Category Archives: Business Issues

Reg BI Webinar Overview

We recently announced a Regulation BI webinar that was held in late May. Below is the summary of that webinar from Justin Schleifer of Aspect Advisors. Please reach out to us or Aspect Advisors if you’d like more information on Reg BI or the webinar.

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Thank you – Reg BI webinar overview

Thank you for attending our Regulation Best Interest (Reg BI) webinar last week.  I would also like to extend many thanks to my fellow panelists, James Dombach and Paul Merolla from the law firm Murphy & McGonigle, and to Bart Mallon of Cole-Frieman & Mallon for hosting.  The webinar provided an overview of Reg BI obligations, defined key terms, reviewed the SEC’s OCIE guidance regarding regulatory expectations, and provided practical suggestions for implementation by broker-dealers (BDs) and registered investment advisers (RIAs) for the June 30 deadline for compliance. 

Here are the key take-aways about Reg BI:

  • When making a recommendation of any securities transaction or investment strategy to a retail customer (as defined), BDs must act in the best interest of the retail customer at the time the recommendation is made.
  • 4 components of obligation:
    • Disclosure:  effective Form CRS content and delivery for BDs and RIAs;
    • Care:  sufficiently understanding the product and the customer;
    • Conflicts of Interest:  review, mitigation/elimination, and disclosure; and
    • Compliance:  effective controls and best practices.
  • SEC Office of Compliance Inspections and Examinations (“OCIE”) expectations include:
    1. Assessment:  Has the Firm sufficiently analyzed and documented its business practices, its registered representatives, and its products to make necessary disclosures?
    2. Implementation: BDs and RIAs are required to provide a brief relationship summary (Form CRS) including appropriate disclosures to both new and existing retail investors.
    3. Documentation:  Firms must have policies and procedures that assess potential risks, rewards, and costs of recommendations in light of a retail customer’s investment profile; how the 4 components of obligation will be met; and the process for Form CRS delivery.

If you (or your colleagues) would like to review any of the webinar content, please email Amanda Brown for a link to the recording.  If you have any questions about Reg BI or need advice about how to implement at your firm, please reach out to any of our panelists.

We hope you enjoyed this event and if you have any feedback, we would love to hear from you.  We look forward to seeing you at our next event!

Best regards,

Justin Schleifer

President of Aspect Advisors

Aspect Advisors

Aspect Advisors is a regulatory compliance consulting firm that provides customized compliance solutions for complex challenges. Our clients are financial service innovators, including fintech companies, registered investment advisers (RIAs), broker-dealers and private fund managers. Our back-office services include regulatory registrations and filings, compliance policies and procedures, conducting annual reviews, outsourced Chief Compliance Officer/FinOP support, and other bespoke items.

Murphy & McGonigle

Murphy & McGonigle is a law firm that serves the litigation, enforcement defense, and regulatory needs of clients across the full spectrum of the financial services industry – from national banks, broker-dealers, investment advisers, and hedge funds, to national and international securities markets and exchanges.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon is a boutique law firm focused on providing institutional quality legal services to the investment management industry. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.

Cole-Frieman & Mallon 2020 Q1 Update

April 16, 2020

Clients, Friends, Associates:

The first quarter of 2020 saw an unprecedented combination of challenges, not only industry-wide but on a global scale as well. Notwithstanding the prevailing circumstances, the first quarter was busy for investment managers and service providers with filing deadlines, regulatory changes, and compliance updates. As we continue through 2020, we have put together this update and checklist to help managers stay on top of the business and regulatory landscape in consideration of the global pandemic affecting nearly every aspect of the industry and our lives. 

Please note COVID-19 related matters appear at the end of this update.

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SEC Matters

SEC Releases 2020 Examination Priorities. The SEC Office of Compliance Inspections and Examinations (“OCIE”), which conducts examinations of SEC-registered investment advisers, investment companies, broker-dealers, and others, publishes an annual list of examination priorities for the upcoming year that provides insight to managers regarding issues that will be examined and an opportunity for advisers to prepare and improve such areas before examination.OCIE’s 2020 exam priorities are as follows: Retail Investors (including seniors and those saving for retirement); Market Infrastructure; Information Security; Focus Areas Relating to Investments Advisers, Investment Companies, Broker-Dealers, and Municipal Advisors; Anti-Money Laundering Programs; Financial Technology and Innovation (including Digital Assets and Electronic Investment Advice); and oversight of the Financial Industry Regulatory Authority (FINRA) and Municipal Securities Rulemaking Board (MSRB). In particular, Information Security and Cybersecurity were focuses of the publication. OCIE released observations that focus on certain approaches taken by market participants in regards to governance and risk management, access rights and controls, data loss prevention, mobile security, incident response and resiliency, vendor management, and training and awareness. 

SEC Division of Trading and Markets Releases FAQ on Regulation Best Interest (Reg BI). Reg BI establishes a “best interest” standard for broker-dealers and associated persons when making recommendations to retail customers involving securities. Since adopting Reg BI on June 5, 2019, the SEC has released responses to frequently asked questions about the regulation, covering topics surrounding Retail Customers, Recommendations, Disclosure Obligations, Care Obligations, Conflict of Interest Obligations, and Compliance Obligations. It should be noted that like all staff guidance, the FAQ does not have legal force or effect, but represents the views of the staff of the Division of Trading and Markets. Reg BI was met with much skepticism as critics found the new regulation ambiguous in many regards. Hopefully the SEC’s guidance will be the first step in addressing this perceived ambiguity. Firms are expected to comply with Reg BI by June 30, 2020.

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FINRA Matters

Amendments to the FINRA New Issue Rule (Rule 5130) and Anti-Spinning Rule (Rule 5131) Became Effective as of January 1, 2020. Generally, the amendments to the FINRA New Issue Rules broaden the types of investors that are exempt from the rules’ restrictions and narrow the types of the securities offerings that are subject to the New Issue Rules. As a result of the amendment, among other things, FINRA member broker-dealers may now sell new issues to additional kinds of investors directly or through investments in private investment funds. Amendment to Rules 5130 and 5131 includes expanding the ways that foreign investment companies can fall within the general exemption, broadening the definition of family investment vehicles, including foreign employee retirement benefits plans under the exemption, excluding sovereign entities from the definition of “Restricted Persons,” and other changes. 

FINRA Releases 2020 Risk Monitoring and Examination Priorities Letter. The 2020 Risk Monitoring and Examination Priorities Letter outlines the priorities for FINRA’s risk monitoring, surveillance, and examination programs for the year. The letter includes a list of practical considerations and questions for firms to use as guidance in evaluating their compliance, supervisory, and risk management program. Among the new or emerging areas in the industry, FINRA discusses compliance with obligations relating to Regulation BI, Form CRS, communications with the public, communications via digital channels, sales of initial public offering (IPO) shares, digital assets, cybersecurity, and other items.  

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Digital Asset Matters

SEC Commissioner Proposes 3-Year Safe Harbor Period for Crypto Token Sales. As mentioned in Commissioner Peirce’s speech, cryptocurrency and digital asset entrepreneurs are faced with a regulatory Catch 22. In order to build a decentralized network in which a token provides access to a function of the network or serves as a means of exchange, a crypto project needs to get its tokens into the hands of users. However, such would-be networks generally cannot freely distribute their tokens to potential users due to existing federal and/or state securities laws. Consequently, these would-be networks cannot mature into functional decentralized networks that are not dependent upon single persons or groups to carry out the essential managerial or entrepreneurial efforts (under the Howey Test). To address this uncertainty, Commissioner Peirce formally proposed a safe harbor for token projects, allowing a three-year time window for networks to mature and become sufficiently decentralized so as not to fall under the “securities” definition contemplated under the Howey Test. If adopted, the safe harbor would impose strict requirements on such crypto projects, including source code disclosures, transaction history disclosures, personal disclosures, public notices and filings, and other conditions. Additionally, the safe harbor would be available for tokens that were previously sold in a registered offering or pursuant to a valid exemption under the Securities Act of 1933, as amended. 

SEC Wins Injunction against Telegram in Landmark Digital Assets Case.  On March 24, U.S. District Judge Kevin Castel of the Southern District Court of New York issued an injunction against Telegram Group Inc. (“Telegram”), the messaging app company that raised $1.7 billion in 2018 selling Gram tokens to investors in the largest ICO to date. In October 2019, the SEC sought to enjoin Telegram from distributing the Gram tokens on the grounds that the company had violated federal law for the sale of unregistered securities. The SEC was granted the preliminary injunction, preventing Telegram from distributing the Gram tokens to investors. The Court stated it “finds that the delivery of Grams to the Initial Purchasers, who would resell them into the public market, represents a near certain risk of a future harm, namely the completion of a public distribution of a security without a registration statement.” Despite the ruling, it has been reported that the Telegram Open Network (TON) Community Foundation remains optimistic as they believe that TON can always be launched by anyone considering the network code is available.  

Crypto Crash Leads to BitMEX Outage, Liquidations.  As the price of Bitcoin crashed from $8,000 to nearly $3,700 in less than 24 hours on March 13, BitMEX faced a 25 minute outage during a day when nearly $1 billion in leveraged long positions were liquidated industry-wide. BitMEX has faced criticism for the outage, with some speculating that it may have shut down intentionally to avoid the possibility of its Bitcoin perpetual swap collapsing to zero due to forced liquidations. BitMEX has stated that a hardware issue caused the outage. No matter the cause, this event highlights the necessity for digital asset managers, especially those using leverage to trade digital assets, to ensure their fund documents contain the necessary disclosures regarding counterparty risk and digital asset exchange risks.  

Wyoming Plans to Create New Bank Dedicated for Digital Assets. Wall Street and crypto veteran Caitlin Long recently announced a plan for Wyoming corporation, Avanti Financial Group Inc., to apply for a bank charter under Wyoming’s special-purpose depository institution law. Under the name “Avanti Bank & Trust,” the future bank is partnering with Blockstream to provide payment, custody, securities, and commodities activities for institutional customers using digital assets (“Avanti”). Though Avanti has yet to submit the bank charter application, the company has raised $1 million in seed funding and has eight products in the works that are not currently available in the U.S. market, including custody for security tokens. If successful, Avanti will be the first U.S. bank dedicated for digital assets. 

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Offshore Matters

Cayman Islands Mutual Funds Law (2020 Revision). Effective February 7, 2020, the Cayman Islands Government enacted an amendment to the Mutual Funds Law (2020 Revision). The 2020 Revision requires registration of previously exempt Section 4(4) Funds (generally, private funds with not more than 15 investors) with the Cayman Island Monetary Authority (“CIMA”). The 2020 Revision operates retroactively, meaning mutual funds that were previously exempted from registration under Section 4(4) will now need to comply with the registration requirements by August 7, 2020. Registration is similar to the requirements for Section 4(3) Funds, including the ‘four-eyes’ principle that necessitates funds to have at least two natural persons in management roles.  

