good reminder that all investment advisers registered with the SEC must maintain tailored compliance policies and procedures, must devote adequate resources towards compliance and endow their compliance officers with authority to enforce the policies and procedures, must conduct an annual review of the policies and procedures, and must work to correct deficiencies in the policies and procedures as they are identified.

SEC Annual Enforcement Report. On November 2, 2020, the SEC Division of Enforcement published its Annual Report, which highlighted its response to the COVID-19 pandemic, the success of its whistleblower program, and it’s continued focus on protecting “main street investors” and bringing actions against individuals (as opposed to just the organizations that employ them). 2020 also saw the SEC continue to police the digital asset arena. So far this year, the SEC brought a total of 715 enforcement actions (down from 862 actions in 2019) and obtained monetary judgments totaling 4.68 billion dollars (up from 4.35 billion dollars in 2019).

Federal Judge Grants SEC Preliminary Injunction Against Telegram. The SEC was granted a preliminary injunction against Telegram Group Inc. (“Telegram”) for an unregistered offering of securities under the Securities Act in connection with their sale of Simple Agreement for Future Tokens (“SAFTs”). The SEC argued, and the court agreed, that the initial sale of the SAFTs to investors and the subsequent sale by the investor of the tokens in the market was one continuous transaction, and thus Telegram’s SAFT sale was an unregistered sale of securities, and the SAFT investors were underwriters to that sale. The SEC argued that because the SAFTs did not require the purchasers to comply with holding periods applicable to the resale of restricted securities, it was a foregone conclusion that the SAFT investors purchased the SAFT with the intention to sell their tokens once received, and therefore Telegram was unable to rely on an offering exemption for the sale requiring the purchaser to not purchase with a view to reselling. Further, as the initial SAFT sale was not compliant with an exemption from registration, the SAFT investors would be unable to rely on Rule 144 or other applicable exemptions when reselling the tokens. As this was a district court case that was settled before appeal, it is not clear that the court’s ruling and analysis in this case would be used as precedent for subsequent cases, however the decision does call into question the suitability of SAFTs for both issuers and investors.

SEC Charges Investment Adviser with Late Filing of Schedule 13D Amendment. The SEC instituted cease-and-desist proceedings against an investment adviser for failure to promptly amend a Schedule 13D under Section 13(d)(2) of the Securities Exchange Act of 1934, as amended. The investment adviser caused its managed funds to acquire 7% of the outstanding stock of a healthcare company with the intention of taking the company private and filed a Schedule 13D as required. Subsequently, however, the investment adviser abandoned its efforts to take the company private and liquidated its positions, but failed to amend their Schedule 13D filing to reflect the change of intent and the sale of 1% or more of the healthcare company’s underlying stock promptly, doing so more than two months after the sale. Notably, the SEC brought this proceeding as an isolated action. It should serve as a warning that the SEC may institute disciplinary actions for failure to comply with mandatory reporting requirements, even for a single, late Schedule 13D filing. The SEC’s action is a reminder to all investment advisers filing Schedule 13D and 13G to monitor their beneficial ownership levels, reporting obligations, and internal compliance processes to ensure amendments to Schedule 13D and 13G are made within the appropriate time limits.

CFTC and NFA Updates.

CFTC Streamlines Form CPO-PQR. On October 6, 2020, the CFTC adopted amendments to Form CPO-PQR that “streamlined” the form and eliminated many of the prior reporting requirements by conforming the substantive and filing requirements of CFTC Form CPO-PQR with the NFA’s version of Form PQR, which registered CPOs also currently file. In addition, the amendments eliminate the “large”, “mid-sized,” and “small” CPO reporting threshold concept so that all registered CPOs will file the same Form CPO-PQR on a quarterly basis within sixty days of the end of the calendar quarter (as is already required by the NFA). Although the rule is effective December 10, 2020, the CFTC intends for the new form to be used starting with reporting related to Q1 2021. As such, the compliance date for the new form is May 30, 2021 (sixty days after March 31, 2021).

CFTC Revises, Broadens Rule 3.10(c)(3). On October 14, 2020, the CFTC adopted revisions to CFTC Rule 3.10(c)(3), which currently provides a registration exemption for a non-U.S. CPO that operates solely qualifying non-U.S. funds with non-U.S. investors. The revised Rule 3.10(c)(3) will:

apply on a “pool-by-pool” basis, allowing a CPO to rely on it for one or more qualifying non-U.S. pools while relying on different exemptions for other pools;
institute a safe harbor for unintended U.S. investments in a non-U.S. pool; provided, that the CPO (i) undertakes certain reasonable efforts (such as disclosures, subscription and other diligence measures, and controls on solicitation activities) to minimize the possibility of U.S. persons being solicited for, or sold, interests or shares in an offshore pool and (ii) maintains documentation adequate to demonstrate compliance with the safe harbor; and
allow seed investments in the relevant pool from qualifying U.S.-based affiliates of the non-U.S. CPO.

The new rules are effective February 5, 2021.

CFTC Adopts New Position Limits. On October 15, 2020, the CFTC adopted new rules regarding federal position limits for certain commodity interest contracts (“Referenced Contracts,” as defined in the new rules and discussed below). This is the CFTC’s latest attempt to adopt federal position limits, having had its last attempt set aside in court in 2012.

The new rules (i) modify existing spot month, single month, and all-months-combined position limits for Referenced Contracts regarding nine “legacy” agricultural commodities and (ii) impose new spot month position limits for Referenced Contracts regarding certain seven addition agricultural commodities, five metals commodities, and four energy commodities. Subject to certain exemptions, “Referenced Contracts” means specifically referenced futures contracts on the 25 commodities, futures contracts and options on futures contracts directly or indirectly linked to those specified contracts, and “economically equivalent swaps” (as defined in the new rules).

With respect to spot month limits, market participants cannot net cash-settled positions and physically-settled positions (although participants can net within those two categories). Other than for spot month limits, cash-settled and physically settled positions can be netted against each other.

