July 20, 2023

Clients, Friends, and Associates:

As we end the second quarter and enter the summer season, we would like to highlight recent industry news that we found to be both interesting and impactful. While we try to summarize these topics at a 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 excited to announce that Cole-Frieman & Mallon LLP has added more expertise to its already stellar team. First, we welcome back Lilly Palmer as a Partner, whose extensive digital asset experience will benefit the firm and all its clients. We also welcome Bill Samuels to the firm, where he will lead a newly launched Intellectual Property practice with new Associate, Stavros Papadopoulos. Finally, we’re pleased to welcome Brett Bunnell as a Counsel and Thomas Gaffney as an Associate in our Corporate and Transactional practice group. We expect these additions to meaningfully contribute to our unwavering commitment to provide excellent legal services to all our clients. Please join us in welcoming them all to our firm.

Cole-Frieman & Mallon LLP, along with industry leaders MG Stover, Harneys, and KPMG, are premier sponsors of the CoinAlts Annual Fund Symposium on October 26, 2023, in San Francisco. Founded in 2017, this event brings together the digital asset community to address investment, legal, and operational issues relevant to private fund managers. The CoinAlts Annual Fund Symposium is a must-attend gathering for industry professionals, providing unparalleled insights and networking opportunities. Join us for expert panels, top-notch speakers, and the chance to stay ahead of the curve in this rapidly evolving industry. More information available at https://coinalts.xyz/.

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SEC Matters

SEC Enforcement Action Against Ripple. On July 13, 2023, the U.S. District Court of the Southern District of New York entered an order which granted in part and denied in part the cross-motions for summary judgment filed by the SEC and Ripple Labs, Inc. (“Ripple”). In December 2020, the SEC charged Ripple and two executives for engaging in unlawful offer and sales of securities in violation of the Exchange Act. The complaint alleged that since 2013, Ripple issued over 14.6 billion units of its native token, XRP, in exchange for consideration of over $1.38 billion without registering the offer and the sale of such token with the SEC. Notably, the July 2023 order stated that XRP “is not in and of itself a ‘contract, transaction[,] or scheme’ that embodies the Howey requirements of an investment contract”. In other words, XRP itself is not a security, and all the facts and circumstances surrounding specific transactions in XRP must be examined to determine whether an “investment contract,” as defined under the Howey test, was issued. As a reminder, the U.S. Supreme Court ruled in Howey that an investment contract requires a finding of an investment of money in a common enterprise with the reasonable expectation of profits derived from the efforts of others.

The District Court examined the sale and distribution of XRP in three types of transactions – direct sales of XRP to institutional investors, sales of XRP through crypto exchanges in blind bid/ask transactions, and distributions of XRP as payment for services to employees and service providers – and held that only the direct sales of XRP to institutional investors constituted an investment contract under the Howey test. While this order constitutes a significant win for Ripple, since it is a District Court order, it may not be the last word.

SEC Enforcement Action Against Coinbase. On June 6, 2023, the SEC charged Coinbase, Inc. and Coinbase Global, Inc. (collectively, “Coinbase”) for failure to register as an exchange, a broker-dealer and a clearing agency, and for failure to register the offering and sale of securities via the Coinbase trading platform in accordance with the Securities Exchange Act of 1934, as amended (the “Exchange Act”). This proceeding follows the Wells Notice that Coinbase received from the SEC in March 2023. The complaint alleges that Coinbase acted as an unregistered exchange, a broker-dealer, and a clearing agency by making available at least 13 crypto assets that are offered and sold as investment contracts on its platform. Additionally, the complaint alleges that Coinbase’s staking program should be considered an investment contract under the Howey test.

On June 28, 2023, Coinbase filed an answer to the SEC complaint denying that the digital assets listed on its platform constitute an investment contract or a security. Additionally, the answer noted that half of the tokens traded on Coinbase’s platform that the SEC alleged are securities were custodied and traded on its platform since April 2021 (i.e., when the SEC approved and declared Coinbase’s S-1 filing to be effective), and, at the time, the SEC did not identify such tokens as investment contracts or securities, nor allege that Coinbase was operating as an unregistered exchange, broker, and clearing agency within the meaning of federal securities law. Coinbase’s answer also denied the SEC’s allegation that its staking program is a security. In addition to filing the answer, Coinbase filed a letter to the court indicating its intention to file a motion to dismiss the complaint. Our firm will continue to closely monitor the situation with Coinbase for new developments.  