Cayman Islands Private Funds Law 2020 (“PF Law”). Effective February 7, 2020 (the “Effective Date”), the PF Law requires any Cayman Islands closed-ended fund that falls under the definition of a “private fund” to register with CIMA. Previously, “private funds” were not required to register with CIMA. A vehicle will be a “private fund” where: (1) its principal business is offering and issuing investment interests; (2) its investment interests carry an entitlement to participate in the profits or gains of the vehicle and are not redeemable or re-purchasable at the option of the investor, i.e. are closed-ended; (3) its purpose or effect is the pooling of investor funds with the aim of spreading investment risks and enabling investors to receive profits or gains from such vehicle’s investments; (4) the investors do not have day-to-day control over the investments; (5) its investments are managed as a whole by or on behalf of the operator, directly or indirectly, for reward based on the assets, profits or gains of the vehicle; and (6) it does not constitute a “non-fund arrangement,” as listed in the schedule to the PF Law. The regulations do provide certain transitional provisions for private funds that began business at any time prior to the Effective Date. Such transitional funds will have six months from the Effective Date to register with CIMA and comply with the PF Law. 

European Union (EU) Announces Cayman Islands is a Non-Cooperative Jurisdiction for Tax Purposes. Effective February 18, 2020, the EU Economic and Financial Affairs Council announced that the Cayman Islands was moved to Annex 1 of Non-cooperative jurisdictions (“Annex 1”) for failing to timely implement appropriate regulations relating to economic substance in the area of collective investment vehicles. For investors or clients using Cayman structures, the move to Annex 1 will have limited or no direct practical consequence. The move to Annex 1 is not expected to trigger prevention of the use of special purpose vehicles established in non-EU jurisdictions under Article 4 of the EU Securitisation Regulation, or result in any EU level sanctions. While the Cayman Islands Government has announced the start of the delisting process, the situation is currently being monitored as dialogue continues between the EU and listed jurisdictions.

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Other Matters

Important Second Circuit Opinion on Insider Trading. In United States v. Blaszczak, No. 18-2825 (2d Cir. Dec. 30, 2019) (“Blaszczak”), the Second Circuit denied application of any personal benefit test to insider trading charges brought under both the criminal securities fraud provisions added in the 2002 Sarbanes-Oxley Act (Title 18) and the wire fraud statutes. Although this precedent controls only in criminal cases, this Second Circuit decision has made it significantly easier for prosecutors to obtain insider trading convictions. The personal benefit test requires prosecutors to show that a tipper acquired a personal benefit by disclosing confidential information in order to charge the tipper or tippee with insider trading. The implications of the ruling are potentially far-reaching as Blaszczak may become expansive precedent for prosecutors seeking to lower the bar for insider trading prosecutions. Analysts, such as the two former hedge fund analysts to whom Blaszczak was charged, that usually communicate with company employees and executive insiders may be at higher risk for insider trading prosecution because the government may not need to allege or prove that the tipper breached a duty of confidentiality or exchange for a personal benefit. While the cascading impact following Blaszczak is yet to be known, it is clear that the Second Circuit ruling has the potential to significantly expand insider trading liability. 

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COVID-19 Pandemic-Related Updates

SEC Regulatory Relief for Funds and Investment Advisers Affected by COVID-19. The SEC announced it will provide conditional relief to investment advisers affected by COVID-19. The SEC order grants relief for advisers from certain Form ADV and Form PF filing obligations. Registered investment advisers (“RIAs”) and exempt reporting advisers affected by COVID-19 can expect conditional relief regarding amendments and reports on Form ADV, respectively. Further, the order provides conditional relief for RIAs affected by COVID-19 in regards to delivering amended brochures, brochure supplements or summaries of material changes to clients where the disclosures are not able to be timely delivered. Private fund advisers affected by COVID-19 can also expect relief from Form PF filing requirements. To rely upon the relief, the order requires a statement of notification to Commission staff (promptly via email to the SEC at [email protected]) of the intention to rely upon the order and the disclosure of information in the form of a brief description by the adviser of the reasons why it could not file or deliver its Form ADV or Form PF on time. Clients and investors of the adviser must also be notified. Disclosure in regards to reliance upon the order for Form PF filings should be made promptly via email to the SEC at [email protected]. The order requires filing Form ADV and/or Form PF, as applicable, as soon as practicable, but not later than 45 days from the original deadline. For general questions or concerns related to impacts of coronavirus on the operations or compliance of funds and advisers, please contact us.

California’s Attorney General Announced No Delay on Enforcement of CCPA. On March 17, a group of over 30 trade associations and businesses sent a letter to California’s Attorney General pushing to postpone the enforcement of the California Consumer Privacy Act (“CCPA”). The CCPA, which took effect on January 1, is expected to be enforced by the Attorney General starting July 1. The group who sent the letter requested a January 1, 2021 enforcement date in order to give businesses more time to prepare for enforcement given that, given the current climate of COVID-19, many are unable to prepare for enforcement and most are in need of prioritizing other business concerns, such as the well-being and health of their employees. Press reports of various statements by members of the Attorney General’s office in response to this request strongly suggest that enforcement will not be delayed. In addition, the Attorney General recently released proposed revisions to clarify the service provider exemption. One such revision would allow service providers to use personal information internally to improve their services subject to certain limitations. Nevertheless, fund managers should prepare for enforcement of the CCPA as scheduled.

Investment Management Firms May Be Considered Essential Financial Businesses Under Federal Guidance and State Orders. The Cybersecurity and Infrastructure Security Agency (“CISA”) lists asset management as a vital component of our nation’s critical infrastructure. As the federal risk advisor, CISA created guidance to help state and local governments ensure that employees essential to operations are able to continue working. In consideration of CISA’s guidance, whether or not investment management firms would be considered essential financial businesses may depend upon each State’s directives. Generally, the best practice for firms moving forward is to require workers to telework or work-from-home if possible, but allow supporting personnel to continue selective operations in the office in order to ensure the firm’s continued operation.Please read here for a state-by-state analysis of the exceptions provided in each States’ executive orders regarding essential business activities in light of the COVID-19 public emergency response.

Amidst Extreme Volatility Managers Must Assess Material Terms in Live Trading Agreements. Given extreme market volatility, managers must assess the deal terms governing trading agreements such as ISDA master agreements, prime brokerage agreements, and others as certain provisions and triggering events may detrimentally affect hedge funds in the midst of current market conditions. Provisions regarding NAV triggers, force majeure, material adverse change/effect, counterparty powers, business day determinations, business disruptions, etc. and should be reviewed in light of current market conditions. In particular, for fund managers with ISDAs in place, please read this article by Dave Rothschild, a Partner at Cole-Frieman & Mallon LLP (“CFM”).

Additional Information on COVID-19 for Investment Managers. We have summarized a number of items from various authorities that pertain to investment managers. This article details the following matters:

  • The Coronavirus Aid, Relief, and Economic Security Act (CARES Act). 
  • CFTC Extended Deadlines for CPOs Due to COVID-19. 
  • SEC Update to Form ADV and Custody Rule FAQs, Relating to “Work From Home”. 
  • NFA Relief for Commodity Pool Operators, Relating to “Work from Home”. 
  • FINRA Pandemic-Related BCP, Guidance and Regulatory Relief, Relating to Regulatory Filings, “Work from Home,” Cybersecurity, and Forms U4 and BR. 
  • Employment Considerations for Investment Management Firms Addressing COVID-19.
  • SEC Temporary Final Rule 10(c) to Address Form ID Notarization Issues.
  • SEC’s Office of Compliance Inspections and Examinations Off-Site Exams via Correspondence for Information on Firms’ Business Continuity Plans.
  • SEC Guidance Relating to Federal Proxy Rules for Annual Meetings, “Virtual” Meetings, and Presentations of Shareholder Proposals. 
  • SEC No-Action Relief for Consolidated Audit Trail Obligations. 
  • Short-Selling Bans in Austria, Belgium, France, Italy, and Spain. 
  • Tax Matters for Investment Managers.

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CFM Events

CFM 2020 IA/BD Compliance Update with Aspect Advisors. We held our 2020 compliance update with Aspect Advisors in January. The discussion covered the critical compliance priorities in our industry for the New Year and decade. We’d like to thank Aspect Advisors for their help with this compliance update and look forward to future events. Aspect Advisors is a modern regulatory consultant providing customized compliance solutions to entrepreneurs. The firm has a focus on fintech companies, broker-dealers, and investment managers (hedge fund, VC, PE, RIA, etc.).  

Bitcoin Mining Panel Event in San Francisco. As we have seen certain venture capital firms increase their investment in bitcoin mining and infrastructure, CFM decided to hold an event discussing the current investing environment, regulatory considerations, and infrastructure landscape for bitcoin mining. The discussion was presented by Michael Fitzsimmons of Williams Trading and featured a panel of bitcoin mining experts – Mathew D’Souza of Blockware Solutions, Thomas Ao of MCredit and Yida Gao of Struck Capital. For a summary of the event, please see our overview

Regulation Best Interest (Reg BI) Webinar. Please stay tuned for more information on an upcoming live webinar, co-sponsored by CFM and Aspect Advisors, discussing practical, regulatory, and other considerations regarding Reg BI and the new Form CRS. We have previously written about Reg BI and how it pertains to private fund managers and investment advisers here. If you are interested in attending and have any questions for us to cover during the webinar, please contact us.

Compliance Calendar Please note the following important dates as you plan your regulatory compliance timeline for the coming months:

Deadline Filing
March 30
SEC deadline to update and file Form ADV – Part 1A, 2A, and Part(s) 2B, as applicable, through IARD.  
April 10
Amendment to SEC Form 13H due if necessary.
April 15SEC deadline to file 1st Quarter 2020 Form PF filing for quarterly filers (Large Liquidity Fund Advisers), through PFRD. 
April 15FinCEN deadline to file Report of Foreign Bank and Financial Accounts on FinCEN Form 114. Required for U.S. person with financial interest in, or signature authority over, one or more foreign financial accounts with total value over $10,000 at any time in 2019.
April 29Distribute Form ADV Part 2 to existing clients.
April 29Distribute audited financial statements to private fund investors that have not invested in fund of funds.
April 29SEC deadline to file Annual Form PF for annual filers (Large Private Equity Fund Advisers and Smaller Private Fund Advisers).
April 29Collect quarterly Transaction Reports from access persons for their personal securities transactions.
May 1SEC filing opens for Form CRS, through IARD. 
May 15*CFTC deadline for Commodity Pool Operators to file Schedules A and B of CFTC Form CPO-PQR, through NFA EasyFile.  