The new rules also (i) establish an expedited regime for market participants to receive approval to exceed federal position limits; (ii) change the self-effecting, bona fide hedge exemption by, among other things, expanding the list of enumerated bona fide hedges; (iii) adopt a self-effecting “spread transaction” exemption; and (iv) clarify that market participants generally may hedge positions either on a gross basis or on a net basis, so long as the market participant does so consistently over time and in a manner that is not designed to evade the federal position limits.

The rules do not allow exchanges to set more lenient position limits than those adopted by the rules. However, with respect to commodity interest contracts that are not subject to the rules, the new rules grant exchanges greater flexibility to (i) set position limits or position accountability levels for those contracts and (ii) grant exemptions from those exchange-established limits.

Generally, the new rules will come into force on January 1, 2022, but certain of the rules will come into force on January 1, 2023.

Digital Asset Updates.

Department of Justice Releases Cryptocurrency Enforcement Framework. The Cyber-Digital Task Force of the Attorney General released “Cryptocurrency: An Enforcement Framework,” (the “Framework”) providing the Department of Justice’s (the “DOJ”) view of the threats and enforcement challenges associated with digital assets. The Framework outlines in detail the DOJ’s view of the threats posed by digital assets associated with crime, money laundering and the avoidance of tax, reporting and other legal requirements and the methods and techniques the various governmental agencies use to enforce federal law. The DOJ emphasized that for digital assets to reach their transformative potential, private industry, and regulators will need to work together to address these threats.

Coinbase Eliminated Margin Trading; Will Others Follow? As we previously discussed, the CFTC considers certain digital currencies (including Bitcoin and Ether) to be “commodities” within the definition of the Commodity Exchange Act of 1936, as amended. In 2017, the CFTC took action against the Bitfinex platform on the basis that the platform dealt in “retail commodity transactions”— leveraged, margined or financed transactions involving a commodity that are offered to persons that are not “eligible contract participants” — without being registered as a “futures commission merchant” with the CFTC. However, certain retail commodity transactions are exempt from CFTC jurisdiction if the seller “actually delivers” the commodity to the buyer within 28 days of the date the contract was entered into.

Based on its experience in that case, the CFTC proposed guidance regarding “actual delivery” of digital assets in late 2017, which it adopted as final on March 23, 2020 and began enforcing on September 22, 2020 (the “Guidance”). The Guidance stated that, in the CFTC’s view, “actual delivery” occurs when a customer has complete control over the asset.

On November 24, 2020, Coinbase announced that they are disabling margin trading on Coinbase Pro because they believe that retention of control over digital assets in accordance with the terms of a margin contract would cause them to violate the Guidance. In light of the difficultly in complying with this Guidance, Coinbase ceased the initiation of new margin trades as of November 25th, and will disable margin trading entirely once all existing margin positions have expired. Advisors that advise persons that are not “eligible contract participants” and that utilize margin trading as part of their trading of digital assets should consider how to alter their trading strategies in case more platforms follow Coinbase’s lead.

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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
December 14	IARD Preliminary Renewal Statement payments due (submit early to ensure processing by deadline)
December 16	Cayman Islands FATCA and CRS reporting deadlines
December 26	Last day to submit form filings via IARD prior to year-end
December 31	Review RAUM to determine 2020 Form PF filing requirement
December 31	Small and mid-sized registered CPOs must submit a pool quarterly report (CPO-PQR)
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 2020 CIMA fees
January 11	Amended Form 13H filing due if any information on the previously filed Form 13H became inaccurate during the prior quarter
January 15	Quarterly Form PF due for large liquidity fund advisers (if applicable)
January 31	“Annex IV” AIFMD filing
February 16	Form 13F due
February 16	Annual Schedule 13G updates due
February 16	Annual Form 13H updates due
March 1	Deadline for re-certification of CFTC exemptions
March 1	Quarterly Form PF due for larger hedge fund advisers (if applicable)
March 31	Deadline to update and file Form ADV Parts 1, 2A & 2B
March 31	Cayman Islands CRS Compliance Form deadline
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

Please contact us with any questions or for assistance with any of the above topics. We wish you and yours a safe and healthy new year.

Sincerely,

Karl Cole-Frieman, Bart Mallon, Lilly Palmer, David Rothschild, & Scott Kitchens

Sample NAV Trigger Waiver

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Over the past few months, many of our hedge fund clients have breached default triggers in their counterparty agreements that are tied to a decline in net asset value (“NAV” resulting in a “NAV Trigger”). NAV Triggers are typically drafted to capture a month over month NAV decline of 15% to 20%, and sometimes that decline includes redemptions.

If you have an ISDA in place, a NAV Trigger will result in an Additional Termination Event (“ATE”) under your ISDA, and you are obligated to formally notify the dealer of that fact. Once notified, you should explicitly request that the dealer waive the ATE. A formal waiver should be in writing, should clearly state the facts that triggered the ATE, and should explicitly waive the dealer’s right to declare an Early Termination Date under the ISDA in respect of that ATE. Below, we have provided a sample waiver that any manager should feel free to use for their funds. Certain of the bracketed facts should be modified to fit a given fund’s particular circumstances, and defined terms should be changed to fit those found in your ISDA.

If you have any questions about the ATEs in your funds’ ISDAs, or about the ATE waiver, please contact us for assistance.

CFM Sample ATE Waiver Download

Regulation D 506(c) Exemption

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Regulation D 506(c) Exemption

General Solicitation Allowed for Private Fund Managers Under 506(c)

Regulation D (“Reg. D”) offers issuers exemptions from registration of their securities under the Securities Act of 1933, as amended (the “Securities Act”). Most managers rely on Rule 506(b) which allows sale of securities to an unlimited number of accredited investors and up to 35 non-accredited investors, so long as there is no general solicitation. Rule 506(c) was enacted as part of the JOBS Act to permit general solicitation, so long as certain steps are followed. While originally many private fund managers eschewed the exemption because of the additional requirements, the exemption has gained popularity with private fund managers in the digital asset space. The main reason is that such managers can more broadly and generally solicit their fund – something that private fund managers in the traditional securities space would not do.