SEC Enforcement Action Against Bittrex and Bittrex’s Chapter 11 Bankruptcy. On April 17, 2023, the SEC charged Bittrex, Inc., Bittrex Global GmbH, and William Hiroaki Shihara, co-founder and former chief executive officer (collectively, “Bittrex”) for the failure to register as an exchange, a broker-dealer, and a clearing agency, pursuant to the Exchange Act.  

On March 31, 2023, Bittrex issued a statement that it began the process of winding down its U.S. operations.  Shortly after the SEC’s complaint, Bittrex ceased its operations in the U.S. and filed for Chapter 11 bankruptcy. On June 13, 2023, the U.S. Bankruptcy Court for the District of Delaware entered an order permitting Bittrex to allow its customers to access and withdraw crypto assets and fiat currency from Bittrex’s trading platform.

The Hinman Speech Documents. On June 13, 2023, the SEC internal communication documents related to William Hinman’s speech on digital asset transactions on June 14, 2018 were released to the public. The documents were made available to the public following an order entered by the U.S. District Court Southern District of New York denying the SEC’s motion to seal the SEC internal communication documents related to William Hinman’s 2018 speech in connection with its lawsuit against Ripple.

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CFTC Items

CFTC Enforcement Action Against Ooki DAO. On June 8, 2023, the U.S. District Court for the Northern District of California entered an order granting the CFTC’s motion for default judgment in its lawsuit against Ooki Dao (formerly bZx DAO), a decentralized autonomous organization and an unincorporated association comprised of holders of OokiDAO Tokens. For background, on September 22, 2022, the CFTC charged Ooki DAO for engaging in unlawful off-exchange leveraged and margined retail commodity transactions, engaging in activities performed by a registered futures commission merchant, and failing to implement appropriate Customer Information Program/KYC/AML procedures in violation of the Commodity Exchange Act of 1936, as amended (the “CEA”). The court granted the motion for default judgement in part due to neither Ooki Dao nor a representative of Ooki Dao appearing or participating in the action (the court previously held that the CFTC had properly served Ooki Dao when it provided notice of the action via the “Help Chat Box” and the discussion forum on Ooki Dao’s public website). In addition to granting default judgment against Ooki DAO on all accounts, the court also enjoined Ooki DAO from further violation of the CEA and ordered Ooki DAO to pay a civil penalty of $643,542. Importantly, Ooki DAO token holders bear some responsibility of the civil penalty, and the case underscores the need of fund managers to limit their investments in DAOs to those that have been legally wrapped and make such investments via special purpose vehicle in an attempt to achieve another layer of liability protection, as noted in our July 2022 Quarterly Update.

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Digital Asset Items

SEC and CFTC Enforcement Actions Against Binance. On June 5, 2023, the SEC charged Binance Holdings Limited, BAM Trading Services Inc., BAM Management US Holdings Inc., and Changpeng Zhao, founder and chief executive officer (collectively, “Binance”), for failure to register as an exchange, a broker-dealer, and a clearing agency, and failure to register the offering and sale of securities via the Binance trading platform in accordance with the Exchange Act. Notably, the complaint also charged Binance for making false representations about the presence of trading surveillance for the detection and prevention of manipulative trading and false statements with respect to the trading volumes on its platform to the public (the SEC did not include such allegations in its complaint against Coinbase).  
 
The SEC complaint was preceded by the CFTC’s complaint filed against Binance on March 27, 2023. The CFTC complaint included an allegation that despite Binance’s implementation of an IP address-based compliance control, such measure had not been effective in preventing U.S.-based customers from accessing and trading on the Binance platform. In fact, Binance’s financial reports reflect that U.S.-based customers contributed substantially to Binance’s revenues. The CFTC complaint also contains detailed and specific allegations regarding Binance’s reliance upon “prime brokers” to facilitate such U.S-based customers’ access to Binance. The prime brokers are alleged to have provided details to such U.S.-based customer to assist in their access to the exchange. Given the details of such allegations, digital asset fund managers should continue to assess how they are accessing digital asset exchanges.
 
Proposed Legislation – Digital Asset Market Structure Bill. Representatives Patrick McHenry (R-NC) and Glenn Thompson (R-PA) proposed the Digital Asset Market Structure Bill (the “Bill”) in a discussion draft reflecting a joint-committee effort to add clarity to the regulatory uncertainty surrounding digital assets in the U.S. The Bill included a proposal to delegate authority to the SEC and the CFTC to jointly issue rules for (i) the definition of a number of digital asset related terms, including blockchain, blockchain network, digital assets, etc., and (ii) rules to exempt the requirement to register with both the CFTC as a digital commodity exchange and the SEC as an alternative trading system to the extent such exemption would foster the development of digital assets for the benefit of the public interest and protection of investors. The Bill also proposed the establishment of a strategic hub for innovation and financial technology and a LabCFTC within the SEC and the CFTC, respectively, with the purpose of educating and advising the regulators on financial technology. Additionally, the Bill further proposed that the SEC and the CFTC form a joint committee on digital assets with the purpose of providing advice on rules, regulations, and policies relating to digital assets, as well as harmonizing policies between the SEC and the CFTC.