NFA deadline for CFTC-registered CPO of CFTC Regulation 4.7 Pool or Non-Exempt Pool to file 2019 Annual Report and distribute to pool participants. 
May 15SEC deadline to file Form 13F for first quarter of 2020.
May 15NFA deadline to file Quarterly Commodity Trading Advisor Form PR filing, through NFA EasyFile. 
May. 29SEC deadline to file 1st Quarter 2020 Form PF filing for quarterly filers (Large Hedge Fund Advisers), through PFRD.
May 29CFTC deadline for Commodity Pool Operators to file Schedules A, B, and C of CFTC Form CPO-PQR, for first quarter of 2020, through NFA EasyFile.  
May 29CFTC deadline for Commodity Pool Operators to file NFA Form PQR for first quarter of 2020 with CFTC and NFA, through NFA EasyFile.
June 12*Distribute Quarterly NAV Report (registered commodity pool operators claiming the 4.7 exemption) to pool participants.
June 26Distribute audited financial statements to private fund investors that have invested in fund of funds.
June 30SEC deadline to file Form CRS, through IARD if necessary. 
VariableDistribute copies of K-1 to fund investors.
Periodic FIlingsForm D and Blue Sky filings should be current.

*Extended deadline pursuant to COVID-19 pandemic-related relief

Please contact us with any questions or for assistance with any of the above topics. Sincerely, Karl Cole-Frieman, Bart Mallon, Lilly Palmer, David Rothschild, & Scott Kitchens

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Cole-Frieman & Mallon LLP is a premier boutique investment management law firm, providing top-tier, responsive, and cost-effective legal solutions for financial services matters. Headquartered in San Francisco, Cole-Frieman & Mallon LLP services both start-up investment managers, as well as multi-billion-dollar firms. The firm provides a full suite of legal services to the investment management community, including hedge fund, private equity fund, venture capital fund, mutual fund formation, adviser registration, counterparty documentation, SEC, CFTC, NFA and FINRA matters, seed deals, hedge fund due diligence, employment and compensation matters, and routine business matters. The firm also publishes the prominent Hedge Fund Law Blog, which focuses on legal issues that impact the hedge fund community. For more information, please visit us at colefrieman.com.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon is a boutique law firm focused on providing institutional quality legal services to the investment management industry. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.

Pandemic Legal & Regulatory Updates for Investment Managers

COVID-19 Investment Management Related Updates

Below is our compilation of communications that are relevant to investment managers. Please let us know if you are looking for additional information and we will strive to update this as time goes on. Stay safe and sane – CFM 4/14/20

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

SEC Regulatory Relief for Funds and Investment Advisers Affected by COVID-19. The SEC announced it will provide conditional relief to investment advisers and investment funds affected by COVID-19. In particular, the SEC order grants relief for investment advisers from certain Form ADV and Form PF filing obligations. Disruptions caused by COVID-19 to transportation, access to facilities, support staff and the ability for gatherings, among other things, may prevent or delay investment advisers and investment funds from meeting regulatory obligations. As a result, registered investment advisers (“RIAs”) and exempt reporting advisers (“ERAs”) affected by COVID-19 can expect conditional relief regarding the filing of amendments to Form ADV and reports on Form ADV part 1A, respectively. Further, the order provides conditional relief for RIAs affected by COVID-19 in regards to delivery of amended brochures, brochure supplements or summaries of material changes to clients where the disclosures are not able to be timely delivered. Private fund advisers affected by COVID-19 can also expect relief from Form PF filing requirements. For an entity seeking reliance upon the conditional relief, the SEC order requires a statement of notification to Commission staff (promptly via email to the SEC at [email protected]) of the intention to rely upon the order and the disclosure of information in the form of a brief description by the adviser of the reasons why it could not file or deliver its Form ADV or Form PF on time. Clients and investors of the adviser must also be notified. Disclosure in regards to reliance upon the order for Form PF filings should be made promptly via email to the SEC at [email protected]. The order requires filing Form ADV and/or Form PF, as applicable, as soon as practicable, but not later than 45 days from the original deadline. The Commission and the staff are continuing to assess the impacts and will be considering further relief designed to help funds and advisers to continue operations and meet regulatory deadlines. For general questions or concerns related to impacts of coronavirus on the operations or compliance of funds and advisers, please contact us.

CFTC Extended Deadlines Due to COVID-19. The CFTC has extended deadlines for Commodity Pool Operators (“CPOs”) in light of recent world events, most notably the COVID-19 global pandemic. The extensions only apply to CPOs which have reporting obligations, generally this means fully registered CPOs and those subject to Rule 4.7 relief. Moreover, these extensions only apply to CPOs “where compliance is anticipated to be particularly challenging or impossible because of displacement of registrant personnel from their normal business sites…in response to the COVID-19 pandemic.” The extension applies to (i) Form CPO-PQR where small and mid-size filers must file their annual Form CPO-PQR by May 15, 2020 and large filers (who were already expected to deliver the annual Form CPO-PQR) may file their Q1 2020 Form CPO-PQR by July 15, 2020; (ii) Pool annual reports under CFTC Rule 4.7(b)(3) and 4.22(c), such annual reports were originally due on April 30, 2020 but the extension allows CPOs to deliver these annual reports to the NFA and pool participants no later than 45 days after the original due date of April 30, 2020 (note: CPOs may also seek up to an additional 180 days from the end of their fiscal year to file under the “hardship” provisions of CFTC Rule 4.22(f); and (iii) Periodic account statements under Commission Regulations 4.7(b)(2) or 4.22(b), these monthly or quarterly reports for periods ending on or before April 30, 2020 may be delivered to pool participants within 45 days after the end of the reporting period. Such relief by the CFTC is not without conditions – if CPOs do indeed rely on such extensions they must: (i) Establish and maintain a sufficient supervisory system reasonably designed to supervise the activities of personnel while working from alternative or remote locations during the COVID-19 pandemic; and (ii) return to ordinary compliance with all CFTC rules covered by the relief as the COVID-19 pandemic abates. Moreover, CPOs should thoroughly document the activation and application of any relevant business continuity policy in response to COVID-19 as the matter could easily become an item of interest on future NFA exams.

Investment Management Firms May Be Considered Essential Financial Businesses Under Federal Guidance and State Orders. The Cybersecurity and Infrastructure Security Agency (CISA) lists asset management as a vital component of our nation’s critical infrastructure. As the federal risk advisor, CISA created guidance to help state and local governments ensure that employees essential to operations are able to continue working. In consideration of CISA’s guidance, whether or not investment management firms would be considered essential financial businesses may depend upon each State’s directives. Generally, the best practice for firms moving forward is to require workers to telework or work-from-home if possible, but allow supporting personnel to continue selective operations in the office in order to ensure the firm’s continued operation.Please see our post for a state-by-state analysis of the exceptions provided in each States’ executive orders regarding essential business activities in light of the COVID-19 public emergency response.

SEC Update to Form ADV and Custody Rule FAQs, Relating to “Work From Home”. Two circumstances are at the forefront of this update, where 1) advisers might otherwise be required to identify home offices as places of business on the Form ADV; and 2) advisers may inadvertently receive securities from clients at an office location at which the advisers’ personnel may not have access to mail or deliveries. In regards to the first circumstance, the SEC FAQ indicates it would not take action against advisers who do not update Item 1F of Part 1A or Section 1F of Schedule D of their Form ADVs to represent remote/home offices from which employees are working as additional offices, unless the remote office arrangement (other than one’s principal office and place of business) is unrelated to the firm’s business and continuity plan. In regards to the second circumstance, under the Custody Rule, an investment adviser that inadvertently receives client funds or securities are required to return such securities to the client within three to five business days; otherwise, such adviser may be deemed to have custody of such securities. The SEC has revised the Custody Rule such that client assets are not considered received until firm personnel are able to access the mail or deliveries. As with most conditional relief provided by the SEC in light of COVID-19, the adviser must be unable to access mail or deliveries as a result of the circumstances caused by COVID-19.

NFA Relief for Commodity Pool Operators, Relating to “Work from Home”. Commodity pool operators (“CPO”), commodity trading advisors (“CTA”), and other NFA members implementing contingencies pursuant to their business continuity plans that permit employees, including registered Associated Persons (“APs”), to work from home, will not be subject to disciplinary action relating to the requirements that firms list as a branch office on its Form 7-R any location other than the main business address and that each branch office must have a branch office manager in compliance with Rule 2-7 that requires successful completion of the Series 30, Branch Manager Examination. The relief requires that the CPO or CTA implement and clearly document alternative supervisory methods and activities, especially surrounding recordkeeping requirements.

FINRA Pandemic-Related BCP, Guidance and Regulatory Relief, Relating to Regulatory Filings, “Work from Home”, Cybersecurity, and Forms U4 and BR. Member firms experiencing complications resulting from COVID-19 should contact their Risk Monitoring Analysists or relevant FINRA department to seek extensions. FINRA may waive late fees and provide conditional relief based on the member firm’s circumstances. As discussed earlier, firms are reminded to review, revaluate, and update their BCPs in consideration of pandemic preparedness. FINRA member firms are encouraged to contact their assigned FINRA Risk Monitoring Analyst to discuss the implementation of their BCPs, as well as challenges in such implementation, including disruption of business operations. In regards to remote offices or telework arrangements, FINRA expects member firms to maintain a supervisory system that is designed to supervise the activities of each associated person working remotely. FINRA further recommends steps to reduce the risk of a cybersecurity breach, including: “(1) ensuring that virtual private networks (VPN) and other remote access systems are properly patched with available security updates; (2) checking that system entitlements are current; (3) employing the use of multi-factor authentication for associated persons who access systems remotely; and (4) reminding associated persons of cybersecurity risks through education and other exercises that promote heightened vigilance.” In regards to Form U4/Form BR, FINRA is temporarily suspending the requirements to update Form U4 information about office employment addresses for registered persons and Form BR information regarding branch office applications for any newly opened temporary office location or space-sharing arrangements. Additionally, if a member firm relocates personnel to a temporary location that is not currently registered as a branch office, the firm must provide written notification to its FINRA Risk Monitoring Analyst. The notification should indicate at minimum the office address, the names of the member firms involved, the names of registered personnel, a contact telephone number, and expected duration, if possible. 

Employment Considerations for Investment Management Firms Addressing COVID-19.  With the spread of COVID-19, many employers are concerned about the health and safety of their employees and evaluating the steps that should be taken in response.  We recommend that managers establish policies and procedures regarding COVID-19 and to ensure that any policies and procedures are uniformly applied, to avoid the risk of employee discrimination.  If any employees exhibit flu-like symptoms, employers may ask such employees if they would like to seek medical attention and may require symptomatic employees to go home without violating the American Disabilities Act.  If an employee’s condition could pose a “direct threat”, i.e. a significant risk of substantial harm to the health and safety of the individual or others that cannot be eliminated or reduced by reasonable accommodation, employers may also request that an employee be tested for COVID-19.  If an employee tests positive for the virus, all employees who were in close contact with such employee should be sent home for a 14-day self-monitoring period, and other employees in the same work location should be informed of their potential exposure.  As a reminder, employers should always ensure the confidentiality of employee medical information.  As many workplaces shift to remote working, employers should make certain that their policies address the provision and proper use of technologies necessary for remote work.  Managers should be especially careful to ensure adequate controls and safeguards are in place to protect confidential or sensitive information, particularly client information.  Managers with questions policies and practices to address COVID-19 should speak with their firm’s outside counsel.

