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Cole-Frieman & Mallon 2022 Q2 Update

July 21, 2022

Clients, Friends, Associates:

As we end the second quarter and enter the summer season, we would like to highlight some of the recent industry updates and occurrences we found to be interesting and impactful. While we try to keep these topics higher-level, please feel free to explore the links included and reach out to us if you have any related questions.

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CFM Items

We are pleased to announce the addition of Alex Yastremski to our firm as Partner to lead our Digital Asset Practice. We’d also like to highlight the addition of Frank J. Martin as Counsel and the promotion of Tony Wise to Partner. Additionally, we have hired Joe Burgess as Executive Director to continue our focus on operational excellence. Please join us in welcoming them all to our firm!

Our annual CoinAlts Fund Symposium is returning to San Francisco and will be held on November 3, 2022. Please mark the date on your calendar and stay tuned for further registration information. Attendance will be complimentary for clients of our firm and those of the other CoinAlts founding firms, MG Stover, Cohen & Company, and Harneys.

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SEC Matters

SEC Risk Alert on Material Non-Public Information Compliance Issues. The SEC recently 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.

OpenSea Insider Trading. A former high-ranking employee of OpenSea was recently indicted for wire fraud and money laundering in what the United States Attorney’s Office for the Southern District of New York characterized as the “first-ever digital asset insider trading scheme.” The former head of Product at OpenSea was in charge of selecting NFTs to feature on the website’s homepage and allegedly misappropriated that confidential information by purchasing those NFTs before they were promoted on OpenSea’s homepage.

While the alleged actions in the indictment are reminiscent of traditional insider trading under Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), since NFTs are not yet categorized as securities under the Exchange Act, the prosecutors here wove allegations of traditional fraud and insider trading concepts into charges for wire fraud and money laundering. The prosecutorial creativity signals that despite lagging legislation, law enforcement is taking notice of the increasing fraudulent activity in the NFT space and is ready to tackle such unsavory business practices and provide greater consumer protection. 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 a registered investment adviser 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 stablecoins. 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.

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CFTC Items

Perpetual Futures and CFTC Regulation. Digital assets managers continue to inquire into the possibility of trading cryptocurrency futures contracts. With the Commodity Futures Trading Commission (“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 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.

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Digital Asset Items

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. Sens. Kirsten Gillibrand (D-NY) and Cynthia Lummis (R-WY) recently 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.

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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.

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Compliance Calendar

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

July 10, 2022

Form 13H Quarterly Filing for Changes. Filing is for calendar quarter that ended June 30, 2022 and should be submitted within 10 days of quarter end.

July 15, 2022

Form PF for Large Liquidity Fund Advisers. Filing is for calendar quarter that ended June 30, 2022.

July 31, 2022

ERISA Schedule C of DOL Form 5500 Disclosure.

August 15, 2022

Form 13F Quarterly Filing. Filing is for calendar quarter that ended June 30, 2022 and should be submitted within 45 days of quarter end.
CTA Form PR. Filing is for calendar quarter that ended June 30, 2022 and should be submitted within 45 days of quarter end.

August 29, 2022

Form PF for Large Hedge Fund Advisers. Filing is for calendar quarter that ended June 30, 2022.
CPO-PQR Form. Filing is for calendar quarter that ended June 30, 2022 and should be submitted within 60 days of quarter end.

August 31, 2022

Deadline to submit Annual FINRA Entitlement Certification for 2022. If not completed, FINRA accounts will be withdrawn.

Consult our complete Compliance Calendar for all 2022 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, Alex Yastremski, & Tony Wise

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 Announces Promotion of Tony Wise to Partner

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San Francisco, Calif. – July 14, 2022: Investment management law firm Cole-Frieman & Mallon LLP (“CFM”) is pleased to announce that Counsel Tony Wise has been promoted to Partner. Mr. Wise joined CFM in 2016 and advises asset managers in fund formation and regulatory matters. Mr. Wise specializes in funds that invest in cryptocurrency and the broader ecosystem, and more recently has focused on digital asset counterparty documentation. Mr. Wise helped Partner Scott Kitchens open CFM’s Denver office in 2019.