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Other Items

SEC Amendments to Form PF. On May 3, 2023, the SEC adopted certain amendments to Form PF, a regulatory filing requirement that mandates certain SEC registered investment advisers to report information to the Financial Stability Oversight Council (“FSOC”). Form PF was created in 2011 by Title IV of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, as amended (the “Dodd-Frank Act”).
      
The amendments included a number of changes to the existing Form PF. Specifically, the amendments introduced a new Section 5 to Form PF and required, upon an occurrence of a trigger event, large hedge fund advisers of qualifying hedge funds to file a current report as soon as practicable but no later than 72 hours after such event. Triggering events include extraordinary investment loss, a significant margin and default event, fund margin default or inability to meet margin call, and significant disruption or degradation of the reporting fund’s key operations. Additionally, Section 6 of Form PF has been amended to require private equity fund advisers to report certain trigger events within 60 days of the end of each fiscal quarter. Such trigger events include the execution of an adviser-led secondary transaction and the investor’s election for the removal of the general partner to the fund, termination of the fund’s investment period, or termination of the fund. Section 4 of Form PF also introduced a new annual reporting event to large advisers of private equity funds with respect to the implementation of a general partner or limited partner clawbacks.
 
The amendments to Form PF Sections 5 and 6 will become effective on December 11, 2023, with the remainder of the amendments to Form PF becoming effective on June 22, 2024.
 
Enforcement of California Privacy Rights Act. The California Consumer Privacy Act of 2018 (the “CCPA”), as amended by the California Privacy Rights Act of 2020 (the “CPRA”, and together with the CCPA, the “Act”), was scheduled to become fully enforceable by the California Privacy Protection Agency (the “CPPA”) on July 1, 2023; however, a recent California court case has delayed this enforcement date, at least in relation to some of the statute’s requirements. By way of background, the CPRA amended the CCPA to add additional consumer data protections and created the CPPA, a state agency empowered to not only enforce these requirements jointly with the Attorney General of California, but also to promulgate final regulations thereunder.  Incidentally, the CPRA required the regulations to be completed by July 1, 2022, and contemplated a one-year “pre-enforcement period” by providing that enforcement of the regulations, “[n]otwithstanding any other law, civil and administrative enforcement…shall not commence until July 1, 2023[.]”
 
Unfortunately, the CPPA failed to complete the regulations by July 1, 2022. On March 29, 2023, the CPPA issued final (but incomplete) regulations, relating to twelve of the fifteen topics contemplated by the CPRA.  Currently, there are still no regulations concerning three key elements of the CPRA – cybersecurity audits, risk assessments, and automated decision-making technology.

The California Chamber of Commerce sued the CPPA, seeking to delay the enforcement of the Act, arguing that since the regulations were only finalized on March 29, 2023, an enforcement date of July 1, 2023 would violate the one-year pre-enforcement period required by the CPRA’s express language. On June 30, 2023, the Sacramento County Superior Court held that the CPPA cannot enforce any of the regulations of the Act before one year has passed from the date any such regulation has been finalized by the CPPA.
 
As the saga of California’s privacy statute continues to play out, businesses subject to the Act should resist the urge to fall into a false sense of security that compliance with the Act is neither imminent nor important.  The Act requires fundamental privacy controls that must be imbued into an organization on numerous planes — culturally, operationally, and technologically – simultaneously. CFM will continue to monitor this situation and advise our clients accordingly.

Establishment of an Ethical Artificial Intelligence Framework for Investment Advisors. On April 6, 2023, the SEC Investor Advisory Committee (the “IAC”) wrote an open letter to SEC Chair Gary Gensler outlining its views on implementing an ethical artificial intelligence (“AI”) framework for investment advisers and financial institutions. The letter referenced the use of algorithmic models and code by investment advisory firms and warned that the use of AI in other industries has highlighted important risks such as harmful algorithmic biases.
             
The letter encouraged the SEC and its staff to consider the following key tenets in developing guidance to investment advisers on the ethical use of AI:

• Equity – understanding of the contextual, historical, and structural problems of the underlying data selected for input, including seeking consultation of experts.
• Consistent and Persistent Testing – consistent testing of algorithms for performance during pre and post implementation stage.
• Governance and Oversight – incorporation of a comprehensive risk management and compliance policy. 