Background Requirements

Under Rule 506(c) of Reg. D, general solicitation is permitted without having to register the issuer’s securities under the Securities Act, so long as (1) all investors are accredited (as defined under Reg. D); (2) reasonable steps have been taken to verify that all investors are accredited, so long as the issuer does not have prior knowledge that the investor is non-accredited; and (3) certain integration, resale restrictions of securities, and bad actor disqualification rules are followed. If these requirements are met, an issuer can broadly solicit and advertise the offering of its securities and still be in compliance with Reg. D.

The second requirement above imposes an obligation for an issuer to proactively take steps in order to verify that an investor is in fact accredited. The list of verification methods recommended in the statute is non-exhaustive but a common method of verification includes, if confirming on the basis of income, reviewing W-2s or other similar tax forms for the previous two years, and obtaining a written representation from the investor that the investor has a reasonable expectation of qualifying as an accredited investor during the current year. Another method often used is having an investor engage certain parties such as a registered CPA or a licensed attorney to represent that the investor is an accredited investor.

A private fund relying on 506(c) must still follow all other applicable securities regulations, such as the 2,000 investor limit pursuant to Section 12(g) of the Securities Exchange Act of 1934, as amended (unless the investor is relying on a different exemption that limits investor count in the private fund). Additionally, the private fund must file a Form D electronically with the SEC, and reflect its 506(c) reliance in the fund offering documents. Each state also has specific securities requirements which typically are met by making a “blue sky filing” (i.e. filing a copy of the Form D) in the applicable state that the private fund is soliciting in.

Positive Aspects

Rule 506(c) offers managers avenues that were previously prohibited under Rule 506(b). This expands investor base and provides for a less restrictive discussion of the fund’s strategy and terms. Further, there is no limit on dollars that can be raised and no limit on dollars from particular investors.

Converting from 506(b) to 506(c)

Many investment managers in the digital asset space are seeking to convert their offering from 506(b) to 506(c). In order to convert a previous offering to a 506(c) offering, the private fund needs to (1) file a new Form D with the SEC, indicating its reliance on 506(c); (2) amend the private fund’s offering documents; and (3) follow the verification methods described above for all subsequent investors in the private fund. We confirmed the foregoing procedures with the SEC. The SEC further indicated in a Q&A that if a private fund that previously relied on Rule 506(b) followed all applicable requirements of Rule 506(b), the private fund would only need to take reasonable steps to verify the accredited investor status of subsequent investors, not existing investors. If existing investors make an additional investment in the fund, the verification methods will need to be taken. Thus, it is recommended as a best practice to verify that all existing investors in the fund are accredited.

Conclusion

We anticipate that many investment managers in the digital asset space will begin to increasingly rely on this exemption. Although general solicitation is permitted under this exemption, all applicable securities regulations still need to be followed (i.e. the anti-fraud provisions under the Investment Advisers Act of 1940, as amended). Counsel should be contacted to further discuss the applicable requirements if you are considering conducting an offering pursuant to Rule 506 (c).

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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 digital currency-focused hedge funds and works routinely on matters affecting the digital asset industry. Bart can be reached directly at 415-868-5345.

Cole-Frieman & Mallon LLP 2019 End of Year Update

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

Clients, Friends, Associates:

As we prepare for a new year, we also reflect on an eventful 2019 year that included developments impacting both traditional hedge fund managers as well as those in the digital asset space. Regardless of all the changes in the investment management space, year-end administrative upkeep and 2020 planning are always particularly important, especially for general counsels, Chief Compliance Officers (“CCOs”), and key operations personnel. As we head into 2020, we have put together this checklist and update to help managers stay on top of the business and regulatory landscape for the coming year.

This update includes the following

California Consumer Privacy Act
Annual Compliance & Other Items
Annual Fund Matters
Annual Management Company Matters
Regulatory & Other Items from 2019

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California Consumer Privacy Act

There has been much discussion about the California Consumer Privacy Act (“CCPA”) passed earlier this year and effective January 1, 2020.Please be aware that most private fund managers will not be affected by the new law. We have provided a detailed overview of the CCPA here, but below are the main items applicable to private fund managers:

CCPA Will not affect most managers – in general, the law will only apply to California managers who receive $25M of annual gross revenue.
What information is subject to CCPA? – in general, if a manager is a SEC RIA, the only information potentially subject to the CCPA is the “personal information” of the fund manager’s (i) entity or or institutional clients and (ii) prospective clients, because an SEC RIA is already subject to the Gramm-Leach-Bailey Act which covers other types of information. Here “personal information” would include most items collecte dby the manager in fund subscription documents.

Given the above, what should managers do if they are potentially subject to the CCPA? We believe managers should start thinking about the following steps:

Be prepared to act – within 45 days of a CCPA request, a manager will need to be able to provide a client with (i) access to their specific personal information, (ii) rights with respect to data portability, (iii) data deletion, and (uv) non-discrimination for exercise of any CCPA right.
Review and/or update privacy policy – managers may need to update their privacy policy to inform clients of their rights under the CCPA and instructions on how to exercise those rights. Managers who are RIAs should also distribute their annual privacy policy update to all clientele in January.
Update website policy if you collect personal information – if a manager operates a website which collects personal information (online portal access, cookies, etc.) that manager must publish a separate CCPA compliant prviacy disclosure on the website. If a manager runs a website that does not collection personal information, then no separate disclosure is needed for the website.
Consider updating service provider agreements – given the fund administrator and the auditor will maintain client personal information, managers may want to consider updating their agreements to include a representation from the service provider that it is in compliance with the CCPA regulations.

Annual Compliance and & Other Items

Annual Privacy Policy Notice. On an annual basis, registered investment advisers (“RIAs”) are required to provide natural person clients with a copy of the firm’s privacy policy if (i) the RIA has disclosed nonpublic personal information other than in connection with servicing consumer accounts or administering financial products or (ii) the firm’s privacy policy has changed. The Securities and Exchange Commission (the “SEC”) has provided a model form and accompanying instructions for firm privacy policies.