“We are proud to advance Tony to the role of Partner. He has undoubtedly earned it,” said Bart Mallon, Co-Managing Partner. “Tony has gained an exceptional standing within the investment industry due to his forward-thinking ability, our clients’ results, and his commitment to helping them achieve their financial business goals.”

“Since joining our firm, Tony has worked diligently on behalf of our clients’ investment interests within the digital asset space. His commitment to the success of our firm is a true value to our team and our clients,” said Co-Managing Partner Karl Cole-Frieman.

Mr. Wise added, “I truly enjoy providing guidance to our asset manager clients and am excited to continue expanding the firm’s digital asset-related legal services.”

About: 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.

Press Release

Cole-Frieman & Mallon Further Expands Cryptocurrency and Digital Asset Practice; Hires Alex Yastremski as Partner

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San Francisco, June 1, 2022: Cole-Frieman & Mallon LLP (“CFM”), a boutique investment management law firm focusing on the digital asset space, has hired Alex Yastremski as a Partner to lead its Digital Asset Practice. Mr. Yastremski is a digital asset industry veteran with significant experience helping large and small companies with their go-to-market strategies. His practice is focused on start-ups through emerging growth companies, venture capital financings, equity issuances (including Web3 platforms and token launches), and other regulatory matters related to blockchain-related businesses. Prior to joining CFM, Alex served as Co-Chair of the Blockchain and Digital Currency Task Force of a large law firm and was General Counsel of DASAN Zhone Solutions and BitFury Group Ltd.

“We are obviously excited to expand the core CFM investment management practice with the addition of specific digital asset equity and financing practice,” said CFM Co-Founder and Co-Managing Partner Bart Mallon. “Alex has strong and varied experience with private companies, financial sponsors, investors, and entrepreneurs dealing with novel legal issues. His skill set is a perfect match for the needs of many CFM clients.”

Alex’s arrival comes at a time of notable growth for CFM. The CFM team includes over 35 professionals, serving over 1,500 clients and launching over 250 private funds per year, predominately in the digital asset space. The addition of Mr. Yastremski also highlights the expansion of the firm’s corporate and finance capabilities and showcases the growth of the firm.

Karl Cole-Frieman, also a CFM Co-Founder and Co-Managing Partner, added, “We could not be more delighted to have Alex join our many talented professionals. Our pioneering and best-in-class work with non-traditional asset classes, notably our work with cryptocurrency fund managers, continues to be our firm’s core strength.”

About: 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, focusing on legal issues that impact the hedge fund community. For more information, please add us on LinkedIn and visit us at colefrieman.com.

Press Release

Schedule to Meet with Our Legal Team During Bitcoin 2022

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We are thrilled to announce that we are sponsoring the Bitcoin 2022 conference in Miami next week. The team from CFM will be attending the conference and many of the ancillary events and look forward to meeting with clients, friends, service providers, and some of the most critical minds in the digital asset space.

Karl Cole-Frieman, Bart Mallon, Dave Rothschild, Tony Wise, Malhar Oza, and Dominic Althoff will all be there.

We welcome you to engage with our team of industry-leading lawyers, so please get in touch with us if you want to catch up or schedule a meeting next week in Miami: https://resources.colefrieman.com/bitcoin2022

Aspect Advisors and C-F&M 2022 IA/BD Compliance Update

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We wanted to take this opportunity to thank everyone who attended and participated in our 2022 compliance update hosted by Justin Schleifer, Co-Founder, President (Aspect Advisors), and Bart Mallon, Co-Managing Partner (Cole-Frieman & Mallon). Our discussion on March 3 touched on many essential topics for financial industry professionals to keep top of mind for the upcoming year.

Some high points included:

Compliance Calendar.