California’s Attorney General Pressed to Postpone Enforcement of CCPA.  On March 17, a group of over 30 trade associations and businesses sent a letter to California’s Attorney General pushing to postpone the enforcement of the California Consumer Privacy Act (“CCPA”). The CCPA, which took effect on January 1, is expected to be enforced by the Attorney General starting July 1. The group who sent the letter requested a January 1, 2021 enforcement date in order to give businesses more time to prepare for enforcement given that, given the current climate of COVID-19, many are unable to prepare for enforcement and most are in need of prioritizing other business concerns, like the well-being and health of their employees. The Attorney General’s office has not officially responded to the letter, and an advisor to the Attorney General suggested that enforcement will either continue as planned or be pushed until CCPA revisions can be finalized. The Attorney General recently released proposed revisions clarifying the service provider exemption. One such revision would allow service providers to use personal information internally to improve their services subject to certain limitations. Fund managers should prepare for enforcement of the CCPA as planned, while awaiting a formal response from the Attorney General.

SEC Temporary Final Rule 10(c) to Address Form ID Notarization Issues. In recognition of the issues caused by the COVID-19 public health crisis for entities and individuals who require access to file in EDGAR and the requisite notarization of the authorized signature on the Form ID application required by Rule 10(b) of Regulation S-T, the SEC announced a temporary rule to allow applicants for EDGAR access to upload a signed copy of the Form ID without notarization. The temporary rule requires that within 90 days of obtaining access to EDGAR, applicants must obtain notarization of the authorized signature on a copy of the completed Form ID and upload it as correspondence to their EDGAR account.

SEC’s Office of Compliance Inspections and Examinations (OCIE) Off-Site Exams via Correspondence for Information on Firms’ Business Continuity Plans (BCP). The SEC’s OCIE has begun off-site examinations through correspondence requests for responses and documents related to firms’ written Business Continuity Plans, Pandemic Continuity of Operations Plans, and/or equivalent informal plans or guidance (collectively, “BCP”).  Firms are expected to provide copies or locations of their BCPs and any firm-issued policies, procedures, guidance and other information tailored to address continuity of business operations relating to pandemics and specifically COVID-19.  Additionally, the OCIE asks for written responses to questions regarding what aspects of plans have been implemented, what limitations firms have faced in their abilities to operate critical systems, whether working remotely has affected oversight of third-party vendors, whether the firms are prepared to operate remotely for several weeks (e.g. 3+) or months, if required, etc. As the economic and operational pressures resulting from COVID-19 are affecting businesses and the industry at large, firms are strongly encouraged to revisit and enhance their BCPs in light of the threats posed by significant business disruptions.

SEC Guidance Relating to Federal Proxy Rules for Annual Meetings, “Virtual” Meetings, and Presentations of Shareholder Proposals. Under state law, issuers are generally required to hold annual meetings with security holders. Issuers with securities registered under Exchange Act Section 12 are required to comply with federal proxy rules when soliciting proxy authority from their shareholders in connection with the annual meeting. These federal proxy rules include the delivery of proxy material such as definitive proxy statements and proxy cards. Under the relief, the SEC takes the position that an issuer that has mailed and filed its definitive proxy materials can notify shareholders of a change in the date, time, or location of its annual meeting without mailing additional soliciting materials or amending its proxy materials if the issuer: 1) releases a press announcement of the change; 2) files the announcements as definitive additional soliciting material on EDGAR; and 3) takes all reasonable steps necessary to inform other intermediaries in the proxy process and other relevant market participants. In regards to issuers contemplating “virtual” shareholder meetings, issuers are reminded that the ability to conduct “virtual” meetings is governed by state law and the issuer’s governing documents. Issuers intending on conducting such “virtual” meetings are expected to notify its shareholders, intermediaries in the proxy process, and other market participants with clear logistical details of how shareholders can access, participate, and vote in such meetings. Lastly, the guidance encourages issuers to provide shareholder proponents or representatives with alternative means of presenting their proposals during the 2020 proxy season. To the extent such a shareholder proponent or representative cannot present a proposal due to COVID-19, the SEC would consider this to be “good cause” under Rule 14a-8(h) to exclude the proposal for any meetings held in the following two calendar years. 

SEC No-Action Relief for Consolidated Audit Trail (“CAT”) Obligations. The SEC Division of Trading and Markets is providing no-action relief for small and large broker-dealers that are required to report trade and order data for all National Market System (“NMS”) securities and over-the-counter (“OTC”) equity securities.  Under Section 19(b)(1) of the Securities Exchange Act of 1934, industry members of a national securities exchange or members of a national securities association (“Members”) are required to report to the CAT, a central depository that receives data on NMS securities and OTC equity securities, among other things. Prior to this relief, broker-dealers would have been required to submit member data to the CAT by April 20, 2020. This deadline has been extended to May 20, 2020. Self-regulatory organizations (“SROs”) responsible for ensuring compliance with the CAT NMS Plan will also not take disciplinary action against their members consistent with this relief. Notwithstanding the above, broker-dealers are reminded to conduct production readiness testing and certification processes 14 days prior to reporting. 

Short-Selling Bans in Austria, Belgium, France, Italy, and Spain. Under EU Short Selling Regulation, the EU member states of Austria, Belgium, France, Italy, and Spain have enacted temporary short-selling bans to prevent destabilizing trading following market decline resulting from COVID-19. Each European countries’ temporary bans vary in scope, and in particular, which stocks are regulated by each ban. Generally, the scope of the bans include prohibitions on creating or increasing net short positions and involve shares, including cash and derivative short positions. Most bans do not apply to indexed financial instruments when the shares subject to the ban represent less than 20% to 50% of the composition of the index, depending on the EU member state ban. For more information in relation to each respective ban, please see the full order of the decisions for each of the following countries: Austria, Belgium, France, Italy, and Spain.

Tax Matters. In consideration of the impacts of COVID-19, many states are passing budgets, emergency COIVD-19 supplemental appropriation and extension of certain deadlines. Please see our post for an outline of certain tax deadlines in salient jurisdictions. 

Amidst Extreme Volatility Managers Must Assess Material Terms in Live Trading Agreements. Given extreme market volatility, managers must assess the deal terms governing trading agreements such as ISDA master agreements, prime brokerage agreements, and others as certain provisions and triggering events may detrimentally affect hedge funds in the midst of current market conditions. Such negotiated provisions regarding force majeure, material adverse change/effect, counterparty powers, business day determinations, business disruptions, etc. and should be reviewed in light of current market conditions. In particular, for fund managers with ISDAs in place, please read this article by Dave Rothschild, a partner of CFM.

For general questions or concerns related to impacts of coronavirus on the operations or compliance of funds and advisers, please contact us.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon is a boutique law firm focused on providing institutional quality legal services to the investment management industry. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.

COVID-19 Tax Matters for Private Fund Managers

Certain tax deadlines in the following salient jurisdictions may or may not be further extended due to disruption caused by COVID-19 as of the time of this publication:

CALIFORNIA

  • The deadline for tax filing and payment is extended until July 15 for all individuals and business entities for the following: 2019 tax returns; 2019 tax return payments; 2020 1st and 2nd quarter estimate payments; 2020 LLC taxes and fees; and 2020 non-wage withholding payments.
  • Interest and penalties for individuals and businesses have also been waived.  Requests for relief from penalties, interest or fees can be made through the California Department of Tax and Fee Administration CDTFA.
  • Payroll Tax: Employers may request up to a 60-day extension to file their state payroll reports and/or deposit payroll taxes without penalty or interest by following the instructions of the Employee Development Department (EDD).

San Francisco

  • Businesses with less than $10 million in gross receipts may defer their first quarter business taxes (which under normal circumstances must be pre-paid by April 30th) until February 2021. The deferral is applicable to gross receipts tax, payroll expense tax, commercial rents tax and homelessness gross receipts tax.
  • No interest payments, fees or fines will accrue as a result of the deferral.  Further details are available in the announcement from the Office of the Mayor.
  • No relief has been provided with respect to property tax.
  • The city has established the Small Business Resiliency Fund which is providing financing to qualified businesses.

Los Angeles

CONNECTICUT

ILLINOIS

  • Illinois has yet to announce an extension of deadlines for tax filings and payments as of the date of this publication.

NEW YORK

  • On March 16, 2020, the New York State Tax Department announced that it had not extended the deadline to file personal income tax or other tax returns.  New York has yet to announce an extension of deadlines for tax filings and payments as of the date of this publication.
  • New York has waived fines for businesses that have missed the sales tax deadline of March 20, 2020.  There is no waiver of accrued interest.

New York City

  • The city is in the process of establishing the Small Business Continuity Fund which intends to provide financing to businesses demonstrating at least a 25% decrease in revenue caused by COVID-19.

For general questions or concerns related to impacts of coronavirus on the operations or compliance of funds and advisers, please contact us.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon is a boutique law firm focused on providing institutional quality legal services to the investment management industry. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.

Hedge Funds & Essential Financial Businesses

Investment Management Firms May Be Considered Essential Financial Businesses Under Federal Guidance and State Orders.

The Cybersecurity and Infrastructure Security Agency (CISA) lists asset management as a vital component of our nation’s critical infrastructure. As the federal risk advisor, CISA created guidance to help state and local governments ensure that employees essential to operations are able to continue working. In consideration of CISA’s guidance, whether investment management firms would be considered essential financial businesses may depend upon each State’s directives. Generally, the best practice for firms moving forward is to require workers to telework or work-from-home if possible, but allow supporting personnel to continue selective operations in the office if necessary to ensure the firm’s continued operation.

CALIFORNIA

  • California Executive Order N-33-20 orders “all individuals living in the State of California to stay at home or at their place of residence except as needed to maintain continuity of operations of the federal critical infrastructure sectors” as outlined by CISA. As discussed earlier, asset managers are included under CISA’s guidance and should be permitted to allow supporting personnel to continue operations in their California offices.

CONNECTICUT

  • Connecticut Executive Order No.7H orders that “non-essential businesses or not-for profit entities shall reduce their in-person workforces at any workplace locations by 100% not later than March 23, 2020 at 8:00 p.m. Any essential business or entity providing essential goods, services or functions shall not be subject to these in-person restrictions.” The order defines “essential businesses” as those that, “include, but not be limited to, the 16 critical infrastructure sectors as defined by the Department of Homeland Security” and as outlined by CISA. Asset managers are included under CISA’s guidance and should be permitted to allow supporting personnel to continue operations in their Connecticut offices.

DELAWARE

  • Delaware Fourth Modification of the Declaration of a State of Emergency defines “essential businesses” as those that employ or utilize workers in financial services who support financial operations, such as those engaged in the selling, trading, or marketing of securities, those engaged in giving advice on investment portfolios, and those staffing data and security operations centers.” Under this definition, asset managers should be permitted to allow personnel to continue operations in their Delaware offices. 