Annual Compliance Review. On an annual basis, the CCO of an RIA must conduct a review of the adviser’s compliance policies and procedures. This annual compliance review should be in writing and presented to senior management, We recommend that firms discuss the annual review with their outside counsel or compliance firm, who can provide guidance about the review process as well as a template for the assessment and documentation. Conversations regarding the annual review may raise sensitive matters, and advisers should ensure that these discussions are protected by attorney-client privilege. CCOs may also want to consider additions to the compliance program. Advisers that are not registered may still wish to review their procedures and/or implement a a compliance program as a best practice.

Form ADV Annual amendment. RIAs or managers filing as exempt reporting advisers (“ERAs”) with the SEC or a state securities authority must file an annual amendment to Form ADV within 90 days of the end of their fiscal year. For most managers, the Form ADV amendment would be due on March 31, 2020. RIAs must provide a copy of the updated Form ADV Part 2A brochure and Part 2B brochure supplement (Or a summary of changes with an offer to provide the complete brochure) to each “client”. Note that for SEC-registered advisers to private investment vehicles, a “client” for purposes of this rule means the vehicle(s) managed by the adviser and not the underlying investors. State-registered advisers need to examine their state’s rules to determine who constitutes a “client”.

Switching to/from SEC Regulation.

SEC Registration. Managers who no longer qualify for SEC registration as of the time of filing the annual Form ADV amendment must withdraw from SEC registration within 180 days after the end of of their fiscal year (June 29, 2020, for most managers), by filing a Form ADV-W. Such managers should consult with legal counsel to determine whether they are required to register in the states in which they conduct business. Managers who are required to register with the SEC as of the date of their annual amendment must register with the SEC within 90 days of filing the annual amendment (June 29, 2020, for most managers, assuming the annual amendment is filed on March 31, 2020).

Exempt reporting advisers. Managers who no longer meet the definition of an ERA will need to submit a final report as an ERA and apply for registration with the EC or relevant state securities authority, if necessary, generally within 90 days after the filing of the annual amendment.

Custody Rule Annual Audit

SEC RIAs. SEC-registered investment advisers (“SEC RIAs”) must comply with certain custody procedures, including (i) maintaining client funds and securities with a qualified custodian; (ii) having a reasonable basis to believe that the qualified custodian sends an account statement to each advisory client at least quarterly; and (iii) undergoing an annual surprise examination conducted by an independent public accountant.

SEC RIAs to pooled investment vehicles may avoid both the quarterly statement and surprise examination requirements by having audited financial statements prepared for each pooled investment vehicle in accordance with generally accepted accounting principles by an independent public accountant registered with the Public Company Accounting Oversight Board (“PCAOB”). Statements must be sent to investors in the fund within 120 days after the fund’s fiscal year end. Managers should review their custody procedures to ensure compliance with the rules.

California RIAs. California-registered investment advisers (“CA RIAs”) that manage pooled investment vehicles and are deemed to have custody of client assets are also subject to independent party and surprise examinations. However, CA RIAs can avoid these additional requirements by engaging an auditor (that is an independent public accountant registered with the PCAOB) to prepare and distribute audited financial statement to all investors ( or other beneficial owners_ of the pooled investment vehicle, and to the Commissioner of the California Department of Business Oversight (“DBO”). Those CA RIA s that do not engage an auditor must, among other things, (i) provide notice of such custody on the Form ADV; (ii) maintain client assets with a qualified custodian; (iii) engage an independent party to act in the best interest of investors to review fees, expenses, and withdrawals; and (iv) retain an independent certified public accountant to conduct surprise examinations of assets.

Other State RIAs. Advisers registered in other states consult with legal counsel about those states’ specific custody requirements.

California Minimum Net Worth Requirement and Financial Reports.

RIAs with Custody. Every CA RIA that has custody of client funds or securities must maintain at all times a minimum net worth of $35,000, however the minimum net worth is $10,000.00 for a CA RIA (i) deemed to have custody for another type of pooled investment vehicle and (ii) that otherwise complies with the California custody rule described above (such advisers, “GP RIAs”).

RIAs with discretion. Every CA RIA that has discretionary authority over client funds or securities, whether or not they have custody, must maintain at all times a net worth of at least $10,000, and preferably $12,000.00 to avoid certain reporting requirements.

Financial Reports. Every CA RIA that either has custody of, or discretionary authority over, client funds or securities must file an annual financial report with the DBO within 90 days after the adviser’s fiscal year end. The annual financial report must contain a balance sheet, income statement, supporting schedule, and a verification form. These financial statements must be audited by an independent certified public accountant or independent public accountant if the adviser has custody and is not a GP RIA.

Annual Re-Certification of CFTC Exemptions. Commodity pool operators (“CPOs”) and commodity trading advisers (“CTAs” currently relying onc ertain exemptions from registration with the Commodity Futures Trading Commission (“CFTC”) are required to re-certify their eligibility within 60 days of the calendar year end. CPOs and CTAs currently relying on relevant exemptions will need to reevaluate whether they remain eligible to rely on such exemptions.

CPO and CTA Annual Updates. Registered CPOs and CTAs must prepare and file Annual Questionnaires and Annual Registration Updates with the National Futures Association (“NFA”), as well as submit payment for annual maintenance fees and NFA membership dues. Registered CPOs must also prepare and file their fourth quarter report for each commodity pool on Form CPO-PQR, while CTAs must file their fourth quarter report on Form CTA-PR. or more infomration on Form CPO-PQR, please see our earlier post. Unless eligibel to claim relief under Regulation 4.7, registered CPOs and CTAs must update their disclosure documents periodically, as they may not use any that are materially inaccurate or incomplete and must be corrected promptly, and the corrected version must be distributed promptly to pool participants.

Trade Errors. Managers should make sure that all trade errors are properly addressed pursuant to the manager’s trade errors policies by the end of the year. Documentation of trade errors should be finalized, and if the manager is required to reimburse any of its funds or other clients. it should do so by year-end.