Imminent Deadlines & Filings
- ADV and CRS – March 31
- Form PF – April 30 (annual filers)
Rule Implementation Dates
- SEC Advertising Rule – November 2022
- Proposed Private Fund Disclosures – Q2 2023
- Proposed Cybersecurity Rules – Q2 2023
Periodic Tasks
- Annual review of policies and procedures
- Business continuity test/review
- Cybersecurity test
- Customer/account reviews
- Employee training
- Code of ethics surveillance

SEC Marketing Rule Implementation. The new SEC Marketing rules will replace the existing regime of no-action letters and establish clear rules for fund managers. These rules will not fundamentally change the spirit of the current regime and instead clarify specifics on today’s issues such as social media use, blog posts, testimonials, and others. The new rules are not expected to impact the investment management industry significantly. Still, fund managers will need to update policies and procedures and review current advertising materials to ensure compliance with the new rules.

Proposed Private Fund Disclosure Rules. The SEC has proposed new rules for private fund disclosures that seek to improve transparency for types of information that investors receive to aid them in making informed decisions. As it stands, the proposals could profoundly impact private fund operations and the relationship between managers and investors regarding investments. The effects would be felt by large fund managers who receive institutional investments. The institutional investor has the leverage to ask managers for preferential rights and other forms of favorable treatment. The SEC is reviewing proposals, and experts believe that some version of the rules will likely be implemented in 2023.

Proposed Cybersecurity Rules. In recent years, there has been a push from the SEC and other financial regulators to improve cybersecurity, so it comes as no surprise that the SEC has formally proposed a set of rules to govern the matter. Like other policy and procedure requirements, many of the new rules lack specifics, meaning that individual firms will need to determine what they view as necessary to include to maintain compliance.

NFTs. From the past six months, everyone’s favorite buzzword has grown in prominence within the investment management industry following the launch of NFT-exclusive private investment funds. Like other digital assets, the primary concerns for managers are custody and the general compliance of the assets. NFTs have also raised novel valuation questions as experts seek ways to appraise the assets in ways beyond their trading price.

DAOs. The emergence of DAOs as legal entities has raised two critical items to follow in 2022. First, DAOs have sought to create real-world investment products, raising questions about how private fund managers can allow a DAO to invest in the fund. Second, DOAs have inquired about launching their private investment fund products, which presents unique legal and compliance challenges that need to be tackled.

Offshore Exchanges. A popular question from fund managers in the digital asset space regards opening accounts at offshore exchanges legally. To date, there is no easy answer, and attempts to do so must be conducted carefully on a client-by-client basis. There will be instances where opening an offshore exchange account is impossible or cost-prohibitive.

BlockFi’s Settlement. The SEC succeeded in sending shockwaves through the digital asset space after it agreed to a $100 million settlement with BlockFi over BlockFi’s interest product. BlockFi has decided to work with the SEC to register the product. Still, experts are unsure of how this will be done and wonder if this settlement will affect the desire of other market participants to develop new products. Furthermore, this settlement reflects the SEC’s troubling pattern of regulating by enforcement instead of publishing new rules and guidance. It also shines a light on how the SEC views these products as securities and could be the first step in considering specific lending-focused smart contracts to be securities.

Crypto Best Practices. There are essential best practices that fund managers in the digital asset space need to be aware of, especially managers experienced in traditional asset classes:

It is essential to conduct and document diligence on counterparties and vendors. Vendors in the digital asset space are often new and unproven, in contrast to the established vendors of traditional asset classes.
Fund managers must have a reasonable basis for custody providers and custody solutions. Nonetheless, while the SEC views custody of digital assets as being out of the ordinary, they have primarily been receptive to new solutions.
Be aware of the potential to receive MNPI.

Unlike traditional asset classes, there are fewer mechanisms for publishing company information to make it public. It is essential that employees understand the meaning of MNPI and how it impacts their business.

Big Predictions for 2022. Justin predicts that the SEC will bring another significant enforcement action that matches the BlockFi action in scale. The agency wants to further apply traditional securities law to digital assets, which means we could see another large settlement or a case fought in public court to set a precedence within the industry. Bart predicts increased activity from DAOs and potentially a significant breakthrough with DAOs in the next six months.

Regards,

Bart Mallon & Justin Schleifer

Aspect Advisors LLC

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

Cole-Frieman & Mallon LLP

Cole-Frieman & Mallon LLP is one of the top investment management law firms in the United States, known for providing top-tier, innovative, and collaborative legal solutions for complex financial services matters. Headquartered in San Francisco, Cole-Frieman & Mallon LLP services both start-up investment managers, 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.