ILLINOIS

  • Illinois Executive Order 2020-10 orders that “all Essential Businesses and Operations are encouraged to remain open. To the greatest extent feasible, Essential Businesses and Operations shall comply with Social Distancing Requirements as defined in this Executive Order, including by maintaining six-foot social distancing for both employees and members of the public at all times.”  Under the order, Essential Businesses are defined as including financial institutions. Accordingly, it is reasonable to take the position that asset managers should be permitted to allow personnel to continue operations in their Illinois offices. 

NEW JERSEY:

  • New Jersey Executive Order No. 107 allows flexibility for businesses with employees that are unable to work-from-home or perform telework. In such situations, the order requires businesses to use its best efforts to allow the minimum number of workers necessary to ensure that essential operations can continue. Accordingly, it is reasonable to conclude that asset managers have the discretion to decide which, if any, personnel can continue selective operations in their New Jersey offices in order to ensure the firm’s continued operations. 

NEW YORK

  • New York Executive Order No. 202.6 orders that employers “reduce the in-person workforce at any work locations by 100%…” with exception to “an entity providing essential services or functions.” In a release expanding on the definition of “Essential Businesses” for the purposes of Executive Order 202.6, such essential financial institutions include “services related to financial markets.” Accordingly, it is reasonable to take the position that asset managers should be permitted to allow personnel to continue operations in their New York offices.

For general questions or concerns related to impacts of coronavirus on the operations or compliance of funds and advisers, please contact us.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon is a boutique law firm focused on providing institutional quality legal services to the investment management industry. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.

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

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

  • Eligibility. Eligible businesses include any business that already meets the applicable regulations to constitute “small business concerns” under the Small Business Act, businesses with up to 500 employees, non-profit organizations, businesses in the accommodation (lodging) and food services businesses with no more than 500 employees at each location, and eligible sole proprietorships and independent contractors.  
  • Terms. An eligible business can borrow 2.5 times their monthly payroll costs, up to $10 million. “Payroll costs” includes salaries, wages, paid sick leave, health insurance premiums, retirement benefits, tips, state and local taxes on employee compensation, but does not include compensation to any individual employee or independent contractor in excess of $100,000.
  • Permitted Uses of Proceeds.Businesses may use PPP proceeds for the following business expenses: payroll costs (as defined above), rent, utilities, and interest payments on any mortgage or debt obligations incurred before February 15, 2020, excluding payments or prepayments of principal.
  • Loan Forgiveness. Borrowers may apply for loan forgiveness in an amount equal to funds used to pay eight weeks of payroll costs, mortgage interest, rent and utilities starting from the date of such Borrower’s PPP loan. The amount of loan forgiveness available is limited to the principal amount loaned under the PPP loan. Furthermore, in an effort to incentivize businesses to keep employees and maintain salaries or wages, the amount of loan forgiveness available is subject to reduction if the Borrower’s average number of full-time employees during the eight week period is lower than the average number of full-time employees in the 12-month period prior, or if there is a 25% reduction of the total salaries or wages of such employees during the eight week period. The 25% reduction guideline does not apply to employees whose annual salary or wages for any pay period in 2019 was greater than $100,000. An exemption from the reductions in loan forgiveness applies if the Borrower had reduced employees or salaries or wages as a result of the COVID-19 pandemic, but eliminates such reduction by rehiring the laid off employees or increasing salaries or wages to prior levels by June 30, 2020.  

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

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon is a boutique law firm focused on providing institutional quality legal services to the investment management industry. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.

Cole-Frieman & Mallon 2019 Third Quarter Update

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

Clients, Friends, Associates:

We hope you had an enjoyable summer. Typically, the third quarter is quieter than the second quarter from a compliance perspective, however we continue to see meaningful enforcement actions taken by regulatory authorities and rapid developments in the digital asset space. Entering the fourth quarter, we would like to highlight some items we hope will help you stay on top of the business and regulatory landscape in the coming months.  But first, a couple of items of firm news:

  • CoinAlts Fund Symposium. In September, In September, founding sponsor CFM broke new ground to host its fourth successful Symposium in Chicago. An impressive line-up of speakers addressed pressing issues for institutions in the digital asset ecosystem, including legal and operational concerns for fund managers, recent trends and innovations in blockchain, and raising capital from institutional allocators.
    • Cole-Frieman & Mallon’s Anniversary. On September 17th CFM celebrated with family, friends, colleagues and clients 10 years of successful growth to become the largest hedge fund practice in the West Coast. We very much appreciate the continued support from our clients and friends in the industry and look forward to the next decade of success.

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Privacy Regulations

Cayman Islands Data Protection Law Effective September 30, 2019. The Cayman Islands Data Protection Law, 2017 (“DPL”) became effective on September 30, 2019 and applies to all investment advisers providing investment advice to Cayman Islands funds. Under the DPL, Cayman investment funds are considered “data controllers” whether or not they are registered with the Cayman Islands Monetary Authority and investment advisers to such funds are considered “data processors.” The DPL requires data controllers to update their Cayman fund’s subscription agreements to include language specific to the DPL and otherwise provide investors with an updated DPL-compliant privacy notice. There is no specific deadline to provide investors with such privacy notice. Fund administrators must also ensure that they are DPL-compliant and updates to the fund’s administration agreement may be required.

California Consumer Privacy Act to be Effective January 1, 2020. The California Consumer Privacy Act (the “Act”) was passed into California law on June 28, 2018 and will be effective on January 1, 2020. The Act will not apply to most fund managers and will generally only impact managers that serve California residents and have at least $25 million in annual gross revenue, have personal data on at least 50,000 Californians, or receive over half their revenues from the sale of personal data of California residents. The Act does not apply to current client data and, on October 11, 2019, Governor Newsom signed seven amendments into law that generally limit the Act’s reach even further. If the Act were to apply to a fund manager, to be in compliance, such fund manager should post a privacy policy on its website disclosing its collection of personal information, maintain an organized data collection process, and provide investors information regarding the use of their information and the right to opt-out of the sale and request the deletion of such information.

New York SHIELD Act Heightens the State’s Privacy Regulations. On July 25, 2019, the Stop Hacks and Improve Electronic Data Security Act (the “SHIELD Act”) was signed into New York law and amends the State’s data breach notification law. The SHIELD Act, which is set to take effect in March 2020, requires certain businesses or individuals implement safeguards to protect the security, confidentiality and integrity of information. The SHIELD Act broadens the definition of “private information” to include credit card or debit card numbers, usernames and passwords (or security questions and answers) used to access an individual’s online accounts, and biometric information, like fingerprints. The SHIELD Act also expands the definition of “breach”, from unauthorized acquisition of private information to include unauthorized access to private information, as well as the scope of the breach notification requirement to include any person or business that owns or licenses private information of a New York resident. This means the law is no longer limited to those conducting business in New York, but could affect managers who, for example, only store a New York investor’s private information. Because of the broad scope of the SHIELD Act, managers who own private information of a New York resident should review the updated security requirements the Act imposes on them, including the need to implement a data security program, as more specifically discussed in the SHIELD Act.

SEC Matters

SEC Publishes Risk Alert on Principal and Agency Cross Trading Compliance Issues. On September 4, 2019, the Securities and Exchange Commission (“SEC”) published a Risk Alert advising readers on common compliance issues identified in investment adviser examinations, related to principal and agency cross transactions under Section 206(3) of the Investment Advisers Act of 1940, as amended (the “Advisers Act”). These transactions occur when investment advisers execute client transactions as a broker or dealer, either acting as a broker or dealer for its advisory client or doing so for both its advisory client and its brokerage client on the other end of the same transaction. The examinations the SEC conducted showed advisers either did not know they had engaged in principal trades or did not disclose or obtain the required consent before completing the transactions. With respect to agency cross transactions, the examinations also showed advisers often engaged in agency cross transactions without properly disclosing this to clients or could not show proof they had complied with the applicable consent or disclosure requirements. The Risk Alert also expressed concern that many advisers engaging in these transactions either did not have proper compliance policies and procedures or failed to follow the policies and procedures that had been established. Advisers should look closely at potential transactions to determine whether they qualify as either principal trades or agency cross transactions and if so, what actions need to be taken to comply with the respective requirements.

SEC Charged RIA for Nondisclosure of Conflicts Arising from Revenue Sharing. On August 1, 2019, the SEC  charged an SEC RIA for failure to disclose conflicts of interest relating to a revenue sharing agreement with the broker used by most of its clients. The revenue sharing agreement provided that, if the adviser invested its client assets in certain classes of mutual funds that paid the broker to be listed on its platform, the adviser would receive a portion of those payments. The adviser received over $100 million from the broker from July 2014 to December 2018 because of this arrangement. However, the adviser never disclosed to its clients that there were other mutual fund investments less expensive than the investments subject to the revenue sharing agreement. The SEC considered these to be material omissions and determined the adviser’s clients did not make these investments with full knowledge of the adviser’s incentives. Fund managers should ensure that all pertinent conflicts of interest, including those related to the receipt of compensation from third parties, are properly disclosed to their clients.

FINRA Matters

FINRA Proposes Changes to Restricted Person and Spinning Provisions.  On July 26, 2019, FINRA, along with the SEC, proposed certain amendments to FINRA Rules 5130 and 5131. One of the amendments would exempt certain additional persons and certain types of offerings from the scope of the rules. Among other changes (eight total), the proposals would (i) include the definitions of “family member” and “family client” as defined under the Advisers Act in the definition of “family investment vehicle” under Rule 5130, (ii) exempt foreign employee retirement benefit plans that meet certain conditions from Rules 5130 and 5131 and (iii) exclude unaffiliated charitable organizations from the definition of “covered non-public company” in Rule 5131. If these changes are approved and become effective, fund managers can expect further regulatory consistency and clarity to result.

Digital Asset Matters

Bakkt Announces that it’s “Cleared to Launch” Bitcoin Futures. Bakkt, a bitcoin futures exchange and digital assets platform founded by the Intercontinental Exchange (“ICE”), announced in mid-August that the CFTC gave its go-ahead for Bakkt’s futures contracts. The announcement discussed that Bakkt’s bitcoin futures would be exchange-traded on ICE Futures U.S. and cleared on ICE Clear US, both of which are regulated by the CFTC. Bakkt further announced that it acquired a New York state trust charter through the New York State Department of Financial Services, and that this approval to create Bakkt Trust Company, a qualified custodian, would allow the Bakkt Warehouse, which is part of Bakkt Trust Company, to provide bitcoin custodial services for physically delivered futures. On September 23, 2019, Bakkt launched its custody and physically-settled bitcoin futures contracts products. Many disagree whether the launch, which had a trade volume during the first seven days of $5.8 million, was successful or not, and certain researchers speculate the launch was partially why bitcoin’s price has recently decreased. Despite this, the news of the launch can potentially benefit fund managers as Bakkt aims to provide access to this market and address issues that have slowed institutional participation in this market in the past.