The letter concluded with additional proposals to the SEC for consideration in developing its best practices guidance on ethical use of AI, including the hiring of staffs with experience in AI and machine learning, the reviewing of AI-related frameworks developed by other regulators such the Federal Trade Commission and the National Institute of Standards of Technology, and tasking the Division of Examinations to monitor the compliance on ethical use of AI.

User Fees and Third-Party Examination of SEC Registered Investment Adviser. On June 5, 2023, the IAC drafted a list of recommendations on oversight of SEC registered investment advisers (“RIAs”) to be discussed at the IAC meeting on June 22, 2023. The draft included two recommendations. First, the imposition of “user fees” on SEC RIAs to fund the SEC’s investment adviser examination program and to achieve an acceptable frequency of examination of SEC RIAs once every four to five years. Second, the adoption of a rule requiring SEC RIAs to undergo examination conducted by an outside firm, with a copy of the exam results submitted to the SEC. 

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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, 2023

• Form 13H Filing for Changes. Filing is for calendar quarter that ended June 30, 2023 and should be submitted within 10 days of quarter end.

July 14, 2023

• Form PF Quarterly Filing for Large Liquidity Fund Advisers. Filing is for the calendar quarter that ended June 30, 2023.

July 31, 2023

• ERISA Schedule C of DOL Form 5500 Disclosure.

August 14, 2023

• Form 13F Quarterly Filing. Filing is for calendar quarter that ended June 30, 2023 and should be submitted within 45 days of quarter end.
• CTA Form PR. Filing is for calendar quarter that ended June 30, 2023 and should be submitted within 45 days of quarter end.

August 29, 2023

• Form PF for Large Hedge Fund Advisers. Filing is for calendar quarter that ended June 30, 2023.
• CPO-PQR Form. Filing is for calendar quarter that ended June 30, 2023 and should be submitted within 60 days of quarter end.

Periodic

• Form D and Blue Sky Filings should be current.
• CPO/CTA Annual Questionnaires must be submitted annually, and promptly upon material information changes, through the NFA Annual Questionnaire system.

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, Lilly Palmer, David Rothschild, Scott Kitchens, Tony Wise, Alex Yastremski, Garret Filler, John T. Araneo, Frank J. Martin, and Bill Samuels 

Cole-Frieman & Mallon LLP is a leading investment management law firm known for providing top-tier, innovative, and collaborative legal solutions for complex financial services matters. Headquartered in San Francisco, Cole-Frieman & Mallon LLP services both start-up investment managers and multibillion-dollar funds. The firm provides a full suite of legal services to the investment management community, including fund formation (hedge, VC, PE, real estate), investment adviser and CPO registration, counterparty documentation (digital and traditional prime brokerage, ISDA, repo, and vendor agreements), SEC, CFTC, NFA and FINRA matters (inquiries, exams, and compliance issues), seed deals, cybersecurity regulatory matters, full-service intellectual property counsel, manager due diligence, employment and compensation matters, and routine business matters. The firm also publishes the prominent Hedge Fund Law Blog. For more information, please add us on LinkedIn, follow us on Twitter, and visit us at colefrieman.com.

Mark your calendar! CoinAlts presents the annual Fund Symposium on October 26, 2023, in San Francisco. Founded in 2017, this premier event brings together the digital asset community to address investment, legal, and operational issues specifically relevant to private fund managers. Premier sponsor industry leaders Cole-Frieman & Mallon LLP, MG Stover LLC, Harneys, and KPMG are dedicated to supporting fund managers in the digital asset space.

The Fund Symposium is a must-attend gathering for industry professionals, providing unparalleled insights and networking opportunities. Join us for expert panels, top-notch speakers, and the chance to stay ahead of the curve in this rapidly evolving industry. Registration is now open on the CoinAlts Fund Symposium website: https://coinalts.xyz/event/coinalts-2023/#tribe-tickets. #CoinAlts2023

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About the CoinAlts Fund Symposium

The CoinAlts Fund Symposium is organized by four firms with practices significantly devoted to fund managers in the cryptocurrency and digital asset space. Cole-Frieman & Mallon LLP is a leading investment management law firm known for providing top-tier, innovative, and collaborative legal solutions for complex financial service matters. MG Stover & Co. is a full-service fund administration firm built by former auditors and fund operators to deliver world-class solutions to the global alternative investment industry. Harneys is a leading international offshore law firm that acts for both issuers of digital assets and investment funds that invest in them. KPMG is a global leader in professional services that specializes in providing comprehensive advisory and consulting services to fund managers in the cryptocurrency and digital asset industry.