Cole-Frieman & Mallon 2021 Half Year Update

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July 13, 2021

Clients, Friends, Associates:

We hope that this message ﬁnds you well and that you are enjoying the ﬁrst months of summer. As we move into the third quarter, we would like to provide you with a brief overview of some items that we hope will help you stay on top of the business and regulatory landscape in the coming months. We are also delighted to report our firm and Co-Managing Partner, Karl Cole-Frieman, were highlighted as leading crypto and blockchain lawyers by Business Insider. For additional firm updates, please follow us on LinkedIn.

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SEC Matters

SEC Revises Qualified Client Threshold. The SEC recently published an order approving adjustments to the tests which define a “Qualified Client” under the Investment Advisers Act of 1940, as amended (the “Advisers Act”). 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. The Qualified Client threshold is critically important for investment advisers because in nearly all jurisdictions, including for SEC registered investment advisers, performance fees and incentive allocations can only be charged to investors who are Qualified Clients. The new definitions become effective August 16, 2021 (the “Effective Date”), but will not be applied retroactively to contractual relationships existing as of such date. Additionally, an investor who satisfied the previous Qualified Client test and who subscribed for interests in a private fund prior to the Effective Date will remain subject to any applicable performance fees, and may make additional subscriptions (subject to performance fees) without needing to satisfy the new threshold amounts.

All investment advisers should promptly update their subscription documents to ensure that new investors who agree to make investments on or after the Effective Date have provided accurate representations regarding their Qualified Client status.

SEC adopts Marketing Rule (replaces Advertising Rule and Cash Solicitation Rule). On May 4, 2021, the SEC adopted new marketing rules for investment advisers. The new rules drastically overhaul and replace the prior cash solicitation and advertising rules applicable to investment advisers, their marketing materials, and their advertising practices to replace. SEC no-action letters pertaining to the prior cash solicitation rule will be nullified as the rule is being rescinded in practice. The most significant changes include the allowance of testimonials and endorsements, which under the prior rules were conditionally permitted to be used in advisers’ marketing materials. The new marketing rule now permits such use only if the adviser complies with specific disclosure, oversight, and disqualification provisions. Third-party ratings are now also permitted, though, just like testimonials and endorsements, they are subject to detailed disclosure and other presentation criteria.

The new marketing rule also overhauls how investment advisers can utilize social media. The SEC created concepts of “adoption” and “entanglement” with respect to posts on social media and, depending on whether an investment adviser has “adopted” a social media post or “entangled” itself in one, there are a series of rules applicable to each such post. More importantly, social media posts of persons associated with an investment adviser can also be viewed as the investment adviser’s communication or advertisement. Thus, investment advisers should adopt policies and procedures which distinguish their associated persons’ personal social media posts from those of the investment adviser.

Specific rules and guidance now apply to various types of performance advertising, including gross, net, hypothetical, related, and extractive performance. Many of these rules now codify prior SEC no-action letter guidance on these topics.

Investment advisers have some room to breathe since the compliance period for these new marketing rules begins on November 4, 2022.

SEC Brings Action for Defrauding Investors in Scheme Involving Pre-IPO Shares. On April 27, 2021, the SEC charged a former broker barred by FINRA with fraudulently raising funds. The complaint alleges that the defendant solicited investors by claiming to purchase shares of notable “unicorn” companies prior to their initial public offerings. However, the defendant failed to invest the funds and instead stole the money, using it to pay family members and purchase a Maserati. The defendant is charged with violating the antifraud provisions of Section 10(b) of the Securities and Exchange of 1934 and Rule 10b-5 thereunder and Section 17(a) of the Securities Act of 1933.