Soft Dollars. Managers that participate in soft dollar programs should make sure that they have addressed any commission balances from the previous year.

Schedule 13G/D and Section 16 Filings. Managers who excercise investment discretion over accounts (including funds and separately managed accounts (“SMAs”) that are beneficial owners of 5% or more of a registered voting equity security must report these position on Schedule 13D or 13G. Passive investors are generally eligible to file the short form Schedule 13G, which is updated annually within 45 days of the end of the year. Schedule 13D is required when a manager is ineligible to file Schedule 13G and is due 10 days after the acquisition of more than 5% beneficial ownership of a registered voting equity security. For managers who are also making Section 16 filings, this is an opportune time to review your filings to confirm compliance and anticipate needs for the first quarter.

Section 16 filings are required for “corporate insiders” (including beneficial owners of 10% or more of a registered voting equity security). An initial Form 3 is due within 10 days after becoming an “insider”; Form 4 reports ownership changes and is due by the end of the second business day after an ownership change; and Form 5 reports any transactions that should have been reported earlier on a Form 4 or were eligible for deferred reporting and is due within 45 days after the end of each fiscal year.

Form 13F. A manager must file a Form 13F if it exercises investment discretion with respect to $100 million or more in certain “Section 13F securities” within 45 days after the end of of the year in which the manager reaches the $100 million threshold. The SEC lists the securities subject to 13F reporting on its website.

Form 13H. Managers who meet the SEC’s large trader thresholds (in general, managers whose transactions in exchange-listed securities equal or exceed two million shares or $20 million during any calendar day, or 20 million shares or $200 million during any calendar month) are required to file an initial Form 13H with the SEC within 10 days of crossing the threshold. Large traders also need to amend Form 13H annually within 45 days of the end of the year. In addition, changes to the information on the Form 13H will require interim amendments following the calendar quarter in which the change occurred.

Form PF. Managers to private funds that are either registered with the SEC or required to be registered with the SEC and who have at least $150 million in regulatory assets under management (“RAUM”) must file Form PF. Smaller private advisers (fund managers with less than $1.5 billion in RAUM or more in RAUM) must file Form PF within 50 days of the end of each fiscal quarter.

Form MA. Investment advisors that provide advice on municipal financial products are considered “municipal advisors” by the SEC, and must file a Form MA annually, within 90 days of their fiscal year end.

SEC Form D. Form D filings for most funds need to be amended on an annual basis, on or before the anniversary of the most recently filed Form D. Copies of Form D are publicly available on SEC’s EDGAR website.

Blue sky filings. On an annual basis, a manager should its blue sky filings for each state to make sure it has met any initial and renewal filings requirements. Several states impose late fees or reject late filings altogether. Accordingly, it is critical to stay on top of filings deadlines for both new investors and renewals. We also recommend that managers review blue sky filings submission requirements. Many states now permit blue sky filings to be filed electronically through the Electronic Filings Depository (“EFD”) system, and certain states will now only accept filings through EFD.

IARD Annual Fees. Preliminary annual renewal fees for state-registered and SEC-registered investment advisers are due on December 16, 2019. If you have not already done so, you should submit full payment into your Renewal Account by E-Bill, check or wire as soon as possible.

Pay-to-Play and Lobbyist Rules. SEC Rules disqualify investment advisers, their key personnel and placement agents acting on their behalf, from seeking to become engaged by a governmental client if they have made certain political contributions. State and local governments have similar rules, including California, which requires internal sales professionals who meet the definition or “placement agents” (people who act for compensation as finders, solicitors, marketers, consultants, brokers, or other intermediaries in connection with offerings or selling investment advisory services to a state or public retirement system in California) to register with the state as lobbyists and comply with California lobbyist reporting and regulatory requirements. Note that managers offering or selling investment advisory services to local government entities must register as lobbyists in the applicable cities and counties. State laws on Lobbyist registration differ widely, so managers should carefully review reporting requirements in the states in which they operate to make sure they are in compliance with the relevant rules.

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Annual Fund Matters

New Issue Status. On an annual basis, managers need to confirm or reconfirm the eligibility of investors that participate in initial public offerings or new issues, pursuant to both Financial Industry Regulatory Authority, Inc. (“FINRA”) Rules 5130 and 5131. Most managers reconfirm investor eligibility via negative consent (i.e. are informed of their status on file with the manager and are asked to inform the manager of any changes), whereby a failure to respond by any investor operates as consent to the current status.

ERISA Status. Given the significant problems that can occur from not properly tracking ERISA investors in private funds, we recommend that managers confirm or reconfirm on an annual basis the ERISA status of their investors. This is particularly important for managers that track the underlying percentage of ERISA funds for each investor, with respect to each class of interests in a pooled investment vehicle.

Redemption Management. Managers with significant redemptions at the end of the year should carefully manage unwinding positions so as to minimize transaction costs in the current year (that could impact performance) and prevent transaction costs from impacting remaining investors in the next year. When closing funds or managed accounts, managers should pay careful attention to the liquidation procedures in the fund constituent documents and the managed account agreement.

NAV Triggers and Wavers. Managers should promptly seek waivers of any applicable termination events set forth in a fund’s ISDA or other counterparty agreement that may be triggered by redemptions, performance, or a combination of both at the end of the year. (NAV declines are common counterparty agreement termination events).

Fund Expenses. Managers should wrap up all fund expenses for 2019 if they have not already done so. In particular, managers should contact their outside legal counsel to obtain accurate and up to date information about legal expenses for inclusion int he NAV for year-end performance.

Electronic Schedule K-1s. The Internal Revenue Service (“IRS”) authorizes partnerships and limited liability companies to issue Schedule K-1s to investors solely by electronic means, provided the partnership has received the investor’s affirmative consent. States may have different rules regarding electronic K-1s and partnerships should check with their counsel whether they may still be required to send state K-1s on paper. Partnerships must also provide each investor with specific disclosures that include a description of the hardware and software necessary to access the electronic K-1s, how long the consent is effective, and the procedures for withdrawing the consent. If you would like to send K-1s to your investors electronically, you should discuss your options with your service providers.