April 20, 2023

Clients, Friends, and Associates:

As we end the first quarter and enter the spring season, we would like to highlight some of the recent industry updates and occurrences we found to be both interesting and impactful. While we try to keep these topics at a 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 John T. Araneo to our firm as Partner to lead our Cybersecurity Law practice. We’d also like to highlight the promotion of Frank J. Martin to Partner and Firm General Counsel. Additionally, we have hired Marcia Delgadillo as Director of Marketing & Business Development to manage our firm’s marketing and business development activities. Please join us in welcoming them all to our firm.

Cole-Frieman & Mallon is hosting a panel discussion on “Navigating the SEC Marketing Rule: Practical Considerations for Fund Managers,” on May 4th in San Francisco. CFM Partner David Rothschild and Senior Associate Malhar Oza will be joined by Managing Director Michael Fitzgerald of TD Cowen and Chief Executive Officer Fizza Khan of Silver Regulatory Associates LLC for a lively discussion. For details, contact [email protected].

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SEC Matters

SEC Charges Staking-as-a-Service Provider. On February 9, 2023, the Security and Exchange Commission (“SEC”) charged Payward Ventures, Inc. and Payward Trading Ltd. (“Kraken”) with failing to register the offer and sale of their crypto asset staking-as-a-service program. In operation since 2019, Kraken’s program allowed public investors to transfer crypto related assets to Kraken for staking in exchange for annual investment returns advertised by Kraken to be as high as 21%. Kraken’s model depended on pooling the assets transferred by investors and staking them on behalf of those investors. The SEC’s complaint alleges that the program produced benefits derived from Kraken’s effort on behalf of investors and that the program should be considered an investment contract subject to registration, disclosure, and safeguard protections required by securities laws. As a result of the charge, Kraken has agreed to cease offering or selling securities through crypto asset staking services and pay $30 million in settlement fees. Although the SEC’s complaint did not allege that staking necessarily always constitutes a security offering, it was determined that this service offered by Kraken did meet the 4-prong test to be considered an investment contract. This signals that the SEC may be increasingly more aggressive at regulating crypto under existing rules and regulations, and managers should consider whether staking services offered by third parties would fit into the Kraken fact pattern.

The SEC’s New Proposed Rule Regarding Safeguarding Advisory Client Assets. In February, the SEC announced a proposed rule to amend the existing “custody rule” applicable to SEC registered investment advisers (“RIAs”) that have custody of client assets. The proposed rule, redesignated as the “safeguarding rule,” imposes potentially significant new requirements on RIAs, including RIAs operating in the digital asset space.

The Existing Custody Rule. As background, the existing custody rule requires any RIA that has custody of client assets to keep “client funds and securities” with a “qualified custodian” at all times. To-date practitioners have debated the extent to which digital assets are captured in the definition of “client funds and securities” and thus whether these requirements apply to RIAs with custody of clients’ digital assets. A qualified custodian generally is a federal or state-chartered bank or savings association, certain trust companies, a registered broker-dealer, a registered futures commission merchant, or certain foreign financial institutions.

Key Elements of the Proposed Safeguarding Rule. The proposed safeguarding rule would make several important changes to the custody rule. Most importantly to digital asset managers, it would expand the existing custody requirements to cover all “client assets” over which an RIA has custody, explicitly including digital assets. It would also require RIAs to enter into written agreements with qualified custodians to ensure basic custodial protections are in place, including requiring a qualified custodian to obtain written internal control reports that include an opinion of an independent public accountant regarding the adequacy of the qualified custodian’s controls. The proposed safeguarding rule would provide a transition period of one year for large advisers and 18 months for smaller advisers to comply with the new rule.

Potential Implications for Crypto RIAs. If implemented as drafted, the proposed safeguarding rule would require RIAs who operate in the digital asset space to custody their digital assets with qualified custodians at all times – no exceptions. While qualified custodians exist today that can custody certain digital assets, there are no qualified custodians that can custody all digital assets. Moreover, when a crypto RIA wants to trade digital assets on an exchange, the crypto RIA would have to move digital assets out of a qualified custodian and on to the crypto exchange. There are currently no crypto exchanges that are qualified custodians, so it may be impossible for crypto RIAs to comply with the proposed safeguarding rule at all times. If adopted as proposed, RIAs could find it much harder to operate in the digital asset space.