SEC Announces Partially Settled Charges After Investment Adviser Fails to Report Bad Investments. On April 15, 2021, the SEC filed a complaint against the co-founder and COO of an investment adviser for violating the anti-fraud provisions of the Securities Exchange Act of 1934 and the Securities Act of 1933. The SEC alleges the defendant defrauded hedge fund clients by creating fake “performing” loans to replace defaulted loans in order to hide losses. The SEC further alleges that the defendant created liquidity or met redemption requests by selling overvalued loans to new investors to pay off earlier investors. Collectively, the series of fraudulent acts hid tens of millions of losses. The SEC has already obtained final judgement against the investment adviser itself, requiring it to pay in excess of $35 million in prejudgement interest and disgorgement.

SEC Brings Action for Failure to Follow Stated Investment Criteria. In a recent enforcement action , the SEC has alleged that a Texas-based registered investment advisor (“RIA”) defrauded investors by failing to follow stated investment criteria. The complaint alleges that the principal along with its investment adviser representative (“IAR”) targeted older and unsophisticated investors with promises of high returns from secure investments in “proven” companies which met the firm’s stated investment criteria. However, the complaint goes on to allege that the firm only invested in high-risk and fraudulent companies which were affiliated with and owned by the firm’s principal and/or his older brother. The SEC alleges that this Texas-based RIA made materially false and misleading statements to investors about expected financial returns and the financial health of these companies. Moreover, the principal and his older brother allegedly falsified the financial documents of their companies to inflate their assets, misused funds for their own benefit, failed to make adequate disclosures of the conflicts of interests, failed to comply with rules governing the custody of client assets, and overall violated federal securities laws, including antifraud provisions. The SEC is seeking permanent injunctive relief, disgorgement of ill-gotten gains plus prejudgement interest, civil penalties, and any equitable and ancillary relief deemed necessary by the court.

SEC Obtains Asset Freeze After Uncovering Cherry-picking Scheme. On June 17, 2021, the SEC announced that it obtained an asset freeze and filed fraud charges in connection to a cherry-picking scheme where a Miami-based investment professional and two investment firms allegedly funneled trading profits to preferred accounts. The complaint alleges defendants engaged in a long-running fraudulent trade allocation scheme. Approximately $4.6 million in profitable trades were allocated to accounts held by relatives of the defendants while several other investment advisory clients bore first day losses totaling more than $5.5 million. This investigation originated in the Market Abuse Unit’s Analysis and Detection Center, which uses data analysis to detect suspicious activity such as impossibly successful trading. The SEC is currently seeking permanent injunctions, disgorgement, prejudgment interest, and civil penalties. It also intends to recover any unlawful gains and prejudgment interest from the preferred accounts.

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Digital Asset Matters

Update on BitMEX Lawsuit. On October 1, 2020, the Department of Justice filed a criminal complaint against specific individuals associated with BitMex for violating and conspiring to violate the Bank Secrecy Act. The CFTC also filed a civil complaint against BitMEX, alleging failure to register with the CFTC and violation of various laws and regulations under the Commodity Exchange Act. Both actions are pending in the U.S. District Court for the Southern District of New York. On February 10, 2021, the Department of Justice intervened in the CFTC case and sought a stay of discovery pending the criminal case’s resolution. On February 11, the CFTC submitted a letter not to oppose the DOJ’s stay. On March 24, United States District Judge Mary Kay Vyskocil granted the motion to permit the DOJ to intervene in the CFTC case for the purpose of seeking a stay of discovery, further noting that the DOJ is permitted to file a motion to stay discovery after the defendants have responded to the complaint. Both cases remain pending. These two lawsuits signal that the DOJ and the CFTC has and will continue to monitor the digital asset market.

SEC Files Action Against Ripple for Unregistered Securities Offering. In December 2020, the SEC filed an action against Ripple Labs Inc. (“Ripple”) and two of its executives in the U.S. District Court for the Southern District of New York, alleging that they raised over $1.3 billion through an unregistered, ongoing digital asset securities offering. The SEC’s case rests on the proposition that XRP is a security because investors who purchased XRP anticipated that profits would be dependent upon Ripple’s efforts to manage and develop the market for XRP. The case remains pending. The outcome of this lawsuit, although uncertain at this point, may have significant impact on the future regulation on cryptocurrencies and blockchain technologies.