“Bad Actor” Recertification Requirement. A security offering cannot rely on the Rule 506 safe harbor from SEC registration if the issuer or its “covered persons” are “bad actors.” Fund managers must determine whether they are subject to bad actor disqualification any time they are offering or selling securities in reliance on Rule 506. The SEC has advised that an issuer may reasonably rely on a covered person’s agreement to provide notice of a potential or actual bad actor triggering event pursuant to contractual covenants, bylaw requirements, or undertakings in a questionnaire or certification. If an offering is continuous, delayed, or long-lived, however, issuers must update their factual inquiry periodically through bring-down representations, questionnaires, and certifications, negative consent letters, periodic re-checking of public databases, and other steps., depending on the circumstances. Fund managers should consult with counsel to determine how frequently such an update is required. As a matter of practice, most fund managers should perform such an update at least annually.

U.S. FATCA. Funds should monitor their compliance with the U.S> Foreign Account Tax Compliance Act (“FATCA”). U.S. FATCA reports are due to the IRS on March 31, 2020 or September 30, 2020, depending on where the fund is domiciled. Reports may be required by an earlier date for jurisdictions that are parties to intergovernmental agreements (“IGAs”) with the U.S. Additionally, the U.S> may require that reports be submitted through the appropriate local tax authority in the applicable IGA jurisdiction, rather than the IRS. Given the varying U.S. FATCA reporting requirements applicable to different jurisdictions, managers should review and confirm the specific U.S. FATCA reporting requirements that may apply. AS a reminder, we strongly encourage managers to file required reports and notifications, even if they already missed previous deadlines. Applicable jurisdictions may be increasing enforcement and monitoring of FATCA reporting and imposing penalties for each day late.

CRS. Funds should also monitor their compliance with the Organisation for Economic Cooperation and Development’s Common Reporting Standard (“CRS”). All “Financial Institutions” in the Cayman Islands and the British Virgin Islands are required to register with the respective jurisdiction’s Tax Information Authority and submit returns to the applicable CRS reporting system by May 31 2020. Managers to funds domiciled in other jurisdictions should also confirm whether any CRS reporting will be required in such jurisdictions. CRS reporting must be completed with the CRS XML v1.0 or a manual entry form on the Aut omatic Exchange of Information portal. We recommend managers contract their tax advisors to stay on top of the U.S. FATCA and CRS requirements and avoid potential penalties.

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Annual Management Company Matters

Management Company Expenses. Managers who distribute profits on an annual basis should attempt to address management company expenses in the year they are incurred. If ownership or profit percentages or adjusted at the end of the year, a failure to manage expenses could significantly impact the economics of the partnership or the management company.

Employee Reviews. An effective annual review process is important to reduce the risk of employee litigation and protect the management company in the event of such litigation. Moreover, it is an opportunity to provide context for bonuses, compensation adjustments, employee goals and other employee-facing matters at the firm. It is not too late to put an annual review process in place.

Compensation Planning. In the fund industry, and the financial services industry in general, the end of the year is the appropriate time to make adjustments to compensation programs. Since much of a manager’s revenue is tied to annual income from incentive fees, any changes to the management structure, affiliated partnerships, or any shadow equity programs should be effective on the first of the year. Make sure that partnership agreements and operating agreements are appropriately updated to reflect such changes.

Insurance. If a manager carries D&O or other liability insurance, the policy should be reviewed on an annual basis to ensure that the manager has provided notice to the carrier of all claims and all potential claims. Newly launched funds should also be added to the policy as appropriate.

Other Tax Considerations. Fund managers should assess their overall tax position and consider several steps to optimize tax liability. Managers should also be aware of self-employment taxes, which can potentially be minimized by structuring the investment manager as a limited partnership. Managers can take several steps to optimize their tax liability. including (i) changing the incentive fee to an incentive allocation; (ii) use of stock-settled stock appreciation rights; (iii) if appropriate terminating swaps and realizing net losses; (iv) making a Section 481(a) election under the Internal Revenue Code of 1986, as amended (the “Code”); (v) making a Section 475 election under the Code; and (vi) making charitable contribution. Managers should consult legal and tax professionals to evaluate these options.

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Regulatory & Other Items from 2019

SEC Updates.

SEC Annual Enforcement Report. On November 6, 2019, the SEC Division of Enforcement published its Annual Report, which highlighted enforcement efforts protecting “main street investors” through the SEC Retail Strategy Task Force, Share Class Selection Disclosure Initiative, misleading risk factor disclosures by public companies, and enforcement efforts regarding ICOs and Digital Assets. The 2019 fiscal year also saw the SEC file its first charges for unlawful promotion of an ICO. Enforcement was also brought against an ICO research and rating service for failing it disclose it was compensated by issuers whose offerings it rated. During teh 2019 fiscal year, the SEC brought a total of 862 enforcement actions and obtained monetary judgments worth 4.3 billion dollars, both of which were increases from 2018 figures.

SEC Enforcement for Failure to Disclose Conflicts Arising from Revenue Sharing. On August 1, 2019, the SEC filed a complain against an SEC Registered Investment Adviser (“RIA”) for its failure to disclose conflicts of interest which arose from a revenue sharing agreement with a broker used by most of the adviser’s clients. The revenue sharing agreement in question provided that, if the adviser invested client assets in certain classes of mutual funds which paid the broker to be listed on its platform, the adviser would receive a portion of such revenue. Between July 2014 and December 2019, the adviser received over $100 million from the broker through this revenue sharing agreement. Through this time, the adviser never disclosed to its clients that there were other mutual fund investments less expensive than the investments subject to the revenue split agreement. Considering such omissions to be material, the SEC determined the adviser’s clients did not make these investments with full knowledge of the adviser’s incentives. Lesson to be learned: fund managers should always ensure all pertinent conflicts of interest, including those related to revenue sharing from third parties, are adequately disclosed to their clients.