Next Steps. We encourage our clients to review the proposed rule and consider submitting comments to the SEC highlighting potential issues and ways to improve the proposed rule. Comments should be received on or before May 8, 2023. Electronic comments may be submitted via the SEC’s internet comment form or by sending an email to [email protected]. Commenters should include File Number S7-04-23 on the subject line if submitting by email. After the May 8, 2023, comment deadline, the staff of the SEC will review the comments and potentially revise the proposed rule. The proposed rule, and any revisions to it, would only become effective after the SEC commissioners vote to approve it as a final rule.

The SEC’s Proposed Cyber Risk Management Rule for Investment Advisers. Last February, the SEC released a proposed rule that portends to create an entirely new cybersecurity compliance regime for investment advisers and certain funds. This new set of cybersecurity risk management rules (the “Cyber Risk Management Rule”) will be codified by amendments to both the Investment Advisers Act and the Investment Company Act. As drafted, the Cyber Risk Management Rule has four (4) cornerstone components: (i) policies and procedures; (ii) a new regulatory reporting regime (including a 48-hour notification period for alerting the SEC of a cybersecurity breach); (iii) cybersecurity disclosure obligations; and (iv) recordkeeping requirements. The Cyber Risk Management Rule was set for a final vote this month, however on March 15, 2023 the SEC unexpectedly reopened its comment period for an additional sixty (60) days, while simultaneously issuing three (3) additional cybersecurity related rule proposals, each with some connective tissue with the Cyber Risk Management Rule.

Cybersecurity continues to be a top priority at the SEC and it has made clear that a new, more mature and comprehensive cybersecurity compliance regime is imminent. Advisers and funds who may mistakenly kick the cybersecurity can down the road in 2023 will likely do so at their peril, primarily for two reasons. First, the SEC still requires registrants to comply with its current cybersecurity requirements, to wit, conducting annual assessments and implementing reasonable policies, procedures, and controls across the core seven (7) elements that constitute a model cybersecurity program (governance and periodic assessments; access rights and controls; data loss prevention; mobile security; incident response; vendor management; and training and awareness (collectively, the “Cyber 7”)). Second, the new regime, via proposed rule 206(4)-9 of the Investment Advisers Act, will actually make it unlawful for a registered adviser to provide investment advice to clients if it fails to adopt and implement these policies and procedures and conduct these periodic assessments. This rule alone is a clear, direct statutory line in the sand that adds one more arrow in the quiver of the SEC’s ample Cyber Unit, which continues to actively pursue penalties against those registrants that fail to meet these threshold requirements.

Fortunately, since the new Cyber Risk Management Rule takes a cumulative approach in setting these new cyber standards, virtually all the advancements asset managers have made in complying with the current Cyber 7 since 2015 will be relevant and accretive to the new requirements. Cybersecurity is indeed a process, as opposed to a project. Demonstrating continued engagement and reasonable progress is the key to cracking the code on cybersecurity compliance, at least in terms of meeting regulatory requirements and the ODD expectations of institutional investors. And thus, advisers need to act now in either creating or sufficiently maintaining an appropriately scaled model cybersecurity set of policies, procedures and controls (a “Cybersecurity Program”). The Firm’s Cybersecurity Law Practice Group is available to assist our clients with any questions or concerns regarding virtually any aspect of cybersecurity compliance.

SEC and NYDFS Commence Actions Against Paxos. The New York Department of Financial Services (“NYDFS”) recently ordered Paxos Trust Company (“Paxos”) to cease minting Paxos-issued BUSD, a fiat-backed stablecoin issued by Binance and Paxos. Each BUSD token is backed 1:1 with US dollars held in reserve. On February 13, 2023, Paxos notified customers of its intent to end its relationship with Binance as a result of the order.

In conjunction with the order from the NYDFS, Paxos reports that it received a Wells notice from the SEC on February 3, 2023. According to a press release from Paxos, the Wells notice states the SEC is considering enforcement action against Paxos alleging that BUSD is an unregistered security. The actions by the NYDFS and SEC could have important implications for stablecoins since it appears that regulators are taking the stance that fiat-backed stablecoins could be securities even though they are intended to function as currency and there would not be an expectation of profit simply by owning them. Moreover, the NYDFS order and SEC Wells notice only appear to target BUSD, while Paxos separately issues a second fiat-backed stablecoin called USDP. It is unclear why USDP appears to be spared so we await further action by regulators and will monitor this situation.

SEC Files Wells Notice Against Coinbase. Coinbase Global Inc. (“Coinbase”) also recently received a Wells notice from the SEC, targeting Coinbase’s staking service Coinbase Earn, Coinbase Prime, and Coinbase Wallet. The Wells notice stems from an SEC investigation conducted into Coinbase in the summer of 2022. Our firm will continue to closely monitor the situation with Coinbase for new developments.