South Korea to Introduce 20% Tax on Crypto Trading Profits. South Korea will implement a 20% capital gains tax on Bitcoin (BTC) and cryptocurrency profits starting January 1, 2022. The tax is expected to be triggered when profits exceed 2.5 million Won, with gain made up to this point being tax-exempt.

Yield Farming Strategies. As decentralized finance (“DeFi”) applications continue to develop, the interest in yield farming has grown exponentially. At a high level, the goal of yield farming is to maximize returns by leveraging various DeFi protocols, and this can be done in a few different ways. To employ a yield farming strategy, a liquidity provider essentially locks its digital assets in a liquidity pool (where users can lend, borrow, or exchange tokens), thus providing liquidity to that pool. In return, the liquidity provider receives an annual percentage return. Liquidity mining, a type of yield farming, provides liquidity providers with reward tokens on top of that annual return. Liquidity providers can then deposit reward tokens into other liquidity pools to earn more rewards and repeat this process countless times. To increase the potential return of an investment, yield farmers can also deposit tokens as collateral to a liquidity pool, then use the borrowed tokens as further collateral to then borrow more tokens, and so on. It is important to note that if a position becomes undercollateralized, there is a risk that the DeFi protocol may liquidate the collateral which could result in a total loss to the liquidity provider. While the potential of impressive returns is enticing, those interested in yield farming strategies should consider the many risks inherent in such strategies, including impermanent loss, price slippage, smart contract code bugs leading to hacks or fraud, “rug pulling” scams, as well as the risk of under collateralization, which can incidentally result from price movements of the borrowed token.

El Salvador Adopts Bitcoin Legal Tender. On June 8, 2021, the Salvadorian Congress approved new legislation, making it the first country to adopt Bitcoin as legal tender. “The purpose of this law is to regulate Bitcoin as unrestricted legal tender with liberating power, unlimited in any transaction, and to any title that public or private natural or legal person require carrying out,” the law reads. Under the new law, prices can be displayed in Bitcoin, taxes can be paid in Bitcoin, and transactions conducted using the digital currency will not be subject to a capital gains tax. The exchange rate with the U.S. Dollar (El Salvador’s current official currency) will be established by the market. The law also adds that the Salvadorian government will implement trainings and other mechanisms to ensure that its citizens can access Bitcoin transactions.

DeFi “Raises Challenges” for Investors, Regulators, SEC’s Gensler Says. In a written testimony before the House Appropriations Committee, SEC Chairman Gary Gensler discussed the challenges posed by decentralized finance. Examples of the challenges of DeFi given include market volatility and novel product offerings. Gensler’s concerns surrounding DeFi did not come as a surprise. In January, SEC Commissioner Hester Peirce offered the following quote: “It’s going to be challenging to us because most of the way we regulate is through intermediaries and when you really build something that’s decentralized, there’s no intermediary…. It’s great for resilience of a system but it’s much harder for us when we’re trying to go in and regulate to figure out how to do that”. Gensler has also previously suggested establishing a dedicated market regulator for cryptocurrency in order to provide protection against market manipulation and fraud. As DeFi continues to grow, it will be interesting to watch regulator’s approach to DeFi as it may have a large impact on the emerging space.

SEC Petitioned on NFTs as NFT Platform is Sued in Class Action. On April 12, 2021, a broker-dealer registered with the SEC and FINRA issued a petition to the SEC, calling for a concept release of regulations for nonfungible tokens (NFTs) and rules addressing when NFTs are considered securities. The petitioner notes that the existing definition of a security does not explicitly include NFTs, but NFTs that promise a “return on investment from the efforts of others”, could be deemed a security under the Howey test. The petitioner further clarifies that if an NFT “relates to an existing asset and is marketed as a collectible with a public assurance of authenticity on the blockchain, it should not be deemed a security.” To date, the SEC has not issued interpretive guidance on NFTs and has not initiated any enforcement actions against an NFT creator or NFT trading platform.