SEC Delays Decision on Three Bitcoin ETFs. On August 12, 2019, the SEC once again delayed a decision on three bitcoin ETF proposals.  As of yet, the SEC has not approved a bitcoin ETF. In previous decisions, the SEC expressed concerns with market manipulation, market surveillance and a possible divergence with futures trading. One of the entities proposing a bitcoin ETF published reports addressing these concerns and indicating that the actual bitcoin market is more regulated and surveilled than expected. This ETF proposal received support from a number of well-known individuals in the industry. In fact, Cole-Frieman & Mallon submitted a comment to the SEC with respect to this ETF proposal in June. Unfortunately, on October 9, 2019, this ETF proposal was rejected as the proposal reportedly did not meet the legal requirements necessary to prevent market manipulation or other fraudulent activities. As another of the entities proposing a bitcoin ETF recently withdrew its proposal from SEC review, there remains only one bitcoin ETF proposal sitting before the SEC. Fund managers interested in the digital asset space should stay apprised of future developments regarding this ETF proposal and others that may follow.

FINRA Approves Membership of Placement Agent for Privately Placed Digital Securities. On August 7, 2019, FINRA approved the membership application of a placement agent for privately placed, digital securities on a permissioned blockchain platform developed by its parent company. It took the placement agent 18 months to get approved, which is longer than what is typically seen, as it had to prove to FINRA that it met regulatory requirements. The approval allows the placement agent to issue securities, provide services as a broker for digital securities, and potentially enter the secondary trading business. This approval stands out as many applications have been waiting to hear back from FINRA for months, and sometimes more than a year. Specifically, this approval will expand investment opportunities for investors and provide fund managers with a streamlined tool to utilize in its investment processes.

SEC Freezes $8 Million in Assets Related to Fraudulent Scheme to Sell Digital Securities to Investors. On August 12, 2019, the SEC froze $8 million in assets raised by an individual and two companies he owns. Allegedly, the parties sold their own token on the internet and induced investors to invest in the token based on material misrepresentations and omissions. The complaint also alleged that the individual manipulated the token price and transferred a significant amount of investor assets to his own personal account. The SEC charged the parties with violating the registration and antifraud provisions of the Federal securities laws and further charged the individual for violating antifraud provisions by manipulating the price of tokens. While this digital asset age has certainly shown promise and innovation, fund managers should be on alert for fraudulent schemes such as this.

SEC Charges Group Operating Unregistered Digital Asset Exchange. On August 29, 2019, the SEC settled charges with a company and its founders who created and sold unregistered tokens to more than 13,000 investors. The founders allegedly falsely claimed each token provided an interest in the company’s cryptocurrency mining facility using below-market rate electricity. In reality, the mining facility did not exist. The company and its founders also allegedly illegally operated an unregistered national security exchange to trade the single token. As new and exciting opportunities in the digital asset space continue to emerge, investors should proceed with caution and should conduct ample due diligence prior to moving forward with such opportunities.

IRS Targets Cryptocurrency Investors with Educational Letter about Back Taxes. In July, the IRS began sending educational letters to taxpayers who have purchased or sold cryptocurrencies but either did not report the income entirely or did not report the income correctly. There are three variations of this letter that more than 10,000 taxpayers will receive, depending on how or if the transactions were reported: Letter 6173, 6174 and 6174-A. In mid-August, the IRS began sending a second round of letters to relevant taxpayers. This notice, which the IRS calls CP2000, is aimed at taxpayers that the IRS has actual records of, showing that there is a discrepancy between the trading profits or losses reported by the taxpayer and what third parties (like exchanges) report to the IRS. The notice includes an amount that each recipient taxpayer is expected to pay in 30 days, with interest. Taxpayers trading cryptocurrency can expect the IRS to ramp up these types of letters and notices and should properly report their transactions to the IRS when filing tax returns to avoid penalties.

SEC Approves First-Ever Reg A+ Token Offering. On July 12, 2019, Blockstack became the first company in history to receive SEC approval for a public securities offering where investors would receive tokens, in this case, called “Stacks”. Blockstack raised a total of $23 million from more than 4,500 investors. $15.5 million was raised through a Reg A+ sale in the United States and the other $7.6 million was raised through a Reg S offering in Asia. Blockstack is working with international exchanges to list Stacks tokens potentially as soon as October 2019. While the full effects of this approval are not yet determined, the SEC’s approval has potential to create a new regulatory roadmap for public token offerings.

FINRA and SEC Issue Joint Statement on Custody of Digital Assets by Broker-Dealers. On July 8, 2019, FINRA and the SEC issued a statement expressing the challenges facing broker-dealer’s custody of digital assets. The statement discussed that a broker-dealer seeking to custody such assets must, like all broker-dealers, comply with the SEC’s Customer Protection Rule. This rule protects customer securities and funds held by broker-dealers by requiring broker-dealers to keep customer assets separate from their firm’s assets, making it more likely that customers’ securities and assets can be returned to them in the case of a broker-dealer’s failure. Many unregistered entities and registered broker-dealers that want to engage in activities involving digital asset securities have been submitting applications to FINRA in the hope that FINRA will allow them to engage in such activities. How these entities could custody digital asset securities while complying with the Customer Protection Rule is still under discussion, but as a start, broker-dealers would need to put in place significant technological enhancements unique to digital asset securities.

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Compliance Calendar.

Please note the following important dates as you plan your regulatory compliance timeline for the coming months:

Deadline Filing
October 10, 2019 Form 13H amendment due if there were changes during Q3
October 15, 2019 Quarterly Form PF due for Large Liquidity Fund Advisers
October 15, 2019 Extended deadline to file Reports of Foreign Bank and Financial Accounts (FBAR)
October 30, 2019 Registered investment advisers must collect access persons’ personal securities transactions
November 1, 2019 Registered investment advisers that seek to withdraw registration with the SEC may begin to submit Form ADV-W‘s, which must be dated 12/31/19
November 11, 2019 Firm may view, print and pay preliminary notice filings (RIA) with all appropriate states
November 14, 2019 Form 13F is due for certain institutional investment managers
November 14, 2019 Form PR filings for registered CTAs that msut file for Q3 within 45 days of the end of Q3 2019
November 29, 2019 Form PF filings for Large Hedge Fund Advisers with December 31 fiscal year-ends filing
November 29, 2019 Large registered CPOs must submit a pool quarterly report (CPO-PQR)
December 16, 2019 Deadline for paying annual IARD charges and state renewal fees
December 31, 2019 Small and mid-sized registered CPOs must submit a pool quarterly report (CPO-PQR)
December 31, 2019 Cayman funds regulated by CIMA that intend to de-register (i.e. wind down or continue as an exempted fund) should do so before this date in order to avoid 2020 CIMA fees
January 1, 2020 California Consumer Privacy Act goes into effect
Periodic Fund managers should perform “Bad Actor” certifications annually
Periodic Amendment due on or before anniversary date of prior Form D and blue sky filing(s), as applicable, or for material changes
Periodic CPO/CTA Annual Questionnaires must be submitted annually, and promptly upon material information changes

 

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

Cole-Frieman & Mallon 2019 Second Quarter Update

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

Clients, Friends, Associates:

We hope you are enjoying the start of summer.  Typically the second quarter is quieter than the first quarter from a compliance perspective, however we continue to see meaningful enforcement actions taken by regulatory authorities and rapid developments in the digital asset space.  Entering the third quarter, we would like to highlight some items we hope will help you stay on top of the business and regulatory landscape in the coming months.

First, though, we’d like to announce a few exciting updates regarding Cole-Frieman & Mallon LLP. Scott E. Kitchens has joined the firm as a partner and will be leading the firm’s new Denver office.  Our firm is once again a founding sponsor of the quickly approaching CoinAlts Fund Symposium. The event will be held in Chicago on September 26th and the founding sponsors will be hosting a pre-conference cocktail hour in Chicago on July 18th.  We look forward to seeing many of you there.

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SEC Matters

SEC Adopts New Regulation Best Interest.  On June 5, 2019, the SEC adopted a package of rules and interpretations to bring a new level of transparency between retail investors, investment advisers and broker-dealers, including the new Regulation Best Interest rule and the Form CRS Relationship Summary.  The new Regulation Best Interest requires broker-dealers to act in the “best interest of retail customers when making a recommendation,” whereas previously broker-dealers were only required to recommend “suitable” investments. Broker-dealers are also required to establish and enforce policies designed to comply with this rule.  The Form CRS Relationship Summary, which will become the new Form ADV Part 3, will require RIAs to provide retail investors with “easy-to-understand information about the nature of their relationship with their financial professional,” including information on services, fees, conflicts, their legal standard of conduct, and prior disciplinary history.  The Form CRS, will be a standardized question-and-answer format and must be presented to retail investors at the beginning of their relationship.  The rules are effective 60 days after their publication in the Federal Register, however broker-dealers and investment advisers are given until June 30, 2020 to ensure compliance.

Individual Liable Under Rule 10b-5 for Knowingly Disseminating False or Misleading Statements Made by Another Person.  On March 27, 2019, the Supreme Court ruled that an individual violated Rule 10b-5 by disseminating statements he knew to be false to potential investors, even though he didn’t “make” the statements himself.  The individual sent an email to potential investors stating the assets of a company seeking investment was $10 million at the direction of his boss, who supplied the content and approved the email, while the individual knew the total assets were worth less than $400,000.  The case may result in an expansion of personal liability for those who transmit false or misleading statements that were made by another.  Managers should ensure that their supervised persons are not repeating false statements even if those statements were made by a superior.

SEC’s Office of Compliance Inspections and Examinations (“OCIE”) Issues Risk Alert.  On May 23, 2019, the OCIE issued a risk alert regarding the safeguarding of customer records and information network storage.  The OCIE observed that many firms did not always use their storage solution’s security features to prevent unauthorized access, including failing to use encryption or password protection.  The OCIE identified the following concerns that may give rise to compliance issues: (i) misconfigured network storage solutions; (ii) inadequate oversight of vendor-provided network storage solutions; and (iii) insufficient data classification policies and procedures. The OCIE encourages registered broker-dealers and investment advisers to evaluate their storage of customer information and consider whether security improvements are necessary.

RIA Settles with SEC for $5 Million for Failing to Implement Compliance Policies Reasonably Designed to Prevent Inaccurate Valuations.  On June 4, 2019, the SEC settled charges and instituted cease-and-desist proceedings against an RIA for failing to adopt compliance policies reasonably designed to prevent the risk that its traders were undervaluing securities by failing to maximize relevant observable inputs, such as trade prices. The RIA’s traders were accused of intentionally marking their bond prices below market value to maximize yield and allow them to sell for a profit when needed, in violation of GAAP.  While the RIA did not admit fault, the SEC alleged that the firm’s policies failed to address how their valuations would be conformed with GAAP, and further, that the adviser failed to implement its existing policy.  The SEC stressed the importance of valuation of client assets in the administrative proceeding, calling it “critically important.”