SEC Releases a “Frequently Asked Questions” Page for the Marketing Rule. In January, the SEC released a FAQ page for questions stemming from its recently enacted rule 206(4)-1 under the Investment Advisers Act of 1940 (the “Marketing Rule.”) The page currently provides responses to three commonly asked questions—most notably regarding its gross and net performance rules—clarifying that when an RIA displays the gross performance of one investment or a group of investments from a private fund, the RIA must show the net performance of the single investment and/or the group of investments, respectively. The SEC noted that they will be updating this page periodically to respond to questions related to the Marketing Rule, and clients should reach out with any specific questions relating to the new Marketing Rule. Our firm will be hosting an event on May 4th to be a discussion of the practical considerations for fund managers under the recently reviewed marking rule, and hope that you all will join us.

Judge Rules that Emojis in a Tweet may Constitute “Financial Advice.” A United States District Court judge recently ruled that the use of emojis can be construed in certain circumstances to meet a factor in the legal test to determine whether an individual is providing financial advice. Specifically, the judge denied the defendant’s Motion to Dismiss, finding that the defendant-company’s use of a rocket ship, stock chart, and money bag emojis in a recent tweet “objectively meant one thing: a financial return on investment.” The emojis were displayed alongside statements touting recent NFT purchase prices on the company’s website, presumably indicating future gains on such NFTs. While the decision specifically rules on the three emojis mentioned above, we advise our clients to use caution in their use of any emojis, whether that be in public or private communications regarding fund matters. In any event, any communications should not be misleading and in accordance with the advisers act and the new marketing rule (if applicable).

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Digital Asset Matters

Liability Issues and Third-Party Engagement in DAOs. As the formation of and investment in Decentralized Autonomous Organizations (“DAOs”) continue to garner attention within the investment community, it is important for DAO participants to continue to analyze how they participate. First, as noted in our July 2022 Quarterly Update, managers should consider only participating or investing in DAOs that are wrapped in a liability blocking entity in order to reduce the risk of personal liability. Second, as an added measure of liability protection, managers should consider participating or investing through special purpose vehicles specific to such activity (e.g., a fund making two DAO investments could segregate each investment through separate, wholly-owned subsidiaries). Third, managers should consider only participating or investing in DAOs that have engaged reputable third-party service providers such as administrators, accountants, tax counsel and, in the case of foreign foundations, independent directors. The use of such independent third-party service providers may help ensure proper functioning and allocation of resources of the DAO, thereby helping to protect its participants.

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Other Items

The Ninth Circuit Blocks California’s Ban on Mandatory Arbitration Agreements. On February 15, 2023, a three-judge panel for the Ninth Circuit Court of Appeals struck down a California bill which would have prevented employers from requiring employees to sign arbitration agreements as a condition of employment. The court held that California Assembly Bill 51 is preempted by the Federal Arbitration Act, which “embodies a national policy favoring arbitration.” After years of uncertainty surrounding the issue, the decision solidifies that employers in California can continue to include mandatory arbitration provisions in their employment agreements.

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Compliance Calendar

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

April 7, 2023

• Form N-MFP Filing for Monthly Schedule of Portfolio Holdings of Money Market Funds, if applicable.

April 10, 2023

• Form 13H Quarterly Filing for Changes. Filing is for calendar quarter that ended March 31, 2023 and should be submitted within 10 days of quarter end. 
• Form 13G Monthly Filing for Applicable Reporting Persons. Filing is for month end of March 31, 2023, and should be submitted within 10 days of month end. 

April 15, 2023

• Form PF Quarterly Filing for Large Liquidity Fund Advisers. Filing is for calendar quarter that ended March 31, 2023.

April 30, 2023

• Form ADV Part 2A Delivery to Existing Clients. 
• Audited Financials Distribution to Private Fund Investors (excluding Fund of Funds).
• Form PF Annual Filing. Filing is for fiscal year end December 31, 2022 and should be submitted within 120 days of fiscal year end. 

May 10, 2023

• Form 13G Monthly Filing for Applicable Reporting Persons. Filing is for month end of April 31, 2023, and should be submitted within 10 days of month end. 

May 15, 2023

• Form 13F Quarterly Filing for Changes. Filing is for Calendar Quarter that ended March 31, 2023 and should generally be submitted within 45 days of quarter end.
• Form CTA-PR Filing with the NFA, which can be filed through NFA’s EasyFile.

May 30, 2023

• Form CPO-PQR Filing with the NFA, which can be filed through NFA’s EasyFile.
• Form PF Quarterly Filing for Large Hedge Fund Traders and Large Liquidity Fund Advisers, if applicable.
• Form N-PORT Filing Monthly Schedule of Portfolio Holdings of Funds other than Money Markey Funds and SBICs, if applicable. 