This petition arrives as Dapper Labs, the creator of the popular NFT marketplace NBA Top Shot, faces a class action lawsuit. The plaintiffs assert that NBA Top Shot’s “moments”, NFTs sold as collectable video highlights, are securities. These allegations center on the argument that moments increase in value as NBA Top Shot rises in popularity, therefore satisfying the Howey Test. The complaint also alleges that Dapper Labs has controlled the marketplace in way that prevents users from “cashing out” their purchases, keeping their value artificially high. It will be interesting to see how these issues are resolved by the SEC and the courts, as if NFTs are determined to be a security either by the SEC or the courts, NFT marketplaces and issuers may be forced to register with the SEC.

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CFTC Matters

Changes for Form CPO-PQR. Beginning with the March 31, 2021 reporting date, a revised and streamlined Form CPO-PQR will be used based on recent CFTC amendments. The revised Form CPO-PQR has been reduced to one schedule (Schedule A), and all reporting commodity pool operators (“CPOs”) will file the revised Form CPO-PQR every quarter, regardless of size. Technical updates have also been made, which make the form easier to fill out.

Default Judgment Entered Against Operator of Cryptocurrency Pool. On March 29, 2021, the U.S. District Court for the District of Nevada entered a default judgement against an Australian national and his Nevada corporation in connection with a cryptocurrency fraud and misappropriation scheme. The court concluded that the defendants made false claims about the individual’s trading acumen and baselessly guaranteed high rates of return in soliciting investors into a pool operated by the Nevada corporation. The pool engaged in off-exchange binary options trading on forex and cryptocurrency pairs; however, the defendants also stole participants’ funds and comingled assets in the individual’s personal cryptocurrency wallet. Additionally, the defendants effected a Ponzi scheme by paying investor redemptions with funds from other investors. Although the default judgment orders the defendants to pay restitution, disgorgement of profits and penalties totaling more than $32 million, the CFTC cautions investors that such order does not guarantee participants a full recovery.

CFTC Establishes Climate Risk Unit. In March, Acting CFTC Chairman Rostin Behnam announced the establishment of the Climate Risk Unit (“CRU”), which will assess the efficacy of derivatives products in addressing climate and weather-related risks in the financial system. Also, in an effort to reduce carbon emissions world-wide, the CRU will represent the CFTC in industry discussions in furtherance of this mission. The CRU also intends to, inter alia, facilitate dialogue regarding emerging climate risks, develop new products to help transition to a “net-zero” economy, support development of climate-related market risk data, and evaluate the utility of other tools (e.g., regulatory sandboxes) in accelerating such products and services.

NFA’s New Notice Requirements for CPOs Became Effective as of June 30, 2021. The NFA’s newly adopted Compliance Rule 2-50 requires CPOs to notify the NFA upon the occurrence of certain events such as a commodity pool’s ability to fulfill its obligations to investors or a potential unplanned liquidation of the pool. CPOs are now required to notify the NFA if they: (1) operate a pool that cannot meet a margin call, (2) operate a pool that cannot satisfy redemption requests in accordance with their subscription agreements, (3) operate a pool that has stopped redemptions unrelated to existing lockups or gates, and pre-planned cessation of operations or (4) receive notice from a swap counterparty that a pool operated by the CPO is in default. This rule applies to all pools operated by a CPO, including pools that meet the “de minimis” threshold pursuant to CFTC Regulation 4.13(a)(3). Generally, notice of a specified event must occur no later than 5:00 pm CT of the next business day; provided that, Interpretive Notice 9080 gives examples of when notice is not required (e.g., if a CPO reasonably expects to meet the margin call within the time prescribed by its FCM).

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Other Matters

Corporate Transparency Act Requires Disclosure of Ownership Information of Certain Entities. Overriding President Trump’s veto, Congress enacted the National Defense Authorization Act for Fiscal Year 2021 on January 1, 2021, which, among other things, includes the Corporate Transparency Act (the “CT Act”) requiring certain ‘reporting companies’ to report their beneficial ownership information to the Financial Crimes Enforcement Network (“FinCEN”). Today, the CT Act excludes from the definition of ‘reporting companies’ registered investment advisers, venture capital fund advisers that file Form ADV, and private investment funds advised by investment advisers and identified by name on such advisers Form ADV. However, investment advisers relying on the private fund exemption are not exempt from the CT Act and, absent changes in the regulations adopted by the U.S. Treasury, will be required to report their beneficial ownership information to FinCEN. The CT Act goes into effect on the date regulations are issued by the U.S. Treasury, which shall occur no later than January 1, 2022. FinCEN is currently soliciting public comment on questions about the new reporting requirements.