SEC Imposes Cease-And-Desist Order and Remedial Sanctions Against an RIA for “Cherry-Picking” Trades and Misusing Soft-Dollars.  On May 16, 2019, the SEC imposed a cease-and-desist order and remedial sanctions against an RIA for “cherry-picking” trades and misusing soft-dollars.  The RIA disproportionally allocated profitable trades to hedge funds of which the RIA’s portfolio manager was personally invested, while allocating less profitable trades to other clients, including a charitable foundation.  Further, the RIA allegedly used soft-dollar credits in a manner not disclosed to clients, including use in a principal’s divorce settlement, rent paid to a principal owned company, and maintenance fees on a principal’s personal timeshare.  In addition to disgorgement for both the RIA and portfolio manager, the portfolio manager has been banned from the industry.  This case is a reminder for investment advisers to only use soft-dollar credit to pay for disclosed expenses.

SEC Charges RIA Firm and COO for Cross Trades that Defrauded Client.  On March 15, 2019, the SEC charged a fund manager (an RIA) and its chief operating officer with breaching its fiduciary duties, including the obligation to seek the maximum price for an asset to be sold.  The RIA solicited two unwilling buyers to participate in a real estate auction under the promise that they would not win in order to artificially depress the price and allow a second private fund managed by the RIA to purchase it at a discount.  The RIA later resold the asset from the second private fund for a significant profit and received associated performance fees.  With the SEC’s continued focus on cross trades, fund managers should ensure their cross trade policies effectively identify and manage conflicts of interest.

SEC Proposals to Address Cross-Border Application of Security-Based Swap Requirements.  On May 10, 2019, the SEC proposed a series of rule amendments and guidance with the intention of improving the regulatory framework governing cross-border security-based swaps.  The proposals address the application of security-based swap transaction requirements to non-U.S. entities with U.S. personnel involved in “arranging, negotiating or executing the swaps,” and is intended to align the SEC’s regulatory regime with that of the Commodity Futures Trading Commission.  The SEC sought public comment on the proposed amendments and guidance, with comments due July 2, 2019.

CFTC Matters 

CFTC Approves Final Rule to Provide Exception to Annual Privacy Notice Requirement.  On April 25, 2019, the CFTC approved a final rule to remove the requirement that commodity pool operators and commodity trading advisers, among others, provide annual privacy policy notices to customers when certain conditions are met.  The new rule provides an exception to such annual notice when a financial institution (i) does not share nonpublic personal information except in accordance with certain exceptions adopted by the CFTC and (ii) has not changed its policies and practices with regard to disclosing nonpublic personal information from those policies and practices that the institution most recently disclosed.

CFTC Publishes Public Enforcement Manual.  On May 8, 2019, the CFTC’s Division of Enforcement published its Enforcement Manual for the first time, providing clarity on the CFTC’s investigations and pursuit of violations processes.  In addition to increasing predictability of CFTC enforcement actions, the guide underscores the CFTC’s intention to incentivize self-reporting and cooperation, noting that the value of cooperation with the CFTC will be considered in deciding what charges and sanctions to impose and whether an individual or entity is eligible for a non-prosecution agreement or deferred prosecution agreement. The manual also provides a summary of prohibited conduct subject to investigation, which in addition to traditional enforcement action such as fraud, includes misappropriation of material non-public information and disruptive trading practices. The Enforcement Manual promises to provide meaningful information to advisers who suspect they may have committed a violation.

FINRA Matters 

FINRA Begins Effort to Simplify Firms’ Digital Experience.  On May 14, 2019, FINRA announced the launching of its Digital Experience Transformation, with the goal of simplifying digital interactions between firms and FINRA to create more efficient and effective compliance programs. The transformation is set to be implemented in stages through 2022, focusing on six solution areas identified as priorities by FINRA member firms, including enhanced interaction with FINRA staff and a simplified experience for users.

FINRA Introduces Peer-2-Peer Compliance Library.  FINRA launched its Peer-2-Peer Compliance Library providing a resource for member firms in locating templates, checklists and other materials to supplement FINRA provided materials. The library includes documents provided by FINRA registered firms on six compliance topics: (i) Customer Information, (ii) Cybersecurity, (iii) New Product Review, (iv) Outside Business Activities, (v) Outsourcing & Vendor Management, and (vi) Supervision.  The Library promises to be a useful resource for FINRA registered firms.

Digital Asset Matters

SEC Delays Decision on Two Bitcoin ETFs.  On May 14 and May 20, 2019, the SEC again delayed a decision on two bitcoin ETFs.  The SEC has yet to approve a bitcoin ETF, and is again seeking public comment on the ETF proposals.  The SEC will ultimately need to make a final decision by mid-October.  Cole-Frieman & Mallon LLP submitted a comment in support of approval, arguing it is in the best interest of the bitcoin market that the ETF be approved as it will allow the continued expansion of the digital asset industry and the related ecosystems.

SEC Publishes First Framework in Determining if an ICO Constitutes a Security.  On April 3, 2019, the SEC published its first framework for analyzing whether U.S. securities laws apply to an initial coin offering.  The SEC has confirmed their view that the Howey test should be used to determine if an “investment contract” exists with respect to the sale of a digital asset, thus requiring the sale to either be registered or qualify for an exemption from registration.  The framework gives insight on each of the prongs of the Howey test, which states that an “investment contract exists when there is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.”  The framework gives examples of several characteristics that are indicative of an investment contract, which promises to provide helpful guidance for those seeking to raise funds through an initial coin offering.

SEC Publishes First No-Action Letter for Cryptocurrency Token Sale. On April 3, 2019, the SEC published the first no-action letter for the offer and sale of tokens by a jet leasing business.  The SEC stated that their no-action position was based on (i) the tokens being fully operational at the time of sale, (ii) the business selling the tokens for $1 each and redeeming each token for $1 of air charter services per token with the business only repurchasing tokens at a discount to face value, and (iii) the restriction on transfer of the tokens to external wallets.  Taken together, the SEC appears to have been satisfied that any purchase of the token would not be for investment purposes.

SEC Sues Online Messaging Application for Conducting $100 Million Unregistered Securities Offering of Digital Tokens.  On June 4, 2019, the SEC sued a Canadian company running a messaging app with conducting an illegal securities offering for raising over $100 million through an initial coin offering without registering the offer and sale as required under securities law.  The complaint alleges that the company advertised the tokens as an investment opportunity and promised to work to promote demand of the token through company efforts, including incorporating the tokens on their messaging app. This case underscores the importance of complying with securities laws when attempting to raise money through coin offerings, as the SEC will seek to enforce such laws if they deem the ICO a securities offering.

IRS Commissioner Announces Cryptocurrency Tax Guidance to be Released Soon.  On May 30, 2019, IRS Commissioner Charles Rettig stated in a letter to congressman Tom Emmer that cryptocurrency tax guidance is a priority of the IRS and should be released “soon.” The Commissioner stated that the IRS is considering several issues, including: (i) acceptable methods for calculating cost basis; (ii) acceptable methods of cost basis assignment; and (iii) tax treatment of forks.  Guidance promises to be welcome by crypto investors as the IRS last issued guidance in 2014, which left several key questions unanswered.  The cryptocurrency market has also seen itself become increasingly complicated since that time with the emergence of forks, airdrops and staking.

SEC Hosts Public Forum to Discuss Distributed Ledger Technology and Digital Assets.  The SEC held a public forum to discuss digital assets on May 31, 2019.  As the second forum on digital assets held by the SEC, it aimed to facilitate greater communication on digital assets between industry, academia, and regulators.  SEC staff moderated panels with fintech insiders covering capital formations, trading and markets, investment management, and distributed ledger technology industry trends.  The SEC also announced at the forum a new program for visiting scholars, seeking qualified professors or PhDs with expertise in blockchain to assists the SEC for one year with their oversight and regulatory processes.  The forum is available to view online.

FinCEN Takes First Enforcement Action Against a Virtual Currency Exchanger.  On April 18, 2019, the Financial Crimes Enforcement Network (“FinCEN”) assessed a $35,350 penalty against a peer-to-peer exchanger of bitcoin for the willful violation of the Bank Secrecy Act’s registration and reporting requirements.  FinCEN found the exchanger was not merely a “user” of virtual currency, but a “money transmitter,” and thus was required to register as a money services business and comply with regulatory requirements applicable to them, including having an effective written AML program, filing SARs on transactions they “know, suspect, or have reason to suspect” are suspicious, and filing currency transaction reports on transactions over $10,000.  Exchangers of virtual currency must be aware they are considered money transmitters and must comply with the Bank Secrecy Act’s regulations or risk monetary penalties and a ban from the industry by FinCEN.  FinCEN has indicated that they will continue to seek enforcement action against exchangers who fail to register as money services businesses.

CFM Summarizes Blockstack Regulation A+ Offering.  We have provided a summary of Blockstack’s Regulation A+ “Tier 2” offering to the SEC.  While Regulation A+ has previously been discussed as a potential avenue for blockchain groups to raise capital, it had been untested until now.  The post summarizes many of the legal and regulatory aspects of Blockstack’s offering, and also highlights interesting business aspects that were revealed.  As Blockstack’s offering was just “qualified” by the SEC, their offering circular promises to work as a guide for future blockchain token projects seeking to raise capital through Regulation A+.

Offshore Matters 

Cayman Islands Announce No Penalties for Delayed Filings.  On April 9, 2019, Cayman Islands announced that while the deadline for Cayman Financial Institutions’ to satisfy their CRS/FATCA reporting obligations was May 31, 2019.  Financial Institutions that report by July 31, 2019 will not be subject to enforcement measures or penalties.

Bermuda Proposes Legislation Exempting Non-Tax Residents from Economic Substance Requirements.  On June 28, 2019, Bermuda’s Economic Substance Amendment Act 2019 became law.  The Amendment creates an exemption from Economic Substance requirements for ‘non-resident entities,’ which is an entity which is a resident for tax purposes in a jurisdiction outside Bermuda, not including those countries in Annex 1 to the EU list of non-cooperative jurisdiction (the so called “black list”).  The change brings Bermuda’s regulations in line with the regulations of the British Virgin Islands and the Cayman Islands, both of which exclude non-resident entities from their substance requirements.

Other Matters 

IRS Issues Qualified Opportunity Fund Guidance.  On April 17, 2019, the IRS issued additional guidance for the deferral of capital gains through investment in qualified opportunity funds.  Crucially, the IRS clarified the “substantially all” requirement for the holding period and use of tangible business property.  Under the regulations, property can qualify as “qualified opportunity zone business property” if substantially all of the use of the property is in a qualified opportunity zone for substantially all of the qualified opportunity fund’s holding period of such property.  The IRS has clarified that the threshold for “substantially all” is (i) 70% with respect to the use of the property; and (ii) 90% with respect to the qualified opportunity fund’s holding period of such property.