 June 7, 2023

• Form N-MFP Filing for Monthly Schedule of Portfolio Holdings of Money Market Funds, if applicable. 

June 10, 2023

• Form 13G Monthly Filing for Applicable Reporting Persons. Filing is for month end of May 31, 2023, and should be submitted within 10 days of month end. 
• Audited Financials Distribution to Fund of Funds Investors. 

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, Lilly Palmer, David Rothschild, Scott Kitchens, Tony Wise, Alex Yastremski, Garret Filler, Frank J. Martin, and John T. Araneo

Cole-Frieman & Mallon LLP is a leading investment management law firm known for providing top-tier, innovative, and collaborative legal solutions for complex financial services matters. Headquartered in San Francisco, Cole-Frieman & Mallon LLP services both start-up investment managers and multibillion-dollar funds. The firm provides a full suite of legal services to the investment management community, including fund formation (hedge, VC, PE, real estate), investment adviser and CPO registration, counterparty documentation (digital and traditional prime brokerage, ISDA, repo, and vendor agreements), SEC, CFTC, NFA and FINRA matters (inquiries, exams, and compliance issues), seed deals, cybersecurity regulatory matters, full-service intellectual property counsel, manager due diligence, employment and compensation matters, and routine business matters. The firm also publishes the prominent Hedge Fund Law Blog. For more information, please add us on LinkedIn, follow us on Twitter, and visit us at colefrieman.com.

TRANSITIONS MATTER.

Done well, they are the first step in a new and exciting chapter for senior investment management professionals. Gone wrong, they can lead to years of acrimonious litigation and missed professional opportunities. When senior investment management employees or partners leave their current firms to join another or start their own, navigating this critical moment requires a deep understanding of the legal and contractual basis of their current arrangements, an honest understanding of the relationship between the principal and their current firm, and a clear set of objectives.

At Cole-Frieman & Mallon (“CFM”), our Principals in Transition practice focuses on the Three Ps – Protecting the departing principal’s economics, Preventing limitations on future professional endeavors, and Preserving the relationship with the principal’s current firm. Protect, Prevent, Preserve. We are industry experts, not employment law litigators, and our ecosystem expertise is both our strategic advantage in these negotiations and an important message to the principal’s current organization that preservation of the relationship is important. We come to facilitate a smooth and fair transition, not to write demand letters or instigate litigation. We achieve this by: 1) bringing our fund expertise when analyzing current partnership agreements, 2) our knowledge of California’s and other jurisdictions’ public policy against non-competition including overreaching non-solicit clauses and overly broad confidentiality restrictions that courts have ruled operate as non-competes, and 3) an understanding that while the investment management ecosystem is global in nature, it is a small community and relationships (among managers, allocators, and LPs) matter.

All of this is done without limiting the principal’s ability to escalate if necessary. There is a time and place for litigation, and when it becomes clear that the best route for our client is litigation, transitioning from the Three Ps approach to another tactic with litigation counsel is seamless.

Protect your economics. Partnership agreements and carried interest grant agreements are complex documents with many hidden (and not so hidden) powers vested in the controlling parties. Understanding how investment funds and the economics of investment funds work is our specialty.

Prevent limitations on future professional endeavors. Few people leave investment managers intending to leave the industry. Most, in fact, are leaving to start their own venture or join another investment manager doing substantially similar work. The key to these negotiations is to ensure that whatever limitations are connected to future economic benefits from the principal’s previous organization are narrowly tailored. Central to this is understanding the principal’s statutory and common law rights in California and other jurisdictions that have a public policy against non-competition agreements. In furtherance of this public policy, California and other state courts have become increasingly hostile to non-solicit and overly broad confidentiality agreements that operate to restrain a person’s ability to work.

Preserve your relationship. CFM’s approach is designed to preserve the relationship with the principal’s current investment manager. The elements necessary to achieve this are: 1) being reasonable in the principal’s requests on economics and limitations, 2) approaching the negotiations collaboratively, 3) having a clear understanding of the other side’s objectives and finding ways to get them what they need from the transition, and 4) being thoughtful in whom you hire to handle this transition. Because CFM is embedded in the investment management ecosystem, hiring our firm in these matters signals the principal’s desire to “get the numbers right,” to ensure that the principal has the freedom they need to start their next endeavor, and perhaps most importantly that this will all be achieved in a collaborative way.

Authored by Frank J. Martin, Partner & General Counsel at Cole-Frieman & Mallon LLP