Executive Orders Prohibit the Purchase of Publicly Traded Communist Chinese Military Company Securities by U.S. Persons. President Trump signed Executive Order 13959 on November 12, 2020, and subsequently amended it with Executive Order 13974 on January 13, 2021, to prohibit the purchase of publicly traded Communist Chinese Military Company (“CCMC”) securities, including securities that are derivative of or designed to provide investment exposure to such CCMC securities. The orders prohibit the purchase by U.S. persons of any such securities beginning 60 days after an entity is designated as a CCMC, and require U.S. persons to divest from those securities within one year of such designation. Therefore, for the CCMCs initially designated on November 12, purchase of such securities was prohibited beginning January 11, 2021, and all U.S. persons must divest by November 11, 2021. While the Office of Foreign Asset Control has issued an FAQ clarifying the orders, neither the orders nor the FAQ provide clarity on whether U.S. persons must divest from foreign private funds that hold CCMC securities, and it remains to be seen if the new administration will seek to amend the order before divestment is required. A list of entities designated CCMCs as of June 16, 2021 can be found here.

New York Eliminates Pre-Offer Filing Requirements for Rule 506 Offerings under Regulation D. The New York Attorney General announced on December 1, 2020, an amendment to New York’s antiquated and controversial securities regulations applicable to offerings made under Rule 506 of Regulation D. The old rule required issuers to file a Form 99 prior to any sale or offering of such “covered securities” in the state. Beginning on December 2, 2020, the updated rule eliminated the Form 99 requirement and provided that notice filings shall be made within 15 days following the date of the first sale of applicable securities via the North American Association of Securities Administrators electronic filing depository system. The filing fee continues to be based on the offering amount and is unchanged from the fees required prior to the adoption of the new rule.

Registration of New York IARs. Starting February 1, 2021, IARs who engage in business within or from New York and principals or supervisors of New York-state registered investment advisers must register with the New York Investor Protection Bureau (the “NYIPB”) by filing a Form U4 or updating an existing Form U4, and must also meet certain exam requirements. IARs with a place of business in New York that represent SEC-registered investment advisers that notice-file in New York must also register with the NYIPB. The new regulations grant IARs operating in New York prior to February 1, 2021, a grace period to submit their Form U4 until August 31, 2021, and such IARs may continue such service without an approval until December 2, 2021.

Employers can Inquire about the Vaccination Status of Employees. On May 28, 2021, the U.S. Equal Employment Opportunity Commission (“EEOC”) updated its guidelines on the COVID-19 vaccine and Americans with Disabilities Act (“ADA”) compliance. The guidelines reaffirmed the EEOC’s previous position that employers can ask their employees whether or not they have received the COVID-19 vaccine but added that any vaccination status documentation must be kept confidential and stored separately from the employee’s personnel file. It is recommended for employers to only ask for the bare minimum, such as a vaccination card or survey response, to prevent employees from providing additional medical information and implicating the ADA. Additionally, employers can “encourage” employee vaccinations by providing information on approved vaccines, addressing common questions and concerns, or by offering incentives to employees who receive the vaccine. As of the date of publication, there are no examples of states passing laws conflicting with EEOC guidance, but this may change as companies continue to return to the office.

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Compliance Calendar

Please consult our Compliance Calendar for key dates as you plan your regulatory compliance timeline for the coming months and contact us with any questions for assistance with any of the above topics.

We wish you and yours a safe and healthy summer.

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

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Cole-Frieman & Mallon LLP is one of the top investment management law firms in the United States, known for providing top-tier, innovative, and collaborative legal solutions for complex financial services matters. Headquartered in San Francisco, Cole-Frieman & Mallon LLP services both start-up investment managers and 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.