IRS Issues Proposed Regulations for Determining Global Intangible Low-Taxed Income.  On  June 14, 2019, the IRS published proposed regulations that provide taxpayers with guidance for determining the amount of global intangible low-taxed income (“GILTI”) to include in gross income.  Importantly for fund managers, the proposed regulations change how the GILTI regime applies to domestic partnerships, adopting an aggregate approach where GILTI is computed at the partner level rather than the entity level.  As the regulations are retroactive to 2018, fund managers who paid GILTI should discuss with their tax advisers if filing an amended tax return is advisable.

Legislature Presented with Two Bills Reforming Cannabis Banking.  Two bills are being considered by Congress that attempt to provide cannabis-related businesses and service providers with access to the banking and financial markets. On March 28, 2019, the House of Representatives Financial Services Committee approved the Secure and Fair Enforcement Banking Act (“SAFE Act”), which would prohibit federal banking and financial regulators and law enforcement from taking action against institutions solely because they provide financial services to cannabis-related businesses and also excludes legitimate cannabis related business from being deemed proceeds from unlawful activity under anti-money laundering laws. On April 4, 2019, the Strengthening the Tenth Amendment Through Entrusting States Act (“STATES Act”) was re-introduced in both the House and the Senate.  The STATES Act would remove state-legal marijuana-related activity from the Controlled Substances Act, significantly restricting federal enforcement abilities of cannabis.  Both bills would significantly alter the cannabis industry, allowing them to access and interact with the economy in ways previously denied to them.

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Compliance Calendar.

 

Please note the following important dates as you plan your regulatory compliance timeline for the coming months:

Deadline Filing
June 29, 2019 Delivery of audited financial statements to investors (private fund managers to fund of funds, including SEC, State, and CFTC registrants)
June 30, 2019 Deadline for Cayman Island registered funds with a fiscal year end of December 31 to file the Fund Annual Return and audited financial statements with Cayman Islands Monetary Authority
June 30, 2019 Deadline for making available AIFMD annual report for funds in or advertising in the EU (Alternative Investment Funds with a financial year ending on December 31)
June 30, 2019 Review holdings to determine Form PF filing requirements
July 10, 2019 Review transactions and assess whether Form 13H needs to be amended
July 15, 2019 Quarterly Form PF due for large liquidity fund advisers
July 30, 2019 Quarterly account statements due (Commodity Pool Operators (“CPOs”) claiming the 4.7 exemption)
July 31, 2019 Cayman Islands CRS and US FATCA reporting deadline without adverse consequences (for those who missed the initial May 31, 2018 deadline)
August 14, 2019 Form 13F filing (advisers managing $100 million in 13F Securities)
August 14, 2019 CTA-PR filing with NFA
August 29, 2019 Quarterly Form PF due for large hedge fund advisers
August 29, 2019 CPO-PQR filing with NFA
September 30, 2019 Review transactions and assess whether Form 13H needs to be amended
September 30, 2019 Deadline to designate a MLRO, DMLRO, and AMLCO for Cayman Islands AML compliance
October 15, 2019 Quarterly Form PF due for large liquidity fund advisers
October 15, 2019 Annual Foreign Bank and Financial Accounts Report deadline (for those who missed the April 17 deadline

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

Simple Agreement for Future Tokens (SAFT)

SAFT Background for Cryptocurrency Funds

As we discussed in a recent post, the SEC Report on the DAO, issued in July of this year, discussed how the SEC views Initial Coin Offerings (ICOs). One key takeaway from this report was that some digital assets/ tokens fall within the definition of securities, depending on the facts and circumstances related to the nature of the particular digital asset/token. If an ICO is considered an offer and sale of a security, then that offering must comply with federal securities laws.  This means the token must either be registered as a security with the SEC or that the token qualifys for an exemption from registration requirements.

In an attempt to comply with SEC regulations and account for some of the uncertainties around regulation of these digital assets, some recent ICOs have launched using a Simple Agreement for Future Tokens (SAFT) along with an accompanying offering memorandum. The SAFT, modeled after Y Combinator’s Simple Agreement for Future Equity (SAFE), is an agreement offering future tokens to accredited investors. Instead of offering an immediately available token, these SAFTs offer the right to a token upon a triggering event. SAFTS are intended to be private offerings exempt from registration with the SEC. Notably, Protocol Labs, Inc. offered the right to purchase Filecoin tokens through a SAFT earlier this year. Since then, multiple other ICOs have launched using SAFTS, including Unikrn, StreamCoin Labs, and Kik Interactive.

Overview of SAFT documentation

As part of some ICO launches, investors are subscribing through a SAFT and accompanying offering memorandum.  The SAFT is an agreement signed by both the issuer and the purchaser of the future tokens. The general SAFT template includes various provisions which we outline below.

  • Country legends – disclaimers directed toward specific countries, including statements on registration and restrictions on transfer of the tokens.
  • Sale information – purchase amount and price, token amounts, and vesting period.
  • Background information – various events including network launch, dissolution events, and termination events are discussed. A network launch will generally trigger an issuance of tokens based on the purchase amount of each investor.
  • Purchaser and Issuer representations – various representations made by both the issuer and purchaser are included. Notably, the purchaser will represent that it has been advised that the SAFT is a security and has not been registered, and cannot be resold without the consent of the issuer. The agreement also includes the procedures for purchase of rights under the SAFT including the form of payment.
  • Miscellaneous/ transfer provisions – various miscellaneous provisions including transfer restrictions and rights under the SAFT.

SAFT Offering Memorandum

The offering memorandum is similar private placement memorandum (PPM) for a traditional hedge fund and provides the prospective investor with information on the structural and business aspects of the offering. Below is a non-exhaustive list of some of the major sections of the offering memorandum:

  • Legends and securities laws notices
  • Table of contents
  • Company overview
  • Description of the directors and management
  • Terms of the purchase rights and the SAFTS
  • Risk factors
  • Description of the use of proceeds
  • Description of the plan of distribution

Potential Issues

There are a number of potential issues, including legal and regulatory, that may arise through the use of SAFTS.

Is a SAFT a security?

The SEC has applied the Howey test to digital assets, concluding that a token may be a security based on specific facts and circumstances. To determine whether tokens are securities, the SEC has looked to whether there is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.

The drafters of SAFTs have generally taken the position that SAFTs are securities (e.g., investment contracts). The SEC has commented in the past on SAFEs with respect to crowdfunding, mentioning that SAFEs are a type of security, warning investors to be cautious. SAFTs that are limited to accredited investors will likely elicit less concern from the SEC as they are not aimed at retail investors. It remains to be seen, however, whether the SEC will also consider SAFTs securities in a similar context with SAFEs. While any determination on whether the SAFT is a security will likely be based on the specific use of the underlying tokens, it seems likely that many SAFTs would be deemed securities because the purchasers are investing money (or other digital assets) in the rights to the future underlying token with the expectation of profits from the efforts of the issuers of the SAFT.

Restrictions on transfer

Under a SAFT, there is typically a restriction on the purchaser’s ability to transfer or make use of the tokens until the tokens are vested. Vesting takes place once the network is launched and the tokens are mined. A purchaser generally can, however, transfer its rights in a SAFT to another person or entity with the consent of the company issuing the SAFT. Below is a non-exhaustive list of some of the major provisions that should be in the transfer agreement.

  • Transfer of the SAFT
  • Consideration
  • Consent of the company that issued the SAFT
  • Transferor representations and warranties that it owns the SAFT and is able to transfer
  • Transferee representations that it will be bound by the terms of the SAFT

Source of funds

Many of these SAFTs allow purchasers to use various forms of consideration for these contracts including US dollars, Bitcoin, and other digital assets. This may raise anti-money laundering concerns around the source of the funds used for these purchases.

How do regulators view SAFTs?

US regulators have not provided specific guidance on the use of SAFTS. As discussed previously, the SEC has stated that some tokens are securities. Additionally, earlier this year, the SEC charged a businessman with allegedly running two fraudulent ICOs and appears to be taking an increasing interest in these issues. The SEC has mentioned the crowdfunding regulations in the SEC Report on the DAO, and the SEC seemed to be highlighting an option for certain fund sponsors. Given also that the SEC has commented on SAFEs with respect to venture and crowdfunding, it is possible that regulators will draw certain parallels between SAFEs and SAFTs in its views on these instruments. Unfortunately, until regulators issue additional guidance, it is not yet clear whether the SAFT in some cases will be sufficient to satisfy the SEC or other regulators.

Looking Forward

The SAFT represents some investment managers’ response to the concerns of the SEC and may encourage more ICOs to be based in the US. We hope the SEC and other regulators comment on their view of SAFTs, although much of the discussion over whether a SAFT or token is a security will remain a facts and circumstances determination.

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For more information on this topics related to the digital asset space, please see our collection of cryptocurrency fund legal and operational posts.

Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP.  Cole-Frieman & Mallon LLP has been instrumental in structuring the launches of some of the first cryptocurrency focused hedge funds. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.

Hedge Fund Bits and Pieces for March 24, 2017

Happy Friday from rainy San Francisco. As a reminder, there is one week left for investment advisers to complete the annual ADV update.

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Notes on cryptocurrency and blockchain – earlier this week Coinbase added a new margin product for leveraged trading in certain leading cryptocurrencies including Bitcoin. We believe that a product like this would be subject to CFTC jurisdiction and certain registration (or exemption) requirements. As we’ve had more discussions with groups in this space over the last couple of weeks we are seeing both the difficulties of running a fund strategy in this space (hard to find banks willing to support crypto managers; lack of audit firms able to audit these strategies) and the possibilities of blockchain technology (potentially uses for compliance in the hedge fund space).  These discussions have come in the wake of significant client interest in this are and our article on bitcoin hedge funds.

Cannabis Investment Management Conference – continuing on our earlier discussion of the rise of investment opportunities in the cannabis space, MedMen and IMN are putting on The Institutional Capital & Cannabis Conference next week in San Jose. The conference will take place on March 28-29 and will include a number of funds and allocators in the cannabis space.

Regulations and Tax – not as much news this week on the regulatory front applicable to hedge funds – we expect to begin hearing more next week (after the Health Care Bill vote) when/if the discussion of tax reform begins. If Trump keeps his word to eliminate the “carried interest loophole”, we may see more discussion of the issue like we did back in 2011 and 2009.

Other Items:

  • SEC Compliance Seminars – the SEC announced compliance seminars in a number of cities. Please see the release here.
  • Connecticut Reminder to Exempt IAs – the Connecticut Department of Banking sent out a regulatory reminder about managers who utilize the Connecticut IA registration exemption (more information in our post about the Connecticut ERA filing) in the state. The release can be found here.
  • SEC Adopts T+2 – the settlement cycle for securities transactions gets shorter by one day on September 5, 2017. We expect to hear more from the brokerage firms about this change in the next couple of months as systems become integrated with the new requirements. The announcement can be found here.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP and focuses his legal practice on the investment management industry. He can be reached directly at 415-868-5345.