SEC Bars Chief Compliance Officer from the Securities Industry. On July 17, 2019, the SEC settled charges of fraud against Colorado investment advisers Salus, LP and S.A.I.C. Limited, and their owners Brandon Copeland and Gregory Prusa, who was also the CCO, for making materially false, statements to prospective investors. The SEC alleged that Mr. Prusa in particular made false or misleading statements in the Form ADV filing for Salus, LP., claiming to have up to $178 million in assets under management and 20 high net worth individual clients. Salus, LP also promoted itself as an SEC RIA. None of this information in the Form ADV was true and Salus, LP never had any assets under management or individual clients.

CFTC And NFA Updates.

CFTC Public Enforcement Manual. For the first time ever, the CFTC’s Division of Enforcement published its Enforcement Manual aiming to provide clarity on the CFTC’s investigations and enforcement of violations. Managers may find the manual useful to evaluate the predictability of CFTC enforcement actions. The manual also highlights the CFTC’s intention to incentivize self-reporting and cooperation with the CFTC as the manual notes such cooperation will be considered in deciding the enforcement outcome, including the possibility of a non-prosecution agreement or deferred prosecution agreement.

Digital Asset Updates.

SEC Emphasis on ICOs. Much like the prior year, throughout 2019, the SEC focused much of its regulatory and enforcement efforts on ICOs. Notable developments included:

On June 4, 2019, the SEC filed a complain against Kik Interactive Inc., the popular messaging application, for conducting an illegal $100 million-dollar securities offering of digital tokens (the “Kin” tokens), without registering the offer and sale as required by law. This action resulted in Kik shutting down its core messaging service,
On September 18, 2019 the SEC filed a complaint against ICOBox and its founder Nikolay Evdokimov for conducting an illegal securities offering of ICOBox’s digital tokens as well as acting as an unregistered broker for other digital asset offerings.
On August 29, 2019, the SEC settled charges against Bitqyck and its founders when it created and sold two digital assets, Bitqu and Bitqym, in an unregistered securities offering raising $13 million dollars.
On August 27, 2019, in an interview with Bloomberg, SEC Chairman Jay Clayton stated when speaking about cryptocurrencies, that people may have gotten excited “that somehow [the SEC] would change the rules” but the SEC and Clayton have been consistent in their position that “form that start, that ain’t happening.”

SEC Releases a Framework for “Investment Contract” Analysis of Digital Assets. On April 3, 2019, in response to the regulatory and enforcement efforts focused on ICOs, the SEC released guidance on response to the regulatory and enforcement efforts focused on ICOs, the SEC released guidance on ICOs and how to comply with U.S. federal securities law. A key tale-away from the SEC’s guidance and framework is that the SEC is willing to exempt certain digital assets from being treated as securities. While a concrete regulatory scheme has not been crafted to deal specifically with ICOs, the SEC’s framework helps potential digital asset developers understand whether their digital asset is offered or sold as an “investment contract” and therefore subject to U.S. federal securities laws.

Internal Revenue Services Publishes Guidance for Calculating Taxes on Cryptocurrency. On October 9, 2019 the U.S. Internal Revenue service (the “IRS”) published its first guidance in five years relating to taxes owed on cryptocurrency holdings. Most notable in this guidance are the liabilities created by cryptocurrency forks. The IRS guidance states that tax liabilities will only apply to the new cryptocurrencies when they are recorded on the blockchain and if the taxpayer can actually control and spend the coins.

Bakkt Cleared to Launch Bitcoin Futures. Bakkt, a bitcoin futures exchange and digital assets platform founded by the Intercontinental Exchange (“ICE”) was given approval by the CFTC for Bakkt’s futures contracts. Bakkt’s bitcoin futures would be exchanged-traded on ICE Futures U.S. and cleared on IC Clear US, both of whom are regulated by the CFTC. Bakkt also announced it had acquired a New York state trust charter through the New York Department of Financial Services to create the Bakkt Trust Company, a qualified custodian, allowing Bakkt Warehouse – part of the Bakkt Trust Company – to provide bitcoin custodial services for physically delivered futures. September 23, 2019 was the launch date of Bakkt’s custody and physically-settled bitcoin futures contracts products which aims to address issues that have slowed institutional participation in this market in the past.

Other Updates.

SEC Approves First-Ever Reg A+ Token Offering. Blockstack became the first company in history to receive SEC approval for a public securities offering where investors would receive tokens. These securities, called “Stacks”, raised a total of $23 million from more than 4,500 investors. In the United States alone $15.5 million was raised through a Reg A+ sale while the other $7.6 million was raised through a Reg S offering in Asia. This approval, although new, has potentially created a regulatory roadmap for public token offerings.

IRS Guidance on Qualified Opportunity Fund. On April 17, 2019, the IRS issued additional guidance for the deferral of capital gains through investment in qualified opportunity funds. Most notable the IRS clarified the “substantially all” requirement for the holdings period and use of tangible business property. Under these new regulations, certain properties are able to qualified as a “qualified opportunity zone business property” if substantially all of the use of such property is in a qualified opportunity zone for substantially all of the qualified opportunity fund’s holding period of such property. This “substantially all” threshold, the IRS clarified, is (i) 70% with respect to the use of the property; and (ii) 90% with respect to the qualified opportunity fund’s holding period of such property.

Offshore Updates.

Cayman Islands Data Protection Law. Effective from September 30, 2019, the Cayman Islands Data Protection Law (the “DPL” and passed in 2017) came into force. The DPL applies to all investment advisers providing investment advise to Cayman Islands funds. Under the DPL, Cayman investment funds are considered “data controllers” even if they are not registered with the Cayman Islands Monetary Authority. Investment advisers to such funds are considered “data processors”. The DPL requires data controllers to update their Cayman fund’s subscription agreements to incorporate DPL compliant language and otherwise provide investors with an updated DPL compliant privacy notice. Fund administrators are also subject to the DPL and must ensure that they are compliant. Updates to a fund’s administration agreement may be required.

Privacy Updates.

New York SHIELD Act. New York State passed the Stop Hacks and Improve Electronic Data Security Act (the “SHIELD Act”) on July 25, 2019 amending the State;s data breach notification law. Designed to take effect in March 2020, the SHIELD Act requires certain businesses and/or individuals to implement safeguards to protect the security, confidentiality, and integrity of information. The SHIELD Act Broadens “private information” to include credit card numbers, debit card numbers, usernames and passwords (including security questions and answers) relating to individual’s online account and biometric information (line fingerprints). The SHIELD Act also expands the definition of “beach” to include unauthorized access to private information (instead of just unauthorized acquisition). The scope of the breach notification was broadened to include persons or businesses that own or license private information of New York resident. This expansion also means the law is no longer limited to those conducting business in New York but also managers who, for example, only store a New York investor’s private information. Managers who own private information of a New York resident should review these updated security measures and implement security programs as specifically discussed in the SHIELD act.

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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
December 26, 2019	Last day to submit form filings via IARD prior to year end
December 31, 2019	Review RAUM to determine 2019 Form PF filing requirement
December 31, 2019	Small and mid-sized registered CPOs must submit a pool quarterly report (CPO-PQR)
December 31, 2019	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 2020 CIMA fees
January 15, 2020	Quarterly Form PF due for large liquidity fund advisers (if applicable)
January 31, 2020	“Annex IV” AIFMD filing
February 14, 2020	Quarterly Form 13F updates due
February 14, 2020	Annual Schedule 13G updates due
February 14, 2020	Annual Form 13H updates due
February 28, 2020	Deadline for re-certification of CFTC exemptions
March 1, 2020	Quarterly Form PF due for larger hedge fund advisers (if applicable)
March 31, 2020	Deadline to update and file Form ADV Parts 1, 2A & 2B
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.

California Consumer Privacy Act

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The California Consumer Privacy Act (the “CCPA”), which was passed as law on June 28, 2019, will be effective as of January 1, 2020. Please be aware most fund managers will not be affected, but given the upcoming date of effectiveness it may be prudent to evaluate the reach of the law.

First, WHO does the CCPA affect?

The CCPA will affect fund managers who do business in California AND either (i) have at least $25 million of annual gross revenue; (ii) buy, sell, share or receive personal data; or (iii) receive over half of their revenue from the sale of personal data of California residents. Most fund managers who do business in California will not meet any of these prongs. The few managers who the CCPA will affect will likely fall under prong (i) – those who do business in California and have at least $25 million in annual gross revenue.

In calculating the $25 million in annual gross revenue, fund managers operating with a bifurcated management structure (separate management company and general partner entities) will likely have to aggregate the revenues of the general partner and management entities. The CCPA expands the definition of a “business” to entities who control or are in common control with another business and which share a common branding. In this case, if the threshold is met across both management entities, each entity will be subject to the provisions of the CCPA. If the general partner and investment manager do not share common branding, our view is that the revenues of the entities will not need to be aggregated.

Second, WHAT information does the CCPA cover?

The CCPA generally covers “personal information” that identifies, relates to, describes, associates with, directly or indirectly, a particular institutional or prospective client. This information includes, without limitation, names, addresses, email addresses, social security numbers, driver’s license or state issued ID number and passport numbers.

Typically, fund managers maintain the personal information of (i) their own employees (ii) individual clients (iii) institutional or entity clients and (iv) prospective clients. Fund managers may be relieved to learn that, due to certain statutory exemptions, information collected (i) about manager’s employees, (ii) via certain business to business transactions and (iii) about individual clients (if a manager is an SEC Registered Investment Adviser), does not constitute personal information and as a result, does not fall under the scope of the CCPA. Thus, the CCPA will generally only cover personal information of a fund manager’s (i) entity or institutional clients and (ii) prospective clients.

The CCPA exempts from coverage all data pre-empted by the Gramm-Leach-Bliley Act (the “GLBA”), which only applies to SEC Registered Investment Advisers (each, an “RIA”). The GLBA protects nonpublic personal information that is provided by a consumer to a financial institution in connection with obtaining financial products/services from the institution. The GLBA’s definition of nonpublic personal information differs from the definition of personal information under the CCPA, and is limited to individual investor information. Thus, while certain individual investor information may be pre-empted from the scope of the CCPA, personal information of entity investors, institutional investors and prospective investors is not within the scope of the GLBA and as such, will be covered by the CCPA.

Third, HOW should fund managers comply?

To the extent that clients or client prospects of fund managers are protected by the CCPA, their rights include the right to request disclosure of information that is collected and shared, the right to delete personal information and the right to non-discrimination. To ensure such compliance with the CCPA, we recommend that managers within the scope of the CCPA take the below actions:

- Fund managers must broadly be prepared to promptly respond to California client rights and requests including clients’ rights to (i) access specific personal information (ii) data portability (iii) data deletion and (iv) non-discrimination for exercise of any CCPA right. Once a fund manager has received a verifiable consumer request from a client, it must be prepared to disclose and deliver the required information to the client within 45 days.

- Typical privacy policies currently used by fund managers may need to be updated to (i) inform clients of their rights under the CCPA and instructions on how to exercise those rights and (ii) reword and incorporate as a comprehensive list all personal information (including drivers licenses, passport numbers or any other personal identifiers) collected and shared with service providers (such as the fund administrator, auditor, legal/regulatory service providers and I.T. providers). RIAs should also distribute their annual privacy policy update to all clientele in January.

- Fund managers operating a website which collects personal information (either through an online portal access, cookies or other website function) must publish a separate CCPA compliant privacy disclosure on such website relating to the collection and use of such personal information. Many fund managers do not collect personal information on their websites, and thus will not need to include such privacy disclosure on their webpage.

- Fund managers should consider updating their agreements with their fund administrator and possibly other service providers that have access to covered information of clients to include a representation from the service provider that it is in compliance with CCPA regulations.

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